Risk-Based Capital

Last Updated: 5/9/2024
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 initially adopted in 1993 (latest revision, 2011). Likewise, the RBC standard for health insurers is the Risk-Based Capital (RBC) for Health Organizations Model Act (#315), which the NAIC initially adopted in 1998 (latest revision, 2009). 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 1975–1990; 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 formulas for each of the primary insurance lines of business: 1) life and fraternal; 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]

For example, RBC requirements in life insurance are based on five categories of risk:

• Insurance affiliates and Misc. Other-this is the risk from declining value of insurance subsidiaries as well as risk from off-balance sheet and other misc. accounts (e.g., DTAs).
• 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.

The health and P/C RBC formulas  consider similar types of risk. However, the risk components may vary slightly between formulas. For example, interest rate risk is included only in the life formula.

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 Authorized Control Level RBC including Basic Operational Risk. 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:

• Health Risk-Based Capital (E) Working Group
• Life Risk-Based Capital (E) Working Group
• Property and Casualty Risk-Based Capital (E) Working Group

RBC formulas are reviewed annually. Adopted Modifications to Risk-Based Capital Formulas and are publicly available on the NAIC website. More details on current-year revisions for RBC reporting can be found in the following websites. Newsletters are published annually in August (under the Documents tab):

• Life Risk-Based Capital (E) Working Group (newsletter)
• Longevity Risk (E/A) Subgroup
• Variable Annuities Capital and Reserve (E/A) Subgroup
• Health Risk-Based Capital (E) Working Group (newsletter)
• Property and Casualty Risk-Based Capital (E) Working Group (newsletter)
• Catastrophe Risk (E) Subgroup

The Capital Adequacy (E) Task Force’s working agenda includes numerous efforts to monitor, evaluate, and consider potential improvements in RBC requirements across all lines of business, including refinements to the updated RBC formulas and ensuring consistency in RBC treatment across asset types and the various components of RBC calculations. RBC-related efforts include, among others,

• monitoring and evaluation of changes to the variable annuities RBC framework,
• recommendations for an appropriate treatment of longevity risk transfers,
• continued development of the economic scenario generator (ESG),
• evaluations of risk charges based on catastrophe model output and other catastrophe risks,
• evaluation of current growth risk methodologies, and
•  evaluation of current underwriting risk framework.

The Risk-Based Capital Investment Risk and Evaluation (E) Working Group is evaluating the appropriate RBC treatment of Asset-Backed Securities (ABS), including Collateralized Loan Obligations (CLO) and similar “complex assets.” The working groups are also charged with reviewing the effectiveness of RBC policies and procedures, as well as comparability between RBC formulas.

For 2023, RBC considerations include:

• an evaluation of refinements to the existing NAIC RBC formulas implemented in 2022,
• Financial Condition (E) Committee consideration of the finalized structure of life and fraternal, property/casualty (P/C), and health RBC formulas,
• consideration of improvements and revisions to the RBC blanks to promote uniformity with respect to changes made in other NAIC areas (and as other needs are identified),
• review of the effectiveness of the NAIC’s RBC policies and procedures with respect to their effect on the accuracy, audit ability, and timeliness of reporting access to RBC results, and
• a review of comparability between the RBC formulas.