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Risk-Based Capital

Last Updated 9/29/17

Issue:Risk-Based Capital (RBC) is a method of measuring the minimum amount of capital appropriate for a reporting entity to support its overall business operations in consideration of its size and risk profile. RBC limits the amount of risk a company can take. It requires a company with a higher amount of risk to hold a higher amount of capital. Capital provides a cushion to a company against insolvency. RBC is intended to be a minimum regulatory capital standard and not necessarily the full amount of capital that an insurer would want to hold to meet its safety and competitive objectives. In addition, RBC is not designed to be used as a stand-alone tool in determining financial solvency of an insurance company; rather it is one of the tools that give regulators legal authority to take control of an insurance company.

Background:Before RBC was created, regulators used fixed capital standards as a primary tool for monitoring the financial solvency of insurance companies. Under fixed capital standards, owners are required to supply the same minimum amount of capital, regardless of the financial condition of the company. The requirements required by the states ranged from $500,000 to $6 million and was dependent upon the state and the line of business that an insurance carrier wrote.  Companies had to meet these minimum capital and surplus requirements in order to be licensed and write business in the state.   As insurance companies changed and grew, it became clear that the fixed capital standards were no longer effective in providing a sufficient cushion for many insurers.

The NAIC’s RBC regime began in the early 1990s as an early warning system for U.S. insurance regulators. The adoption of the U.S. RBC regime was driven by a string of large-company insolvencies that occurred in late 1980s and early 1990s. The NAIC established a working group to look at the feasibility of developing a statutory risk-based capital requirement for insurers. The RBC regime was created to provide a capital adequacy standard that is related to risk, raises a safety net for insurers, is uniform among the states, and provides regulatory authority for timely action.  It has two main components: 1) the risk-based capital formula, that established a hypothetical minimum capital level that is compared to a company’s actual capital level, and 2) a risk-based capital model law that grants automatic authority to the state insurance regulator to take specific actions based on the level of impairment.

The Risk Based Capital Formula was developed as an additional tool to assist regulators in the financial analysis of insurance companies. The purpose of the formula is to establish a minimum capital requirement based on the types of risks to which a company is exposed. Separate RBC models have been developed for each of the primary insurance types: Life, Property/Casualty, Health and Fraternal. This reflects the differences in the economic environments facing these companies.

The risk factors for the NAIC’s RBC formulas focus on three major areas: 1) Asset Risk; 2) Underwriting Risk; and 3) Other Risk. The emphasis on these risks differs from one formula to the next. As a generic formula, every single risk exposure of a company is not necessarily captured in the formula. The formula focuses on the material risks that are common for the particular insurance type. For example, interest rate risk is included in the Life RBC formula because the risk of losses due to changes in interest rate levels is a material risk for many life insurance products.

Under the RBC system, regulators have the authority and statutory mandate to take preventive and corrective measures that vary depending on the capital deficiency indicated by the RBC result. These preventive and corrective measures are designed to provide for early regulatory intervention to correct problems before insolvencies become inevitable, thereby minimizing the number and adverse impact of insolvencies.

The NAIC RBC formula generates the regulatory minimum amount of capital that a company is required to maintain to avoid regulatory action. There are four levels of action that a company can trigger under the formula: company action, regulatory action, authorized control and mandatory control levels. Each RBC level requires some particular action on the part of the regulator, the company, or both. For example, an insurer that breaches the Company Action Level must produce a plan to restore its RBC levels. This could include adding capital, purchasing reinsurance, reducing the amount of insurance it writes, or pursuing a merger or acquisition.

The NAIC RBC system operates as a tripwire system that gives regulators clear legal authority to intervene in the business affairs of an insurer that triggers one of the action levels specified in the RBC law. As a tripwire system, RBC alerts regulators to undercapitalized companies while there is still time for the regulators to react quickly and effectively to minimize the overall costs associated with insolvency. In addition, the RBC results may be used to intervene when a company is found to be in hazardous condition in the course of an examination.

Status: The RBC system is periodically updated to meet the changing regulatory environment. The RBC calculations are maintained by the NAIC Capital Adequacy (E) Task Force and its working groups and subgroups. In recognition of the evolving risk landscape, the NAIC’s current focus has been on adding granularity to its reporting categories or expanding the risks quantified in the RBC formula. Changes to the 2016 RBC system are summarized in the Insurance Summit Presentation Risk-Based Capital Update. For the 2017 reporting year, the number of RBC categories for bonds was expanded from the current six categories (plus the exempt category) to 20 categories (plus exempt). The expansion eliminates the incentive to invest in lower quality bonds within the same NAIC designation. Additionally, a charge was added to the property/casualty (P/C) RBC formula for catastrophe risk from the hurricane and earthquake perils. More detail on these and other revisions for the 2017 RBC reporting can be found in the most current Life RBC Newsletter, Fraternal RBC Newsletter, Health RBC Newsletter and P/C RBC Newsletter.