Odomirok Ch 19: Risk Based Capital Flashcards
What are the risks included in RBC?
- R0: Subsidiary insurers
- R1: Fixed Income
- R2: Equity
- R3: Credit
- R4: Reserve
- R5: Net Written Premium
- Rcat: Catastrophe Risk
- Operational Risk
Formula for RBC before Operational Risk
RBC before Operational Risk = R0 + (R1^2 + R2^2 + R3^2 + R4^2 + R5^2 + Rcat^2)^.5
- The sq rt reflects diversification of risks
- R0 is not in the sq rt because it correlates directly with insurer risk
Two main components of the RBC system
1a. ) RBC formula: calculates the minimum level of capital that the insurer should hold based on the risks to which it is exposed.
1b. ) RBC Ratio: the ratio of the actual to the required capital
2. ) RBC Model Act for Insurers: provides the state regulator the authority to take action if the RBC ratio falls below a threshold level.
Which insurers are exempt from the RBC procedure:
- Title insurance companies
- Monoline financial guaranty insurance companies
- Monoline mortgage guaranty insurance companies
By when must the RBC report be filed:
March 1
List some risks that are excluded from the RBC formula:
Business plans & strategy, Management, Internal Controls, Systems, Reserve adequacy, Ability to access capital
List some investments that generate a R0 charge:
- Investments (stock, preferred stock & bonds) in an insurance subsidiary
- Investments in alien insurance company affiliates
- Off-balance sheet items
2 accounting methods used to record common stock investments in subsidiaries:
- Market valuation approach: based on the market value, adjusted for the ownership percentage
- Equity method: based on the statutory equity, adjusted for any unamortized goodwill, and adjusted for the ownership percentage.
Formula for RBC charge if the market valuation approach is used:
Min (Affiliate RBC, Statutory surplus) * ownership %
Formula for RBC charge if the equity approach is used:
R0 = min (Affiliate RBC * ownership %, Book/Adjusted Carrying Value of stock)
R0 charge for Preferred Stock investments in Insurance Subsidiaries:
RBC = min (Pro rata share of excess RBC, Book/ adjusted carrying value of preferred stock)
*Where the pro rata share is the share of the total outstanding preferred stock that is owned by the insurer.
**Excess RBC is the total RBC after the covariance adjustment in excess of the value of the stocks
RBC charge for a directly owned alien insurance affiliate:
RBC charge = Book/ adjusted carrying value x 0.5
4 categories of off-balance sheet items included in the R0 charge:
- Non-controlled assets
- Contingent liabilities
- Guarantees for the benefit of affiliates
- Deferred tax assets
RBC factor applied to off-balance sheet items:
1% (except to the securities lending programs, which receive 0.2% and DTA gets 0.5%).
RBC Charge for Unaffiliated Bonds & Bond Size Factor
RBC Charge = Factor * book/adjusted carrying value of bonds
List the bond factors for all the different classes.
NAIC bond class: Factor
Class 1 - Highest credit quality - US gov guaranteed by US gov: 0.000
US gov not guaranteed by US gov: 0.003
All other class 1: 0.003
Class 2 - High credit quality: 0.010
Class 3 - Med credit quality: 0.020
Class 4 - Low credit quality: 0.045
Class 5 - Lowest credit quality: 0.100
Class 6 - In or near default: 0.300
Bond types included in the bond size factor adjustment:
Unaffiliated bonds in classes 2 - 6 Non US government bonds in class 1
Procedure to determine bond size adjustment factor:
- For the first 50 issuers, the weight is 250%.
- For the next 50 issuers, the weight is 130%.
- For issuers between 101 & 400, the weight is 100%.
- For the issuers above 400, the weight is 90%.
