© 2012 the national association of insurance commissioners evolution of rbc system in the usa lou...

© 2012 The National Association of Insurance Commissioners

Evolution of RBC System in the USA

Lou Felice

1


Presentation Agenda

• Overview of Current RBC System• Milestones and Developments Since

the Launch of the RBC System• Key Areas and Challenges of Current

Reforms• Differences between RBC and

Solvency II in Terms of Capital Requirements

• RBC in Context of Group-wide Supervision

2


OVERVIEW OF CURRENT RBC SYSTEM

3


Current U.S. RBC – Framework / Structure

RBC Is Part of Regulatory Safety Net Licensing in Each State Restrictions on and Regulatory Approval

of Key Risk Transactions Statutory Accounting and Reporting, CPA

Audit and Actuarial Opinion RBC, Other Intervention Tools and

Financial Analysis Corporate Governance and ERM (ORSA) Risk-Focused Financial Examinations

4


US Solvency Framework Primary goal is to ensure financial health

of insurers for purposes of protecting policyholders Work with companies to remedy areas of concern More severe interventions if company continues to deteriorate

e.g. regulators will run off or liquidate the insurer if necessary to ensure protection of existing policyholders

Provide a consistently applied set of standards

Additional goals include availability and affordability of insurance, stable and competitive markets

5


Current RBC Formula Regulatory Purpose / Use Rules Based, Formulaic / Factor Driven

Some company results adjust factors for Life Some modeling used for interest rate and market risk Industry Averages used for some risks

Reflects Unique Risks Inherent in Operating an Insurance Company (Compared to Banks, etc.)

Reflects Risk profile of Company Type (Life v. P&C) and Specific Company (e.g. Investment Strategy and Insurance Lines of Business)

Not All Risks Are Accounted for; Material Risks by Industry

Provides Regulatory Authority for Timely Action

6


Overview of NAIC RBC Formulas

Formula vs. Full Modeling Approach Signaling Mechanism between

Regulators and Insurers to Identify Poorly Capitalized Companies (Different Levels) Unlike Banking RBC that also Has:

• “Well Capitalized”• “Adequately Capitalized”

7


NAIC RBC System

• Four formulas: • Life, Fraternal (copy of Life), P & C, and Health

• NAIC Risk-Based Capital for Insurers Model Act serves as a guide

• RBC law adopted in each state makes the system operational and consistently applied

• RBC Law incorporates the formulas by reference so Law need not be changed when formula changes

• NAIC produces the RBC formulas but the content is maintained and modified by State regulators

8


Overview of Formula Construction

Generic Component Information Asset Risk – Affiliated Investment Risk Asset Risk – Default Risk / Market Risk Asset Risk – Credit / Other Underwriting/Insurance Risk Other Types of Risk (Varies by Formula)

• Business Risk (Life & Health)• Interest Rate Risk (Life)

9


Overview of Formula Construction (Cont.)

Asset Risk – Investments Bonds = Default on Principal and/or Interest Preferred Stock = Default and Past

Dividends Common Stock = Decrease in Fair Value Mortgages = Default on Principal and/or

Interest Real Estate = Decrease in Fair Value Schedule BA Assets = Risk Similar to

Underlying Characteristics10



Asset Risk – Receivables (Credit Risk) Risk of Non-Recovery of Receivable

Amounts

Asset Risk – Other Investment Concentration Risk = Additional

Risk of High Concentrations in Single Exposures

11



Underwriting/Insurance Risk

Reserve Risk = Obligations from Past Business Are Understated (Underestimated Reserves)

Premium Sufficiency Risk = Premiums Are Inadequate to Cover Claims and Expenses for Policies Written (Under-Priced)

12



Other Types of Risk (Varies by Formula) Business Risk (Life and Health) =

Primarily Litigation and Guaranty Fund Risk Life Formula Adds a Risk Charge for Separate Account Reserves P&C and Health Formulas Add Growth Risk

Interest Rate Risk/Market Risk (Life) = Risk of Losses Due to Changes or Mismatch in Interest Rate

Levels (See Presentation Section on C-3 Interest Rate Risk) Risk of market fluctuation in asset values vs. liability cash flows

13



Detail in the Formulas was Developed to Focus on the Areas of Most Material Risk for Each Formula

