The simple side of Risk-based Capital (RBC)

Rewriting the Malaysian Risk-Based Capital (RBC) for underwriters and claims handling personnel.

A Weblog from the past on RBC framework as seen from the eyes of a General Insurance underwriter……

RBC - Creation into an unknown

RBC - Creation into an unknown

Compared to the previous solvency margin methodology, this RBC is abit tricky from operations perspectives so much so underwriters and claims practitioners should acquire a reasonable level of understanding in order to prevent the company from slipping trouble waters. Unfortunately this is not happening for our industry, most if not all underwriters and claims practitioners are not made to play any strategic part in this new regime. It is still very much a “finance and accounting” forte, and the Central Bank is not driving the message across yet. This I believe is a carry-over effect from the days of the solvency-margin regime but time is surely changing as in RBC, the biggest chunk of the capital charges are related to General Insurance Liabilities ie. Premium Liabilities and Claims Liabilities. So why are senior underwriters having limited access to documentation, not to mention the zero contact time with the actuary and their actuarial investigation and analysis. Why are claims personnel have limited or almost no knowledge of how the actuary made assumptions and their computational methodology in arriving at the IBNR figures? Why are there premium deficiencies and how can underwriters work toward unplugging the root cause of a particular portfolio?

This blogpost attempts to put some basic understanding in perspectives for benefits of underwriters and claims practitioners…..

So what is Risk-Based Capital (RBC) in short?

It is really about the need to have the correct amount of capital to support the business that the insurer has written into its books. This means there must be adequate capital for an insurer to meet its obligations to existing policyholders and also to continue writing new business in the future in any adverse conditions. The capital requirement is generally computed by applying the RBC regimented risk charges on those prescribed exposures, namely credit, market, technical reserve and operational risks.

How to get started?
It is not difficult to understand the objective of RBC but it can be quite tricky if we are to go into the mechanism in working out whether the capitalavailable to the company is adequate to support the risks underwritten. Welcome to the journey through the working intricacies surrounding the RBC framework.

Firstly always remember the following important formula:

Capital Adequacy Ratio (CAR) = Total Capital Available (TCA) / Total Capital Required (TCR) x 100%

Always remember, the Central Bank had as of now imposed that the supervisory CAR (or SCAR) must be > 130% otherwise the company must raise more capital in order to continue doing business.

 

Simply what is TCA?

Simplistically, you can get these details from the company’s financial statement or more specifically, the balance sheet. To make our brain think simple just add up the following:

  • Fully Paid-up shares capital
  • Retained profits

In a nutshell, the total should give you the TCA. Forget those complicated stuff like tier-1 and tier-2 capital as they will suffocate you…. You can counter-check with this equation: Equity (E) = Asset (A) – Liability (L). TCA should be approx. that to E.

 

Simply what is TCR?

TCR is the aggregate of the total capital charges for the insurance fund and total capital charges for all assets in the shareholders or working fund. We can simply illustrate the computation of TCR with the following diagram:

Table I
The TCR items General Insurance (GI) Fund Shareholders’ (SH) Fund
Credit Risk capital charges (CRCC) Total of all charges in respect of GI fund on credit Total of all charges in respect of SH fund on credit
Market Risk capital charges (MRCC) Total of all charges in respect of GI fund invested Total of all charges in respect of SH fund invested
General Insurance Liabilities(GCC):
 
(a) Claims Liability risk capital charges
(b) Premium Liability risk capital charges
Total of all charges in respect of GI fund as reserves requirement Non-applicable
Operational Risks capital charges (ORCC) Apply 1% on GI fund Apply 1% on SH fund
Total Capital Total of risk charges under GI Fund Total of risk charges under SH fund

(Summary of Table I) Some Notes – General Insurance Funds relate to the total of Claims Liabilities and Premium Liabilities that need to be computed and certified by a qualified actuary. These funds are separated from the Shareholder funds as depicted in any financial statements. Thus there is no computation of capital risk charges for General Insurance Liabilities under column “Shareholders’ Fund”. All the calculations will be eventually summarized within the above Table.





Illustrating the TCR items:





(1)   Credit Risk Capital Charges (CRCC) aims to mitigate risk of losses resulting from assets default and related loss of income, and the inability or unwillingness of a counterparty to fully meet its contractual financial obligations.

