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Evolution of RBC System in the USA

Evolution of RBC System in the USA. Lou Felice. Presentation Agenda. Overview of Current RBC System Milestones and Developments Since the Launch of the RBC System Key Areas and Challenges of Current Reforms Differences between RBC and Solvency II in Terms of Capital Requirements

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Evolution of RBC System in the USA

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  1. Evolution of RBC System in the USA Lou Felice

  2. Presentation Agenda Overview of Current RBC System Milestones and Developments Since the Launch of the RBC System Key Areas and Challenges of Current Reforms Differences between RBC and Solvency II in Terms of Capital Requirements RBC in Context of Group-wide Supervision

  3. Overview of current rbc system

  4. Current U.S. RBC – Framework / Structure RBC Is Part of Regulatory Safety Net • Licensing in Each State • Restrictions on and Regulatory Approval of Key Risk Transactions • Statutory Accounting and Reporting, CPA Audit and Actuarial Opinion • RBC, Other Intervention Tools and Financial Analysis • Corporate Governance and ERM (ORSA) • Risk-Focused Financial Examinations

  5. US Solvency Framework • Primary goal is to ensure financial health of insurers for purposes of protecting policyholders • Work with companies to remedy areas of concern • More severe interventions if company continues to deteriorate e.g. regulators will run off or liquidate the insurer if necessary to ensure protection of existing policyholders • Provide a consistently applied set of standards • Additional goals include availability and affordability of insurance, stable and competitive markets

  6. Current RBC Formula Regulatory Purpose / Use • Rules Based, Formulaic / Factor Driven • Some company results adjust factors for Life • Some modeling used for interest rate and market risk • Industry Averages used for some risks • Reflects Unique Risks Inherent in Operating an Insurance Company (Compared to Banks, etc.) • Reflects Risk profile of Company Type (Life v. P&C) and Specific Company (e.g. Investment Strategy and Insurance Lines of Business) • Not All Risks Are Accounted for; Material Risks by Industry • Provides Regulatory Authority for Timely Action

  7. Overview of NAIC RBC Formulas • Formula vs. Full Modeling Approach • Signaling Mechanism between Regulators and Insurers to Identify Poorly Capitalized Companies (Different Levels) • Unlike Banking RBC that also Has: • “Well Capitalized” • “Adequately Capitalized”

  8. NAIC RBC System • Four formulas: • Life, Fraternal (copy of Life), P & C, and Health • NAIC Risk-Based Capital for Insurers Model Act serves as a guide • RBC law adopted in each state makes the system operational and consistently applied • RBC Law incorporates the formulas by reference so Law need not be changed when formula changes • NAIC produces the RBC formulas but the content is maintained and modified by State regulators

  9. Overview of Formula Construction Generic Component Information • Asset Risk – Affiliated Investment Risk • Asset Risk – Default Risk / Market Risk • Asset Risk – Credit / Other • Underwriting/Insurance Risk • Other Types of Risk (Varies by Formula) • Business Risk (Life & Health) • Interest Rate Risk (Life)

  10. Overview of Formula Construction (Cont.) Asset Risk – Investments • Bonds = Default on Principal and/or Interest • Preferred Stock = Default and Past Dividends • Common Stock = Decrease in Fair Value • Mortgages = Default on Principal and/or Interest • Real Estate = Decrease in Fair Value • Schedule BA Assets = Risk Similar to Underlying Characteristics

  11. Overview of Formula Construction (Cont.) Asset Risk – Receivables (Credit Risk) • Risk of Non-Recovery of Receivable Amounts Asset Risk – Other • Investment Concentration Risk = Additional Risk of High Concentrations in Single Exposures

  12. Overview of Formula Construction (Cont.) Underwriting/Insurance Risk Reserve Risk = Obligations from Past Business Are Understated (Underestimated Reserves) Premium Sufficiency Risk = Premiums Are Inadequate to Cover Claims and Expenses for Policies Written (Under-Priced)