• Life – Asset Risks• P&C – Underwriting Risks (Pricing and

Reserving)

14


Life Industry Distribution of Risk Components

Life RBC Components:• C-0 Asset Risk - Affiliates 15%• C-1cs Asset Risk - Common Stock 16%• C-1o Asset Risk - All Other 33%• C-2 Insurance Risk 18%• C-3a Interest Rate & Market Risk 10%• C-3b Health Credit Risk 0%• C-3c Market Risk 2%• C-4a Business Risk 5%• C-4b Business Risk Admin. Expenses 1%

15


P/C Industry Distribution of Risk Components

Property/Casualty RBC Components:

• R0 – Asset Risk Affiliated Insurance 15%Company Assets

• R1 – Asset Risk Fixed Income Investments 2%• R2 – Asset Risk Equity Investments 25%• R3 – Credit Risk 5%• R4 – U/W Risk Reserve 34%• R5 – U/W Net Premiums Written 19%

16



Health RBC Components:• H0 = Asset Risk – Affiliated Company Investments 11%

• H1 = Asset Risk – Other Invested Assets 15%

• H2 = Insurance/Underwriting Risk 60%

• H3 = Credit Risk 4%

• H4 = Business Risk 10%

17


How Does the Formula Work? Data Sources and Calculation

Financial Amounts: Automated Data Pulls from the Statutory Annual Statement Manual Data Entry from Company Records

Multiplied by Risk Factors Equals Risk Charges Covariance Calculation Groups Correlated Risk Charges into Same

Component Recognizing Independence vs. Correlation of the Risks

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Covariance Calculation (Continued): Square Root of Sum of Component

Amounts Squared = Adjustment to Reflect the Remote Likelihood of Losses from Multiple Formula Components Occurring Simultaneously (Uncorrelated)

Combination of Risks < Sum of Each Component Risk

19



Covariance Calculation:Life RBC

Property/Casualty RBC

Health RBC

(C1o+C3a)2+(C1cs+C3c)2+(C2)2+(C3b)2+(C4b)2

C0+ C4a+

R0 + (R1)2+(R2)2+(R3)2+(R4)2+(R5)2

H0 + (H1)2+(H2)2+(H3)2+(H4)2

20


How Does the Formula Work?The Ratio and Action Levels

The RBC formula calculates Total Adjusted Capital (Capital and Surplus from the Statutory Balance Sheet Adjusted for Certain Items)

The RBC formula also calculates a minimum capital level (Authorized Control Level RBC)

The other Action and Control Levels are calculated from the ACL RBC: Company Action Level = 200% of ACL Regulatory Action Level = 150% of ACL Authorized Control Level (ACL) = 100% ACL Mandatory Control Level = 70% of ACL 21



Total Adjusted Capital (TAC): Capital & Surplus from Liabilities Page Adjustments

AVR (Life and Life Subs) Dividends (Life & Life Subs) Hedging Credit (Life) Non-US Insurance Subsidiaries (Life) Non-tabular Discount (P/C & P/C Subs) Tabular Discount (P/C & P/C Subs) Credit for Capital Notes (Subject to a Limit)

= Official TAC

22



Total Adjusted Capital (Continued): Tax Sensitivity Total Adjusted Capital

Total Adjusted Capital + Additional Adjustments DTA, DTL Subsidiary DTA, DTL

= FYI TAC

Additional Sensitivity Tests Remove Surplus Notes Additional Charge for Off-Balance Sheet Items

23



Action/Control Levels:

Authorized Control Level RBC (ACL RBC)= 50% of Calculation after Covariance• Company Action Level

= 200% of ACL RBC• Regulatory Action Level

= 150% of ACL RBC• Authorized Control Level RBC• Mandatory Control Level

= 70% of ACL RBC24



Comparison of Total Adjusted Capital (TAC) to Action Levels:

“Official” TAC, NOT (Tax) Sensitivity TAC Level of Action Indicators

None Company Action Level Regulatory Action Level Authorized Control Level Mandatory Control Level

RBC Ratio = TAC/ACL RBC

25


Overview of RBC Model Laws

Section 3 - Company Action Level Event:

• TAC >= Regulatory Action Level RBC but• TAC < Company Action Level RBC OR• Trend Test Triggered

= • Insurer Submits RBC Plan to Commissioner

26


Overview of RBC Model Laws (Cont.)RBC Plan:

• Identify Conditions• Proposed Corrective Actions• Current + 4 Year Financial Projections• Key Assumptions for Projections• Quality of & Problems with Insurer’s Business• Submitted within 45 Days of Company Action

Level Event

Commissioner Response to RBC Plan (60 Days):• Plan to be Implemented, or• Unsatisfactory (Revised RBC Plan or Reg. A.L.

