WHAT is risk-based capital (RBC)? On its website, the United States’s National Association of Insurance Commissioners (NAIC) defines it as “a method of measuring the minimum amount of capital appropriate for a reporting entity to support its overall business operations in consideration of its size and risk profile.”
“RBC limits the amount of risk a company can take. It requires a company with a higher amount of risk to hold a higher amount of capital. Capital provides a cushion to a company against insolvency. RBC is intended to be a minimum regulatory capital standard and not necessarily the full amount of capital that an insurer would want to hold to meet its safety and competitive objectives,” NAIC explains.
“In addition, RBC is not designed to be used as a standalone tool in determining financial solvency of an insurance company; rather, it is one of the tools that give regulators legal authority to take control of an insurance company,” it adds.
The first RBC regime was introduced by NAIC in 1992. It was the product of realization that simply requiring a fixed and specific amount to serve as an insurer’s capital was sorely insufficient. More precisely, it was a product of numerous crises—happening one after another—of insurance companies that were becoming insolvent. RBC is intended to improve risk management by ensuring the continuous solvency of a company. Thus, the higher the risks assumed, the higher the capital. Insurance liabilities can only be estimated; an inaccurate estimate exposes the company to higher risks.
Before 2006 the Philippine capital regime was totally based on a fixed- capital requirement. RBC, as the term might suggest, is the requirement of capital based on relevant risks that an insurance company might face. Through the issuance of a 2006 circular of the insurance commissioner (Circular 6-2006, October 5, 2006), RBC was formally adopted in the Philippines, ahead of Malaysia (2009), Thailand (2011) and Sri Lanka (2016).
Under this circular, risk is classified into four categories: asset-default risk, insurance-pricing risk, interest-rate risk and general-business risk. The impairment of capital is then measured on the basis of ratios, with 100 percent as the minimum RBC ratio. Depending on how impaired the capital is, or how low the RBC ratio goes, certain actions are authorized to be taken, the most extreme of which is a regulatory intervention by the Insurance Commission (IC). A specific formula is required in the computation of the RBC requirement.
Although the circular enumerates four general risks, there are, actually, other specific risks, such as credit risk, concentration (of assets) risk, market risk (reduction in market value), reinsurance risk (due to default of a reinsurer), catastrophe risk (occurrence of extreme events) and operational risk (losses due to internal processes).
There are various forms of RBC throughout the world. Unlike in the banking sector, where there is a global capital standard in the form of the Basel regime, there is none in the insurance sector.
The IC is in the process of improving its solvency regime, perhaps, something similar to the Solvency Modernization Initiative of NAIC in 2008. Under Section 194 of the Amended Insurance Code, “the commissioner may require the adoption of the risk-based capital approach and other internationally accepted forms of capital framework.”
A recent, significant development is the European Union’s issuance of a directive on insurance regulation to reduce the incidence of insolvency, called the Solvency II Directive. After much discussion, it is scheduled to take effect on January 1, 2016. This was issued in pursuit of a single European insurance market. The Solvency I Directive was issued in 1973. Solvency II is now being touted by some quarters as the Basel regulations for insurance companies. Basel, of course, refers to the capital-requirement rules for banks.
The components of Solvency II are not really new; the difference, perhaps, is that they have been enhanced considerably. These components, called framework pillars, are, essentially, currently in existence. Pillar 1, for example, provides for quantitative requirements, or the imposition of a specific capital requirement in monetary terms. Pillar 2 provides for good corporate governance and enterprise risk management. At present, the IC is adopting the Association of Southeast Asian Nations Corporate Governance Scorecard, as well as other good-governance practices, such as the requirement of an independent board of directors. And Pillar 3 provides for disclosure and transparency requirements. As it is now, there are numerous reportorial requirements for insurance companies, with some being required to be posted on their websites.
While the general traits of Solvency II are familiar, the details are new and even controversial, even among European
insurers. In Pillar 2, for example, one controversial aspect is the assessment of credit risk by private-rating agencies. This has been criticized as a yielding of regulatory authority in favor of the rating agencies. The impact of Solvency II, especially on European insurers with a commercial presence in the Philippines, remains to be seen.
Atty. Dennis B. Funa is the Insurance Commission’s deputy commissioner for legal services.