In the early to late 1980s and early 1990s, the financial community was in desperate need of a general overhaul. Much like the current environment, risky investments, lax oversight and poor judgment brought storm clouds that threatened federal regulation and scared the financial community into action. The banking industry developed asset classification and portfolio underwriting standards by risk and the insurance industry quickly followed suit.
Risk based capital (RBC) standards were instituted and regulate the insurance industry today. For some, understanding the elements of insurance regulation may seem tedious and of little merit. For serious insurance professionals who want to meet their client’s needs fairly, accurately and with a sense of probity, a general knowledge of RBC will help them better understand reserving requirements and offer a more complete sense of our current environment.
Understanding how products, features, interest rates and risk affect insurance companies should help producers make more accurate assumptions of future performance.
Since this is meant to be a general overview, we will leave the percentages, numbers and formulas to the bean counters in home offices. What is necessary to know is that the RBC ratio each company has is not meant to be a yardstick for individuals (or for that matter, industry professionals) to use as a means of judging a company for purposes of making a recommendation or a sale. Industry rating companies like A.M. Best look at a company’s overall health, while others such as Standard & Poor’s and Moody’s look at a company’s claims paying ability. They are each readily available to all and are an acceptable measure when comparing the suitability of a client recommendation.
On the other hand, risk based capital ratios are meant for the use of the National Association of Insurance Commissioners (NAIC) and are not generally available for publication. That doesn’t mean you can’t find out what they are (try VitalSigns) or have a general knowledge of what goes into calculating them.
There are a few things you need to know once you have located a company’s RBC ratio. There are four basic components to the formula: asset risk, insurance risk, interest-rate risk and business risk. A brief description of each follows:
Asset Risk. The quality of a company’s assets is measured on a weighted scale. Investment grade bonds require less capital reserves than non-investment grade bonds and/or bonds in or near default. Full recourse collateralized mortgages have a lower requirement than non-recourse mortgages, etc. A company may use any asset it chooses, provided it can support the reserve levels. It was only about 10 years ago that an executive of one insurance company bragged about the returns that his company earned by funding venture capital projects for dot-com companies. Not surprisingly, that company is no longer with us.
Insurance Risk. Different lines of business have different cash flow needs; different underwriting requirements; and different patterns of claims, redemptions, surrenders, etc. While they share common elements, each line of business (life, health, disability income, long term care, annuity, etc.) has its own particular characteristics, and reserving standards are tailored to each. This leads many companies to diversify the lines of insurance that they underwrite and market.
Interest-Rate Risk. Since the underlying investments of most insurance companies are interest-rate sensitive, interest-rate risk can be one of the most critical elements to manage. As we all should know, when interest rates go up, bonds go down, and vice versa. Mortgages, CMOs and other interest-rate sensitive assets respond in kind.
Matching assets to liabilities is a key element to managing interest-rate risk. Mismatching assets to liabilities or creating disintermediation requires a company to reserve for a 3 percent interest rate movement in either direction. We said we wouldn’t get into the numbers, but one can imagine the reserve requirements for a company that has an annuity with a five-year surrender that is funded with a portfolio of 10-year average maturity bonds. A 2 percent increase in interest rates creates an approximate 8 percent decrease in a bond’s value in the fifth year, or the year that the annuity is no longer protected by surrender charges.
Can you imagine a company saying to a client at time of maturity, “So sorry, Mrs. Client, interest rates went up and so we don’t have enough money to pay you everything that we owe you.” That would generate a phone call or two!
One element of asset matching is to remember that when market interest rates move, the dividend yield or coupon of existing bonds, mortgages, etc., generally does not change. Rising rates means a decrease in the asset’s value, not an increase in rate.
Business Risk. One of the easier elements of RBC to describe is business risk. Insurance companies are businesses like any other. Things change, challenges occur, operating expenses must be paid, administration and management are required, premiums must be collected, and the list goes on and on. Each line of business presents challenges specific to that line and are weighted according to that challenge. There are certainly similarities among some lines, such as long term care and disability income insurance. From a sales and marketing viewpoint, LTC insurance is a natural extension of disability insurance. However, the underwriting, client profile, utilization and pricing are significantly different from each other and must be viewed from a risk perspective and reserving challenge in a very different way.
The above discussion is meant to give insight into why some companies include various features in products while others don’t. A market value adjustment in an annuity helps a company manage interest-rate risk. Maintaining a high level of asset quality reduces required reserve levels at the cost of potentially higher investment returns. Making a product attractive in the marketplace requires carriers to make assessments for each line, product and product feature to determine the viability of the product under the current reserving rules.
As a rule of thumb, look for carriers with a minimum of a 200 RBC ratio with 300 to 400 as a much more attractive comfort level. Each company is different, but they all play by the same rules.
