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Risk-Based Capital and Ratemaking

Two movements have emerged in parallel in the insurance industry: financial pricing and solvency monitoring. Long ago, pricing actuaries set rates-at least ostensibly-by assuming a five percent profit margin on premium. Arbitrary pricing formulas do not long survive in a competitive marketplace, and actuaries have since adopted return on capital, discounted cash flow, and internal rate of return models. Most of these models use assumed surplus requirements or benchmark surplus levels to calculate the needed profit margins for insurance contracts.

The second movement sprang from regulatory concerns over insurance solvency. Long ago, states set minimum surplus requirements that were tiny fractions of business volume for the largest companies. The actual surplus held was compared to arbitrary leverage ratios, such as the 2 to 1 Kenney rule that originated in fire insurance regulation. In the 1990s, the NAIC developed new risk-based capital requirements, which set surplus standards that varied by line of business and by the company's operating characteristics.

Pricing actuaries were concerned lest the regulators' opinions regarding surplus requirements affect the surplus assumptions used in their pricing models. Actuaries insisted that the risk-based capital formula not be used to determine the surplus assumptions in the financial pricing models, and regulators wrote this prohibition into the law.

In hindsight, we can only smile at this. Indeed, we scratch our heads and ask: "Just what did those actuaries mean?" So let us look first at rationale for this actuarial view, for there once was merit in the argument.

The insistence that the new risk-based capital formula not affect the surplus assumptions in the financial pricing models was tied to a second actuarial request: that the risk-based capital formula set minimum surplus requirements, not target surplus requirements.

Consider a company with a stable portfolio of private passenger automobile business or workers' compensation business. The company's actuaries examine the various risks of the insurance operations, such as underwriting risks, reserving risks, investment risks, and credit risks, and they determine that the company needs $200 million of surplus to protect its policyholders. This figure is used in the financial pricing model to produce reasonable and competitive rates.

Suppose that the risk-based capital formula determined minimum surplus requirements of $100 million. "That's fine," said the actuaries, "this is a minimum surplus requirement. Let not the rate regulators adopt this figure and allow us a return only on the minimum $100 million instead of on our target $200 million." In this scenario, the insistence that the risk-based capital requirements not be used for pricing makes sense.

Suppose instead that the risk-based capital formula produces target surplus requirements. For this company, perhaps, it produces a surplus requirement of $240 million. What now should the pricing actuaries say? Should they say: "That's fine, but we need a return only on the theoretically required $200 million, not on the $240 million required by the regulators?" Of course not. The company will allocate $240 million of surplus to this portfolio of business, and the premium rates must achieve an adequate return on this $240 million of surplus.

This is the result of the risk-based capital efforts. Many companies now allocate capital by these regulatory targets or by the similar rating agency targets, not by actuarial theory alone. Capital allocation is never easy, whether by actuarial theory or by regulatory targets, since companies must consider covariances of risks and marginal surplus needs, but the overall effect is the same: Capital allocation and surplus assumptions have moved from actuarial theory to state regulation and rating agency formulas.

Some companies with greater actuarial expertise may ask their actuarial staff to see if some changes to the regulatory numbers might be warranted. But most actuarial recommendations will not get too far. If the actuary says: "We don't need $240 million, we need only $200 million," what can management reply but "We must carry $240 million to satisfy the regulators and the rating agencies; we need an adequate return on this $240 million."

"Wait," you say; "everyone agreed that the risk-based capital formula should be geared to minimum surplus requirements, not target surplus requirements. How did it come about that the formula is setting target surplus allocations for some lines of business?"

The regulators who set the risk-based capital formula may not have been adept at expected policyholder deficits or probabilities of ruin, but they were excellent tacticians. "The actuaries want minimum surplus requirements?" they said. "Then so shall it be. Our numbers are henceforth minimum surplus requirements." With great fanfare, they set target surplus figures, and they called them minimum surplus requirements.

Well, it's not that simple, of course. Perhaps we give too much credit to the tactical expertise of the regulators; perhaps we are too dismissive of the random pattern of accounting data. The NAIC surplus requirements are a mixed bag, they are high in some lines and more moderate in others. Some actuaries believe that the regulators wanted more effective control over the actions of insurance companies, and the high surplus requirements satisfied this objective. Other actuaries believe that the regulators had a minimum threshold in mind, but they did not fully appreciate the effects of the risk-based capital formula.

That's the story of surplus. One might wonder, "Is this all that bad? Does it make a difference who sets the surplus targets, whether it's the pricing actuary or the regulator?"

Insurance deals with the economics of risk. Insurance companies transfer risk away from those less able to bear them, such as individual drivers and homeowners, or small businesses and medium-sized corporations. They pool risks to allow the law of large numbers to diversify the random loss fluctuations, thereby enabling risk-bearers to safely accept the exposures.

Economic operations are most efficient when risk is transferred and pooled efficiently. Economic efficiency requires that the appropriate amount of capital be used to support the insurance operations. Actuaries have begun the task of quantifying the needed capital amounts. This is a difficult task, and it will be many years until actuaries have a firm grasp on the answer. It is a worthwhile task, since an understanding of needed capital amounts will allow our economy to run more efficiently.

It is a task cut short, curtailed by regulatory fiat. The regulators have set the capital requirements. Actuaries are no longer needed. They may now go back and ponder their loss reserve triangles.

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