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Risk Based Capital Management
PREETI CHANDRASHEKHAR & RAMA WARRIER
a “principles based approach”
to insurer solvency management
Introduction
Liberalization and emerging business
models have led to changes in the risk
profile of insurance companies. Insurers
now need to manage risks in a more
structured and informed manner. And the
importance of risk management has
assumed much larger proportions than it
used to.
A complementing area of focus is efficient
management of capital. Efficient capital
management is a function of the insurer’s
ability to properly assess its assets and
liabilities.
Regulators have also responded to this
paradigm shift and are now emphasizing on
Risk Based Capital (RBC) as the basis for
capital adequacy and insurer solvency. In
this approach the minimum acceptable
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capital depends upon how risky the
underwriting and investment operations of
the company are. This is a major deviation
from the fixed ratio approach which was in
vogue world over for assessment of capital
adequacy.
Risk Based Capital exists in various forms
and differing degrees of sophistication in
various countries, ranging from the
rudimentary fixed ratio approach to a more
advanced level of stochastic modeling as in
U.K. and Canada.
This paper is aimed at discussing:
- Different approaches to solvency
assessment
- Challenges in moving towards a
principles based approach
- Operational Challenges in moving
towards a principles based regime
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Risk based solvency assessment
This paper considers RBC from a broader
perspective, rather than from a regulatory
stand point alone. Hence, the reference to RBC
throughout this document is not to be confused
with the RBC in the United States of America
as it exists today.
RBC is an approach towards efficient and
prudent management of capital for an insurance
company. According to the definition of
Society of Actuaries, RBC “represents an
amount of capital based on an assessment of
risks that a company should hold to protect
customers against adverse developments”1
RBC is a method used to assess the capital
adequacy of an insurance company. Since
different stakeholders have different objectives,
their view of “capital adequacy” would also be
different - for the policyholders it is the ability
to honour claims; for the shareholders it is the
ability of the company to generate expected
levels of profits; for the regulator it is the
ability to fulfill contractual obligations.
Solvency, on the other hand, reflects the
company’s ability to meet its liabilities together
with any margin that the supervisory authority
may require the company to hold. From the
regulatory perspective, both capital adequacy
and solvency are used to assess the sufficiency
of the insurer’s capital to meet the obligations
or liabilities under all its contracts at all points
in time. In that sense, they are synonymous.
However, it needs to be noted that differences
can be observed in some markets. For example,
in life insurance in Australia, capital adequacy
considers assessment on a going-concern basis
(including new business) whereas solvency
refers to the assessment on a run-off basis (only
existing contracts)].
A traditional approach to capital adequacy and
solvency assessment that involves calculating
the capital requirement based on static
1 “Solvency Assessment Models compared”, CEA
Society of Actuaries, Schaumburg, Illinois, U.S.A.
www.soa.org/professional-
interests/files/pdf/riskbased_capital.pdf - 2007-
th
02-28 (downloaded on 28 May 2007)
accounting results is limited in scope. It does
not go beyond the balance sheet.
This leads us to consider a solvency assessment
based on risk. A “Risk based solvency
assessment” involves considering the risks that
the company is exposed to and factoring these
risks while addressing the capital needs.
The principles on capital adequacy and solvency
of insurers as laid down by IAIS2 talks of 14
principles. One of the principles (#6) suggests
that “Capital adequacy and solvency regimes
have to be sensitive to risk”. This means that
while the valuation of assets and liabilities
depends on the regulations in the geography of
operations, the solvency margin should also
consider risks that have not been adequately
reflected in this valuation i.e. “off-balance sheet
items”.
Models for solvency assessment
A review of the various solvency assessment
models that are used across various countries
reveal different levels of sophistication. The
models can be classified on multiple
dimensions.
