Risk Based Capital Beyond the CAR
After two years of parallel reporting, and several years of preparation prior to that, Sri Lankan insurance industry moved to a risk-based capital (RBC) regime on 1 January 2016. With initial roadblocks dealt with during the period where parallel runs under the both gross premium valuation methodology and the net premium valuation methodology were mandatory, most insurers should now be comfortable with the process that should be followed to comply with the new regulations. It is time for insurers to start looking beyond churning the numbers out and producing the reports that the regulator is demanding, and focus on using RBC as an indicative measure the business is managed to.
What does RBC mean to the insurer?
Of course, the CAR is of utmost importance to an insurer as the continuation of the license to operate in the Sri Lankan market depends on meeting the minimum requirements on CAR set by the regulator. However, RBC must be considered as a concept, and not just a number stated as the capital adequacy ratio (CAR). It provides significant information about the risk exposure of the insurer in the form of liabilities written, investment strategy, use of reinsurance, and operational procedures.
Following are a few broad questions that management should be asking the actuaries and the finance professionals when reviewing RBC results:
- What products are less capital intensive, and hence a better product to sell more of from a policyholder perspective?
- What are the dominant risk exposures in our products: mortality, lapse or investment markets?
- Are higher lapses good or bad for each type of product? What does this imply about current premium rates?
- How do our existing best estimate assumptions compare with actual experience? How does this impact the required capital?
- How does the regulatory capital requirement impact the competitiveness of our products?
- What is the overall exposure to investment risks?
- Should we be more worried about rising or falling interest rates?
- How can we minimize surplus volatility?
- Is our investment strategy optimal in terms of risk and return?
- Are our current reinsurance arrangements optimal? Should we increase or decrease our retention limit?
- Are our operational procedures in collecting and reporting premiums efficient?
- Are our investments in portfolios other than the policyholder portfolios optimal?
- Can we sustain a comfortable CAR ratio if actual sales meet targets over the next 12 months?
And the list goes on.
Business decisions within RBC framework
In addition to providing useful insights in to the current status of different aspects of the business, senior management must evaluate business decisions within the RBC framework, considering the overall impact of the decision on the CAR. Capital requirement must be considered at pricing as well as at product design. A capital projection must be created along with sales plans that must be factored in to the overall business plan. An internal target must be set for the CAR above the regulatory minimum of 120%, to allow for fluctuations due to market movements and other key determinants identified.
Stay tuned for our continued discussion on the topic and to learn how to practically implement a governance framework centered on RBC.