Page 98 - India Insurance Report 2023- BIMTECH

86 India Insurance Report - Series II

3. What is Risk-Based Capital (RBC)?

We discussed in the forgoing paragraph that the relationship between risk and capital requirement
is tenuous in the current Solvency I regime. Let us see some examples to establish this:

1. The capital requirement is retrospective and does not consider future business plans and risks of the
insurer. All the premiums, claims, reinsurance and assets relate to the period for which the balance
sheet is being prepared and completely ignore the insurer’s future business plans, future reinsurance
arrangements and expected future claims for the planned business;

2. The solvency calculations do not consider the quality of the reinsurer, and all reinsurance arrangements
receive the same treatment under solvency calculations. The risk of non-recovery of reinsurance
dues increases as the credit rating of reinsurers goes down. Companies that have reinsurance
arrangements with low credit risk reinsurers should be required to hold more capital than those
who buy reinsurance from reinsurers with high credit ratings;

3. The risk of reserve inadequacy is not factored in solvency calculations, which should be based on
3
past reserve inadequacies, and capital requirement should correspond to this risk;

4. Market risk, Liquidity risk, Operations risk, etc., are not factored in solvency calculations;

5. Solvency calculations are based on written premiums. In a soft market, the premium rates go down
for the same risk exposure, and accordingly, the capital requirement goes down and vice versa;

6. The valuation of assets and liabilities is not market-consistent under Solvency I. In simple terms,
this simply means that the values of assets and liabilities used in solvency calculations are not the
values at which they can be traded, at arms-length, for cash.

The above is not a comprehensive list of reasons but only a few examples of how the capital
requirement under the current solvency regime has a poor relationship with the risks of different insurers.

Risk-based capital is an approach that attempts to solve these shortcomings of Solvency I by making
capital requirements prospective and more responsive to the risks of each insurer at different points in time.

Risk-based capital is the risk-weighted capital (probabilistic figure and not a point estimate) required
to back all of the insurers’ liabilities over a foreseeable future period (one year under the Solvency II
guidelines) with a confidence of 99.5%. In layman’s terms, it is the amount of capital that should be
sufficient to back all of the insurer’s liabilities 99.5% of the time with a probability of failure of just 0.5%
or 1 in 200. The RBC for each insurer can be estimated using a standard formula or using internal models
developed by each insurer, which takes into account all the risks faced by the insurer and its risk
management practices.

In addition, RBC is not just about the mathematical calculation of capital required but also
encompasses additional areas like Insurers’ internal controls, risk management, corporate governance
and stress testing, disclosure requirements and supervisory reporting.

3 Insurers hold reserves for claims outstanding. These reserves are an estimate of claims liability which
may differ from the ultimate claims liability that insurers have to pay.