Simple formula to work out the Capital charges for credit risks:

CRCC = Exposure to counterparty x Credit risk charge

Filter off those special purpose vehicles related securities, debt obligations and the likes from our thoughts as we only need to focus on Table II (Risk charges for other assets), items (c), (d), and (e).

Table II
Item Types of exposure Risk charges
(c) Receivables from and reinsurance deposits with (re)insurers licensed under the Insurance Act 1996 1.6%
(d) Receivables from and reinsurance deposits with (re)insurers not licensed under the Insurance Act 1996, with the following rating:
(i) AAA 1.6%
(ii) AA 2.8%
(iii) A 4%
(iv) BBB 6%
(v) Unrated or with lower rating 12%
(e) Outstanding premiums, agent balances and other receivables due from:
(i) other licensees under the Insurance Act 1996 or agents 4%
(ii) others 6%

Underwriters need to be focused on item (d) as this item involves making choices on the (re)insurers when placing facultative reinsurance outward and approving the panel of treaty reinsurers.

In (c), the framework provides for a fixed credit capital charge of 1.6% for all (re)insurers licensed under the Malaysian Insurance Act 1996 irregardless whether these (re)insurers have any internationally recognised rating or otherwise. Therefore risks that were facultative reinsured to local insurers, the capital risk charge in respect of credit risks shall be 1.6% – incidentally, risks ceded to Tahan would merely attract a 1.6%, far cry when compared to risks having been ceded to syndicates at Lloyds’!

The Parental Guarantee – Coming back to item (d), the framework did provide some leeways for reinsurers licensed under the Labuan Offshore Insurance Act 1990 (Lofsa). If these reinsurers can provide a “parental” guarantee (explicit and irrevocable by their Home Office) with at least an A- rating to fully support their Labuan operations in event of financial difficulties shall be subjected to  only a risk charge (1.6%) equivalent to that of a reinsurer licensed under the Insurance Act 1996. It is a known fact that most registered reinsurers are actually branches, thus not sure why is there any need for such parental guarantee – NOT very clear….

However, what do you think about Labuan Re? They cannot provide any parental guarantee…..as they are the parent themselves. Can Labuan Re provide their own guarantee in this respect? Looks illogical and there is no provision for this! Anyway, the industry irrespective of the framework applies the risk charge at 1.6%… Looks like they had been given an unofficial waiver…..

It is good to know in recent days, Lloyds’ syndicates that do not have any registered operation in the country are treated as foreign reinsurers – they can no longer hide and gain the Lofsa status via the Lloyds’ Labuan banner.

What about item (e)? This applies to debts or outstanding due from intermediaries or from direct (or corporate) accounts. Underwriters and Claims practitioners must play a more proactive role in reviewing any such outstanding before adopting any decision, ie. Enforcement of Premium warranty cancellation, full premium payment must be in before settlement of a claim or issuance of renewal notices……

 

(2)   Market Risk Capital Charges (MRCC) aims to mitigate risks of financial losses arising from:

  1. the reduction in the market value of assets due to exposure to equity, interest rate, property and currency risks,
  2. the non-parallel movement between the value of liabilities and the value of assets backing the liabilities due to interest rate movement,
  3. concentrations of exposures to particular counterparties or asset classes

 

Simple formula to work out the Capital charges for Market risks:

MRCC = market exposures x market risk charges

Underwriters need not be too concerned with MRCC – a simple understanding that TCR items relate to Equity, Property, Interest Rate, Currency, Financial derivatives, collective investment schemes, etc should suffice. However, if we write a substantial number of risks with limit of coverage involving foreign currency, then we should raise this up with the Finance people and also it is appropriate if we acquire a thorough understanding of the company’s treaty programme in respect of currency clause or currency fluctuation clause.

 

 

(3)   The General Insurance Liabilities Risk Capital Charges (GCC) aims to address risks of under-estimation of the insurance liabilities and adverse claims experience developing over and above the amount reserves already provided, be it related to claims or unexpired risks. These are where actuaries are heavily involved in. The RBC currently set the actuarial computation at the 75% level of confidence.

