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18 Cards in this Set

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Risk-Based Capital formulas are used by:
 Regulators, to set minimum capital requirements and determine when to take regulatory action;
 Rating agencies, to assess an Ins Cpy’s financial strength;
 Ins Cpys themselves, to allocate capital between product lines, and to assess financial performance.
THE NAIC’S RISK-BASED CAPITAL MODEL ACTS
A model act is a suggested set of laws that States may wish to adopt. If all the states adopt the model act, then the insurance regulations will be consistent in every state.

There is a different “RBC model act” for each branch of insurance (Health, Life, P/C). This chapter focuses on the Health Insurance RBC formula.
How the NAIC Health Model Act Works
 The authorized control level (ACL) is the level of capital that is so low that regulators are authorized to seize control of the company. The ACL is defined as 50% of the company’s required risk-based capital.
 Compare the Ins Cpy’s Total Adjusted Capital (TAC) with the company’s ACL.
So, if TAC / ACL = 2.0, then the company has capital exactly equal to its RBC.
 If the ratio is too low, disciplinary action must be taken.

Ratio of TAC / ACL Capital Regulatory Action
> 2.0 None. The company has at least the required amount of capital.
1.5 – 2.0 Company Action. The company must submit a corrective action plan to the Commissioner.
1.0 – 1.5 Regulatory Action. The company must submit a corrective plan, and the Commissioner may order specific corrective actions.
0.7 – 1.0 Authorized Control. That is, the Commissioner may seize control of the company.
< 0.7 Mandatory Control. The Commissioner must seize control.


But, the Model Acts do not specify what RBC formulas to use.
 The NAIC suggests formulas, but the states don’t need to adopt those particular formulas.
 The NAIC revises its suggested formulas periodically.
A Health Ins Cpy’s RBC depends on:
 the amounts and types of assets held
 the amounts and types of products sold
 provider reimbursement methods
 reinsurance use
Health Risk-Based Capital, Adjusted for Covariance is
RBCAC = H¬¬0 + {H¬¬12 + H¬¬22 + H¬¬32 + H¬¬42}1/2

where the H’s refer to capital needed to cover different risks:
H0 = Asset Risk of Affiliates
H1 = Asset Risk from other assets
H2 = Underwriting Risk
H3 = Credit Risk
H4 = Business Risk

“Adjusted for covariance” means that we assume the risks H1 through H4 are independent. It is unlikely that two different risk-related losses will occur at the same time. Accordingly, the quantity {H¬¬12 + H¬¬22 + H¬¬32 + H¬¬42}1/2 is smaller than the simple sum H1 + H2 + H3 + H4.
THE COMPONENTS OF HEALTH RBCAC
The capital amounts H0, H1, H2, H3, and H4 each consist of several subcomponents. Each subcomponent is expressed as a dollar amount times a risk factor. (This product is often capped at a certain maximum.)
H0 – Asset Risk of Affiliates
This is the risk that an affiliated company (subsidiary, partner, parent company) will lose value.


H0 has the following subcomponents:
 Asset Risk of affiliates that are subject to RBC (owned subsidiaries)
 Asset Risk of affiliates that are not subject to RBC (investments in the parent cpy)
 Off Balance-Sheet Items

Calculation of the Subcomponents:
 H0: of an affiliate subject to RBC = (Affiliate’s RBCAC) * (% ownership)
Note that this is a dollar amount times a risk factor — in this case, the risk factor is the level at which the Ins Cpy owns the affiliate.

 If several subsidiaries are partially owned, add up the H0’s for each.
 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)
This is the risk inherent in stocks, bonds, and other securities and fixed assets that the Insurance Company owns.

