Capital adequacy for insurance companies

Using the capital-to-asset ratio is an international requirement for banking institutions. This ratio, also called the capital adequacy ratio, determines the minimum amount of capital a financial institution must keep on hand to meet its financial needs. Insurance companies must also maintain adequate capital and use financial formulas to determine the amount required.

The capital-to-asset ratio is used primarily by financial institutions. The ratio analyzes the institution's (usually a bank's) ability to pay its bills compared with how much financial risk the company has acquired (through loaning funds, for example). This ratio is an international standard for banks to make sure they can meet the needs of their customers if they make poor risk-based investments. Although banks have an internationally required capital-to-asset ratio (8 percent), insurance companies also must meet certain capital adequacy levels. In fact, the National Association of Insurance Commissioners (NAIC) has a Capital Adequacy Task Force to measure and monitor the required capital for all kinds of insurance companies.

This ratio is calculated by taking "tier 1 capital" and adding it to "tier 2 capital" and dividing these by "risk-weighted assets." Tier 1 capital refers to capital that is easy to liquidate, such as common stock. Tier 2 capital refers to capital that is difficult to liquidate or complicated to calculate, including money that is misplaced and unknown in amount. Risk-weighted assets are those capital assets the financial institution must possess to pay its outstanding liabilities.

Assume that Financial Institution A needs to determine its capital-to-asset ratio. Financial Institution A has $1 million in tier 1 capital and $2 million in tier 2 capital. Its risk-weighted assets total $37 million. To determine the capital-to-asset ratio, Financial Institution A adds its capital together. The total is $3 million. It divides this $3 million by the risk-weighted assets total of $37 million. Financial Institution A's capital to asset ratio is 8.1 percent.

Insurance companies are also required to calculate capital adequacy to maintain minimal capital to meet financial obligations. The NAIC has a risk-based capital (RBC) system that is the insurance company standard for capital adequacy. There is a different formula for each insurance type, and the formulas are complex. They are not referred to directly as capital-to-asset ratios. However, they function in a similar way -- determining the minimum capital level an insurance company must maintain to meet financial needs. RBC considers the various types of risk insurance companies encounter, including asset risk, underwriting risk and business risk. The formulas use these risks to determine the risk-based capital amount required. RBC compares an insurance company's actual capital level with a minimum hypothetical level. The NAIC has a regulatory body within the RBC system, and there are five levels of possible regulatory action that range from "no action" to "mandatory control level," depending on the company's level of capital adequacy. The "mandatory control level" is the most severe level and mandates that the regulatory body begin to place the insurance company under its control.

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