Risk-Based Capital for Insurers: The U. S. System

National Association of Insurance Commissioners (NAIC) Association of chief regulators in 50 states, District of Columbia, American Samoa, Guam, Puerto Rico and U.S. Virgin Islands Established in 1875 to enhance coordination between states Maintains common database Has no authority in and of itself – regulatory powers reside with members

Historical Development RBC Formulas Developed During 1990s Life Formula Introduced In 1993 P&C Formula Introduced in 1994 Health Organizations Formula Introduced in 1998 Same Time Frame Saw a Variety of Initiatives Including FAST, Accreditation, Accounting Changes Significant Input From Industry On Design Of Formula And Formula Components American Academy of Actuaries Interested Parties Regulators NAIC Staff RBC Is Only One Component In Regulatory Toolbox

THE NAIC RBC System Risk-Based Capital Formulas  Life Insurer Version  Property/Casualty Version  Health Organizations Version  Fraternal Version Risk-Based Capital for Insurers Model Act Serves As A Guide for State Laws Risk-Based Capital Law In Each State Makes System Operational NAIC Produces Common Formula By Agreement But Regulatory Powers Reside With States RBC Is Meant To Streamline Regulatory Process, Not To Introduce New Regulatory Powers

Purpose of Regulatory Capital To ensure that the insurer does not use excessive financial leverage To reasonably guaranty that the insurer’s promises are met To allow timely intervention in case of financial distress To conserve the remaining assets in the wake of financial distress to an insurer To avoid unreasonable interference with the financial decisions and management of the insurer

Other Capital Standards Significant Developments in Tandem with NAIC RBC Regulatory Purpose is to Establish Minimum Standards while Rating Agency Purpose is to Establish Qualitative Standards Regulatory Capital Standards Can And Do Differ Significantly From An Insurer’s Own Internal Capital Standards And From Standards Set By Private Rating Agencies

Minimum Capital Standards Vary From State to State Generally Range From $1 Million to $2 Million Multi-line Requirements Are Usually Less Than Aggregate Monoline Requirements Can Include "Experience" Factor for Longevity In Some States, a Variable Minimum Standard Is Applied With Some Recognition of Risk Minimum Is Material to Most Companies Because of Size But Immaterial to Large Companies That Make Up Bulk of Industry Volume RBC System Is a Complement to State Minimums

Regulatory Minimum RBC Regulatory minimum RBC standards are set at minimum levels so as to impose a floor level of safety on the operations of an insurance company System allows companies freedom to operate as long as capital exceeds the regulatory minimum Minimizes market disruptions by non-managers while still maintaining minimum safety levels Regulatory minimum standard makes comparisons between companies inappropriate Regulatory minimum is NOT “best” capital amount

Problems With Common Standards "One Size Fits All" Approach Must Be Applied Uniformly To All Companies Reliance On Accounting Values Not All Risks Accounted For Simplicity Tradeoffs Measurement Errors Political Considerations Each Component is Material to Someone Regulatory Approaches Differ Concerns About State Sovereignty

Basic NAIC Formula Computation Apply risk factors against annual statement values (factor approach) or use proprietary data (internal review approach) Sum risk amounts and adjust for statistical independence Calculate Authorized Control Level Risk-Based Capital (ACL RBC) amount, which is the amount of capital necessary to avoid automatic regulatory intervention Compare ACL RBC to Total Adjusted Capital (TAC)

Major Categories of Risk in the Life Formula C0 – Affiliates Risk C1cs-- Asset Risk – Unaffiliated Common Stock C1o – Asset Risk – Other Assets C2 – Insurance Risk C3a – Interest Rate Risk C3b – Health Credit Risk C4a – General Business Risk C4b – Administrative Expense Risk

Life Industry Aggregate RBC By Size Source: NAIC Research Quarterly April 1997, page 37

The RBC Ratio Determines the Action Level According To State Statute NAIC RBC standard is a minimum standard that is GRADUATED so that regulators have freedom and discretion to deal with troubled insurers. Definition of “financial impairment” is now codified Total Adjusted Capital (Actual Capital) is divided by Authorized Control Level RBC (Hypothetical Minimum Capital) to get the RBC Ratio No Action (98% of companies) -- TAC/RBC over 200% Company Action Level -- TAC/RBC is 150% to 200% Authorized Control Level -- TAC/RBC is 70% to 100% Mandatory Control Level -- TAC/RBC is less than 70%

Company Action Level Insurer submits a comprehensive financial plan that: Identifies conditions that led to financial problems Contains proposals to correct financial problems Provides projections future financial conditions Lists key assumptions underlying the projections Identifies problems areas and quality areas of insurer's business Insurer is expected to comply automatically with these provisions, or drop to the Regulatory Action Level

Regulatory Action Level Insurer is required to file an action plan as required under the Company Action Level. In addition, the state insurance commissioner is required to perform any examinations or analyses of the insurer’s business and operations deemed necessary. The state insurance commissioner issues appropriate corrective orders to address the company’s financial problems.

Authorized Control Level This is the first point at which the state insurance commissioner is authorized by law to take control of the insurer – the first point at which the insurer is technically insolvent. This authorization is in addition to the remedies available at the higher action levels. The insurance company should still be have more assets than liabilities (capital greater than zero) Commissioner is authorized to take control, but not required to take control Maximizes Commissioner's discretion.

Mandatory Control Level State insurance regulator is required to take steps to place the insurer under regulatory control Requirement protects all policyholders by imposing an absolute limit on regulatory discretion Insurer may still be solvent, with assets greater than liabilities, but in many cases insurer is fully bankrupt All regulatory remedies under other action levels apply here as well Appeals process is included in Model Law to ensure due process

Capital-to-Assets and RBC-to-Assets By Size Groups Source: NAIC Research Quarterly April 1995 Life Companies

Variations in Capital By Size Smaller insurers have much greater variation in capital than larger insurers, which is why they already hold more capital. The degree to which capital can move is also a function of size. RBC is meant to establish a floor level of capital, not an average or optimal.

Omissions From Regulatory RBC Not All Risks Are Accounted For In The Formula (e.g., Liquidity Risk) Measures Of Risk Are Continually Refined (e.g., Interest Rate Risk) Some Risk Measures Are Inappropriate For A Public, REGULATORY MINIMUM Formula Approach (e.g., Management Quality) Awareness Of Risks Included AND Excluded Is Primary Benefit Of On-Going Formula Development

Conclusions Regarding NAIC’s Regulatory Minimum RBC Formula It is better than what existed before It is part of A comprehensive toolbox Most criticism of the NAIC RBC formula is based on its inability to predict insolvency, but that is not how it is designed and is not the underlying purpose Complexity does not mean accuracy, but does enhance awareness Simplicity tradeoffs often produce an equal, if not better, measurement of risk in a regulatory formula Primary benefit has been increased awareness of risk by all parties as well as greater information sharing between industry players