A primary function of state regulators is to ensure that to the extent possible companies will be able to meet their current and future obligations to policyowners. Life insurance companies will have the financial capability to meet these obligations as long as they are solvent and operate with sufficient safety margins to ensure future solvency. In recent years the NAIC has concentrated on developing tools to identify companies that are currently solvent but have adverse operating trends or potentially insufficient capital to withstand a period of sustained losses. The purpose of these tools is to identify companies whose position and operations should be reviewed by state regulators. In many (or most) cases of the companies so identified, no regulatory action will be required because the regulatory review will have shown that the adverse operating trends that triggered the review are not material or that the company has already taken appropriate actions to remedy the problems. In other cases the regulators will find that the triggering conditions are material and that the company has not adequately addressed them. In these circumstances the regulators will oversee the development and implementation of a plan to remedy these conditions or trends.

The two types of tools state regulators currently use are the insurance regulatory information system (IRIS) ratios and, starting with 1993, Risk-Based Capital (RBC). Unlike the ratings of the rating services that are intended to be measures of company risk, these regulatory tools are not, and are not intended to be, such measures of risk. Additional investigation by regulators is required to determine if a company that "failed" the tests must take any actions and what these actions should be. Failure of these tests does not by itself indicate that a company has a significant risk of insolvency or impairment. This is true regardless of whether or not regulators make the company take remedial actions.

The IRIS ratios are successors to the early warning system developed by the state insurance regulators about 20 years ago. They identify companies for whom regulatory review and perhaps regulatory oversight is appropriate.

IRIS involves 12 ratios for life and health insurance companies. Each ratio is computed as a percentage, and depending on the ratio, it may be positive or negative. The specific IRIS ratios are presented in table 31-3, along with the usual range for each ratio. To establish the usual ranges for the IRIS ratios, state regulators reviewed the ratios for companies that had become insolvent or had experienced financial difficulties in recent years. The NAIC expects that in any year 15 percent of the companies will fall outside the usual ranges on four or more ratios.

There are no specific rules that determine the degree of regulatory response for a company whose results fall outside the usual ranges in a number of the IRIS tests. The response depends on such factors as the number of outside-the-usual- range results, their severity, the trends in the number and severity of previous outside-the-usual-range results, and the effects of previous reviews and actions.

The capital standards imbedded in state law for life insurance companies have traditionally been quite low, ranging from a few hundred thousand dollars in some states to $2 million in New York. Moreover, such standards have never adequately recognized company size or risk.

In the early 1990s the NAIC developed, in consultation with industry experts, a risk-based capital (RBC) measure. As indicated earlier, this measure is used to determine whether and to what degree regulatory intervention is required. The RBC measure first became a requirement with the 1993 financial statements.

Under the RBC approach, a company determines the RBC standard amount of capital and surplus (based on the RBC formulas) each year. It then compares its actual capital and surplus, including the asset valuation reserve (AVR), to the computed RBC measure. The regulatory response, if any, depends on the results of this comparison. A company whose actual capital and surplus exceeds the computed RBC standard requires no regulatory action. If the company�s actual capital and surplus falls between 75 percent and 100 percent of the computed RBC standard, the company is required to file a plan of the actions it intends to take to eliminate this gap with its state regulators. If the company�s actual capital and surplus falls between 50 percent and 75 percent of the computed RBC standard, the home state regulator has an obligation to undertake a detailed review of the company�s operations and to mandate corrective actions. If the company�s actual capital and surplus is below 50 percent of the computed RBC standard, the company is considered to be a candidate for seizure by the state regulator.

During the 20 years leading up to the NAIC�s formal adoption of the RBC standards, there was a steady evolution in the identification and evaluation of the risks facing life insurers. The actuarial profession classified risks into these four categories:

For example, the bond factors (before adjustment) range from 0.3 percent for AAA bonds to 30 percent for bonds in default. These basic rates are then multiplied by the applicable degree of diversification factor (based on the number of issuers whose bonds are held in the portfolio). For less than 50 issuers, this factor is 2.5; for 200 issuers the factor is l.45; for 500 issuers, the factor is 1.16. For other key asset classes, the basic factors applied to the amounts of assets to determine the asset default risk are as follows: for mortgages, 0.l percent to 20 percent, depending on quality level and company experience; for common stock, 30 percent; for owned real estate, 10 percent to 15 percent, but 20 percent if held in a partnership; and for cash and short-term investments, .3 percent. For large companies the asset default (C-l) risk constitutes almost 75 percent of the total calculated RBC standard. For smaller companies the percentage of the RBC standard attributable to C-l risk factors is somewhat smaller.

