Investment under the Risk-Based Capital (RBC) and the ...

RECORD, Volume 22, No. 1*

Marco Island Spring Meeting May 29?31, 1996

Session 25I Investment under the Risk-Based Capital (RBC) and Rating Agencies Requirements

Track: Key Words:

Investment Investments

Moderator: Panelist: Recorder:

MICHAEL J. COWELL JAMES F. REISKYTL MICHAEL J. COWELL

Summary: Insurance companies' investment decisions are influenced by RBC and rating agencies requirements. An interview session will be conducted to help provide answers to the following questions:

How to evaluate needs? How to evaluate whether the expected net return will outweigh the RBC/rating agency penalty of added surplus requirement from a return-oninvestment perspective? What if volatility in returns is factored in? Should assets with high RBC requirements be used to back product portfolios, required surplus portfolios, or free surplus portfolios? What are the limits on amounts of various assets?

Mr. Michael J. Cowell: I'm with UNUM in Portland, Maine. I've been involved in risk-based capital from the beginning as far as the NAIC is concerned. I was involved with the Industry Advisory Committee on Risk-Based Capital that came up with the NAIC's current formula, and I spend probably more time on this subject at UNUM than I do on anything else. In the audience is my helper, Jim Reiskytl, from Northwestern Mutual. Jim has also worked on this same industry advisory group. We've been working on this and its related derivative activities approximately six years now. Jim has a great deal of experience in this area. He has also spent a large amount of time on the Asset Valuation Reserve (AVR) Task Force and is involved in many other NAIC, ACLI, and SOA activities involving investments and risk capital.

*Copyright ? 1997, Society of Actuaries

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This is the audience's program. I'm just going to ask questions and get responses. I'm not going to go through the program item by item. These questions are supposed to get to the issue of how risk-based capital is changing companies' investment strategies.

We spent quite a fair amount of time at UNUM on how to evaluate what we call indifference spreads that tell you more or less what you need to know. If you're invested in risk-free Treasuries, and you want to make a move to some other kind of investment, how much do you have to earn over and above what you're yielding on Treasuries?

The critical factor that drives this formula is the rate of change of the risk-based capital relative to the C-1 factor, which you can calculate very simply. How many in the audience have worked with the NAIC risk-based capital formula and understand it? (About two-thirds to three-fourths indicated yes.) So you understand what the C-1 component is and what the total risk-based capital is. It's just a matter of taking your current calculation and adding $1 million to C-1 and seeing how much it increases your RBC. Depending upon the relationship of C-1 plus C-3 to C-2, this result can vary a great deal. That's a critical component. The other factor is your target ratio. What is your company trying to hold its RBC level at?

As an example, you'd need two basis points if you were going to move from riskfree Treasuries into the NAIC's category risk, which has an RBC C-1 factor of 0.3%. You'd need six basis points for the NAIC risk 2 and so forth across the various categories of investments. The only change is to common stock investments where I have a federal income tax rate of 35% across all the other investments. I assumed a slightly lower rate because more of the common stock earnings are achieved by capital gains rather than ordinary income, and that has a slightly lower marginal federal income tax rate. This gives you a fairly good idea that you need anything from 2 basis points for the least risky, to 157 basis points under this particular scenario for the most risky departure from a "risk-free" investment. Then, if you change things like your target risk-based capital ratio to 200% instead of 175%, all of those numbers increase. If you want a return on capital (ROC) goal of 18% instead of 15%, then the numbers also increase; it's a fairly simple algorithm.

Let's get some comments from the floor as to what you do on either of the first two items--evaluating net returns or determining whether or not your net return will outweigh the cost of the added capital requirement. This is of course on the NAIC RBC basis, but the same concept can be applied if you're using Moody's or Standard & Poor's (S&P) formula. As you know, they have sometimes used the same approaches as the NAIC, and sometimes they use slightly different factors in their risk-based capital calculations, but the concept is similar.

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Mr. David C. Florian: When you increase the amount of C-1 that's necessary, are you calculating the C-1 on the C-1?

Mr. Cowell: The C-1 on the C-1?

Mr. Florian: In other words, if I need to put up say, an extra $10,000 in C-1, are you then calculating the C-1 for that extra $10,000?

Mr. Cowell: Yes, but the impact of it at the margin is quite small. If we would be looking at a very substantial departure, shifting our current structure, we would be concerned with the capital requirement for assets to support capital itself. What you're asking is about a second order difference.

Mr. Florian: Right. I noticed that we've done this exact same project. As we moved up in NAIC-risk 4, it did become at least material to us in the investments that we could get. In other words, if we wanted 25 basis points because you calculated it, you may not want to move to NAIC-risk 3 or NAIC-risk 4 because of the C-1 on C-1. I just began to wonder if it made sense to take that into consideration.

Mr. Cowell: I think it would depend on whether or not you were making a decision about whether to go into that kind of investment, or whether you were simply trying to optimize your investment return. If your sole objective was to optimize your investment return, then you probably would take it into consideration. If you were just using this to make a basic strategic decision as to whether to go into mortgages or common stock, I think ignoring the second-order difference would be satisfactory, unless you were going to make a major shift in investment strategy. It's a very good question. It gets fairly complex; you get an auto-regressive formula, and I have not tried to build anything that complex yet. What are other companies doing?

