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Risk-Based Capital

Last Updated 11/11/2021                                                                                                                                                                                                 

Issue: Regulators are charged with ensuring that insurance companies can fulfill their financial obligations to policyholders. One way they do this is by imposing a risk-based capital (RBC) requirement. The RBC requirement is a statutory minimum level of capital that is based on two factors: 1) an insurance company’s size; and 2) the inherent riskiness of its financial assets and operations. That is, the company must hold capital in proportion to its risk. RBC is intended to be a regulatory standard and not necessarily the full amount of capital that an insurer would need to hold to meet its objectives.

The purpose of RBC requirements is to identify weakly capitalized companies, which facilitates regulatory actions to ensure policyholders will receive the benefits promised without relying on a guaranty association or taxpayer funds. In essence, the RBC formula calculations are critical thresholds that enable timely regulatory intervention. RBC requirements are not designed to be used as a stand-alone tool in determining financial solvency. Rather, RBC is one of the tools that gives regulators legal authority to take control of an insurance company.

Background: Regulators use RBC requirements to determine the minimum amount of capital required for an insurer to support its operations and write coverage. The RBC standard for life and property/casualty (P/C) companies is based on the Risk-Based Capital (RBC) For Insurers Model Act (#312), which the NAIC adopted in 2012. Likewise, the RBC standard for health insurers is the Risk-Based Capital (RBC) for Health Organizations Model Act (#315), which the NAIC adopted in 2015. The model laws outline methods for measuring this minimum amount of capital.

Before the RBC standard was established, regulators generally used fixed capital standards as a primary tool for monitoring the financial solvency of insurance companies. Under fixed capital standards, every insurance company was required to hold the same minimum amount of capital, regardless of its financial condition, size,  and risk profile. Fixed minimum capital requirements were largely based on value judgements of the drafters of the statutes, and they varied widely among the states.

A large number of insurer insolvencies in the 1980s was the driving force for the NAIC’s RBC standard. A 1992 report by the U.S. General Accounting Office (GAO) details 176 life and health insurer insolvencies from 19751990; 80% of these insolvencies occurred after 1982. The multitude of insolvencies made clear the inherent problems with fixed capital standards. One problem was  that fixed capital standards did not address the variation in fundamental risks across sectors and companies. Another problem was that they did not address the differences in the size of insurers in determining the appropriate minimum amount of capital.

In the early 1990s, the NAIC established a working group to look at the feasibility of developing a statutory RBC requirement for insurers. In 1992, the NAIC adopted a life RBC formula, which was implemented in 1993. There are now separate RBC models for each of the primary insurance lines of business: 1) life; 2) P/C; and 3) health. Differences in RBC across lines of business reflect differences in the economic environments facing these companies. Although the components in the RBC calculation differ across lines of business, the formulation is roughly the same. The generic RBC formula works by:  

  • Adding up the main risks insurance companies commonly face.
  • Considering potential dependencies among these risks.
  • Allowing for the benefits of diversification.[1]

RBC requirements in life insurance are based on four categories of risk:

  • Asset risk—Asset risk refers to risks associated with investments held by the insurer. These risks include the possibility of default of bonds or loss of market value for equities (mostly common stock).
  • Insurance (underwriting) risk—Insurance (or underwriting) risk reflects the amount of surplus (assets – liabilities) available to offset possible losses from excess claims.
  • Interest rate risk—Interest rate risk involves potential losses due to changing interest rates.[2]
  • Business risk—Business risk reflects the general health of the insurer. This involves largely operational risks, such as the potential for losses or insolvency due to poor management.

There is also a risk category to account for the default of affiliates and off-balance-sheet items such as derivatives. The RBC calculation considers similar risks for health insurers and P/C insurers. However, interest rate risk does not enter the calculation for these lines of insurance business.

Under the RBC system, regulators have the legal authority to take preventive and corrective measures. These measures vary depending on the capital deficiency indicated by the RBC result. Capital sufficiency is the ratio of total adjusted capital to RBC. There are four levels of regulatory intervention.[3] If the ratio is at or above 200%, no regulatory intervention is needed. Below that ratio, interventions range from submission of action plans to a regulatory takeover of the management of the company. If the ratio is below 70%, a regulator is obligated to take over management of the company. 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.

Status: The RBC system is consistently updated to meet the changing regulatory environment. The Capital Adequacy (E) Task Force and its working groups and subgroups manage the RBC calculations. These groups include the:

RBC formulas are reviewed annually. Adopted Modifications to Risk-Based Capital Formulas since 2019 and the Task Force’s working agenda for 2021 are publicly available on the NAIC website. More details on current-year revisions for RBC reporting can be found in the following newsletters, which were published in July 2021:

The Capital Adequacy (E) Task Force’s 2022 proposed charges include several efforts. First, the RBC working groups would evaluate potential refinements to the RBC formulas implemented in 2021. Second, they would consider improvements to RBC blanks. This includes additional reporting formats within existing RBC blanks. Third, they would monitor accounting and reporting changes resulting from the revised Accounting Practices and Procedures Manual (AP&P Manual). The working groups are also charged with reviewing the effectiveness of RBC policies and procedures, as well as comparability between RBC formulas.

 


[1] See Tom Herzog, “The Simple Algebra of the Square Root Formula Behind RBC and Solvency II,” CIPR Newsletter, Volume 1, October, 2011. Solvency II is the European risk aggregation method (or RBC equivalent).

[2] These risks include disintermediation and spread compression. Disintermediation typically is associated with rising interest rates and involves the surrender of insurance products with fixed payouts (such as fixed annuities) in favor of higher-yielding assets. Spread compression is associated with lower interest rates. For products with fixed payouts, the insurer could find itself earning lower returns on its assets with no commensurate fall in interest rates on liabilities with fixed payouts.

[3] See Martin Eling and Ines Holzmüller, 2008, “An Overview and Comparison of Risk-Based Capital Standards,” Journal of Insurance Regulation, 26(4), 31–60.

 

Committees Active on This Topic

Additional Resources

Risk-Based Capital (RBC) for Insurers Model Act (#312)

Risk-Based Capital (RBC) for Health Organizations Model Act (#315)

Investment RBC Charges (NAIC, March 2018)

Adopted Modifications to Risk-Based Capital Formulas (since 2019)

Aggregated Life RBC and Annual Statement Data  for 2008–2020 (NAIC Financial Regulatory Services, June 2021)

Aggregated Health Risk-Based Capital Data for 2016–2020 (NAIC Financial Regulatory Services, June 2021)

Aggregated P&C RBC Data for 2014–2020 (NAIC Financial Regulatory Services, June 2021)

Contacts

Media queries should be directed to the NAIC Communications Division at 816-783-8909 or news@naic.org.

Jane Barr
Company Licensing and RBC Manager
Phone: 816.783.8413

Dave Fleming
Senior Insurance Reporting Analyst
Phone: 816.783.8121

Eva Yeung
Senior Insurance Reporting Analyst
Phone: 816.783.8407

Crystal Brown
Senior Insurance Reporting Analyst
Phone: 816.783.8146

Center for Insurance Policy and Research

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