This paper was presented at the conference "Financial services at the crossroads: capital regulation in the twenty-first century" as part of session 5, "International capital allocation at financial institutions." The conference, held at the Federal Reserve Bank of New York on February 26-27, 1998, was designed to encourage a consensus between the public and private sectors on an agenda for capital regulation in the new century.Insurance industry ; Capital ; Risk

Robert E. Lewis

English

Research Papers in Economics

FRBNY ECONOMIC POLICY REVIEW / OCTOBER 1998 183
Capital from an Insurance Company 
Perspective
Robert E. Lewis
This morning, I would like to give a few practical com-
ments on capital adequacy from an insurance company
perspective. In doing so, I will present two views on capital
adequacy and capital allocation in the insurance industry.
The first view is the regulatory perspective, that is, the
motivations behind regulatory capital requirements in the
insurance industry, the structure of those requirements,
and the relationship between regulatory capital amounts
and the actual risks facing insurance companies. The second
view is an insurance company perspective, in particular, the
approach taken by the American International Group (AIG)
to determine adequate capital allocations for our various
businesses and for the firm overall.
REGULATORY PERSPECTIVE
The regulatory perspective on capital adequacy was well
summarized, in June 1996, by B.K. Atchinson, president of
the National Association of Insurance Commissioners
(NAIC):
The most important duty of insurance commis-
sioners is to help maintain the financial stability of
the insurance industry—that is, to guard against
insolvencies. . . .  Among the greatest weapons against
insolvency are the risk-based capital requirements.
In other words, the NAIC recognizes the important role
that capital can play in preventing insolvencies and has
implemented a set of risk-based capital requirements
intended to address this concern.
Without going into the details of the calculations,
the NAIC’s risk-based capital requirements are intended to
capture several forms of risk facing insurance companies.
For life/health companies, these risks include:
• asset risk: the risk of default or a decline in the market
value of assets;
• insurance risk: the risk that claims exceed expecta-
tions;
• interest risk: the risk of loss from changes in interest
rates; and
• business risk: various risks arising from business
operations, including guarantee fund assessments for
the eventuality that one insurance company fails and
others have to stand by with capital to assume some of
those losses.
For property/casualty companies, the risks covered by the
capital calculations are different, because the business is
quite different. In brief, the risk-based capital calculations
are intended to cover:
• asset risk: the risk of default or a decline in the market
value of assets;
• credit risk: the risk of loss from unrecoverable reinsur-
ance and other receivables; Robert E. Lewis is chief credit officer at American International Group, Inc.184 FRBNY ECONOMIC POLICY REVIEW / OCTOBER 1998
• underwriting risk: the risk of loss from pricing and
reserving inadequacies; and
• off-balance-sheet risk: the risk of loss from factors
such as contingencies or high business growth rates.
While the regulatory capital requirements are
intended to cover a wide range of the risks facing insurance
companies, the rules have a number of shortcomings. From
a technical perspective, the calculations impose overly
harsh capital requirements along several dimensions. For
one, the calculations do not include covariance adjustments
within risk groups, so the benefits of diversification of risks
are not fully recognized. Further, the requirements impose
undue penalties on affiliated investments, ceded reinsur-
ance, and adequate reserving, as well as on affiliated foreign
insurers. The NAIC’s risk-based capital rules also have a
number of shortcomings from a practical or operational
perspective. In particular, the requirements are applied
only to insurance firms in the United States; there is no
international acceptance of these requirements and, there-
fore, no level playing field with regard to capital regula-
tion. Even within the United States, not all states apply the
NAIC guidelines. Finally, since the requirements do not
cover the full range of risks facing insurance firms, supervi-
sors typically expect insurers to maintain multiples of the
minimum risk-based capital requirement.
Further, in practice, the requirements have not
proven to provide either a good predictor of future insol-
vency or a consistent rating of relative financial strength
among insurers. History has shown that only a small per-
centage of insolvent insurers failed the risk-based capital test
prior to their insolvency. Conversely, of those insurers that
fail the risk-based capital test, only a small percentage
actually become insolvent. Thus, the risk-based capital rules
provide a very noisy indicator of the actual financial strength
of U.S. insurance companies. On the plus side, however, the
rules have permitted supervisors to take prompt regulatory
steps against insurers without court action.
INSURANCE COMPANY PERSPECTIVE
A number of factors are influencing insurers’ views con-
cerning capital adequacy in the current insurance industry
environment. Overall, a shortage of capital is not a prob-
lem for most insurers operating today; indeed, in the view
of many, there is overcapacity in the industry. However,
current conditions in the insurance industry may not
prevail in the future. Overcapacity has intensified com-
petition in the market for insurance products, driving a
loosening in underwriting standards. While combined
ratios—a measure of an insurer’s overall underwriting
profitability—are improving, this improvement largely
reflects a lack of “catastrophes” and the resulting surge of
claims, rather than strong underwriting practices. In
many cases, loss reserves are not increasing commensurate
with premium growth and profitability is being driven