There are different approaches for classifying
solvency assessment models. CEA and Mercer
Olivier Wyman3, suggest the following
classification, at a very basic level,:
2
Principles on capital adequacy and solvency
(2002), www.iaisweb.org (downloaded on 28th
May 2007)
3
and Mercer Oliver Wyman;
www.cea.assur.org/cea/download/publ/article221.pdf,
downloaded on 25th May 2007,
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Simple factor based models involve
applying factors to accounting results as of a
particular point in time. Solvency 1 regulation,
for example, adopts simple factor based
models.
Risk factor based models apply multiple
factors to specific accounting results. The
NAIC model is perhaps a good example
wherein factors are applied to different risk
elements like Market risk, Credit Risk,
Insurance risk, Interest rate risk, Business risk
(and Off-balance sheet items for life insurance).
The calculation method is standardized and
pre-defined.
Both the models cited above are based on
specific guidelines with rigid, prescriptive
rules. The analyses and the formulae to be
applied are clearly defined. These are
categorized as “rules based” models.
While the “rules-based” approach to solvency
assessment is simple and easy to apply, it has
certain drawbacks. For instance, company
specific risk profiles are not considered. There
is no allowance (or a limited allowance) for
interdependency of risks and the valuation of
assets and liabilities is generally not based on
market-consistent approaches.
The follwing two models are dynamic models
as the calculations are not dependent on the
position at a particular “point in time”. Rather,
they are based on cashflow projections.
Cashflow approach is generally considered to
be better than the “rules based” approach since
complex scenarios can be modeled.
Under the Scenario based model, the
insurance company applies the discounted
cashflow method to ascertain the effect of
certain predefined scenarios to its net asset
value. Credit, Market, Insurance risks etc.
originating in a one year time horizon are
considered. The scenarios are clearly defined.
The Swiss Solvency Test or SST as it is known,
is an example of this approach.
Lastly, under the Principles based
approach, no rules are specified to arrive at
the risk measure. The insurance company is
expected to apply the principles laid down by
the regulatory or financial authority in the
geography of jurisdiction. The models to which
these principles can be applied can be the
company’s internal model. The UK-FSA model
for capital requirement is a good example.
The four models described above are the basic
ones. In practice, the model that a company
adopts need not fit into one of these types
exclusively. It can have flavors of more than
one type.. For instance, the insurance company
can adopt dynamic scenario based model for
some risks (asset liability mismatch) and use an
overall risk-factor based approach.
It should not be construed that the “rules based”
approach is not based on principles. Indeed, all
the detailed and prescriptive rules have sound
base of financial and actuarial principles.
However, in such a scenario, the regulator has
a bigger role to play in ensuring that the
companies adopt sound business practices while
keeping the stakeholders interests in mind.
Principles-based approach, on the other hand
transfers the onus of sound business practices
on to the insurance companies and their senior
management. Companies need to align their
risk management practices with regulatory
solvency and capital requirements. They need
to move up from being “risk evaluators to risk
managers”4.
Moving from a “rules based” to “principles
based” model has challenges at various levels.
Both the regulator and the insurance companies
have to work together to make it happen.
While the uncertainty and lack of clarity may
not seem unfounded from the insurance
company’s perspective, there is a clear shift in
the role of the regulator from a watchdog to a
guide. The regulator is expected to provide
clear and unambiguous guidance in
understanding the principles.
4
“Principles-based regulation – looking into the
future” Speech by John Tiner, Chief Executive
Officer, FSA; FSA Insurance Sector Conference,
21st March 2007. downloaded on 28th May 2007
www.fas.gov.uk,
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Solvency 2 – a step in this direction
European market has taken steps to adopt a
principles based approach for insurer solvency.
Solvency 2, is a new, risk-sensitive system for
measuring the financial stability of insurance
companies in the EU. It is intended to provide
greater security for policyholders and stability
for financial markets by providing insurance
supervisors with better information and tools
to assess the financial strength and the overall
solvency of insurance companies.
Even before it is fully implemented, Solvency 2
is expected to usher in large scale changes in
product portfolio, operations as well as the
reporting requirements of insurance
companies.