Event)27


Overview of RBC Model Laws (Cont.)

Section 4 - Regulatory Action Level Event: TAC >= Authorized Control Level RBC but TAC < Regulatory Action Level RBC

= RBC Plan (within 45 days) to Commissioner AND Commissioner Examination or Analysis AND Commissioner’s Order for Corrective Actions AND Experts to Review RBC Plan at Insurer’s Expense

28


Overview of RBC Model Laws (Cont.)

Section 5 - Authorized Control Level Event: TAC >= Mandatory Control Level RBC but TAC < Authorized Control Level RBC

= RBC Plan (within 45 days) to Commissioner AND Commissioner Examination or Analysis AND Commissioner’s Order for Corrective Actions AND Experts to Review RBC Plan at Insurer’s Expense

OR Place Company under “Regulatory Control”

29


Overview of RBC Model Laws (Cont.)Section 6 - Mandatory Control Level Event:

• TAC < Mandatory Control Level RBC=• Place Company under “Regulatory Control”

Section 7 – Hearings (Insurer’s Right to Challenge)• Adjusted RBC Report• Unsatisfactory RBC Plan or Revised RBC Plan

that Resulted in a Regulatory Action Level Event• Notice of Failure to Adhere to RBC (or Revised)

Plan with Substantial Effect on Company Action Level Event

• Corrective Order from Commissioner 30


MILESTONES AND DEVELOPMENTS SINCE LAUNCH OF RBC SYSTEM

31


Milestones and Development

• Formula Implementation 1993 = Life RBC Formula 1994 = P/C RBC Formula 1998 = Health RBC Formula

• Sensitivity Tests Expanded over Time• C-3, Phase II Project for Life RBC

Incorporated stochastic modeling into the Risk Charge for Annuities

• Trend Tests32



Sensitivity Tests Expanded over Time Increases RBC risk charges for affiliated

investments, restricted assets, contingent liabilities and guarantees, and long-term leases

Added tax sensitivity adjustment to TAC Back out Deferred Tax Assets (DTAs) Add back Deferred Tax Liabilities (DTLs) Same adjustments for subsidiary amounts

33



Trend Tests Life RBC

TAC > 200% ACL and < 300% ACL; AND Trending downward for prior 2 years (e.g., 1st

prior year 270% and 3rd prior year 230%) P/C RBC

TAC > 200% ACL and < 300% ACL; AND Combined Ratio > 120%

Health RBC TAC > 200% ACL and < 300% ACL; AND Combined Ratio > 105%

34


KEY AREAS AND CHALLENGES OF CURRENT REFORMS

35


Challenges and Current Reforms

• Incorporating Catastrophe Risk Charge

• Considering Calibration of Formulas

• Assessing Asset Risk Charges

• Assessing Underwriting charges (P&C)

• How to Incorporate Operational Risk

• Role of Scenario Testing (Stress Testing)36


DIFFERENCES BETWEEN RBC AND SOLVENCY II CAPITAL

REQUIREMENTS

37


Differences between RBC and Solvency II

Accounting Differences SII market consistent balance sheet gives a going

concern view of solvency position US statutory balance sheet gives more of a winding

up basis Capital Requirement Calculation Differences

SII uses independent MCR and SCR calculations for an insurer

RBC uses a single formula for a specific insurer to generate 4 action/control levels

38


Differences between RBC and Solvency II (cont.)

Capital Requirement Calculation Differences (cont.)

RBC uses separate formulas by industry type – life (& fraternal), property/casualty, health

SII SCR is a single formula with sub-components utilized based upon insurer type

39



Capital Requirement Calculation Differences (cont.)