  13. Overview of Formula Construction (Cont.) Other Types of Risk (Varies by Formula) • Business Risk (Life and Health) = • Primarily Litigation and Guaranty Fund Risk • Life Formula Adds a Risk Charge for Separate Account Reserves • P&C and Health Formulas Add Growth Risk • Interest Rate Risk/Market Risk (Life) = • Risk of Losses Due to Changes or Mismatch in Interest Rate Levels (See Presentation Section on C-3 Interest Rate Risk) • Risk of market fluctuation in asset values vs. liability cash flows

  14. Overview of Formula Construction (Cont.) Detail in the Formulas was Developed to Focus on the Areas of Most Material Risk for Each Formula Life – Asset Risks P&C – Underwriting Risks (Pricing and Reserving)

  15. Life Industry Distribution of Risk Components Life RBC Components: • C-0 Asset Risk - Affiliates 15% • C-1cs Asset Risk - Common Stock 16% • C-1o Asset Risk - All Other 33% • C-2 Insurance Risk 18% • C-3a Interest Rate & Market Risk 10% • C-3b Health Credit Risk 0% • C-3c Market Risk 2% • C-4a Business Risk 5% • C-4b Business Risk Admin. Expenses 1%

  16. P/C Industry Distribution of Risk Components Property/Casualty RBC Components: • R0 – Asset Risk Affiliated Insurance 15% Company Assets • R1 – Asset Risk Fixed Income Investments 2% • R2 – Asset Risk Equity Investments 25% • R3 – Credit Risk 5% • R4 – U/W Risk Reserve 34% • R5 – U/W Net Premiums Written 19%

  17. Overview of Formula Construction (Cont.) Health RBC Components: • H0 = Asset Risk – Affiliated Company Investments 11% • H1 = Asset Risk – Other Invested Assets 15% • H2 = Insurance/Underwriting Risk 60% • H3 = Credit Risk 4% • H4 = Business Risk 10%

  18. How Does the Formula Work? Data Sources and Calculation • Financial Amounts: • Automated Data Pulls from the Statutory Annual Statement • Manual Data Entry from Company Records • Multiplied by Risk Factors • Equals Risk Charges • Covariance Calculation • Groups Correlated Risk Charges into Same Component Recognizing Independence vs. Correlation of the Risks

  19. Overview of Formula Construction (Cont.) Covariance Calculation (Continued): • Square Root of Sum of Component Amounts Squared = Adjustment to Reflect the Remote Likelihood of Losses from Multiple Formula Components Occurring Simultaneously (Uncorrelated) • Combination of Risks < Sum of Each Component Risk

  20. Overview of Formula Construction (Cont.) (C1o+C3a)2+(C1cs+C3c)2+(C2)2+(C3b)2+(C4b)2 C0+ C4a+ R0 + (R1)2+(R2)2+(R3)2+(R4)2+(R5)2 (H1)2+(H2)2+(H3)2+(H4)2 H0 + Covariance Calculation: Life RBC Property/Casualty RBC Health RBC

  21. How Does the Formula Work?The Ratio and Action Levels • The RBC formula calculates Total Adjusted Capital (Capital and Surplus from the Statutory Balance Sheet Adjusted for Certain Items) • The RBC formula also calculates a minimum capital level (Authorized Control Level RBC) • The other Action and Control Levels are calculated from the ACL RBC: • Company Action Level = 200% of ACL • Regulatory Action Level = 150% of ACL • Authorized Control Level (ACL) = 100% ACL • Mandatory Control Level = 70% of ACL

  22. Overview of Formula Construction (Cont.) Total Adjusted Capital (TAC): • Capital & Surplus from Liabilities Page • Adjustments • AVR (Life and Life Subs) • Dividends (Life & Life Subs) • Hedging Credit (Life) • Non-US Insurance Subsidiaries (Life) • Non-tabular Discount (P/C & P/C Subs) • Tabular Discount (P/C & P/C Subs) • Credit for Capital Notes (Subject to a Limit) • = Official TAC

  23. Overview of Formula Construction (Cont.) Total Adjusted Capital (Continued): • Tax Sensitivity Total Adjusted Capital • Total Adjusted Capital + Additional Adjustments • DTA, DTL • Subsidiary DTA, DTL • = FYI TAC • Additional Sensitivity Tests • Remove Surplus Notes • Additional Charge for Off-Balance Sheet Items

