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Risk-Based Capital Formulas
Blank
Risk-Based Capital formulas are used by:
 Regulators
 Rating agencies
 Ins Cpys, to allocate capital between lines; to assess financial performance.
How the NAIC Health RBC Model Act Works
Ratio of Total Adjusted Capital to Authorized Control Level capital Regulatory Action
> 2.0 none
1.5 – 2.0 Company Action (corrective plan)
1.0 – 1.5 Regulatory Action
0.7 – 1.0 Authorized Control by Commissioner
< 0.7 Mandatory Seizure of Control
But, the Model Acts do not specify what RBC formulas to use.
THE HEALTH RBC FORMULA
A Health Ins Cpy’s RBC depends on its:
 Assets (amounts; types)
 Products
 Provider reimbursement methods
 Reinsurance use
the Health Risk-Based Capital, Adjusted for Covariance, is
RBCAC = H¬¬0 + {H¬¬12 + H¬¬22 + H¬¬32 + H¬¬42}1/2

where:
H0 = Asset Risk of Affiliates
H1 = Asset Risk from other assets
H2 = Underwriting Risk
H3 = Credit Risk
H4 = Business Risk

The risks H1 through H4 are independent.
THE COMPONENTS OF HEALTH RBCAC
Each subcomponent is a dollar amount times a risk factor (often capped)

H0 – Asset Risk of Affiliates
 The risk that an affiliated company will lose value.

Subcomponents:
 affiliates subject to RBC
 affiliates not subject to RBC
 Off Balance-Sheet Items

Calculation of the Subcomponents:
 H0: of an affiliate subject to RBC = (Affiliate’s RBCAC) * (% ownership)
 H0: of an affiliate not subject to RBC = (Affiliate’s Book Value) * 30%
 H0: off balance-sheet items = (Book Value of the item) * 1%
H1 – Asset Risk (other assets)
 Risk inherent in stocks, bonds, and fixed assets:
 Asset risk
 Asset Concentration Risk
 H1: of an investment or fixed asset = (Book Value of the held asset) * (Risk Factor)
 The risk factor reflects the safety / riskiness of the investment:
 gov’t bonds safest; junk bonds riskiest
 stock varies
 property/equipment
H2 – Underwriting Risk
 Risk of premium inadequacy.

H2 has the following subcomponents:
 Claim Experience Fluctuation Risk
 for Medical coverage
 for DI, LTC, and Other coverages
 Rate Guarantees


Calculation of the Subcomponents:
 H2: Claim experience for medical insurance
= MAX {Net Alternative Risk Charge,
(Revenue * Loss Ratio * risk factor * (1 – MC discount factor) }*
* Note the error in the textbook.
where:
 Net Alternative Risk Charge equals 2 * highest NAR
 risk factor is based on tiered revenue.

See numerical example in chapter notes

 Managed Care discount factor is highest for capitations and other structured reimbursements; 0 for Ffs.

 H2: Rate Guarantees = (yearly earned premium) * (rate guarantee risk factor)
– (premium stabilization reserve) * (50%)
 H2: Disability and Long Term Care;
 H2: Other coverage types
 Both computed using a “tiered premium” method
H3 – Credit Risk
 The risk of not recovering money or service that is owed.

Source of Risk Major Risk Amount at Risk Risk factor
Reinsurance Ceded default risk Value of the recoverables 0.5%
Capitation Providers may quit the contract One year of capitation income 2%-4%
Other Receivables (premiums, etc.) Credit Risk Value of the receivables 5%
H4 – Business Risk
 The risk that administrative expenses will be higher than expected. And the risk that the RBC will grow too much.

Subcomponents:
 H4: administrative expenses for underwritten business
 H4: administrative expenses for nonunderwritten business (ASO business)
 H4: excessive risk-level growth
 happens if the ins cpy changes to riskier mix of business

Calculation of the Subcomponents:
 H4: administrative expenses for underwritten business
= (expenses on first $25 million of premiums) * 7%
+ (expenses on remaining premium) * 4%

 H4: administrative expenses for ASO business = (claim & admin expenses) * (1% or 2%)
 H4: excessive risk-level growth = (Excessive Growth in RBC) * 50%
DEVELOPMENT OF AN RBC FORMULA
“Describe the methods and considerations you’d use in developing an RBC formula.”
Answer:
1. Consider the risks the product is subject to:
 Catastrophic claims
 Statistical fluctuation
 Misestimation of trends; pricing errors
 Length of time needed to notice and correct pricing errors

2. Use a Ruin Theory model:
 Determine amounts of capital (H0, H1, etc.) so there is a 95% probability of remaining solvent for 5 years.

3. Make the formula easy to adopt into State Regulations
Characteristics of a Good RBC Formula:
 Simple
 Data it uses must be easily available
 Limited Scope
 Takes into account industry’s input.


Done.