H1 has the following subcomponents:
 Asset risk for each investment
 Asset Concentration Risk

Calculation of the Subcomponents:
 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, as follows:
Type of Investment Major Risk Risk Factor
Bonds (fixed income secs) Default risk 0% - 30%, depending on its rating (gov’t bonds are safest; junk bonds worst)
Equity: Preferred Stock Default risk 2% - 30%
Common Stock Capital loss; volatility 0% - 15%
Property & Equipment Illiquidity 10%

 H1: Asset Concentration Risk
 The Asset Concentration Risk applies when an Ins Cpy holds too great a proportion of its assets in a single security. It is not further described in this chapter.
H2 – Underwriting Risk
This is the risk of premium inadequacy.
H2 has the following subcomponents:
 Claim Experience Fluctuation Risk for Medical Insurance
 Rate Guarantees
 Underwriting Risk for Disability and LTC coverages
 Underwriting Risk for Other Coverages
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 is simply the risk of a catastrophic claim of the highest-insured policyholder. It equals two times the highest annual Net Amount At Risk on any single person (but capped by a certain dollar amount depending on policy type)

 The risk factor in the second part is given by Table 19.4 in the textbook. It is based on tiered revenue. That is, the total revenue is split into different blocks, and each block has its own risk factor. A weighted average risk factor over all the blocks is then taken.

 the Managed Care risk discount factor indicates how structured the contract is between the MCO and the providers. The more fixed and nonvariable the payments to providers are, the less risky the insurance plan. By contrast, fee-for-service providers might suddenly increase their fees, causing the insurance company to suffer a shortfall.
H2 - more
 H2: Rate Guarantees = (yearly earned premium) * (rate guarantee risk factor)
– (premium stabilization reserve) * (50%)

The rate guarantee risk factor is:
 0%, if premiums are guaranteed for less than 15 months
 2.4%, if premiums are guaranteed for 15-36 months;
 6.4%, if premiums are guaranteed for more than 36 months

 Notice that holding a premium stabilization reserve lowers the required capital.
 H2: Disability and Long Term Care;
 H2: Other coverage types
 These two risk-based capital components are computed using a “tiered premium” method, similar to the one shown in the example above. (See Tables 19.7 and 19.8 in the textbook)
H3 – Credit Risk
This is the risk of not recovering money or service that is owed.
H4 – Business Risk
This includes the risk that administrative expenses will be higher than expected. It also includes the risk that the company’s risk level (required risk-based capital) will grow.
Subcomponents:
 H4: administrative expenses for underwritten business
 H4: administrative expenses for nonunderwritten business (ASO business)
 H4: excessive risk-level growth
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%

 If the RBC requirement grows in one year by more than “10% plus the growth in revenue”, then the amount of RBC beyond this level is the “excessive growth” amount.
 Excessive Growth will occur if:
 the ins cpy changes to a riskier mix of business, or
 the ins cpy moves to riskier provider reimbursement arrangements.
DEVELOPMENT OF AN RBC FORMULA
The best use of this section would probably be an exam question which says, “You are an actuary working for the NAIC in developing an RBC formula for a new kind of insurance product. Describe the methods and considerations you would use in developing the formula.”
Answer:
1. List the types of risks the product is subject to. These risks are:
 Catastrophic claim risk
 Statistical fluctuation of claims
 risk of Misestimation of trends; pricing errors
 Length of time needed to notice a pricing error and implement an adjustment

2. Use a Ruin Theory model:
 determine amounts of each type of risk capital (H0, H1, etc.) necessary so that there is a 95% probability that the insurance company will remain solvent over at least a 5-year period.

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
No RBC formula is applicable to too wide a variety of company types.
 Takes into account industry and regulatory input and comments.

Or, a question might give you an RBC formula with flaws (e.g. tries to apply to too many types of business, leaves out important risks, doesn’t adjust for covariance, etc.), and ask you to criticize the formula.
Differences In The RBC Formulas For Health, Life, And P/C
 Which components are subject to the covariance adjustment
 Which types of risks are included
e.g. LI includes an interest rate risk factor; HI and P/C don’t.
 The underwriting risk factors

Done.