Simple formula to work out the Capital Charges for General Insurance Liabilities Risks:

GCC = [Unexpired risk reserves (URR) x URR(Risk Charges)]

+[Claims liability (CL) x CL(Risk Charges)]

What is Unexpired Risk Reserves or URR in short? You can simply just call it “Premium Liabilities” or PL.

The URR Risk Charges and CL Risk Charges are as follow:

Table III – Risk Charge applicable
Class Risk Charge applicable on

Claims Liabilities

Risk charge applicable on

Premium Liabilities (URR)

1 Motor – ACT 25% 37.5%
2 Motor – Others 20% 30%
3 Fire 20% 30%
4 Marine, Aviation & Transit – Cargo 25% 37.5%
5 Marine, Aviation & Transit – Hull 30% 45%
6 Contractors’ All Risks & Engineering 25% 37.5%
7 Liability 30% 45%
8 Medical and Health 25% 37.5%
9 Personal Accident 20% 30%
10 Workmen’s Compensation & Employers’ Liability 25% 37.5%
11 Bonds, Offshore Oil & Gas related and Others 20% 30%

Most important to Underwriters & Claims Practitioners – This part of TCR is perhaps the most important to underwriters and claims practitioners. Underwriters with a better understanding of these will be able to work towards steering the company into attaining a more viable or strategic portfolio mix – so that premium growth and underwriting profitability can be better realised and optimised. This simply means as the company works towards realising its growth target, such growth should not be at the expense of its capital.

However, before we work out the relevant capital charges it is important that we have a reasonable good understanding of what CL and PL or URR mean… or perhaps also peppered it with some basic understanding of how actuary makes assumption and methodology adoption.

On Claims LiabilitiesMost underwriters and claims practitioners should have a reasonable understanding of what “Claims Liabilities (CL)” is all about. CL refers to the obligation, whether contractual or otherwise, to make future payments in relation to all claims that have been incurred as at balanced sheet date and includes provision for claims reported, claims incurred but not reported (IBNR), claims incurred but not enough reserved (IBNER) and also direct and indirect claims expenses.

Claims personnel will work towards preparing the “case-reserves”, which include handling expenses for all claims reported, determine the final payment amount and reviewing the case reserves of all known outstanding claims as realistic as possible. The total of these reserves established within any period is then subject to valuation by professional qualified actuary with the prescribed valuation bases that aim to secure an overall level of sufficiency of claims reserves at best estimate value and then apply a “Provision of Risk Margin for Adverse Deviation” (PRAD) to arrive at the 75% confidence level. The actuary will make numerous assumptions in arriving at the Ultimate Loss Amount from the total case reserves derived. From thereon, they will determine whether is there additional IBNR and IBNER, or even the handling expenses are required to be added on (or topping up) as part of the total CL.

On Premium Liabilities or Unexpired Risk Reserves (URR)The other component is Premium Liabilities (PL) which refers to the reserves for unexpired risks (URR) and includes liabilities for all benefits, claims and expenses, acquisition costs, maintenance costs and exposures after the end of the particular accounting period on which the actuarial investigation is conducted. In short we can summarise PL as:

PL = URR = Unearned Premium Reserves (UPR) + premium deficiency reserves

What is UPR? Underwriters should be familiar with UPR or more specifically, unearned premium reserves. The usual computation method is the use of 1/24th method reduced by the actual commission payable except for marine cargo, which is calculated by applying 25% to the net premium without any deduction for acquisition costs. If you have a habit of reading your company’s finance accounts, you should see this reported as part of the NOTES to the accounts….

What is a premium deficiency reserve? If there is a portfolio loss then premium deficiency needs to be factored into the equation, otherwise, UPR = URR + unrealised profit. Please check the relationship between URR and UPR (Our latest addition 13th March 2012). We can rephrase it as “unallocated expenses and deferred acquisition costs”. Before we can get to the quantum of deficiency in premium reserves, the actuary must have worked out the best estimate ultimate loss ratio (to have some idea, refer to PL….). From this best estimate, an additional % loading is imposed (ie. 4%) for policy administration expenses expected. This ratio is then further adjusted by the actuary to account for the actual deferred acquisition cost that the company has factored into the calculation of the UPR earlier on. The final adjusted ultimate loss ratio is then applied to the UPR to derive an estimate of the URR, ie. URR = UPR + premium deficiency reserves = UPR x ULR (Adjusted).