Factor = (Weighted Issuers / Issuers) - 1
If the portfolio has more than 1,300 bonds, the adjustment is 0
RBC Charge for Off-balance sheet collateral & Schedule DL Part 1 Assets:
RBC Charge = Factor of the asset * book/adjusted carrying value
RBC charge for Mortgage loans:
RBC Charge = 0.05 x book/ adjusted carrying value of loans
RBC Charge for Other Long Term Assets: Working Capital
RBC Charge = Factor * book/ adjusted carrying
value of Working Capital Finance Investment
Factor:
- NAIC Designation 1: 0.0038
- NAIC Designation 2: 0.00125
RBC Charge for LIHTC (Low Income Housing Tax Credit)
RBC charge = Factor * book/ adjusted carrying value
Factors:
- Federal & State guaranteed: 0.0014
- Federal & state non guaranteed: 0.026
- All Other: 0.15
RBC charge for Miscellaneous Assets:
RBC Charge = Factor x book/ adjusted carrying value of assets
Where, the factor is:
- Cash, net cash equivalents, other short-term investments: 0.003
- Admitted collateral loans: 0.05
Describe Replication (Synthetic Asset) transactions:
Derivative transactions that are made in combination with other investments in order to replicate the investment characteristics of a certain type of investment.
RBC charge for Replication (Synthetic) Assets:
RBC Charge = Factor of the equivalent investment * Annual Statement value
- The charge is reduced by charge that had already been applied to the cash instrument
**50% allocated to R1, 50% allocated to R2
Describe Mandatory Convertible Securities:
securities (bonds) which are mandatorily
convertible to common stock on or before a contractual conversion date.
RBC Charge for Mandatory Convertible Securities:
RBC Charge = max(0, Charge for converted
security – Charge for original security)
*50% allocated to R1, 50% allocated to R2
How is the charge from replication transactions & mandatorily convertible securities allocated:
Distributed to both R1 and R2 (50% each)
What types of equity investments does the R2 charge reflect?
*R2 is the RBC charge for asset risk associated with equity investments
- Affiliates investments
- Unaffiliated stocks
- Real estate
- Schedule BA assets
- Miscellaneous assets (including receivables for securities, aggregate write-ins for
invested assets, derivatives) - Replication (synthetic asset) transactions and mandatory convertible securities
RBC charge for Investment affiliates:
Same as if the insurer owned the investments directly
RBC Charge for Holding Company:
0.225 * (Holding company value - carrying value of the indirectly owned insurance companies)
** subtract because carrying value of indirectly owned insurance companies already has RBC charge from R0.
RBC charge for Upstream Affiliate/ Affiliate not subject to RBC/Other Affiliates
RBC Charge = 0.225 * carrying value of common/ preferred stock
RBC charge for Unaffiliated Common Stocks
RBC Charge = 0.15 * book/ adjusted carrying value of stock
*non-government money market funds have a factor of 0.003 instead of 0.15
RBC charge for Unaffiliated Preferred Stocks
RBC Charge = Factor * book/ adjusted carrying value of preferred stock
Unaffiliated Preferred Stock Factors
NAIC preferred stoc class: Factor
Class 1 - Highest credit quality: 0.003
Class 2 - High credit quality: 0.010
Class 3 - Med credit quality: 0.020
Class 4 - Low credit quality: 0.045
Class 5 - Lowest credit quality: 0.100
Class 6 - In or near default: 0.300
Factors applied to carrying value of the following:
- Real Estate
- Other LT invested assets other than collateral loans
- Receivables for securities
- Aggregate write ins for invested assets
- Not likely to show up on exam
- Real Estate = 0.1
- Other LT invested assets not collateral loans = 0.2
- Receivables for securities = 0.025
- Aggregate write ins for invested assets = 0.05
What does the asset concentration factor do?
It doubles the RBC charge of the 10 largest issuers that the insurer is exposed to.
How is the RBC charge for asset concentration allocated?
RBC from fixed income is allocated to R1
RBC from equity is allocated to R2
With the asset concentration factor, what is the total charge factor for each asset limited to?
Limited to 0.3
Name the two aspects of credit risk that R3 accounts for.
- The counterparty will default (on at least part of the debt)
- The risk associated with estimating the amounts due
3 sources of R3 charge:
- Non-invested assets
- Reinsurance recoverable (largest portion)
- Health credit risk
List some examples of non-invested asset that receive a R3 charge:
- Investment income due & accrued
- Amounts receivable relating to uninsured plans
- Federal income tax recoverable
- Guaranty funds receivable or on deposit
- Recoverable from parent, subsidiaries and affiliates
- Aggregate write in for other than invested assets
RBC Charge for non-invested assets:
0.05 x net admitted value
Except for investment income due & accrued, which uses 0.01
Why are regulators concerned about reinsurance?