RBC is not based on an overarching calibration target; only specific calibration at individual risks level

SII SCR is calibrated to an overall value at risk with a confidence level of 99.5%

RBC covers a specified list of material risks at the industry level

SII SCR takes into account all quantifiable risks, while the MCR is a linear formula based on a set of risk factors applied to individual company liabilities 40



Use of Internal Models Life RBC allows some risk factors to be modified by

insurer/industry experience; partial models are currently limited to life/ annuity products with guarantees subject to interest rate/market fluctuation risks Models are not approved, but regulators set prescribed

statistical parameters and time horizons and may apply a standard model that acts as a floor on capital

SII MCR requires a standardized approach, but insurers can choose between the standard approach or the use of an internal model for either specific risk modules or for all its risks for SCR

41



Use of the Capital Requirement RBC has some influence on insurers’ risk

management (e.g. Reserves reduced for reinsurance, but not for collateral); addressed mainly through other supervisory tools

SII is designed to provide incentives for risk management

Capital add on may be required by regulator, but it is not part of the RBC capital amount

SII capital add on increases SCR

42



Use of the Capital Requirement in the U.S. Other oversight tools are used with RBC

Many prioritization and analysis tools focus on specific activities within the insurer; these are addressed to prevent a future capital problem

Hazardous Financial Condition Regulation in addition to RBC Specific Legal Action

For example, a company with 1000% RBC ratio could still trigger a Hazardous Financial Condition trigger by having a large drop in surplus

43



Own Risk & Solvency Assessment (ORSA) US – exemption for insurers under $500 million in

premiums (commissioner can still require) SII – required of all insurers and groups US – legal requirement tied to analysis and

regulatory oversight with more discretion left to the company to determine/justify risk assumption and mitigation methods

SII – more prescriptive legal requirement linking risk and capital management (including how the risk profile deviates from SCR assumptions)

44


RBC IN CONTEXT OF GROUP-WIDE SUPERVISION

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RBC and Group-Wide Supervision

RBC assesses risk charges on each legal entity insurer for ownership of parent, subsidiaries and affiliates; but it does not establish specific capital requirements for non-insurance entities

RBC aggregation does not recognize diversification benefits, but those benefits tend to disappear when groups are stressed

US system focuses on understanding the risks outside of the insurance entities and how they may impact the insurers

46



US does not support a consolidated approach to a group capital calculation How do you construct a reasonably accurate group

capital requirement that works for the many different group structures, types of businesses included, differing legal system requirements, etc.?

Where does the group capital reside and how is the priority of distribution established in a liquidation when it resides at the holding company (and issues of fungibility)?

47



US does support a legal entity based approach to assessing group capital which includes and understanding and assessment of group-wide risks that may adversely impact the legal entities as a result of group-wide activities occurring outside of the legal entities but within the broader group Perhaps use simple but effective ratios and scenario

(stress) tests to perform group capital assessments US system will use ORSA Summary Reports to see

the group’s material risks (including in stressed environment) and how the capital objective is structured to account for those risks (including in stressed environment) 48


Questions???

49


Reserves- P/C- Life

ASSAL – November 2012

Lou Felice

50


Property and Casualty Reserves

51


SSAP No. 55—Unpaid Claims, Losses and Loss Adjustments Expenses

Claims, losses, and loss/claim adjustment expenses shall be recognized as expense when a covered or insured event occurs.

A covered or insured event: Occurrence

The occurrence of an incident which gives rise to a claim or the incurring of costs.

Claims Made Reporting to the entity of the incident that gives rise to a claim.

52


Insurance Data Organization

Accident Date• The date on which the loss occurred.

Report Date• The date on which the loss is first reported to the

insurer.

Recorded Date• The date on which the loss is first entered into the statistical

records of the insurer.

53


Who Sets the Reserves?

Case Reserves: Claims Representatives IBNR/Bulk: Actuaries & Company Management

SSAP 55: “Management’s Best Estimate” By line of business and in Aggregate Reserve will NOT be accurate with certainty. All reasonable outcomes to be considered – not all possible

outcomes If all points within a range are probable (RARE), record the midpoint.

54


Management’s Best Estimate

"Management's best estimate" is the value of the ultimate settlement amount, undiscounted except for some small amounts of fixed and reasonably determinable claim values that can be discounted. It can be viewed that margin exists equal to the difference in the best estimate reserve and a discounted reserve, but there is not to be conservatism in the estimate. Financial reporting in Schedule P via loss development triangles provides a means to test for implicit margins/conservatism in a company's reserves, showing development in accident year incurred values.