  24. Overview of Formula Construction (Cont.) Action/Control Levels: Authorized Control Level RBC (ACL RBC) = 50% of Calculation after Covariance • Company Action Level = 200% of ACL RBC • Regulatory Action Level = 150% of ACL RBC • Authorized Control Level RBC • Mandatory Control Level = 70% of ACL RBC

  25. Overview of Formula Construction (Cont.) Comparison of Total Adjusted Capital (TAC) to Action Levels: • “Official” TAC, NOT (Tax) Sensitivity TAC • Level of Action Indicators • None • Company Action Level • Regulatory Action Level • Authorized Control Level • Mandatory Control Level • RBC Ratio = TAC/ACL RBC

  26. Overview of RBC Model Laws Section 3 - Company Action Level Event: • TAC >= Regulatory Action Level RBC but • TAC < Company Action Level RBC OR • Trend Test Triggered = • Insurer Submits RBC Plan to Commissioner

  27. Overview of RBC Model Laws (Cont.) RBC Plan: • Identify Conditions • Proposed Corrective Actions • Current + 4 Year Financial Projections • Key Assumptions for Projections • Quality of & Problems with Insurer’s Business • Submitted within 45 Days of Company Action Level Event Commissioner Response to RBC Plan (60 Days): • Plan to be Implemented, or • Unsatisfactory (Revised RBC Plan or Reg. A.L. Event)

  28. Overview of RBC Model Laws (Cont.) Section 4 - Regulatory Action Level Event: • TAC >= Authorized Control Level RBC but • TAC < Regulatory Action Level RBC = • RBC Plan (within 45 days) to Commissioner AND • Commissioner Examination or Analysis AND • Commissioner’s Order for Corrective Actions AND • Experts to Review RBC Plan at Insurer’s Expense

  29. Overview of RBC Model Laws (Cont.) Section 5 - Authorized Control Level Event: • TAC >= Mandatory Control Level RBC but • TAC < Authorized Control Level RBC = • RBC Plan (within 45 days) to Commissioner AND • Commissioner Examination or Analysis AND • Commissioner’s Order for Corrective Actions AND • Experts to Review RBC Plan at Insurer’s Expense OR • Place Company under “Regulatory Control”

  30. Overview of RBC Model Laws (Cont.) Section 6 - Mandatory Control Level Event: • TAC < Mandatory Control Level RBC = • Place Company under “Regulatory Control” Section 7 – Hearings (Insurer’s Right to Challenge) • Adjusted RBC Report • Unsatisfactory RBC Plan or Revised RBC Plan that Resulted in a Regulatory Action Level Event • Notice of Failure to Adhere to RBC (or Revised) Plan with Substantial Effect on Company Action Level Event • Corrective Order from Commissioner

  31. Milestones and developments since launch of RBC system

  32. Milestones and Development • Formula Implementation • 1993 = Life RBC Formula • 1994 = P/C RBC Formula • 1998 = Health RBC Formula • Sensitivity Tests Expanded over Time • C-3, Phase II Project for Life RBC • Incorporated stochastic modeling into the Risk Charge for Annuities • Trend Tests

  33. Milestones and Development • Sensitivity Tests Expanded over Time • Increases RBC risk charges for affiliated investments, restricted assets, contingent liabilities and guarantees, and long-term leases • Added tax sensitivity adjustment to TAC • Back out Deferred Tax Assets (DTAs) • Add back Deferred Tax Liabilities (DTLs) • Same adjustments for subsidiary amounts

  34. Milestones and Development • Trend Tests • Life RBC • TAC > 200% ACL and < 300% ACL; AND • Trending downward for prior 2 years (e.g., 1st prior year 270% and 3rd prior year 230%) • P/C RBC • TAC > 200% ACL and < 300% ACL; AND • Combined Ratio > 120% • Health RBC • TAC > 200% ACL and < 300% ACL; AND • Combined Ratio > 105%

  35. Key areas and challenges of current reforms

  36. Challenges and Current Reforms Incorporating Catastrophe Risk Charge Considering Calibration of Formulas Assessing Asset Risk Charges Assessing Underwriting charges (P&C) How to Incorporate Operational Risk Role of Scenario Testing (Stress Testing)

