Insights

The COVID-19 pandemic has put the spotlight on capital adequacy in the financial services industry, which needs adequate capital to withstand adverse and unexpected conditions. Life insurers, in particular, have long-term financial obligations towards policyholders which need to be settled as they fall due. Holding adequate capital, therefore, is crucial as the impact of a single insurer's failure could lead to systemic risk in the economy and loss of public confidence in the sector. Therefore, ensuring the solvency of insurers is one of the major focus areas of insurance regulators worldwide.

The current capital regime in India requires capital to be calculated using a two-factor-based formula approach where the first factor applies to the mathematical reserves (statutory liabilities towards policyholders) and the second factor applies to the sum at risk (excess of sum assured over the mathematical reserves). Moreover, the statute requires that a solvency ratio (ratio of available capital to required capital as calculated by the two-factor formula) of 150% is to be maintained. Entities, where the level of capital falls below the minimum, are subjected to course correction as prescribed by the IRDAI.

The current capital framework is simple to understand, calculate and communicate. Also, the approach is conservative and time-tested. However, this approach has some disadvantages. Capital levels are not necessarily aligned with actual risk and it does not consider all the risks. For instance, counterparty default risk is not included. Also, there are few incentives for insurance companies to promote better risk management as limited credits are available for risk mitigation actions.

Need for a Risk-Based Capital (RBC) framework

Many countries with a significant insurance industry have either transitioned or are transitioning to a risk based capital (RBC) framework. The EU fully transitioned to an RBC framework called Solvency II in 2016. Closer home, in Asia, many countries follow some form of the RBC framework. In India too, the IRDAI has articulated its position of working towards transitioning towards an RBC regime.

RBC is a method of measuring the minimum capital required by an entity given its risk profile. It requires an entity with higher risk exposure to hold more capital. The key objective of RBC is to enhance the protection of policyholders by establishing a measure of solvency which is commensurate with the risks to which an entity is exposed. It is not aimed at increasing overall capital levels but rather at ensuring a high standard of risk assessment and efficient capital allocation. Ultimately, the aim of RBC is to achieve the following:

• Risks are considered for capital requirements.
• Enable entities to control risk exposure to individual risk factors and provide early warning signals to the regulator.
• Promote better risk management as credits are available for risk mitigation actions such as ceding of risk to reinsurers. Currently, there is a limit on the credit that can be taken for such risk mitigation actions.
• Ensure consistency in the valuation of assets and liabilities which is an increasing requirements of International Financial Reporting Standards (IFRS) and Ind-AS.
• Align the capital to the risk profile which may free up capital which could be used for enhancing insurance penetration in the country.

Implications of introducing the RBC framework

The adoption of RBC is a fundamental change from the current regime and is expected to have far-reaching implications. Let’s examine some of the key ones.

The RBC framework can enable the management of an insurance company to keep control over its overall risk exposure while steering its underwriting, investment and product strategies. RBC should eliminate false incentives to take risks which are not charged heavily enough by the current framework (such as credit risks). Consequently, a key benefit of RBC for the insurance industry is expected to be the enforcement of risk-adequate pricing of insurance products and product innovation that brings together customised products with manageable risk features. Thus, the RBC framework is likely to reinforce an insurers’ focus on economic value creation, which is linked to strong risk management. By incentivising insurers to manage risks better and thereby reduce their capital requirements, the RBC framework can foster enhanced insurance penetration as freed-up capital can be deployed back for the growth of the market.