Mr. James F. Reiskytl: I'll comment on one of the questions just asked. Clearly you're going to get different answers depending on whether you assume that the additional surplus you hold is going to be in a Category 4 or not. I don't know if your question implied that you had extra surplus, because you assumed that the surplus would also be in Category 4. Clearly that wouldn't have to be the case. I agree wholeheartedly with Mike. You have to take into account the asset default risk along with any other risk that exists when you have an asset. You'll get a different answer if you invest in a Treasury or whatever it is that you're investing in. If you methodically go through the formula, you may end up with a much higher factor than what you would get in reality, depending on what your philosophy was.

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The answer might be right if you, in fact, intend to hold that surplus in that particular risk level here; it may be wrong if you're not; that's fairly obvious.

I wonder how many people here view the surplus requirement as a penalty. Speaking for myself and Northwestern Mutual, we look at this as being a reasonable way of looking at what the risk is. The fact is, the RBC factors are probably imperfect; we'd admit that. But I think they're a very good estimate, and they're probably somewhere in the ballpark. There may be occasional asset classes that aren't quite precise. One may get into some detail about that, but I don't view it as a penalty; I view it as just good sound management that enables you to make decisions. How many people here view it as a penalty, and how many view it as just good sound investment philosophy?

Mr. Cowell: I think that's a very good area that Jim's touching on. Could I see another show of hands before we get specific answers to Jim's question? How many of your companies have made a major change in your investment strategy over the last two or three years, as a result of the NAIC's, Moody's, and Standard & Poor's formulas? By the way, I think Moody's and Standard & Poor's are now following the NAIC lead. So I think it's sort of one question. How many have made some significant changes in their investment strategy as a result? (A few hands raised.) It looks like it has had a relatively minor impact, Jim.

Mr. Reiskytl: There were only a few hands, but if you look at the overall results, one would assume either this group is not representative of the industry, or there are other areas in which they have made significant changes. I think the latest Townssend and Schupp study clearly has shown that risk-based capital has produced stronger results for the industry over time. Something is occurring. Let's go back to that first question. Very few people were influenced in their investment structure and their investment philosophy by risk-based capital, so that may also make it clear that they, in fact, have been recognizing something like this in their decisions already. The risk-based capital just gave it a formality.

We've done an analysis that is similar to yours. I would introduce a couple of other comments. I think you can get very wound up in the mathematics and actuaries love to do that. Then we use a term that we call the optimal view. You might conclude, for example, that junk or big bonds are the way to go, but you may not wish to do this for other reasons. This analysis by itself is useful, but it may not be a determinant of your investment philosophy, and you may get into that aspect of it.

Mr. David Levene: I'm with Metropolitan Life Insurance Company. I would be interested in knowing how the investment departments of many of these companies view NAIC risk-based capital. At Met Life I see a questioning of a number of the

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RBC factors, and whether or not we, as a company, should work our investments around NAIC RBC requirements. Should we be looking at changes in economic value or total return and perhaps not be quite so concerned over RBC factors? I think the common stock factor is one concern for our company. We think that if a company is operating close to the RBC threshold level, that's one thing. But, if a company is way over the threshold and has the ability to take a long view, perhaps the factor might be a little too heavy. I think the investment department has its own views aside from what the NAIC might have. I'd be curious to know how and what other companies do in their investment departments.

Mr. Steven P. Miller: I work in the investment department at Mutual of Omaha. Whenever we talk about RBC or whenever my boss talks about RBC, he talks about "what those actuaries did to him." That might help in answering your question.

Do I think there's a penalty? There are some things in there that are very good. If anybody works in a derivative house, they love this stuff because they can find two things that are totally economically equal with totally different RBC requirements. For example, what if I hold a stock? Let's say I hold a Standard & Poor's 500 index fund, and I go into an over-the-counter call option or a put option on the S&P 500. In five years I have a 30% RBC factor multiplied by all those numbers, so I'm probably going to have RBC equal to 50% or so of my surplus. If I do the same thing in an equity-linked note, with exactly the same economics, I have a AAA bond. That is one of the major things that I think the investment department gets frustrated with in our company. However, I tend to agree, in most cases, that the relationships between a C-1, C-2, and C-3 bond are probably very good indications of the relationship with risk.

Mr. Cowell: I sense that investment departments look at these capital requirements as penalties rather than opportunities. I think it depends on where they're coming from. Certainly when we, on the Industry Advisory Committee, developed the numbers, we knew in advance that there was no one set of numbers that was going to be perfect. We were not trying to come up with the kind of precision that I think has been imputed to the process in the last three years. Our charge from Terry Lennon of the New York Department, who led the NAIC effort on the life and health side, almost became a mantra. The whole purpose of the process was to distinguish well-capitalized from poorly capitalized companies. But what has happened now is that people get very paranoid over minuscule differences in their NAIC ratios and particularly their S&P ratio or what they think their Best's ratio is. Since the C-1 risk ratio, for many companies, drives the process, these factors for the various investment classes are quite critical. One of the problems is that the whole process of insurance accounting and investment accounting for insurance, and this gets into the AVR and IMR as well, is in such need of an overhaul. Given what we

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