What Is Risk-Based Capital: A Primer for Captives

Most captive insurers and risk retention groups would be well advised to have a working knowledge of risk-based capital (RBC) and its implications. Not all captives domiciled in the United States are subject to RBC. However, as of January 1, 2017, all EU-domiciled captives will be subject to Solvency II regulations.

RBC is a method developed by the National Association of Insurance Commissioners (NAIC) to measure the minimum amount of capital that an insurance company needs to support its overall business operations. RBC is used to set capital requirements considering the size and degree of risk taken by the insurer. As the current measurement stands, there are four major categories of risk that must be measured to arrive at an overall RBC amount. These categories are as follows.

Asset risk—This is a measure of an asset's default of principal or interest or fluctuation in market value as a result of changes in the market.

Credit risk—This is a measure of the default risk on amounts that are due from policyholders, reinsurers, or creditors.

Underwriting risk—This is a measure of the risk that arises from underestimating the liabilities from business already written or inadequate pricing on current or prospective business.

Off-balance sheet risk—This is a measure of risk due to excessive rates of growth, contingent liabilities, or other items not reflected on the balance sheet.

According to the NAIC's website, "Risk-Based Capital," July 12, 2018, the RBC methodology was developed to provide the following.

• A capital adequacy standard that is related to risk
• A safety net for insurers
• Uniformity among all of the states
• Regulatory authority for timely intervention

The RBC system has two main components: 1) the RBC formula, which establishes a hypothetical minimum capital level that is compared to a company's actual capital level, and 2) the RBC model law, which grants automatic authority to the state insurance regulator to take specific actions based on the level of impairment. While companies typically hold capital in excess of the minimum RBC requirement, capital requirements under RBC typically are one consideration a management team will review prior to making a decision.

RBC is one component used by regulators to conduct a financial analysis of insurance companies. The formula is used to derive a measure of "minimum capital" that an insurer would be expected to hold based on the types of risk to which the company is exposed. Recognizing these risks will differ, sometimes significantly, based on the type of insurance that the NAIC has adopted. There are four different formulas, one for life companies, one for property and casualty companies, one for health companies, and one for fraternal organizations.

While the formulas may vary, the four main components of risk analyzed, as outlined above, do not. The RBC model generates required capital levels for each of these risk categories. These capital requirements are then aggregated, and a covariance¹ factor is applied to arrive at the minimum capital level that a company must maintain to avoid regulatory action.

The actual RBC model and underlying algorithms are complex, and in fact, the final RBC report produced by the model runs over 50 pages. The output generates the regulatory minimum amount of capital a company is required to maintain in order to avoid regulatory action. The extent of regulatory intervention and action increases as the level of surplus to RBC falls. The first level is the company action level and requires an insurer to submit a plan of corrective actions to the regulator if surplus falls below 200 percent of the RBC amount. The regulatory action level occurs if surplus falls below 150 percent of the RBC amount. The authorized control level occurs if surplus falls below 100 percent of the RBC amount. The fourth action level is the mandatory control level as defined by the NAIC, which requires the relevant insurance commissioner to place the insurer under regulatory control if surplus falls below 70 percent of the RBC amount.

Captives that are not subject to the RBC test in their domiciles but are interested in how they would fare can ask their actuaries, auditors, brokers, or managers to run the test for them and report on the results. Also, while A.M. Best performs an analysis with their Best's Capital Adequacy Relativity (BCAR) that is similar to an RBC analysis, the model and underlying formulas are not the same. Therefore, a BCAR score is not directly translatable to an RBC score.

The actual NAIC RBC model is under constant review by various working groups within the association. There has been a considerable discussion concerning changes that may occur as a result of the increased focus on enterprise risk management (ERM). One shift may entail the use of Own Risk and Solvency Assessment, a company-driven model(s) intended to capture the amount of capital necessary to support all of the risks associated with ERM.

Regardless of how it all plays out, captive insurers would be well advised to understand the concept of RBC. If nothing else, a captive board should know the captive's own indicated RBC number. It can prove beneficial in discussions with brokers, reinsurers, and regulators.

Footnote

1. Covariance definition—Covariance is a measure of how changes in one variable are associated with changes in a second variable. Specifically, covariance measures the degree to which two variables are linearly associated ("Covariance & Correlation," Medium.com, January 2, 2018).