Insurance. The C-2 (insurance risk) element is intended to provide additional protection (over and above the required reserves) for adverse trends and experience in life insurance mortality and/or health insurance morbidity or for premium inadequacies. The life insurance factors, which are applied to the net life insurance risk, decrease as the company�s insurance risk amount increases; this element therefore is a relatively more important component of the RBC standard for smaller companies than it is for larger companies. The health insurance factors are applied to premiums and vary by both type of health insurance coverage (hospital and medical insurance, disability income, and so on) and premium volume, with lower ratios applying to premium amounts in excess of $25 or $50 million per year for a coverage. For both life and health insurance, smaller factors apply to group insurance than to individual coverages. The C-2 factors represent about 10 percent to 15 percent of the RBC standard for larger companies and, as noted above, a relatively greater percentage for smaller companies.

Interest. The interest risk (C-3) is determined by applying factors to the amounts of insurance reserves. These factors depend on the level of risk (low, medium, or high) and on whether the company has received an unqualified actuarial opinion. Low-risk reserves include individual life insurance reserves and individual annuity reserves that cannot be withdrawn or that have a low withdrawal risk because of a market value adjustment feature. Individual annuity reserves permitting surrenders at book value but with large surrender charges (5 percent or more) are considered to be medium risk. The interest-risk factors range from about 10 percent of the total RBC standard for larger companies down to less than 5 percent for smaller companies for whom the insurance risk is relatively more important.

Business. The business risk (C-4) factors are 2 percent of life insurance premiums and annuity considerations and 0.5 percent of health insurance premiums. This element generally constitutes 5 percent or less of the total RBC standard for companies of all sizes.

In recognition of the fact that there are interrelationships among the different types of risks and that the separate risk calculations may overstate the total risk requirement, the total of the four risk elements is adjusted using the following formula:

The result is to reduce the RBC capital standard to about 80 percent to 90 percent of what it would have been without this adjustment. As an example, let�s assume that a company has determined the following preadjustment RBC standards:

Asset risk $750 million

Insurance risk 200 million

Interest risk 125 million

Business risk 50 million

After the adjustment, the RBC standard is $948 million, compared to $1.125 billion when the standard components are independently calculated.

Because the RBC standard is so new, there has been no opportunity yet to test its effectiveness in helping companies and regulators prevent life insurance company failures and policyowner losses. Clearly, it is an improvement on the previous minimal capital standards. But whether a standard with such heavy emphasis on responding to the asset-risk lessons of the late 1980s and early 1990s will serve the industry and regulators well in the unknown (and certainly different) world of the late 1990s and into the next century without substantial modification is still to be determined. (For example, could the more conservative investment philosophy that will inevitably follow the emphasis on the asset-risk component of the RBC significantly increase the interest rate deficiency risk or substitute the asset-liability mismatching risk for the asset-default risk?) The other critical dimension will be state regulators� effectiveness in monitoring the progress or, in some cases, guiding the improvement efforts of companies whose capital and surplus fall below the computed RBC standard.

The purpose of the RBC calculations and comparisons is to identify companies where regulatory oversight and action may be beneficial in preventing future failures and policyowner losses. There is no compelling evidence, however, that a company whose capital and surplus approximates the computed RBC standard has significantly greater risk than a company with substantially more capital and surplus (say, 150 percent of the computed RBC minimum standard). Except for companies with very weak current capital positions, the risk of future failure usually depends more on future business actions and results than on current capital strength.

Beginning in 1993, a company�s statutory financial statement must disclose its total adjusted capital (the amount of the company�s capital and surplus for purposes of the RBC comparison) and its authorized control level of capital (the amount of capital below which the regulators are authorized to seize the company), which is 50 percent of the computed RBC standard. RBC results are intended to be kept confidential, and there are explicit prohibitions on the use of RBC results in a company�s sales promotions and advertising. Nevertheless, it will not be difficult for outside parties to prepare lists showing the ratio of each company�s actual capital and surplus to the computed RBC standard and for these lists to become available to policyowners and prospective policyowners.