The Dummy’s Guide to Risk-Based Capital
Too Big To Fail, Risk-Based Capital, SIFI, ORSA, Solvency Ratio. These terms and acronyms really get your blood moving, don’t they? Or maybe not…
At PriSim, we work closely with several leading insurance and financial companies and are thus actually interested in financial risk. We’ve put together a brief description below of 5 commonly used risk terms.
The bottom-line is that large financial institutions are deeply intertwined with the economy; if they are not in good financial health, the collateral impact to the economy and to society could be tremendous. The risk measures and approaches below attempt to describe the financial health of these companies.
- Risk-Based Capital (RBC): A quantitative approach to estimating the risk buried in a financial company’s equity via “risk charges”. Describes the quality of the company’s capital, not just the quantity.
The RBC Ratio = Equity / “Risk Charges”. In general, the higher the ratio the healthier the company.
Read a great overview of RBC here.
- Systemically Important Financial Institution (SIFI): A bank or insurance firm closely watched by the U.S. Federal Reserve due to the impact it would have on the economy if it collapsed. SIFIs are held to higher financial-health standards and will likely be propped up by the government if they are at risk of failing.
Read about some recent developments involving SIFIs here.
- Too Big To Fail: A more dramatic term used to describe a SIFI.
- Own Risk and Solvency Assessment (ORSA): A self-assessment of a company’s financial risks, capital needs, and the sufficiency of its current and forward-looking capital.
See more here.
- Solvency Ratio: The core metric used in the European Union as part of Solvency II, a regulatory program begun in 2016 to assess whether an insurance company is holding enough capital to provide certainty to policyholders that claims can be covered in abnormal years.
The Solvency Ratio = Surplus / Solvency Capital Requirement (SCR). An insurance company’s Solvency Ratio should be well above 100%.
Read a brief overview of the Solvency Ratio here, and more detail here.
While the concepts of risk-based capital seem like common sense, the head of the FDIC recently wrote that risk-based systems can actually hide risk. Instead, the author recommends using a Leverage Ratio, such as comparing Debt to Equity or Equity to Assets.
How do you quantify and describe financial risk at your company? Do you periodically re-assess the adequacy of that process as the economy changes?
As a side note, PriSim’s 2017 version of our Insurance Challenge simulation will include solvency metrics so that participants can see the impact of their decisions on financial risk.