PROPERTY-CASUALTY RISK-BASED CAPITAL REQUIREMENT-A ...

PROPERTY-CASUALTY

RISK-BASED CAPITAL

REQUIREMENT-A

CONCEPTUAL FRAMEWORK

Actuarial Advisory Committee to the NAIC Property & Casualty Risk-Based Capital Working Group

PROPERTY-CASUAL,TY RISK-BASED CAPITAL REQUIREMEIVT A CONCEFI'UAL FRAMEWORK

Prepared by the Actuarial Advisory Committee to the NAIC Property & Casualty Risk-Based Capital Working Group

Actuarial Advisory Committee Members

David G. Hartman, Chairman Paul Braithwaite Robert P. Butsic Sholom Feldblum Walter J. Fitzgibbon, Jr. David P. Fly~

Patricia A. Furst Man M. Kaufman Stephen P. Lowe Daniel K. Lyons Michael G. McCarter Dale A. Nelson

February, 1992

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PROPERTY-CASUALTY RISK-BASED CAPITAL REQUIREMENT

A CONCEPTUAL FRAMEWORK

FOREWORD

This paper develops a conceptual framework for a risk-based capital requirement for property-casualty insurance companies. It has been written to assistthe National Association of Insurance Commissioners (NAIC) asthey work on developing appropriate risk measurements in the context of a series of initiatives designed to improve solvency regulation. We believe the NAIC will find this paper useful.

Risk-basedcapital is the theoretical amount of capital neededto absorb the risks involved in the operation of a business. Different companies face different risks and, therefore, should have different levels of capital based on those different risks, rather than on some arbitrary basis. The major areas of risk facing a property-casualty insurance company include asset risk, reserve risk, pricing risk and credit risk.

State regulators of property-casualty insurance companies have had two tools with which to monitor required capital. One is a statutory minimum capital and surplus requirement which has been characterized as unrealistic and archaic, and the other is a premium-to-surplus rule-of-thumb, which does not effectively reflect relative riskiness. Many regulators feel they lack the statutory authority to require a company to increase their capital until the company's surplus falls below the statutory minimum. A risk-based capital requirement would help raise that safety net up off the floor and could apply uniformly in all states as a threshold capital requirement.

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Table of Contents

I. Statementof purpose of a risk-based capital requirement for property-casualty companies

II. Historical perspective of risk-based capital III. Bank/thrift comparisons to insurance IV. Underlying principles V. Discussion of risk and risk-based capital VI. Elements of risk for property-casualty insurance companies VII. SAP, GAAP and risk-based capital VIII. Ramifications of the level of a risk-based capital requirement

Appendices Current minimum capital and surplus requirements Risk-based capital requirements in the banking industry Testing the formula Statementof Principles Regarding Property and Casualty Valuations Performing Cash Flow Testing for Insurers Using the expected policyholder deficit risk measure to determine risk-based capital factors Canadian Annual Statement- minimum assettest

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