Group Insurance Chap 41: Risk-Based Capital Formulas Flashcards
Introduction
Risk-Based Capital is a method to measure the minimum amount of capital appropriate for an insurer to support its overall business operations, taking into account the insurer’s size and risk profile. It helps provide protection against insolvency, though it’s not necessarily the entire amount that an insurer would want to hold to meet its objectives.
Risk-based capital formulas include any formula that calculates a target capital based on factors that reflect the level of financial risk of an organization. More commonly, it refers to specific formulas used by state regulators in the US to set minimum capital requirements for insurance companies and determine when to take regulatory action.
This chapter focuses on the Health Risk-Based Capital (RBC) formula. Life RBC is similar and was in existence prior to the Health RBC. Life RBC has different parameters and focuses more on longer term risks and more asset-based risks than the Health RBC
History of RBC Formulas
- Before RBC, regulators used fixed capital standards to monitor solvency of insurers
a. Insurers required to hold same amount of capital, regardless of financial condition
b. Based on the state and lines of business - NAIC adopted risk-based formulas for life and property & casualty companies in the early 90s
a. Prior to this, some states (NY, MN, WI) had experimented with their own RBC formulas - In mid-90s, some health insurers were calculating RBC ratios and some were not, depending on their classification as Life insurers, P & C insurers or otherwise
- 1998 – NAIC adopted RBC formula for health organizations
- RBC formula that applies to the insurer (health or life) depends on which statement blank that the insurer files
a. By 2001, some frustration had emerged for certain health insurers still filing under Life or P & C, so these companies were encouraged to file under the Health blanks. By 2006, most fall under this category
- Though a significant amount of health business (such as comprehensive medical, dental and vision) still reported on the blue blank with the Life RBC formula
- Most companies that primarily write Disability, LTC or Group Life file under the Life RBC formula
b. “Health Blank Test” determines which blank is appropriate for insurer to file – added in 2003
- Health premiums and reserves are compared to total premiums and reserves
- Health includes hospital or medical policies, comprehensive major medical, and managed care contracts
* Disability, Long-Term Care, AD&D, Credit Insurance and Workers’ Compensation carve-out are excluded
- If ratio is greater than 95% for current and prior year, insurer uses Health Blank
NAIC RBC Model Acts
- 2015 – Health RBC statute became accreditation standard and most states had adopted it
- Model act specifies the regulatory actions available or required of the Insurance Commissioner
- Level of action depends on the ratio of insurance company’s actual capital to their required capital
(based on the risk-based capital formula) - Actual formula is specified by the NAIC (not the model act), so it allows the NAIC to change this over time without requiring each state to take legislative action to adopt the changes
- Compare Total Adjusted Capital (TAC) to Authorized Control Level (ACL) capital requirement
a. If TAC / ACL falls below 200%, varying degrees of legislative or regulatory action apply - Insurers typically benchmark goals against the ACL or Company Action Level (CAL)
- “Trend Test” – 2009 – if TAC/ACL is between 200%-300% and they have a combined ratio greater than 105%, could trigger a Company Action Level Event (same action as if in 150%-200% range)
- Formally, these levels apply only to states that have adopted the model act, but it still has influence for the following reasons:
(1) All companies filing an Orange blank (medical) must calculate Health RBC for annual statement, and this is a matter of public record
(2) Regulators are familiar with the RBC concept and express concerns when TAC/ACL ratio is below 200%
(3) Quasi-regulatory agencies like Blue Cross/Blue Shield have embraced Health RBC ratios and may require these levels from companies associated with them
o Company Action – company must submit corrective action plan to Commissioner
o Regulatory Action – company must submit corrective action plan and Commissioner may
examine the company and issue an order specifying corrective actions
o Authorized Control – Commissioner may take actions identified above or place company
under regulatory control if deemed in the best interests of policyholders and creditors o Mandatory Control – Commissioner must take regulatory control of the company
Health RBC Formula
- Defines capital requirement based on key factors such as types of products sold by the insurance company, health plan performance and loss ratios, reimbursement methods to providers and types of assets held
a. Factors in the formula represent an aggregate perspective on risk that can be applied uniformly across companies and time periods
b. Designed to identify financially weak companies, not to be a measure of relative financial strength of companies
* i.e. a company with a ratio of 400% is not necessarily less financially sound than one with 600% - RBC ratios that are too high may be perceived as hoarding reserves and likely charging prices that are too high
- Best range for reasonable reserve levels and ratio is decided by company’s directors and management
Calculation of RBC After Covariance (RBCAC)
- Authorized Control Level (ACL) = RBCAC / 2 (using the RBCAC including operational risk)
- Covariance adjustment refers to the use of the square root of the sum of squares, instead of just summing the pieces
a. Covariance adjustment made because of largely independent nature of each category, so large swings in risks are unlikely to occur simultaneously
b. Covariance adjustment lowers the level of capital required
- For most health companies, H2 dominates the formula (other categories are of diminished importance)
Underwriting Risk (H2)
- Dominates the RBCAC formula
- Reflects risk of underestimating the cost of insurance or inadequate premiums in the future