Now, you have finally arrived…..at what should be the amount for Premium Liabilities or URR and the Claims Liabilities. But, please ensure that you separate out these into: (1) Business within Malaysia, (2) Business outside Malaysia. Don’t worry or be bothered if you are having a hard time digesting what I have said, these are not for us to know in detail, they are for the actuary to work them out, and indeed they will work out or rather massage up another level, ie. at 75% level of confidence.

At 75% level of confidence, is the RBC framework hurting the insurers? Insurers are expected to be ready since they have had numerous years preparing themselves for this eventuality. But in reality, insurers writing substantial motor business have their CAR severely challenged. In simple terms, most insurers in the past have the habit of massaging their claims case reserves in order to prop up a show for the year-end financial reporting. At 75% confidence level and with the fast rising industry loss ratio for third party bodily injury claims, any actuary is not about to make assumptions that could compromise their professional position. Therefore if the claims practitioners do not have an inkling of how their decision on claims reserving can impact the company’s CAR, they need to be shot! They must know, time is an essence and interest works on a compounding basis over time…. The old phrase, “Let’s sleeping dogs lie” must surely goes…..

The Underwriters’ Position – With reasonable understanding of how those relevant risk charges (refer to the table above) are applied on this actuarial-computed amount to derive the total of General Insurance Capital Charges underwriters should be in a better position to deal with individual risks or a portfolio of risks coming for underwriting mention. If an LSR risk has a higher than normal loss ratio or adverse loss exposure, underwriters must make attempt to resist it, and if a portfolio of risks is showing signs or trends of deterioration, then underwriters must make attempts to arrest the deterioration otherwise the reality would surely sinks in after those actuarial computation. If there are sizeable risks requiring fronting by insurer, it is important to understanding the claims related impact of those risks. Risks having long tail claims settling nature must be properly scrutinised – you can imagine the amount of capital charges in respect of outstanding claims due from your aviation reinsurer(s) in an event of a major air disaster – claims could run into USD100 million and time taken for final settlement may takes more than 36 months if there involves third party liability claims! In the next 36 months your company would be hit by a 30% risk charge applied on the claims reserves due from your reinsurer(s), and this can be crippling in terms of the RBC framework! Worst still what if the risk was substantially placed to a single reinsurer and that reinsurer is having financial constraints? Thus, it is best practice not to put all eggs into one basket….

From the capital risk charges applicable to the Premium Liabilities, underwriters may want to avoid aviation, marine hull and professional liability risks, simply because they attract a much higher risk charge, ie. at 45% unless those risks are clearly of the better grade. Writing substandard risks under such category is also likely to produce a double whammy in the guise of the capital risk charges applicable on the claims liabilities, at 30% if there are claims incurred. With this “45% & 30%” capital risk charges, it would wear out the capital of the insurer fast if it has underwritten a large portfolio of such risks.  It is not too difficult to understand the effects by looking at the Table III.

(4)   Operational Risk Capital Charges (ORCC) aims to mitigate the risk of losses arising from inadequate or failed internal processes, people and systems. This is the simplest as the authority has not come up with the more established and internationally recognised methods for doing so……thus the formula: ORCC = 1% of total asset. In this case we can work it out as “Total Asset = Total Shareholders’ Fund + Total General Insurance Fund”

Summing up

From the TCR table (above), you can have the figure for TCR which is equal to CRCC + MRCC +GCC + ORCC. Now you already have all the charges total-up into TCR, then apply this to the formula of “TCA / TCR x 100%”. However, what is most important here is not the final amount in respect of the TCR and TCA calculations but really about how underwriters can minimise further TCR build-up within the underwriting books on one hand…. and how claims practitioners can work towards ensuring that the claims case reserves are always adequately (especially those risks having long-tailed complexities) provided so that the company need not have to go through any IBNR-related “shocks”.

For the full document on RBC framework:

Revised Risk Based Capital Framework for Insurers (07 November 2008)

Do you like this write-up? Do put in some comments to enable us to further improve on it. 😉

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29 comments for “The simple side of Risk-based Capital (RBC)

  1. Pingback: Insurance Investigator Malaysia | Insurance
  2. Jimmy Star
    February 13, 2013 at 12:24

    Is the takaful RBC to be put in place soon?

