Risk Based Capital : As it applies to life insurers in the US
Is RBC applicable to Indian Life Insurance Companies?
Although, as of this writing (August 2023), Risk Based Capital (RBC) is not yet applicable to Indian life insurers, IRDAI is collecting data from Indian insurers (via QIS1), and making a concerted effort towards implementing RBC in India.
What is RBC and how does it work?
Risk Based Capital simply represents an expected dollar amount of loss that the insurer may suffer due to asset risk (defaults), insurance risk (underwriting losses), interest rate risk (asset-liability mismatch) and other operational risks. The credit risk within the asset portfolio, i.e., risk of default of corporate bonds and loans, is the primary driver of RBC for a life insurer, provided that the insurer is solvent and is operating normally.
Risk Based Capital = Book value x RBC Factor
Let us assume that an insurer holds 100 different high-quality investment-grade bonds (from 100 issuers) each worth Rs. 1 crore book value, and the RBC factor is 1.5%. In that case, the expected loss from defaults can be approximated to be around Rs. 1.5 crores (total). RBC = Rs. 100 crores X 1.5% = Rs. 1.5 crores. So, the RBC for this portfolio is Rs. 1.5 crores.
As is evident, RBC is a formula-based approach where RBC factors play a key role. RBC factors increase with increasing asset concentration (opposite of diversification). The RBC factors are calculated using cash flow analysis and historical default rates. The exact methodology and parameters of calculation (percentile risk, time horizon, size of portfolio, covariance adjustments, etc.) are determined by experts.
RBC factors
How many different RBC factors are available?
Using cash flow testing devised by experts, RBC factors have been determined for most asset classes – such as for different grades of bonds and most types of asset-backed loans, including mortgages, preferred and common stocks, etc. RBC factors are regularly updated. The higher the default risk, the higher will be the RBC factor. For instance, a home loan in good standing may have an RBC factor of just 0.14%, while a defaulted farm loan (non-performing asset) may have an RBC factor of 20%. RBC factors have also been determined for other sources of risk besides asset risk, such as insurance (underwriting) risk (~0.2%), interest rate and market risks (~ 1%-3%), and other business risks (~3%). The RBC factors for the assets are much higher in comparison to these other risks, hence asset portfolio drives much of the RBC calculation.
By applying the prescribed RBC formula to the asset book value and business details, and using the updated RBC factors, RBC calculation becomes (somewhat) straightforward.
Consequences : Regulatory Action
What could happen if the life insurance company’s surplus falls below the prescribed level of RBC?
A life insurer in the US is expected to hold an amount of capital greater than 3 x RBC. If the capital falls below 1.5 x RBC, the regulator will take action. Once RBC is implemented in India, we expect such a situation (of surplus falling below a threshold level of RBC) to automatically trigger a set of interventional events to be overseen by IRDAI.
How can an insurer decrease its RBC requirement?
An insurer can either raise capital or reduce its RBC requirement. It can a) reduce asset risk by replacing low-grade bonds with high-grade (less risky) bonds; b) raise capital by issuing stocks; c) free-up reserves by reinsuring policies; d) redesign policies in order to have lower RBC requirement.
Here at Annuity Risk, we are ready to assist you with assessing the impact of RBC implementation and making all preparations for its future implementation.
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Copyright © 2023 Annuity Risk India Pvt. Ltd.