Solvency Series: The Role of Risk-Based Capital and Required Reserves for Insurance Carriers
September 20, 2021
One of the main elements of judging and maintaining the solvency of any particular carrier, or insurance as a whole, is in carrier capital and reserve requirements. Simply put: States require carriers to have a minimum amount of money easily accessible to pay out claims – if the carrier can’t handle the statutory reserve requirements, that’s a giant red flag.
Before we dive deeper into insurance reserves, it’s worth noting this isn’t the only piece of the solvency stack for keeping public faith in insurance. We’ve covered many other solvency measures in-depth in our series, so be sure to check those out if the integrity of the insurance industry is an itch you want to scratch.
It’s also worth noting that this (albeit smartly reported and diligently compiled) article is meant to be informational only. If you’re subject to asset and reserve requirements, you need to do your own due diligence to maintain compliance with your relevant jurisdictions.
The discussion on capital requirements, statutory reserves, and such is much easier if you first understand that, ultimately, insurance companies make their money from investing insureds’ premium payments in the market, in stocks, bonds, and other financial instruments. That’s the basis of profit. However, unlike insurance, the stock market’s returns aren’t guaranteed. So, if there’s a market downturn, an insurer might be forced to sell its shares at a loss – not a good long-term plan.
In many cases, longer-term investments yield higher returns. But that’s hardly a good place to put money an insurer might need tomorrow. Additionally, if the market experiences a downturn, insurers don’t want to have to pay claims out of depreciated assets, particularly ones that may rebound with the market.
Claims that may need to be paid one day count against the assets on a balance sheet. This may seem obvious, but the difficulty of accurately predicting claims and maintaining assets to insure them is the central conflict of the entire solvency situation.
It’s one thing when it’s a straightforward risk, like a term life policy with a very definite benefit limit. It’s another when it’s a more nebulous policy that generally covers a risk without a hard dollar amount limitation.
For example, one concern with previously written cyber insurance contracts is that “implied coverage” may put the carrier on the hook for massive ransomware payments unforeseen when coverage was first issued. The 9/11 attacks are infamous in insurance not only because of the horrific devastation but because of ongoing claims, such as health care and specialty cancer care for the first responders who breathed in noxious fumes in their work. These were unanticipated liabilities from the standpoint of insurer funding.
What is RBC in insurance?
Traditionally, insurers were required to have enough capital to cover their claims liabilities, and then of course preferably have a surplus to pay out to stakeholders and reinvest in the business. So, they needed capital coverage for 100 percent of their outstanding claims. However, after some notable insurer failures in the 1980s, states began using what was called a risk-based capital (RBC) formula to determine a minimum amount insurers needed to maintain in assets.
The RBC formula is complex and nuanced, but the key aspect is that it essentially establishes a protocol for determining not just the XYZ calculation of outstanding claims, but also a consideration for the risks an insurer takes on. So, an insurer that’s underwriting more risk may need closer to 110 or 115 percent of claims. The RBC formula basically carves out how much of an insurance carrier’s surplus should be set aside for claims-paying, as well.
What are incurred-but-not-reported claims?
Part of the RBC formula accounts for incurred-but-not-reported (IBNR) claims, claims where the insured event has occurred, but the total claims haven’t been discovered. For example, if someone is injured in the workplace, perhaps there’s an immediate claim for an emergency room visit, and in the shorter term, perhaps there are physical therapy costs, but what if the issue is chronic? The company’s insurance may be on the hook for ongoing costs related to surgeries or other chronic care that would be impossible to account for the day or even month of the initial incident.
States still mandate that IBNR costs be counted as liabilities in audits and carrier self-reporting, which is a significant piece of the discussion of funding liabilities and maintaining capital.
Reserves are also on the liabilities side of the balance sheet – some mistakenly think of them as part of the surplus, but reserves are part of claims-paying funds.
What are an insurer’s statutory reserves?
Insurance reserves are money the state government requires an insurer to have in cash or easily liquidated securities, money that the insurance carrier can easily access to pay out claims in a timely manner.
Each state has its own reserve requirements, which may vary by the type of carrier, and the statutory reserve requirement will likely be based on a percentage of the potential claims a carrier has underwritten. This may also be called a reserve ratio, because it’s based on the ratio of reserves to claims. According to Investopedia, most states’ insurance legal minimum reserve requirements are somewhere from 8 to 12 percent of anticipated claims.
In this way, the reserve system functions similarly to a savings account in personal finance. The market is where you’ll see passive income and gains being made, but it’s not where you’ll turn if you have a costly car repair, appliance replacement, or other high-dollar immediate need. For that, you hopefully have a sizable emergency savings. In much the same way, insurer claims reserves are for their immediate payout needs.
That’s not to say the insurance carriers have to keep the funds in a low-interest savings account. This isn’t cash stuffed under the mattress. Their reserves can still be in marketable securities like common stock, Treasury bills, or money market instruments. It’s more a matter of ensuring that money is accessible at a moment’s notice, unlike their longer-term investments.
What are actuarial reserves?
While the state has statutory reserve requirements for carriers, the carriers themselves often also have what are called actuarial reserves. These are reserve requirements that are based on the actuarial calculations of how likely the insurer is to have to pay out a significant number of claims at once. Actuarial reserves are calculated based on product specifications and historical data, and are higher than the state minimums.
So, if a state says the claims reserves are 10 percent of anticipated claims, but a company can see that they have additional claims risks – think property and casualty insurers with coastal businesses in hurricane season, or life and health insurers in a global pandemic – the insurer may decide to have closer to an actuarial reserve requirement of more like 15 percent or higher.
Other capital requirements
Reserve ratios and minimum liability coverage are not the only restrictions on insurer assets. Insurers have to use a certain percentage of premiums for claims-paying, and most carriers have state-imposed limitations on how much they can pay out premiums or profits to investors or stakeholders.
The overall financial solvency of an insurance carrier is also regulated based on how easily it meets its capital requirements. Again, the exact capital requirement is based on the type of company and state it’s operating in, and to even get licensed in a state typically means fronting a certain amount of money as a deposit or collateral source. But the ongoing process of capital management is what the states are primarily concerned with when determining solvency, because you never want to compound a down market with a slew of unexpected claims – that’s a combination for disaster, both for individual insurers and the greater economy as a whole.
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Risk-Based Capital FAQs
New insurers and “alien” insurers often are required by a state to meet a collateral threshold before doing business in that state. This is basically a deposit toward their claims-paying ability that makes sure they have money in the bank before they make any guarantees about anything.
MGAs are such a unique beast – many solvency requirements are dependent primarily on the contract they hold with an insurer or insurers. If, however, they’re responsible for not only underwriting but also paying claims for a product, then it’s safe to assume they’re responsible for maintaining solvency required to pay those claims.
As far as collateral requirements, the MGA Act says an MGA will need to have some collateral, some skin in the game, with any insurer they’re working with:
“The insurer shall require the MGA to obtain and maintain a surety bond for the protection of the insurer. The bond amount shall be at least $100,000 or 10 percent of the managing general agent’s total annual written premium nationwide produced by the MGA for the insurer in the prior calendar year, but in no event greater than $500,000.”