U. S. Risk-Based Capital Requirements and Their Context

Alfred W. Gross Virginia Commissioner of Insurance National Association of Insurance Commissioners October 11, 2002

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What is RBC? *

• • Basic formula compares reported capital to risk-based capital requirement Requirement calculated by applying factors to various asset, credit, reserve and off balance sheet items * taken from NAIC Financial Analysis Handbook Property/Casualty Edition, 2001 Annual 2

What is RBC? (continued)

• • • Factor is higher for those items with greater underlying risk Risk-based capital ratio is defined as a ratio of actual capital (i.e. “total adjusted capital”) divided by required capital (i.e. authorized control level risked based capital”) Regulatory action taken on basis of this ratio 3

Standard U. S. Regulatory Filings: Financial Reporting

• • • • • • Annual Statements Quarterly Statements Management Discussion and Analysis Actuarial Opinion Annual Audited Financial Statements Risk-Based Capital Report 4

Standardized Risk-Based Capital (RBC) Report

• Uniform Approach Across Companies and U. S. Jurisdictions • Based on U. S. Statutory Annual Statement Blank (A.S.) –

Values are taken from A.S. and have no meaning outside of A.S. context + U. S. statutory accounting model

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Formulas and calibration of results are based aggregate industry statistics taken from A.S. reporting

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Standardized RBC Report (continued)

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Based on historical financial reporting, not “forward looking”

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Dependent on accounting definition of solvency (asset-liabilities) Works within the “surplus geography” of the A.S., e.g., hidden margins in conservatively valued assets and technical provisions

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The RBC System

• Background: – – – –

1993 Life 1994 Property/Casualty 1998 Health Designed to provide regulators with some degree of control in monitoring risks taken by insurers

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Designed to provide companies with some cost benefit mindset in their asset allocation decisions

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The RBC System (continued)

• Tensions in Capital Regulation and Standards –

Desire to minimize free surplus so as to focus investment in underwriting business and to use financial leverage (e.g., debt) to provide greater returns (management perspective) VS.

Need to hold a minimum amount as free surplus to ensure company performance (regulator perspective)

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The RBC System (continued)

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Need for a straight-forward, transparent, legally workable and fair approach across all companies in a competitive market VS.

Need to be sensitive to individual company characteristics, e.g., types of risks, levels of exposure, and management capabilities

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The RBC System (continued)

• RBC is a Regulatory Tool –

Signaling mechanism between regulators and insurance companies as to poorly capitalized companies

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Act as a tripwire providing clear regulatory authority for intervention at defined action levels

• RBC is not: – – –

A “silver bullet” to stop insolvencies A system for ranking or rating companies A precise diagnostic tool to define problematic companies

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RBC Formulas

• • • Life and Health Property and Casualty Health 11

Life RBC - Components

• • • • • • • • •

Insurance Affiliate Investment and Non-Derivative off balance Sheet Risk (C0) Invested Asset Risk - Common Stock (C1cs) Invested Asset Risk - Other (C1o) Insurance Risk or Pricing Risk (C2) Interest Rate Risk (C3a) Health Provider Credit Risk (C3b) Business Risk - Guaranty Fund Assessment Risk (C4a) Business Risk - Health Administration Expense Risk (C4b) Covariance Adjustment

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RBC - Action Levels

Total Adjusted Capital/Authorized Control Level RBC

No Action Level Company Action Level Regulatory Action Level Authorized Control Level Mandatory Control Level 200% + 150% - 200% 100% - 150% 70% - 100% Under 70%

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Historical RBC Results (Life, Property and Health)

No Action Company Regulatory Authorized Mandatory Total 1996 3,799 3,740 3,707 3,870 3,953 59 22 11 1997 54 14 8 1998 54 31 22 1999 (Life - 1993; Property - 1994; Health - 1998) 84 64 23 2000 92 67 28 31 27 43 46 53 3,922 3,843 3,857 4,087 4,193

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Life RBC - RBC Requirement & Percentage After Covariance

• • • • • • • • • • •

Asset Risk-Affiliate (C0) Asset Risk-All Other (C1) Insurance Risk (C2) Interest Rate Risk (C3a) Health Credit Risk (C3b) Total (C3) Risk Business Risk-Prem/Liab (C4a) Business Risk-Health (C4b) Total (C4) Risk RBC After Covariance Authorized Control Level RBC $ 22.0 billion $ 51.1 billion $ 19.1 billion $ 10.9 billion $ 32.0 million $ 10.9 billion $ 3.7 billion $533.6 million $ 4.3 billion $ 96.1 billion $ 48.0 billion 23% 53% 20% 11% <1% 11% 4% <1% 4% 100%

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NAIC Accreditation: Base - Line Laws and Regulations

• Key standards include:

1. Examination Authority 2. Corrective Action 3. Risked Based Capital 4. Reinsurance 5. Investments 6. Reserves 7. Receiverships 8. Guaranty Funds 9. Accounting Practices

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Risk Assessment Working Group

• • Recognition of new financial services marketplace: rapid product innovation, convergence among the sectors, global competition, role of technology Need for a “forward-looking” perspective responsive to the specific risk exposures of a company’s operations 17

General Goals

• To create a framework for identifying and assessing risk exposures – Categorize risks – Analyze and evaluate risk exposures, both inherent and control risks – Document results in a manner useful in focusing regulatory oversight – Produce a type of risk profile or matrix for each company 18

General Goals (continued)

• To make more effective current approaches to on-site examinations and on-going financial analysis by targeting resources to material risk exposures • To encourage insurers to establish effective risk management systems 19

Challenging Assumptions

• Regulator’s reliance on internal company processes to identify, evaluate, and manage the risks. Has top management the ability to circumvent internal controls?

• Increased reliance on work of outside auditors 20