Risk-Based Capital and Solvency Screening: Hypotheses and Empirical Tests

This paper is a substantially revised and extended version of a preliminary paper presented at the 1993 ARIA Meeting in San Francisco. This research was funded in part by the National Association of Insurance Commissioners. The conclusions expressed here are the authors' and do not necessarily reflect the opinion of the National Association of Insurance Commissioners. Introduction The National Association of Insurance Commissioner's (NAIC) concluded in 1990 that risk-based capital (RBC) standards for insurers were feasible and preferable to traditional fixed minimum capital standards. The NAIC subsequently adopted RBC formulas for life-health insurers (effective in 1994) and property-casualty insurers (effective in 1995) and an RBC model law that allows or requires certain regulatory actions when insurers fail to meet certain minimum RBC thresholds. The stated purpose of the NAIC RBC requirements is to establish more meaningful minimum standards of capital adequacy related to an insurers' risk of insolvency than the fixed minimum capital requirements that regulators have imposed in the past. At the same time, the NAIC has clearly stated that the ratio of an insurer's RBC to its actual capital should not be used as a measure of its overall financial strength and the model law prohibits the use of RBC ratios for marketing purposes. RBC standards have far-reaching implications for the financial regulation and operation of insurers. Despite the limited intended purpose of RBC, the standards raise a number of issues for insurance regulators, including their utilization in solvency screening or "early warning" systems for financially troubled insurers. Regulatory solvency screening systems, such as the NAIC's Financial Analysis Tracking System (FAST) developed in the early 1990s and the earlier Insurance Regulatory Information System (IRIS), are designed to screen and prioritize insurance companies for more in-depth financial analysis. 1 The practical objective is to identify insurers that are in or headed toward financial trouble to facilitate timely regulatory intervention to prevent insolvency or reduce the costs of insolvencies that do occur. 1 Klein (1993) provides detailed discussion of NAIC solvency screening systems and regulation. 2 As a measure of capital adequacy, RBC might be expected to play some in solvency screening systems, because an insurer's actual capital (surplus) compared to its RBC requirement should provide information concerning an insurer's financial strength. An important question is how well the ratio of an insurer's capital to its RBC (or, alternatively, the ratio of RBC to capital) will predict the likelihood of …