  3. Gloria Nyip
    October 13, 2012 at 19:16

    Hi! Anyway to provide some updates on the RBC?

    • October 21, 2012 at 18:19

      Still checking for updates, nothing significant update except for those that relate to ICAAP. See how things go….

  4. Billy
    March 14, 2012 at 09:36

    Thank you for the sharing of knowledge

  5. Anonymous
    March 9, 2012 at 16:24

    UPR is that portion of premium which is not earned by the insurer i.e. the amount of premium that the insurance company is yet to receive from the policy holder.

    The insurer has to maintain a reserve for this unearned premium to meet the sudden need of cash if the policy holder or the insurer decides to cancel the policy anytime during its tenure.

    All the insurance companies have to maintain the minimum level of ‘unearned premium reserve’ in order to meet the condition set by the insurance regulatory board.

    Unexpired risk reserve works somewhat similarly like ‘unearned premium reserve’. The insurer can maintain an extra level of reserve if he feels that the specified ‘unearned premium reserve’ level is not sufficient to meet his requirements. However, it is not specified by the regulatory board. The insurer may or may not maintain this extra reserve depending upon his needs.

  6. Anonymous
    March 9, 2012 at 13:18

    I am not the expert but the following is what I usually would refer to….

    Unearned Premium Reserves (UPR) = Unexpired Risk Reserves (URR) (Best Estimate) + Provision of Risk Margin for Adverse Deviation (PRAD) + Unrealised Profits (if any) = URR (at 75% or any other % of confidence level) + Unrealised Profits.

    However if you are in the situation of a consistent portfolio loss, you may see the following being true….

    URR (at 75% or any other % of confidence level) = Unearned Premium Reserves (UPR) + Premium Deficiency Reserves

  7. November 15, 2011 at 20:32

    Attractive section of content. I simply stumbled upon your web site and in accession capital to say that I acquire in fact enjoyed account your weblog posts. Anyway I?ll be subscribing for your feeds or even I achievement you get right of entry to persistently rapidly.

    • Anonymous
      January 26, 2012 at 19:59

      I got a feeling that RBC seems to align with the much talked about indications by Bank Negara on the removal of caps on operating expenses of insurers and the deregulation of pricing of motor and fire insurance products. I interpret that insurance companies with better capital adequacy capabilities would be in a better position to manage their operating expenses, including commissions to agents and agency related expenses, and also leeway to set their own product pricing based on their intended portfolio mix…….am I correct or incorrect to interpret so? In your opinion, when do you think the removal of expense caps and tariff rates would likely come into the scene? Soon…..not so soon……or not likely at all by year 2020? I will appreciate your further sharing. Thanks.

      • January 28, 2012 at 15:32

        What you are saying here is correct. RBC is about a framework for BNM to monitor and control how insurers work with their available capital. Capital available determines or control how insurers run their business in as far as the framework is concerned. In the spirit of the framework BNM had agreed to remove the management expense cap so that insurers could go about making sense of the money that they utilised in carrying out their business. Previously if the insurers are not able to cap their management expenses they are not able to pay for agency profit commission and also organise agency convention for their more deserving agents…. and so on.

        If the insurers could show that they are able to keep the SCAR and ICAR above 130% and 180% respectively then they are giving a freer hand to carry out most of their business plans otherwise the management would have to show to the BNM’s supervisory team as to the best manner to tackle the below par achievement….

        Whilst expense cap had been taken off, the detariffication of our fire and motor tariff is not in sight yet. It has already been prescribed earlier that the motor tariff would be maintained (off course with some gradual changes over the next couple of years) till end of 2015. Fire tariff is likely to be maintained, at least for 2012 – think BNM has managed to convince the Competition Act Commissioner that the fire tariff as a whole is beneficial to the consumers although I am not sure how…. As to whether the fire tariff will fall apart after this year would depend on the consumer association and how capable are they are to pick up their argument for detariffication….

  8. November 30, 2010 at 02:35

    Hello fellow blogger! I’m new to blogs but I just wanted to say that I like your blog here on work from home bbb certified. It kept me reading all the way to the end… And then I went and searched for some more posts after that. 🙂 Keep up the good work, I’m always looking to learn more about Online Home Business, in particular.