55


What Costs are Considered?

Generally, the amount necessary to settle unpaid claims…

SSAP 55: Reported losses Incurred but not reported claims (IBNR)

Can include “Development on Known Claims” Loss adjustment expenses

Defense and Cost Containment (DCC) Adjusting and Other (AO)

56


Loss Adjustment Expenses (LAE)

DCC Defense, Litigation, Medical Cost Containment Cost of Experts …(potentially testify in court) In DEFENSE of Claim:

Private investigators, appraisers Attorney Fees – (Duty to Defend)

AO: All other LAE Claim Adjusters In Determination of Coverage:

Private investigators, appraisers Attorney Fees – (Litigation in determining coverage)

57


How Are Reserves Estimated?

SSAP 55 Loss Reserve Projections by line of

business Not Just for Company in TOTAL…it’s by line

Results of More than One Method Should be Considered

58


How Are Reserves Estimated?Loss Development Analysis: Triangle

Accident Year

Cumulative Paid Losses at Age

Estimated

Ultimate12 24 36 48

2002 100 200 300 300 Predict $300 each year

2003 100 200 300

2004 100 200

2005 100

Loss Development = Change in Loss Over Time

59


How Are Reserves Estimated?Are They Right?

Compare:Indicated Reserve: Actuarial EstimateCarried Reserve: Amount on the Books

Are They Adequate or Inadequate?

Same as…Are They Redundant or Deficient?

60


Salvage and Subrogation

Salvage: Car value when it’s totaled.Subrogation: Paid claim but reimbursed by at-fault person.

Received: Adjust Paid Losses for amounts received.

Anticipated: If choose to anticipate recoverables, then estimate & deduct from the liability for unpaid claims or losses. (Required to maintain data & perform actuarial tests to support reasonableness.)

61


Discounting

Time Value of Money No discounting, unless authorized

See SSAP 54 and 65

Fixed and reasonably determinable payments

(Issue Paper No. 65)Example: Workers compensation

Tabular indemnity reserves Long-term disability claims

62


Catastrophe Reserves

Catastrophe Loss Reserves Are established only AFTER a

catastrophe has occurred

Any reserves for the “Potential for a CAT” are Special Surplus FundsTorna

do

Wind

Earthquake

Hail

63


Actuarial Opinion

In the Statement of Actuarial Opinion, the Appointed Actuary must address the risk of material adverse deviation. This gives the regulators better knowledge of the possibility for unfavorable reserve development impacting the solvency of a company. What does (or could) impact the management best estimate is the actuary's best estimate and/or range of estimates in the Actuarial Opinion Summary. Significant difference between the actuary's and the management's estimates leads to regulator/management discussion, so management is often significantly influenced by the actuary's best estimate.

64


Life Insurance Reserves

65


Life Insurance Policy Reserves• Excess of the present value of future

benefits over the present value of future net premiums1. Based on an interest rate – minimum

determined annually (largely set by regulation)

2. Based on a mortality table – changed every 10 – 15 years

3. Cash value floor

4. Zero Lapses in calculation

66



• Determination of future benefits1. Face amount

2. Indexed (Cost of Living)

3. Universal / Variable Life

67



• Net premiums1. Based on the interest and mortality of the

reserve2. Level percentage of the guaranteed

gross premiums3. Other patterns

• Net level premium reserves (NLP)• Commissioners Reserve Valuation Method (CRVM)• CRVM graded to NLP

4. May limit period of insurance

68



• Deficiency Reserves1. Present value of the excess of net

premiums over guaranteed gross premiums

2. 1976 – Difference between actual reserve and minimum reserve based on maximum interest rate and specified mortality table

3. 1990’s – Allowed to modify specified mortality with actuarial certification

69


Deferred Annuity Reserves

• The greatest present value of all possible future guaranteed benefits streams over future considerations. (CARVM) – discount at interest only.1. Surrenders

2. Partial Withdrawals

3. Annuitizations

4. Death Benefits

70


Heath Reserves

• Contract Reserves Similar to Life• Claims Reserves Similar to P&C

71


U.S. SolvencyModernization Initiative

Principle-Based Reserving

72


Why is it needed? Good public policy

• Requires understanding of the real economic condition of the company. • Improves the price of products to consumers

Eliminate flaws in current methodology• Eliminates need to constantly develop new rules• Focused on “what could happen” instead of “what happened”

International• More consistent with international reserving initiatives and accounting if

the NAIC moves in that direction.• Allows U.S. to compete in the global insurance market

Principles-Based Valuation Project

73


SVL PBR Requirements Include:

• Quantification of benefits, guarantees, and funding at a level of conservatism for unfavorable events that have a reasonable probability of occurring.