- It is believed that uncollectible reinsurance has been responsible for the insolvency of insurers in the past (e.g. Mission Insurance & Transit Casualty)
- Reinsurance has been used by the insurers to enhance the surplus position/ hide poor financial results
How is the RBC charge for reinsurance recoverable allocated?
The RBC charge for reinsurance recoverables is split equally between R3 & R4, unless:
Reserve RBC (R4) < ( Credit Risk RBC for non-invested assets + 0.5 * RBC for reinsurance recoverables )
If the above inequality holds, the total is allocated to R3.
RBC Charge for reinsurance recoverables:
0.1 reinsurance recoverable
Where the recoverables have been reduced by the provision for reinsurance
Why has the 10% charge for reinsurance recoverables been criticized by insurance carriers:
It does not differentiate by the reinsurer strength, or whether the recoverables are collateralized.
Why does the 10% charge for reinsurance recoverables remain in force, despite the heavy criticism:
Due to the need to be conservative when reinsurance is involved:
- Uncollectible balances have historically been responsible for several insurance failures
- Reinsurance has been used to overstate surplus
What does the reserve risk (R4) address?
The Reserve risk addresses the risk that reserves will develop adversely.
Formula for Base loss & LAE reserve RBC charge:
RBC = [(Company RBC % + 1) x Adjustment for investment income - 1] x (Net loss & LAE reserve + Other discounts not in reserves)
Where the net loss & LAE reserves are taken from Schedule P, Part 1 (and are gross of non-tabular discounts, but net of tabular).
Purpose of the Company RBC %:
Provide a surplus cushion against adverse development.
How is the Company RBC % derived:
Taking the straight average of:
- Industry reserve RBC %
- Industry reserve RBC % adjusted for company experience
Formula for Industry RBC %:
Industry RBC % = (net incurred loss & DCC development during the year (from Schedule P, Part 2)) / (net loss & DCC reserves from the prior year)
- Uses industry data
Formula for Adjustment for Company Experience:
Company Avg Dev/ Industry Avg Dev
In what situations should the insurer not make the company adjustment:
- Either the initial or current loss values are negative for any year
- Current value is 0 for any year
- Sum of initial values is 0 across all years
Formula for company avg dev:
Company Avg Dev = (Sum of Inc Loss & DCC from 9 prior AYs) / (Initial valuations of Inc & DCC for the same AYs)
*Factor capped at 400%
Formula for Industry Reserve RBC% adj for company experience
= Industry reserve RBC % * Adj factor for Company Exp.
Where Adj factor for Company Exp. = Company Avg Dev/ Industry Avg Dev
Adjustment for Investment Income
- This is an input to the Base LLAE Reserve RBC by Line
- Should be provided
- Based on 5% interest rate and payment patterns
RBC Charge after loss sensitive discount`
RBC = Base loss & LAE Reserve RBC – loss sensitive discount
Formula for Loss Sensitive Discount:
Loss Sensitive Discount = (Loss Sensitive Disc. Fact) * (% Loss Sensitive Direct Loss & Expense Reserves) * (Base Loss & LAE Reserve RBC)
Loss sensitive discount factor:
30% for direct business, and 15% for assumed.
*The resulting amount is subtracted from RBC because it is a discount
Why does assumed business have a lower Loss sensitive discount factor:
The benefit is often partially offset by the fact that the commissions are loss sensitive as well.
