Insurers in the US and Canada are required to state their own internal Risk Capital Standard in their ORSA Summary Report. From RISKVIEWS observations over the years of actual insurer actions, insurers have actually operated with four levels of Risk Capital Standards:
- Solvency – enough capital to avoid take-over by regulators
- Viable – enough capital to avoid reaching Solvency level with “normal” volatility
- Secure – enough capital to satisfy sophisticated commercial buyers that you will pay claims in most situations
- Robust – enough capital to maintain a Secure level of capital after a major loss
In many cases, this is not necessarily a clear conscious decision, but insurers do seem to pick one of those four levels and stick with it.
Insurers operating at the Solvency levels are usually in constant contact with their regulator. They are almost always very small insurers who are operating on the verge of regulatory takeover. They operate in markets where there is no concern on the part of their customers for the security of their insurer. Sometimes these insurers are government sponsored and are permitted to operate at this level for as long as they are able because the government is unwilling to provide enough capital and the company is not able to charge enough premiums to build up additional capital, possibly because of government restrictions to rates. This group of insurers is very small in most times. Any adverse experience will mean the end of the line for these companies.
Many insurers operate at the Viable level. These insurers are usually operating in one or several personal/individual insurance lines where their customers are not aware of or are not sensitive to security concerns. Most often these insurers write short term coverages such as health insurance, auto insurance or term insurance. These insurers can operate in this manner for decades or until they experience a major loss event. They do not have capital for such an event so their are three possible outcomes: insolvency and breakup of the company, continued operation at the Solvency level of capital with or without gradual recovery of capital to the Viable level.
The vast bulk of the insurance industry operates at the Secure level of capital. Companies with a Secure capital level are able to operate in commercial/group lines of business, reinsurance or the large amount individual products where there is a somewhat knowledgeable assessment of security as a part of the due diligence process of the insurance buyer. With capital generally at the level of a major loss plus the Viable capital level, these companies can usually withstand a major loss event on paper, but if their business model is dependent upon those products and niches where high security is required, a major loss will likely put them out of business because of a loss of confidence of their customer base. After a large loss, some insurers have been able to shift to operating with a Viable capital level and gradually rebuild their capital to regain the Secure position and re-engage with their original markets. But most commonly, a major loss causes these insurers to allow themselves to be acquired so that they can get value for the infrastructure that supports their high end business model.
A few insurers and reinsurers have the goal of retaining their ability to operate in their high end markets in the event of a major loss by targeting a Robust capital level. These insurers are holding capital that is at least as much as a major loss plus the Secure capital level. In some cases, these groups are the reinsurers who provide risk relief to other Robust insurers and to the more cautious insurers at the Secure level. Other firms in this groups include larger old mutual insurers who are under no market pressure to shed excess capital to improve Return on Capital. These firms are easily able to absorb moderate losses without significant damage to their level of security and can usually retain at least the Secure level of capital after a major loss event. If that major loss event is a systematic loss, they are able to retain their market leading position. However, if they sustain a major loss that is less broadly shared, they might end up losing their most security conscious customers. Risk management strategy for these firms should focus on avoiding such an idiosyncratic loss. However, higher profits are often hoped for from concentrated, unique (re)insurance deals which is usually the temptation that leads to these firms falling from grace.
One of the goals of Solvency II in Europe has been to outlaw operating an insurer at the Solvency or Viable levels of capital. This choice presents two problems:
- It has led to the problem regarding the standard capital formula. As noted above, the Solvency level is where most insurers would choose to operate. Making this the regulatory minimum capital means that the standard formula must be near perfectly correct, a daunting task even without the political pressures on the project. Regulators tendency would be to make all approximations rounding up. That is likely to raise the cost of the lines of insurance that are most effected by the rounding.
- It is likely to send many insurers into the arms of the regulators for resolution in the event of a significant systematic loss event. Since there is not ever going to be regulatory capacity to deal with resolution of a large fraction of the industry, nor is resolution likely to be needed (since many insurers have been operating in Europe just fine with a Viable level of capital for many years). It is therefore likely that the response to such an event will be to adjust the minimum capital requirement in one way or another, perhaps allowing several years for insurers to regain the “minimum” capital requirement. Such actions will undermine the degree to which insurers who operate in markets that have traditionally accepted a Viable capital level will take the capital requirement completely seriously.
It is RISKVIEWS impression that the Canadian regulatory minimum capital is closer to the Viable level. While the US RBC action level is at the Solvency level.
It is yet to be seen whether the US eventually raises the RBC requirement to the Viable level or if Canada raises its MCCSR to the Secure level because of pressure to comply with the European experiment.
If asked, RISKVIEWS would suggest that the US and Canada waits until (a) the Europeans actually implement Solvency II (which is not expected to be fully inforce for many years after initial implementation due to phase in rules) and (b) the European industry experiences a systematic loss event. RISKVIEWS is not likely to be asked, however.
It is RISKVIEWS prediction that the highly theoretical ideas that drive Solvency II will need major adjustment and that those adjustments will need to be made at that time when there is a major systematic loss event. So the ultimate nature of Solvency II will remain a complete mystery until then.