• Quantification of significant tail risk.• Assumptions, risk analysis, financial models, and

management techniques consistent with company’s overall risk assessment process.

• Provide margins for uncertainty such that the greater the uncertainty the larger the margin.

• Prescribed formulaic component may be included.

74


Life PBR Requirements in VM• Found in VM-20• Life PBR Scope:

– Variable and Non-Variable Individual Life Contracts Issued on and after the Operative Date of the Valuation Manual

– Option Provided to Use Three Year Transition Period.– Excludes Preneed and Credit Life Products.

• VM-20 PBR is the greatest of three reserves*:– Net Premium Reserve (NPR) – prescribed formulaic– Deterministic Reserve (DR) – single economic scenario– Stochastic Reserve (SR) – multiple economic scenarios

* Exemption criteria apply depending on product. Product may be exempted from SR or both DR & SR.

75


Net Premium Reserve (NPR)• A non-PBR prospective calculation • Intended to be a floor for the PBR reserve• May ultimately be the basis for the tax reserve• NPR is developed for Term• NPR revisions for Universal Life with secondary

guarantees currently in discussion.• NPR is not developed yet for other products and

would default to current reserve requirements until developed.

• ACLI will work to develop NPR for other products.

76


Deterministic Reserve (DR) A PBR reserve calculation which models

cash flows over a single economic scenario. Cash flows include projected benefits,

expenses, premiums and related amounts. Assume you have blocks of business which

can be modeled together ( i.e. – only one “model segment”)

The Deterministic Reserve is the present value of the projected benefits, expenses, and related amounts less the present value of the projected premiums and related amounts. 77


Stochastic Reserve (SR)

A PBR reserve which models cash flows using stochastically generated economic scenarios.

Assume you have blocks of business which can be modeled together (i.e. – only one “model segment”)

For each economic scenario starting assets (& reinvestment assets) are projected and increased/reduced at each future year by the projected the cash flows to find any future deficits.

The largest present value of a future deficit is added to starting assets to produce a reserve for that economic scenario.

Calculate the average of the largest 30% of the economic scenario reserves (referred to as the 70th percentile Conditional Tail Expectation or CTE 70).

SR = CTE 70 + any additional amount for material risk not reflected.

78


PBR – Transition & Exclusions

Transition period from VM operative date Provides up to 3 years to apply VM-20 PBR Must continue to apply VM-20 once elected Current requirements apply during use of 3 year transition.

Products not subject to VM-20 continue with current requirements. Includes Preneed life and Credit life insurance.

Products subject to VM-20 can be excluded from the rigor of PBR requirements via exclusion tests. Stochastic & Deterministic exclusion tests.

79


Stochastic Reserve Exclusion Tests

Products can be excluded from stochastic reserves if:

• Certification provided by qualified actuary of no material interest rate risk or asset return volatility risk; or Does not apply to certain products such as universal life with

secondary guarantees.

• Stochastic exclusion ratio test is passed; or• Demonstration provided that reserves will not increase

under stochastic requirements.

80


Deterministic Reserve Exclusion Test

• Products can be excluded from the deterministic reserve requirements if the sum of net valuation premiums are less than the sum of the corresponding guaranteed gross premiums.

• This exclusion test cannot be used for: Products which are required to calculate the stochastic reserve. Universal life products with a secondary guarantee.

81


Exemption - Doing Business Only in One State

• The SVL provides an option the Commissioner may consider during legislative adoption to exempt specified products of a domestic company that does business only in that state from the requirements of the Valuation Manual.

• Any products exempted will apply current reserve requirements in addition to any requirements established by the commissioner by regulation.

82


Questions?

83

© 2012 the national association of insurance commissioners evolution of rbc system in the usa lou...

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