What is Risk-Based Capital?
The method for measuring the least measure of capital appropriate for a reporting entity to maintain its overall business operations in a reflection of its size and risk outline is known as Risk-Based Capital Model or RBC. It puts a limit on the quantity of risk that an organization can take. According to RBC, a company having a higher amount of risk should hold a higher amount of capital. A cushion is provided by capital to a company against solvency. It is not necessarily the whole sum of capital that an insurer would desire to hold to reach its safety and competitive aims but is intended to be a minimum regulatory capital standard. RBC provides legal authority to take control of an insurance company to the regulators.
Capital standards were used as a major tool to monitor the financial solvency of insurance companies prior to the creation of RBC. Regardless of the financial condition of a company, owners were required to supply the same minimum amount of capital according to fixed capital standards. Depending upon the state and the line of business that an insurance carrier wrote, the requirements of states ranged from $500000 to $6 million. For licensing and writing business in the state, companies needed to satisfy these requirements. With change and growth in insurance companies, the fixed capital standards were no more effective in presenting a satisfactory cushion for many insurers.
An early warning system was begun in the 1990s by NAIC’s RBC regime for US insurance regulators. The adoption of the US RBC regime was the result of a string of large-company insolvencies that took place in the 1980s and early 1990s. A working group was established to take care of the feasibility of developing a statutory risk-based capital requirement for insurers. The purpose of creating the RBC regime was to provide a capital adequacy standard that is related to risk, raise a safety net for insurers, is uniform among the states, and provides regulatory authority for timely action.
The two main components of this regime are:
- The risk-based capital formula, that built a hypothetical minimum capital level that is associated with a company’s actual capital level.
- A risk-based capital model law that gives automatic authority to the state insurance regulator to take particular actions depending on the level of impairment.
Importance of Capital Model
As an additional tool, the Risk-Based Capital Formula was developed to assist regulators in the financial analysis of insurance organizations. Based on the kind of risks a company is exposed to, establishing a minimum capital requirement is the purpose of this formula. Different RBC models have been created for all primary insurance types like Life, Property/Casualty, Health, and Fraternal. The RBC law specifies action levels that are triggered by the business affairs of an insurer. Using this law, regulators have a clear legal authority to intervene in business affairs. While there is still time for regulators to react quickly and effectively to minimize the overall costs associated with insolvency, RBC alerts regulators to undercapitalized companies as a tripwire system.
Three main areas where the risk factors for the NAIC’s RBC formulas focus are:
- Asset Risk
- Underwriting Risk
- Other Risk
The RBC system receives periodic updates in order to satisfy the evolving regulatory environment. The NAIC Capital Adequacy(E) Task Force and its working groups and subgroups maintain the RBC calculations. With the information about the changing risk landscape, the formulas are reviewed annually. The NAIC Capital Adequacy(E) Task Force webpage under the Related Documents tab contains the proposals and changes adopted for the next year and is updated accordingly.