by attractive financial market returns, rather than by core
underwriting activities. These conditions suggest that
capital adequacy may become more of an issue in the
not-too-distant future.
In March 1994, these views were nicely summa-
rized by Alan M. Levin of Standard and Poor’s:
Of course, a strong capital base is an important
determinant, but without good business position
and strategy, management acumen, liquidity and
cash flow, favorable trends in key insurance
markets, dependable reinsurance programs, and
numerous other factors, a strong capital base can
be rendered inadequate in an astonishingly short
time.
As this quotation suggests, there are many sources of unex-
pected losses that can quickly erode an insurer’s capital
base. These include adverse claims development (as the
result of one or more catastrophes or because general
expectations of claims were understated); unrecognized
concentrations of risk exposures in investments and credit
extensions; unexpected market risk developments that
adversely affect investment returns; and legal risks such as
legislation requiring retroactive coverage of exposures.
Given these considerations and the general environ-
ment in the insurance industry today, AIG has developed a
set of basic principles concerning our approach to capital
adequacy and business strategy. To begin, capital must be
sufficient to cover unexpected losses while maintaining
AIG’s credit rating. We feel that the credit rating, the best
credit rating, is absolutely important for an insurance
company to maintain soundness, to maintain credibilityFRBNY ECONOMIC POLICY REVIEW / OCTOBER 1998 185
and confidence, and to be able to seek any opportunity that
it finds profitable. 
Further, the insurance business must return an
underwriting profit, without consideration of returns from
the investment portfolio, and underwriting decisions must
be kept separate from investment decisions. We find “cash-
flow underwriting,” as the term is called in the industry, to
be a disturbing situation where risks are written assuming
discount rates that require an insurer to take financial risk
in order to achieve a profit. In a similar vein, operating
cash flow and liquidity must be adequate to insulate the
corporation from the need to liquidate investments to
cover expected claims and losses. Finally, reserves must be
built consistent with the company’s current underwriting
risk profile.
Our approach to modeling capital adequacy
reflects these basic principles. First, we begin with actuarial
assessments of capital and reserve adequacy for our under-
writing business. We then look at balance-sheet capital,
make economic adjustments, and allocate the adjusted
capital to profit centers throughout the corporation. Each
profit center must meet a hurdle rate of return without
benefit of investment income. In this way, we assess capital
adequacy in relation to the basic underwriting business,
without relying on investment returns. To assess invest-
ment and other forms of credit risk, we are installing a
credit risk costing model. Finally, we are in the process of
implementing a market risk measurement model to assess
market risks in our insurance-related investments as well as
in our financial services businesses.
One important aspect of risk modeling that
deserves special attention is concentration risk. Diversifica-
tion of businesses is key to providing stable earnings,
reserving, and capital growth. Ideally, capital modeling
would be done using full covariance matrices to assess the
degree of diversification—or, conversely, the degree of
concentration—in business activities and other risks.
However, designing an approach that makes use of full
covariance matrices is a complex undertaking. Instead, we
plan to emphasize stress testing of correlation risks. In this
way, we can assess the impact from adverse events on insur-
ance, investment, liquidity, and financial services, and get a
picture of the extent of concentration risk across our busi-
ness activities.
In our firm, we try to stress test through scenarios
that look at the correlation of insurance investments, mar-
ket risks, and liquidity risks. For example, we might look
at an eight-point Richter Scale earthquake in Tokyo, which
our geologists tell us is a highly positively correlated event
with a sizable earthquake in California. When we look at
that scenario and at what could happen from an insurance
company perspective, we look at the possibility that finan-
cial markets are disrupted or closed for a period of time. In
this environment, companies have to react and respond, have
the liquidity to be able to make the investment decisions,
and not have to sell assets into a very disrupted market. At
the same time, we want to have enough capital, and a
strong enough credit rating, to be the corporation that
we are today. These are the types of stress tests that we
undertake, and judgment is a big component of the
whole exercise.
CONCLUSION
This paper has provided a brief overview of the factors
affecting capital adequacy in the insurance industry, both
from the perspective of insurance regulators and an indi-
vidual insurance company. The key idea is that we try to
approach capital adequacy from the perspective of not only
being able to play the game after adverse events have
occurred, but being able to play the game the way we play
it today. While risk modeling is an important part of this
assessment, we use the modeling only with a very high
degree of reason and discussion.
Thank you.
The views expressed in this article are those of the author and do not necessarily reflect the position of the Federal Reserve
Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or
implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any information
contained in documents produced and provided by the Federal Reserve Bank of New York in any form or manner whatsoever.

Capital from an insurance company perspective

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Capital from an insurance company perspective

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