Property/Casualty Insurance Company Risk-Based Capital Requirements

The risk-based capital requirements adopted by the NAIC in 1994 are a major advance in the solvency regulation of property/casualty insurance companies. The components of the risk-based capital formula are grounded in actuarial and financial analyses of the risks faced by insurance companies and of the capital needed to guard against those risks. The intricacy of the risk-based capital formula, the manifold considerations that shaped it, and the lack of explanation provided by the NAIC make the new capi-tal requirements difficult to follow. This paper leads the reader through the formula, illuminating its workings and its rationale. The paper first takes the reader through the compo-nents of the risk-based capital formula, as well as the “covariance adjustment ” connecting them. The empha-sis is on the development and justification of the charges, not simply on the accounting entries needed. Casualty actuaries were instrumental in developing several components of the risk-based capital formula: the covariance adjustment, the offset for claims-made business, the offset for loss-sensitive contracts, the treat-ment of workers compensation tabular loss reserve dis-counts, and the additional charges for rapidly growing companies. In discussing the actuarial considerations in these five issues, the paper demonstrates how actuarial science has major practical implications for insurance regulation. To be effective, the risk-based capital formula must be combined with statutory enactments empowering regula