Equation for Loss concentration factor:
0.3 (Net loss & LAE reserves in line with highest reserves) / (Net loss & LAE for all lines) + 0.7
Equation for final net loss & LAE Reserve RBC after adjustment for LCF
= Total reserve RBC after discount for all lines * 1,000 * LCF
**Multiply by 1,000 because LLAE comes from schedule P which omits the 1,000s
List 2 reasons that the reserves are subject to a lot more uncertainty if the insurer is growing rapidly:
- The insurer wont have as much insight into the new business
- The estimate of unpaid claims is more difficult for a growing company relative to one in a steady state: the average writings of the insurer are going to be skewed towards the end of a policy year. It is difficult to adjust the analysis for this shift, and also quite likely that insurers will neglect to make an adjustment
Threshold for an insurer to be Defined as having excessive growth:
3yr average growth rate in GWP (capped at 40%) exceeding 0.1
** cap each year at 40% before averaging
Average growth rate factor formula:
=Max(Avg growth over 3 years, 0.1)-0.1
**When calculating avg growth for each of the past 3 years, cap each year at 40%
Excessive premium growth charge formula for reserves:
Charge = Average growth rate factor x 0.45 x net losses & LAE reserves
What does WP RBC reflect:
Risk that future business may be unprofitable
Base NWP RBC formula:
RBC = Current yr. NWP * (Company RBC loss ratio * Adjustment for investment income + Underwriting expense ratio - 1)
Formula for Company RBC LLAE Ratio
straight average of:
- Industry RBC loss & LAE ratio
- Industry RBC loss & LAE ratio adjusted for the company’s experience
Formula for Industry RBC loss & LAE ratio adjusted for the company’s experience
Industry RBC LLAE ratio * Adjustment for Company Experience
Formula for Adjustment for company experience
** For R5 calculation
Adjustment for Company Experience = Company Avg Loss & LAE Ratio / Industry Avg Loss & LAE Ratio
Underwriting expense ratio
Other UW Expenses Incurred in Current Year / NWP in Current Year
** Ratio is capped at 400% (with floor of 0)
Adjustment for loss-sensitive business (for R5)
- Based on portion of written premium
- 30% for direct business, and 15% for assumed.
** These are the same factors used in R4
Premium concentration factor formula: (applied to R5)
0.3 x (NWP in largest line) / (NWP for all lines) + 0.7
Excessive premium growth charge formula for NWP:
Charge = Average growth rate factor x 0.225 x NWP
** growth rate factor is the same one used in R4 calculation
Derivation of Rcat
i. Apply a risk charge factor of 1.0 to the net of reinsurance losses (excluding LAE) @ 1 in 100 year level for both earthquakes & hurricanes
ii. Apply a 0.048 factor to the modeled losses ceded to reinsurance based on the 1 in 100 year loss in order to factor in the contingent credit risk that the reinsurer
would default in this scenario.
iii. Rcat = [(Total earthquake risk)^2+ (Total hurricane risk)^2]^0.5
This assumes that the two risks are independent
What type of reinsurers are exempt from the credit charge portion of Rcat?
- US affiliates
- Mandatory pools
Purpose of RBC charge for operational risk
risk of financial loss due to operational events that have not been reflected in the existing risk charges, such as inadequacy or failure of internal systems,
personnel, procedures, or controls, as well as external risk. Also included in this category is legal risk
Final RBC charge (including operational risk)
RBC charge = 3.0% * Total RBC After Covariance Before Basic Operational Risk
- the covariance thing is squaring all the R’s, summing, then taking the square root
Formula for total adjusted capital
= Surplus - Non-tabular discount (from Schedule P, Part 1) - Tabular discount on medical reserves
Formula for RBC ratio:
RBC ratio = Total adjusted capital / ACL
*Where the ACL = RBC after covariance x 50%
Define ACL
(Authorized Control Level) is essentially the point at which the insurance commissioner is authorized to take control over the insurer
What two RBC metrics are published in the annual statement?
- Total adjusted capital
- ACL
4 levels of actions permitted/ required based on RBC ratio, as well as the respective ratio:
** This is highly tested
- Company action level (150%-200%)
- Regulatory action level (100%-150%)
- Authorized control level (70%-100%)
- Mandatory control level (<70%)
Action required by DOI & Insurer for Company Action Level:
** This is highly tested
DOI: No action
Insurer: Submit plan to commissioner outlining how it will reduce risk/ increase capital
Action required by DOI & Insurer for Regulatory Action Level:
** This is highly tested
DOI: Right to take corrective action
Insurer: Same as Company Action Level
Action required by DOI & Insurer for Authorized Control Level:
** This is highly tested
DOI: Authorized to take control of insurer
Insurer: None initially
Action required by DOI & Insurer for Mandatory Control Level:
** This is highly tested
DOI: Must rehabilitate/ liquidate insurer
Insurer: None initially
Criteria for the insurer to undergo a trend test:
- RBC ratio between 200 & 300%
AND - Combined ratio >120%
Formula for combined ratio
Combined Ratio = Loss & LAE Ratio + Dividend Ratio + Expense Ratio;
Purpose of the trend test:
Early warning of companies that may incur RBC ratios below 200%.
What action must be taken if insurer fails trend test?
Insurer must meet requirements of Company Action Level.
- Submit plan to commissioner outlining how it will reduce risk/increase capital
