MONITORING INSOLVENCIES – RISK BASED CAPITAL

(March 2023)

Besides recommendations on regulatory reform from the Federal Insurance Office, primary responsibility for overseeing the financial health of property and casualty insurers rests with the individual states. For most of their oversight tenure, states established a common benchmark for measuring an insurer’s status. They used minimal levels of capital and surplus and these levels varied substantially among the various states. The problem was that such levels were similar to the approach used with vehicle laws that establish financial responsibility (F.R.) minimums. In the former, the low levels of required capital and surplus bore no resemblance to the actual level of funds insurers needed to meet their financial obligations. In the latter, the F.R. amount rarely reflected the potential cost of damages or injuries caused by significant accidents.

Related Article: Financial Responsibility Limits

One unintended result of the traditional approach was that the same mechanism put in place to monitor insurers actually encouraged companies to assume higher, more hazardous levels of risk. Fortunately, there is an increasingly used method that more accurately measures an insurer’s vulnerability to failing to maintain adequate resources. It is called the risk-based capital concept (RBC).

Traditional approach vs. RBC

Under RBC, regulators consider the business type and mix that a given insurer writes. Property-based business is short-tailed and losses are predictable, so a higher policyholder surplus to premium ratio may be fine. However, a higher level of long-tailed business means that a lower ratio is necessary in order to meet possible obligations. Conversely, it also means that a situation of quick growth calls for quicker action with insurers that write business with longer tails. Connecting capital requirements to a given insurer’s appetite for risk resulted in a more effective system of monitoring. As a simple illustration, consider the following:

Example: Scenario One–insurers A, B, C and D write the same type of business, primarily residential property and casualty.
Insurer	Policyholder Surplus	Written Premium	Evaluation Approach
			Traditional	RBC
A	5,000,000	15,000,000	Acceptable	Acceptable
B	10,000,000	15,000,000	Acceptable	Acceptable
C	3,000,000	12,000,000	Borderline	Borderline
D	3,000,000	15,000,000	Danger	Danger

Under the above circumstance, there’s no difference between the two approaches. Now let’s make a change in the business mix.

Example: Scenario Two–In this situation Insurer A writes mostly large contractors, B specializes in professional liability while C and D still write primarily residential property and casualty.
Insurer	Policyholder Surplus	Written Premium	Evaluation Approach
			Traditional	RBC
A	5,000,000	15,000,000	Acceptable	Danger
B	10,000,000	15,000,000	Acceptable	Danger
C	3,000,000	12,000,000	Borderline	Borderline
D	3,000,000	15,000,000	Danger	Danger

Under this situation, the RBC approach would consider the type of business written, so it would also identify companies A and B as insurers that should be scrutinized closely while nothing changes under the older, traditional approach.

However, RBC Standards do not only consider type or mix of business, but also evaluates other factors, such as geographic location and vulnerability to catastrophes.

Example: Insurers A and B both write a high amount of mid-ranged value residences and have the same surplus to premium ratio. Without any other information, the two companies should be evaluated similarly using RBC standards. However, that premise changes when it’s known that Company A operates solely in the Midwest while Company B operates on the Southeastern Coast. The latter company’s vulnerability to wind loss would make it subject to closer scrutiny.

Under RBC Standards, insurers are required to submit their financial information, including data run through various RBC formulas. RBC formulas are complex. For illustration’s sake, here is the actual formula used (provided by the NAIC Website):

P/C Covariance Calculation = R0 + Square Root of [(R1)2 + (R2)2 + (R3)2 + (R4)2 + (R5)2]

R0: Asset Risk – Subsidiary Insurance Companies

R1: Asset Risk – Fixed Income

R2: Asset Risk – Equity

R3: Asset Risk – Credit

R4: Underwriting Risk – Reserves

R5: Underwriting Risk – Net Written Premium

Another name for the P/C Covariance Calculation is the Authorized Control Level of risk-based capital calculation or ACL. The ACL acts as an appropriate benchmark of minimum capital that reflects a given company’s level of existing operating risk. In other words, this amount represents the minimal amount of operating capital an insurer must have in order to maintain operations at its current level of operating risk.

The significance of a company’s ACL is the relationship between it and a company’s Total Adjusted Capital (TAC). The TAC consists of a given company’s average, historical financial data.

Regulators can monitor insurers by comparing a company’s Total Adjusted Capital with the Authorized Control Level. Regulators can act, suggested by the relationship that exists between those figures, at the time a financial picture is snapped.

The following table displays what action should be taken according to the relationship.

Total Adjusted Capital (T.A.C.) vs. Authorized Control Level (ACL)	Appropriate Action Step
T.A.C. is greater than 200% of ACL	No Action
T.A.C. equals 150% to 200% of ACL	Insurer must prepare a report identifying company’s financial condition including possible corrective action
T.A.C. equals 100% to 150% of ACL	Regulator requires an insurer to file an action plan combined with regulator performing audits and exams of the insurer
T.A.C. equals 70% to 100% of ACL	Regulator acquires authorization to take control of the insurer, implementing its own action plan, ideally to assure solvency
T.A.C. is less than 70% of ACL	Regulator is mandated to take control of insurer, usually involves a technically insolvent insurer

Example: A state regulator is examining an insurer that, two years earlier, expanded into a new line of business. It determines an ACL of $187 million dollars. Studying the last five years of financial data, the regulator develops a T.A.C. of $423 million dollars. Since the T.A.C. is well over 200% of its ACL, the insurer is in excellent operating condition.

While the use of RBC does not guarantee the identification of every dangerous situation, it does substantially increase the effectiveness of monitoring solvency and assisting with earlier, corrective action that might avert permanent impairment.