The risk-based capital or RBC ratio is calculated by dividing the total adjusted capital of an insurer by the authorized control level, or ACL risk-based capital.
The calculation of ACL risk-based capital considers four broad categories.
Asset risk covers the risk of loss of market value or defaults from investments.
Insurance risk captures the risk of underestimation of liabilities or mispricing of policies written in the next year.
Interest rate risk for life insurers covers the risk of loss from changing interest rates, and business risk relates to the general health of the insurer and largely involves operational risk.
The total from these categories is offset by a covariance factor, which reduces the overall ACL risk-based capital, taking into account the diversification effect between the various risk factors.
The ACL risk-based capital is calculated on a formulaic prescribed basis, so is never based on internal models, as may be the case for European insurers under Solvency II.
Neither of these two components of the RBC ratio, the total adjusted capital or the ACL risk-based capital, is publicly disclosed. Instead, they are only used by the NAIC as a regulatory trigger rather than a public measure of the level of current capitalization of the insurer.
So what are the implications of the RBC ratio? Well, it's used by insurance supervisors as an early warning signal of signs of distress and undercapitalization in insurance companies, with additional actions taken by the regulator below certain thresholds.
If the RBC ratio is above 300%, no additional supervision is required.
If the ratio, though, is between 200% and 300%, which is referred to as the company action level by the NAIC, the insurer must submit an action plan to improve capitalization to their regulator.
Next, if the RBC ratio is between 150% and 200%, we are at the regulatory action level, where the regulator may require additional actions to be taken by the company. If the ratio falls between 100% and 150%, we're at the authorized control level, and the regulator has the authority to take over control of the insurer.
And then finally, if the RBC ratio falls below 70%, the regulator is obligated to take over control of the insurer.
