Risk-based capital and life insurer solvency

Risk-based capital (RBC) is a formula state regulators use to set the minimum amount of capital a life insurer must hold, scaled to the size and riskiness of its investments and policies. When a company's capital falls below set multiples of that minimum, the law gives regulators escalating powers to step in, up to taking over the company. It is a floor for supervision, not a grade you can use to pick a carrier.

Why capital sits on top of reserves

A life insurer promises payments decades away, so it holds reserves, liabilities that represent what it expects to owe on policies already sold. Reserves are meant to be enough if things go roughly as planned. Capital is the extra cushion above reserves that absorbs bad surprises: bonds that default, a pandemic that raises claims, interest rates that fall and squeeze returns on long-term guarantees.

Before RBC, many states simply required a fixed dollar amount of capital, the same for a tiny company and a giant. The NAIC introduced risk-based capital for life insurers in the early 1990s so that the requirement would move with the risk a company actually takes. State insurance departments adopted it through the NAIC's model act, so the rules are close to uniform across states, though each state's statute governs its own domestic insurers.

What the formula measures

According to the NAIC's explanation of RBC, the requirement is a statutory minimum based on two factors: the insurer's size and the inherent riskiness of its financial assets and operations. For life insurers the formula looks at several families of risk:

• Asset risk: the chance that bonds, mortgages, stocks and other holdings default or lose value. Riskier and less liquid assets carry higher charges.
• Insurance risk: the chance that claims run higher than priced for, or that reserves prove too low.
• Interest rate and market risk: losses when rates move and a company's assets and promises no longer match, which matters most for annuities and permanent policies with guaranteed rates.
• Business risk and affiliate risk: operational and management exposure, plus the value of subsidiaries.

Each category produces a dollar charge. The formula combines them with a statistical adjustment (so that every risk is not assumed to go wrong at once) to arrive at the Authorized Control Level (ACL) RBC. The company's total adjusted capital is then compared with that figure.

The action levels

State RBC laws set four trigger points, expressed as total adjusted capital divided by ACL:

These percentages come from the NAIC model act as written into state law; for example, Texas's rule and Delaware's statute use the same 2.0, 1.5 and 0.70 multiples of ACL. Control usually means insurer rehabilitation, a court-supervised effort to fix the company or sell its business, and in the worst case liquidation. See what happens if your life insurance company fails for what policyholders experience in each case.

What an RBC ratio does and does not tell you

Companies often publish RBC ratios of several hundred percent. A high ratio is reassuring, but read it carefully.

• It is a minimum standard, not a ranking. The NAIC states that RBC is "not intended or appropriate as a means to rank insurers generally." Two companies with 400% and 450% ratios are not meaningfully different on that basis.
• Companies compute it themselves. The figure is self-reported in annual filings, under statutory accounting rules that differ from the accounting in a company's stock-market reports.
• It reflects the assumptions in the formula. Regulators have revisited the charges for newer assets such as collateralized loan obligations and for reinsurance arrangements, which is one reason the debate over private equity ownership and offshore reinsurance often returns to capital rules.
• It lags events. A ratio reflects year-end data, filed months later.

For a fuller picture, read the AM Best, S&P, Moody's and Fitch ratings explained from agencies such as AM Best, which weigh capital together with earnings, investments and management.

A hypothetical example

Say a life insurer's formula produces an ACL of $100 million. Its levels would then look like this:

1. At $250 million of total adjusted capital (250% of ACL) it is above every trigger and owes regulators nothing special.
2. If losses cut capital to $190 million (190%), it crosses the Company Action Level and must submit a plan showing how it will restore capital.
3. At $140 million (140%), the commissioner can examine the books and order specific fixes.
4. At $95 million (95%), the commissioner may take control.
5. At $65 million (65%), the commissioner has to.

The numbers are invented to show the steps. Real failures tend to unfold over months or years as regulators intervene early, often while the company is still above 100%.

If a company does fail

RBC is the first line of defense; the second is the state guaranty association system. Every state has one, with coverage limits that vary by state and benefit type. Use the state guaranty association coverage lookup tool and state life and health guaranty associations for your state's limits. In practice most troubled insurers are rehabilitated or sold with policies intact; outright payouts from guaranty associations are the backstop.

Key takeaways

• RBC sets a minimum capital level scaled to a life insurer's risk; falling to 200%, 150%, 100% and 70% of the Authorized Control Level triggers progressively stronger regulatory action.
• A healthy-looking ratio is necessary but not a company ranking; the NAIC says RBC should not be used to rank insurers.
• Ratio data are self-reported, based on statutory accounting, and lag real events.
• Combine RBC with independent financial-strength ratings and your state's guaranty limits when judging safety.