  9. rina
    August 2, 2010 at 15:46

    Dear writer,
    Can you explain about life insurer RBC especially the LCC part which I think a bit difficult.

  10. rina
    August 2, 2010 at 15:39

    Dear writer,

    Can you give the simpler way to calculate RBC for life insurer especially the LCC part which I completely dont understand.

    • August 2, 2010 at 23:34

      Are you a student? Our current batch of writers are all expert in non-life RBC. But let me digest what’s in it at the Life RBC before we reply you.

  11. farah
    July 20, 2010 at 17:50

    hi,

    i check the RBC framework issued by BNM and find you risk charges in Table III and Appendix IV in RBC framework of BNM differs.

    kindly advise. dah confuse sgt neh.

    for example, no mention risk charge for transit there in Appendix IV, RBC framework.

    Regards.
    Fara.

    • July 21, 2010 at 01:28

      This posting was made back in mid 2008 for an old website, it was subsequently transferred (reproduced) to this blogsite in late-2009. The writer did not amend the Table III to mirror that of Appendix IV simply because there were no changes to the risk charges set in the July 2008 BNM’s RBC framework albeit there were some reclassification of the class of insurance in the November 2008 version.

      The reclassification were as follow:
      – Aviation with RC 30% and 45% (break from the 2007’s item 5)
      – Oil & Gas with RC 20% and 30% (break from the 2007’s item 11)
      – Created “Others” with RC 20% and 30%, which was a break off from the 2007’s item 11

      The word, “transit” may be confusing to some but it is always a part of “Cargo” although the “transit” should not have appeared under Marine Hull (2007’s item 5)
      If you have any further question do give me a email or click through the “contact me” button on the mid-right widget bar.

  12. June 19, 2010 at 01:32

    Malaysia Risk based Capital | Malaysia Insurance Online was kind of helpfull, but insurance underwriter could be more in detail. Averall, was good info about insurance underwriter

    • June 19, 2010 at 13:49

      Just let us know as to which area to be more specific… we can rewrite those segment for better digestion and understanding….

  13. June 5, 2010 at 12:14

    [New Post] The simple side of Risk-based Capital (RBC)…. – via @twitoaster http://www.malaysiainsurance.info/?p=804

  14. Anonymous
    May 5, 2010 at 16:54

    Hello I’m a student,
    I’m curious on calculation matter,
    For example on CRCC with charge 1.6%
    Which one is correct?

    RM1000 x 1.016 or RM1000 x 0.016

    And do you know what is the best estimation for Premium Deficiency reserve?

  15. Anonymous
    May 5, 2010 at 16:50

    Hello I’m a student,
    I’m curious about calculation,
    For example in CRCC, let say charge is 1.6%
    Which one is correct?

    RM1000 x 1.016 or RM1000 x 0.016

    Thank you. And can you suggest what is the best estimation for Premium Deficiency Reserve?

    • May 6, 2010 at 07:08

      It should be RM1,000 x 1.6/100 = RM1,000 x 0.016.

      Premium deficiency reserves is already explained in the writeup. You cannot use the above example to make the calculation. We need a couple of years statistics where the Ultimate losses are compared to the premium charged. Consideration is given to the acquisition costs as well as claims adjustment costs. Since we are not actuary, it is best you pose the question to actual non-life actuaries. Ultimately how this is calculated would depends much on their understanding of the portfolio that is being analysed.

  16. Anonymous
    December 28, 2009 at 09:05

    Dear sirs,
    Firstly, I am a Claim person. After reading, I am still blur. Can you provide me with writeup solely on claims and RBC matters? Appreciated & thnks

    • December 29, 2009 at 18:48

      Will do once I find the time to rewrite those relevant parts for claims personnel

    • Anonymous
      February 2, 2010 at 08:44

      Ye, still blur! Need some ABCs of the subject.

      • February 2, 2010 at 22:47

        Okay lah! Have to admit my writing is not good enough. Let me find a better way to put it in another form….. one day, hopefully not too long from now.

  17. Kent
    December 10, 2009 at 18:14

    Hope you can attach the original risk base capital document for us. Thank you.

    • December 11, 2009 at 22:24

      Yes, I have already slot the 7th November into my posting. You can scroll to the bottom of the post and click on the file hyperlink.
      Thank you for reading…..

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