- Calculated separately for each health insurance product by applying a risk factor against some measure of exposure
- Risk factors are generally common across all companies, with two exceptions:
a. Factors are tiered by size (large company achieves a lower average risk per exposure unit)
b. Factors are adjusted to reflect the nature of the provider reimbursement contracts - Underwriting risk is divided into Claims Fluctuation Risk and Other Underwriting Risk
- Claims Fluctuation Risk
a. Six product groupings:
i. Comprehensive Medical & Hospital – all group and individual medical products, excluding FEHBP and TRICARE programs and ASO coverages. Medicare Advantage and Medicaid risk products are reported separately from commercial products. Medicaid pass-through payments reported as premiums – excluded from this category
ii. Medicare Supplement
iii. Dental and Vision
iv. Stand-Alone Medicare Part D
v. Other Health – includes standalone drug products and any other coverage not specifically addressed above
vi. Other Non-Health – includes Life and Property & Casualty coverages
b. Risk Charge = Premium xx Incurred Claims / Premium x Risk Factor x Managed Care Risk Adjustment Factor
- There is a floor on the risk charge called “Alternative Risk Charge”
* Only relevant for small insurers or insurers writing a very small amount of business in one of the product groupings
- Note – Medicaid pass-through payments reported as premiums – should be removed from experience fluctuation risk charge
c. Risk Factors are shown below (Page 72)
d. Relative level of factors by product grouping reflects differences in relative volatility of experience
e. Managed Care Risk Adjustment Factor reflects fact that certain contractual reimbursement arrangements lead to greater predictability of claim levels and reduce the need for capital to support fluctuations in experience
f. Claims paid over the previous 12 months are assigned into managed care categories (Note – formula uses paid claims rather than incurred claims) as shown below:
- Other Underwriting Risk
a. Includes health insurance coverages not included in Claim Experience Fluctuation Risk portion and some additional adjustments
- Disability Income - Factors are applied to earned premium
* All individual products are combined and all group products are combined, but individual and group products are not combined with each other
* E.g. Company has $40M in LTD premium and $40M in STD premium: entire LTD premium receives 15% factor, first $10M of STD receives 5% factor, next $30M of STD receives 3% factor
* If company then has $40M of non-cancelable individual DI, that entire premium gets a factor of 35%
* Additional factor of 5% of claim reserves
- Long Term Care – Based on three components:
- Premium – 10% applied to first $50M of earned premium and 3% applied to the excess. Additional 10% factor applies to non-cancelable premiums
- Incurred Claims – 25% applied to first $35M of claims and 8% applied to the excess (these percentages will change to 37% and 12% if earned premiums are not positive values)
- LTC Claims Reserves – 5% times LTC claims reserves
- Other Coverages (Page 74)
- Rate Guarantees – when premium rates are guaranteed, the risk of future underwriting losses increases. Factor for guarantees of 15-36 months is 2.4% and 6.4% for longer guarantees
- Premium Stabilization Reserves – underwriting risk is reduced by 50% of the amount of these reserves held
Insurance Affiliates and Misc. Other Risk (H0)
- Risk that an investment in stock of an affiliated company may lose value
- For investments in affiliates that are also subject to risk-based capital, RBC is calculated on “see-through” basis
a. RBC requirement for a stock investment in such affiliates is based on RBCAC for the subsidiary, prorated for the percentage ownership of that subsidiary - For other investments in affiliates, RBC requirement is 30% times the book value of the stock of those affiliates (for non-US insurance subsidiaries, this factor is 100%)
- Also includes provision for certain off-balance sheet items such as contingent liabilities, non-controlled assets, assets as collateral and guarantees to affiliates (if they can’t meet obligations). RBC requirement is 1% of the reported value of these items
Asset Risk - Other (H1)
- Risk that investments may default or decrease in value
- Risk-based capital requirement is typically the book/adjusted carrying value of an asset times a
factor
a. Factor varies from 0-30%
b. Factor is doubled (but capped at 30%) for certain assets held in the 10 largest securities issuers (reflects concentration risk) - Some assets (such as reinsurer receivables) are covered in H3(Credit Risk) or not contemplated in RBC formula
- Cash and Bonds – US govt. bonds have a factor of 0%. Cash, money market mutual funds, and corporate bonds rated NAIC 01 have a factor of 0.3%. Other bonds range from 1% (Class 2) to 30% (Class 6)
- Common Stock – risk factor of 15% (with exception of Federal Home Loan Bank stock at 2.3%)
a. Appears that risk charge for investments in non-affiliate (H1) is half of comparable investment in affiliate (H0) (15% vs 30%), but this ignores the impact of covariance. Within the formula, the effective charge is considerably smaller for unaffiliated stock than affiliated - Property & Equipment – risk factor of 10%, applied to the admitted asset balance only
Credit Risk (H3)
- Risk that amounts owed to the health insurer will not be recovered
- Also calculates possibility that capitated providers won’t fulfill contractual obligations
- Significant for companies with heavy use of capitation agreements
- RBC adjustment for capitation is 2% of annual capitations paid directly to providers and 4% of annual capitations paid to intermediaries
- Other types of credit risks and associated factors:
a. 0.5% of reinsurance receivables from non-affiliates, 1% of investment income receivable, 5% of health care receivables, 5% of amounts due from affiliates, and 5% of receivables relating to ASC and ASO plans
Business Risk (H4)
- Risk related to several miscellaneous types of general business risks
- Administrative Expense Risk – admin expenses are subject to misestimation. Weighted average risk factor of 4-7% of annual administrative expenses, depending on premium volume.
