Abstract:

The services sector occupying lion's share of the country's Gross Domestic Product (GDP) is one indicator of a nation's economic development. The sector has a huge impact on the lives of the country's population. The financial health of the organisations in this sector is now almost synonymous with the financial health of the country. In view of the risk profile of the financial sector, in advanced countries, the RBC has emerged as a key concept to guard the health of this sector, prompting similar initiatives in other emerging markets. It can be equally effective and rewarding in all other sectors/segments of the economy. Today the term surprisingly carries a mystic aura around it. This article is an attempt to present to the reader a preliminary understanding of RBC and some dimensions associated with its implementation / adoption.

1. Introduction

Capital has two primary/basic functions.

1. First, providing the necessary wherewithal and energy for the commencement and continuance of all operations of the entity,
2. Second and no less important, simultaneously providing safety and security to customers, creditors, and other stakeholders, by guaranteeing the solvency of the entity.

The organisations which are well capitalised are able to successfully withstand the onslaught of threats of all kinds.  This criticality of capital for the viable economic survival of an organisation, which in turn guarantees protection to all other stakeholders, is well recognised. Minimum capital requirements to commence a business, and prescribed capital adequacy norms / solvency norms, either in the form of a minimum absolute amount or as a percentage of the volume of operations  are nothing but a reflection of such recognition. And the latest concept of “Risk-Based Capital” (RBC), is a natural progression in this journey of capital.  Over the years it was realised that the size of capital need not be in proportion to the volume of operations. Rather it should be in proportion to the risks to which an organisation is exposed. Put in simple words RBC says, that the greater the risks faced by the organisation,  greater is the capital needed and vice-versa. The concept of RBC attempts to answer the following questions .

 What is the right amount of  capital for an organisation to have?

 What is the right method of ascertaining the right amount of  capital?

The steps involved (RBC Process) in arriving at the right amount of capital  can be summarised as follows.

1. Identification of all the resources an organisation owns.

2. Identification of the sources of threats to which each of these resources are exposed.

3. Risk-weighing - Assessment of likelihood of the threats operating on the resources and extent of consequent effect on organisational resources. The methods employed and the approach to risk-weighing will vary depending on the risk element (asset/activity/ liability/peril). It involves the selection of a base, primarily representing the exposure and establishing the factor/charge/margin to be applied. (Mostly based on empirical evidence, alternatively based on simulation exercises, with adjustments considered necessary). It also involves some amount/degree of professional judgment.       

4. Quantification of the buffer (Capital) needed, by summing up the results of risk-weighing. Here, the aggregate requirement  may not be equal to the sum of individuals. Therefore some               co-variance adjustment is needed  alongwith sensitivity testing for economic/Industry          downturns, market risk events, and liquidity conditions.

5. Decide the framework for regulator's intervention. RBC Process also includes regulatory steps

6. Decide the composition of the available capital.

1. RBC's Greater Relevance to Financial Sector

Though the concept of Risk-Based Capital (RBC) has universal application, because of the following special features of the sector (Organisations engaged in Banking and Non-banking activities, Mutual Funds, and Insurance Companies), the concept has greater relevance to the financial sector.

               The sector's operations are predominantly driven by customers' funds.

               The sector's assets are dominated by financial assets and assets which are not tangible.

               Such assets have a comparatively very high degree of volatility, and

               The sector also faces a very high level of contagion effect,

               Liability risks too are as serious as threat of asset risks.

Therefore Banking and Insurance Regulators have been very active in shaping the contours of this concept of 'Risk-Based Capital (RBC)'.

1. Superiority of Risk-Based Capital

1. Under RBC regime you know where exactly your risks are lying. And also the relative magnitude. Currently the “Required Solvency Margin”  is stated as an absolute amount. The RBC regime will clearly tell as to why  the said amount is required, as It will give us the requirement with a break up, under different risk categories like, asset risks,  insurance risks, operational risks and off-balancesheet items separately. Further breakups (like market risks, credit risks, currency risks, concentration risks, reserving risks, growth risks  etc) under each of the above           categories can also be made available.  Thus it transforms the imposed governance into self- governance, a high level democratic value.

2. It is more scientific. The estimates are backed and supported by objective data, proven methods. As against this, earlier methods of capital prescription look like thumb rules.

3. Facilitates proper leveraging of capital. Adds to efficiency in utilisation of capital by differentiating between organisations with different risk profiles and by avoiding un-necessary blocking of capital. The rigidity of the current practice might have prompted IRDA in its recent             tweaking of some of the solvency provisions. RBC has the inbuilt flexibility necessary to support   business strategies.

4. Also contributes to effective ERM and Performance Management.

1. Some issues on which further work is required before RBC is implemented in Indian Insurance Sector.

• Developing risk factors appropriate for Indian Insurance Market.
• Choosing, between  Standard Approach and Internal Ratings Based /Specific Approach.the ratings and rating agencies in the standard approach. from amongst different risk weighing methods/approaches (factor-based, stochastic, scenario-based, market/economic value-based)period elements in developing risk factors – Strike a balance between current trend and adequate experience.

• Deciding, confidence level/s to be achieved.extent of categorisations and sub-categorisations of different elements/components.co-variance, stress testing stages, additional buffer and monitoring levels.

• Establish / define the relationship of bond yields and interest rate changes and similar inter-relationships.
• In the current solvency mechanism certain items receive different treatment (like “Fair Value Change Account”, a result / consequence of market fluctuations and some more items under the description “inadmissible assets”).  Is it really necessary to continue the practice of different treatment ?   Uniform approach makes things simple. Issue needs closer examination.

The impact of the RBC on different organisations is a matter of specifics. Indian Insurance market with a huge potential, can not afford to delay adoption of a proven concept like RBC. Sooner the better. 

S H Gejji

Retired Official of The New India Assurance Co. Ltd.

Ex-faculty and PGDM Co-ordinator at National Insurance Academy Pune.