Academic journal article Journal of Risk and Insurance

Risk-Based Capital and Solvency Screening in Property-Liability Insurance: Hypotheses and Empirical Tests

Academic journal article Journal of Risk and Insurance

Risk-Based Capital and Solvency Screening in Property-Liability Insurance: Hypotheses and Empirical Tests

Article excerpt


The national Association of Insurance Commissioners (NAIC) concluded in 1990 that risk-based capital (RBC) standards for insurers were feasible and preferable to traditional fixed minimum capital standards. The NAIC subsequently adopted RBC formulas for life-health insurers (effective in 1994) and property-liability insurers (effective in 1995) and a RBC model law that allows or requires certain regulatory actions when insurers fail to meet minimum RBC thresholds. The stated overall purpose of the NAIC RBC requirements is to establish more meaningful minimum standards of capital adequacy related to an insurer's risk of insolvency than fixed minimum capital requirements. At the same time, the NAIC has emphasized that the ratio of an insurer's capital to its RBC should not be used as a measure of its overall financial strength, and the model law prohibits the use of RBC ratios in marketing for both property-liability insurers and life-health insurers.

Despite this caveat concerning the purpose of RBC, the RBC standards have significant implications for the financial regulation and operation of insurers. The standards raise a number of issues for insurance regulators, including their utilization in solvency screening or "early warning" systems for financially troubled insurers. Regulatory solvency screening systems, such as the NAIC's Financial Analysis Tracking System (FAST) developed in the early 1990s and the earlier Insurance Regulatory Information System (IRIS), are designed to screen and prioritize insurance companies for more in-depth financial analysis.(1) The practical objective is to identify insurers that are in, or headed toward, financial trouble to facilitate timely regulatory intervention to prevent insolvency or reduce the costs of insolvencies that do occur.

As a measure of capital adequacy, RBC can be expected to play some role in solvency screening systems, because an insurer's actual capital (surplus) compared to its RBC requirement should provide information concerning the insurer's financial strength.(2) An important question is how well the ratio of an insurer's capital to its RBC (or, alternatively, the ratio of RBC to capital) will predict the likelihood of an insurer becoming financially impaired or insolvent, including insurers whose actual capital exceeds their minimum RBC requirement.(3) Empirical comparisons of RBC ratios for property-liability insurers that later became insolvent to those for insurers that survived indicate that insolvent firms on average had significantly lower ratios of capital to RBC than solvent insurers (Grace, Harrington, and Klein (GHK), 1993; Cummins, Harrington, and Klein (CHK), 1995). However, these studies also indicate that fewer than half of the insurers that later failed had an RBC ratio below the threshold level needed to avoid increased regulatory scrutiny and that RBC ratios have fairly low power to identify weak companies. In addition, the NAIC RBC formula has been criticized on a variety of conceptual and theoretical grounds including its static nature, its alleged reliance on worst case scenarios to establish underwriting risk factors, its failure to include charges for interest rate risk, and its reliance on book values of fixed income securities.(4)

The development of the life-health and property-liability RBC formulas by NAIC working groups was a highly visible process that involved extensive input from both regulators and industry. Exposure drafts of the formula were widely disseminated and debated. While some of the components of the final RBC ratio for both property-liability and life-health insurers are calculated from confidential information that the insurer reports to regulators, the final formula is publicly available, and an insurer's RBC and actual capital are public information reported in its annual statement.

In contrast to RBC, the FAST system was developed in relative privacy by regulators. The FAST score (described below) is based on a set of financial ratios with individual scores assigned to various ranges for each ratio. …

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