  37. Differences between rbc and solvency ii capital requirements

  38. Differences between RBC and Solvency II • Accounting Differences • SII market consistent balance sheet gives a going concern view of solvency position • US statutory balance sheet gives more of a winding up basis • Capital Requirement Calculation Differences • SII uses independent MCR and SCR calculations for an insurer • RBC uses a single formula for a specific insurer to generate 4 action/control levels

  39. Differences between RBC and Solvency II (cont.) Capital Requirement Calculation Differences (cont.) • RBC uses separate formulas by industry type – life (& fraternal), property/casualty, health • SII SCR is a single formula with sub-components utilized based upon insurer type

  40. Differences between RBC and Solvency II (cont.) Capital Requirement Calculation Differences (cont.) • RBC is not based on an overarching calibration target; only specific calibration at individual risks level • SII SCR is calibrated to an overall value at risk with a confidence level of 99.5% • RBC covers a specified list of material risks at the industry level • SII SCR takes into account all quantifiable risks, while the MCR is a linear formula based on a set of risk factors applied to individual company liabilities

  41. Differences between RBC and Solvency II (cont.) Use of Internal Models • Life RBC allows some risk factors to be modified by insurer/industry experience; partial models are currently limited to life/ annuity products with guarantees subject to interest rate/market fluctuation risks • Models are not approved, but regulators set prescribed statistical parameters and time horizons and may apply a standard model that acts as a floor on capital • SII MCR requires a standardized approach, but insurers can choose between the standard approach or the use of an internal model for either specific risk modules or for all its risks for SCR

  42. Differences between RBC and Solvency II (cont.) Use of the Capital Requirement • RBC has some influence on insurers’ risk management (e.g. Reserves reduced for reinsurance, but not for collateral); addressed mainly through other supervisory tools • SII is designed to provide incentives for risk management • Capital add on may be required by regulator, but it is not part of the RBC capital amount • SII capital add on increases SCR

  43. Differences between RBC and Solvency II (cont.) Use of the Capital Requirement in the U.S. • Other oversight tools are used with RBC • Many prioritization and analysis tools focus on specific activities within the insurer; these are addressed to prevent a future capital problem • Hazardous Financial Condition Regulation in addition to RBC Specific Legal Action • For example, a company with 1000% RBC ratio could still trigger a Hazardous Financial Condition trigger by having a large drop in surplus

  44. Differences between RBC and Solvency II (cont.) Own Risk & Solvency Assessment (ORSA) • US – exemption for insurers under $500 million in premiums (commissioner can still require) • SII – required of all insurers and groups • US – legal requirement tied to analysis and regulatory oversight with more discretion left to the company to determine/justify risk assumption and mitigation methods • SII – more prescriptive legal requirement linking risk and capital management (including how the risk profile deviates from SCR assumptions)

  45. Rbc in context of group-wide supervision

  46. RBC and Group-Wide Supervision • RBC assesses risk charges on each legal entity insurer for ownership of parent, subsidiaries and affiliates; but it does not establish specific capital requirements for non-insurance entities • RBC aggregation does not recognize diversification benefits, but those benefits tend to disappear when groups are stressed • US system focuses on understanding the risks outside of the insurance entities and how they may impact the insurers

  47. RBC and Group-Wide Supervision • US does not support a consolidated approach to a group capital calculation • How do you construct a reasonably accurate group capital requirement that works for the many different group structures, types of businesses included, differing legal system requirements, etc.? • Where does the group capital reside and how is the priority of distribution established in a liquidation when it resides at the holding company (and issues of fungibility)?

  48. RBC and Group-Wide Supervision • US does support a legal entity based approach to assessing group capital which includes and understanding and assessment of group-wide risks that may adversely impact the legal entities as a result of group-wide activities occurring outside of the legal entities but within the broader group • Perhaps use simple but effective ratios and scenario (stress) tests to perform group capital assessments • US system will use ORSA Summary Reports to see the group’s material risks (including in stressed environment) and how the capital objective is structured to account for those risks (including in stressed environment)

  49. Questions???

  50. Reserves- P/C- Life ASSAL – November 2012 Lou Felice

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