However, the transition to a principles based
approach under Solvency 2 is likely to pose
several implementation challenges to the
insurance industry.
Challenges in moving towards a
principle based approach
Risk Based Capital and Solvency assessment are
not just accounting or actuarial issues. They
affect the entire organization and require
changes at all levels covering the entire
operations.
The “principles based approach”, aims at
establishing a system that helps the insurance
company to manage risks in a more structured
and informed manner, reflecting current
market needs while allowing for greater
transparency based on generally accepted
accounting and actuarial principles. The
detailed methodology is left to the discretion of
the insurer as long as it is consistent with the
principles set out.
This brings with it implementation challenges
in multiple dimensions. For one, though the
approach is “principles based”, the
implementation of the principles would require
“rules”. The rules should be such that they
allow flexibility to adapt to unforeseen
circumstances. The absence of detailed rules
that translate the principles into practice leaves
much to the judgment of the individual
company on how best to represent the
principles.
Another important aspect that is closely linked
with the above is the choice of risk measure A
good risk measure should consider the upside
and downside differently. There are various
risk measures like Value at Risk (VaR) and Tail
VaR that would perhaps represent the
individual risks (Market, Credit, Insurance
etc.). But what is required is an assessment of
the combined effect of these risks and its
impact on the overall risk profile of the
company. The positive and negative correlation
between the risks and the effect of
diversification must be assessed.
This gets compounded due to scarce data or
complete absence of accurate data . This is
particularly important in the assessment of
extreme events or the tail of the probability
distribution that represents such risks. in the
case of stochastic modeling.
Each accounting practice defines the assets and
liabilities differently. The same set of
principles and rules applied for capital adequacy
and solvency requirement may produce
different results. This may lead to a “hidden”
surplus or deficit that is highly undesirable. The
solvency assessment model should be
independent of the accounting system. This,
from a practical perspective, is a challenge
especially for the static models since most of
them are based on accounting values.
Move towards a “principles based” approach
involves having a comprehensive view of the
balance sheet. However, the insurance
company’s balance sheet consists of liabilities
other than that of policyholders (shareholders,
other investors etc.). The interpretation and
valuation of these liabilities would depend upon
the primary aim of solvency assessment. In
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 addition, the company would also need to treat
the discretionary liabilities appropriately5.
In addition, there are challenges associated with
time horizon regardless of whether it is a static
or dynamic approach. The cashflow approach
also needs to consider the total projection
frequency chosen. There needs to be a right
balance between accuracy and time taken to
run the model keeping in mind the costs
associated with running the model.. The
conflict between pragmatism and technical
accuracy needs to be addressed.
The inherent risks associated with an insurance
company interact at different levels. This leads
to complex and myriad effects. These require
non-linear risk modeling at the enterprise level.
The choice between deterministic and
stochastic approaches is a fundamental
challenge . The overall inclination of the
industry is towards stochastic modeling. This
however, does not mean that stochastic risk
models would replace the deterministic ones.
In fact, stochastic and deterministic models
complement each other. Very often, a
deterministic model can be extended to include
the stochastic element so as to determine the
variability of the estimates with a desired level
of confidence.
Regardless of the approach, the effectiveness of
the model depends largely on the structure of
the data within the model.
A smart and sophisticated system is required to
 Model complex risks (assets –liability
mis-match, operational risks etc.)
 Handle multiple scenarios
 Perform Scenario modeling and
sensitivity analysis
 Conduct Stress Tests
5
“CEA Working Paper on the Total Balance Sheet
Approach”,
http://www.cea.assur.org/cea/v1.1/actu/pdf/uk/anne
xe315.pdf, downloaded on 29th May 2007
The following section details some of the steps
required in modeling and also highlights some
data and technology challenges associated with
it.
Operational challenges –baby steps from
theory to practice
The implementation of Risk Based Capital
involves, at the core, identifying and modeling
the risks and appropriately aggregating them at
the enterprise level.