(Excludes ASC/ASO revenues, expenses and commissions) - Risks from ASC/ASO Business – risk that insurer may misestimate the amount it charges the customer for admin services. Risk factor of 2% applied against annual expenses for ASC/ASO contracts. ASC contracts have additional 1% risk factor applied because health insurer is fronting the cash for benefit payments in this arrangement. (In ASO, benefits are paid from an account owned or funded by a third party)
- Guaranty Fund Assessment Risk – Factor of 0.5% to premiums subject to state guaranty fund assessments
- Excessive Growth Risk – Applies if underwriting RBC increases from one year to the next by more than “safe harbor” level. Safe harbor level is current year underwriting revenue divided by prior year underwriting revenue, plus 10%. Excessive growth RBC requirement is 50% of growth in underwriting RBC beyond this safe harbor amount
Operating Risk
- Risk of financial loss resulting from operational events as well as external events
a. E.g. inadequacy or failure of internal systems, personnel, procedures or controls - Added to Health RBC formula in 2018
a. To account for risks not already reflected in other categories - Includes legal risk but excludes reputational risk and risk arising from strategic decisions
- Charge is 3% add-on to the RBC After Covariance Before Operational Risk
a. Charge can be reduced by certain offsets and adjusted to reflect ownership percentage
b. Total charge, after offsets, cannot be less than zero
Reserving Risk
- Health RBC doesn’t contain capital provision for reserving risk to reflect possibility that insurer’s future surplus will be impaired due to unfavorable development in the claims liabilities and reserves as of the valuation date
- Instead, the formula implicitly assumes that insurer’s claims liabilities are accurately stated
- Two implications of the absence of reserving risk in RBC formula:
a. Implies that insurer’s capital requirement is disconnected from the level of conservatism in its actuarial reserves
b. Implies that reserve level would be adequate with high probability to cover the Total Asset Requirement (statutory reserves plus required capital) with no additional risk
Development of the Health RBC Formula
- NAIC requested the American Academy of Actuaries (AAA) to assist in developing a RBC formula for health insurers in 1993
- Group used stochastic “ruin theory” model
a. Model determined level of capital needed to give 95% probability that an insurance company wouldn’t become insolvent over a five year time period - Key factors in the model included:
a. Risk of catastrophic claims and other fluctuations in claim levels
b. Risk of misestimating trends or other pricing errors
c. Length of time needed to recognize a pricing error, implement an adjustment and have that
adjustment become effective
Life RBC Formula
- Most companies writing Disability Income, Long Term Care or Group Life file the Blue blank and must use the Life RBC formula
- Life RBC formula is more complex and level of complexity has increased in recent years
- Insurance Risk Factors (C2)
a. Similar approach as to Underwriting Risk in Health RBC, with the following key differences:
(1) Individual Medical – Life formula applies 20% load to RBC requirement for
individual comprehensive medical coverage
(2) Claims Reserves – Life formula applies 5% charge against all health claim reserves in Exhibit 6 of Life and A&H annual statement (reserves for unaccrued benefits) whereas health formula only does this for long term care and disability reserves
(3) Disability Income and Long Term Care – risk factors in Life formula appear higher, though once tax effects are netted out, they are consistent with the health formulas
(4) Group Life – Life includes a provision for group life insurance (tiered factors times net amount at risk). The factor is tiered based on premium volume from 0.18% for first $500M down to 0.08% for amounts over $25B
(6) Workers’ Compensation Carve-Out – Special factors for this risk to be consistent with the treatment in the P&C formulas
Comparison of Life, P&C and Health RBC Ratios