This process can be broadly split into three
parts: (1) Identification of risks (2) Identification
of the model (3) Running the model
Identification of risks: As mentioned earlier
in this paper, risks faced by the insurance
company are diverse in nature and complexity.
Risks that are straight forward and already form
an important aspect of product design and
pricing is perhaps a “no-brainer” for insurance
companies – that is their core strength. It is the
identification of risks and their interdependence
at the enterprise level that requires expertise in
risk management. Arriving at a reasonably
complete list of potential risk exposures is
essential for successfully implementing a risk
based solvency assessment.
Given below is an illustrative sample of the risks
to which an insurance enterprise is exposed.
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identifying the models:
The models that can be used have been detailed in
the previous section. Any model that is chosen has
to suit the underlying risk.
Perhaps it is equally challenging to identify the most
appropriate model that truly represents the impact
of underlying risk or group of risks.
 The model should be valid for the purpose for
which it is used
 It should have the capability of handling all the
relevant parameters
 It should not be too complex – a model that is
easy to understand and interpret is what is required
Running the model: After the risks and the
models have been identified, the most daunting task
is to run the model, test and interpret the results.
Model points have to be appropriately chosen to
ensure that they adequately represent the
underlying portfolio to be modeled. They should
also ensure that the right business mix is
considered.
Information Technology plays a critical role in this
phase. Insurance companies usually have different
systems covering the whole spectrum of technology
sophistication. And this diversity gives rise to
challenges in collecting data – acceptable from an
accuracy and time perspective.
The following diagram gives a conceptual view of
the IT model for implementing a Risk Based Capital
model
Implementation of an RBC based model is a
major IT initiative in an insurance company.
Hence, it carries all the challenges which any
large initiative would.
The major challenges from an IT perspective
could be categorized into two – data related
and application related. The following diagram
indicates the IT priority areas for
implementation of a risk based solvency assessment
model.
Conclusion
Managing and optimizing the capital
requirements of an insurance company requires
a more dynamic and flexible approach. It needs
to minimize the risk of insolvency and properly
align the interests of all the stakeholders.
Towards this end risk based solvency assessment
founded on a “principles based approach”, is
being widely recognized as the way forward in
the insurance industry as demonstrated by the
Solvency 2 initiative. Success of risk based
solvency assessment depends upon how
effectively the companies are able to address
the operational challenges.
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Authors:

Rama Warrier and Preeti ChandraShekhar are consultants focusing on the fields of insurance and risk. They
have varied experience across the globe with leading insurance and reinsurance companies. They have
published several papers in international journals. These papers could be accessed on www.conzulting.in

The authors could be reached at warrier@conzulting.in and Preeti.Chandrashekhar@towerswatson.com

References:

1. Society of Actuaries, Schaumburg, Illinois, U.S.A. www.soa.org/professional-

interests/files/pdf/riskbased_capital.pdf - 2007-02-28 (downloaded on 28th May 2007)
2. Principles on capital adequacy and solvency (2002), www.iaisweb.org (downloaded on 28th May
2007)
3. “Solvency Assessment Models compared”, CEA and Mercer Oliver Wyman; downloaded on 25th
May 2007 www.cea.assur.org/cea/download/publ/article221.pdf
4. “Principles-based regulation – looking into the future” Speech by John Tiner, Chief Executive
Officer, FSA; FSA Insurance Sector Conference, 21st March 2007, www.fas.gov.uk, downloaded
on 28th May 2007
5. “CEA Working Paper on the Total Balance Sheet Approach”,
http://www.cea.assur.org/cea/v1.1/actu/pdf/uk/annexe315.pdf, downloaded on 29th May
2007
6. “Solvency 2 – the IT perspective”, Rama Warrier & Nandha Kumar, The Actuary, April 2007
7. “An approach to ERM in the insurance industry” Preeti ChandraShekhar & S R Warrier, APRIA
2002
8. ST2 – PN- 06 Course notes ActEd Study material, Institute of Actuaries, UK

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