The Actuarial society of Ghana (ASG) has been made aware of the impending introduction of National Insurance Commission’s (NIC) new required capital system for comments soon. The word is out that it will take the form of the old minimum Fixed Capital Standards, but with the prior limits eventually tripled. While this in itself is not a bad idea, it is almost anachronistic to have regulated insurance capital requirements set in fixed amounts. The world’s insurance industry moved away from a Fixed Capital Standard to a Risk Based Capital (RBC) system a long time ago. The RBC system is based on general business and actual risk profiles of the company.
The old capital system of using Fixed Capital Standards for regulated capital for all insurance companies under a jurisdiction worked somewhat well for the industry until 40 years ago. After the formation of OPEC in the 1970s and the worldwide inflation caused by the spike in oil prices, the world’s financial system changed for good.
Today, with all the financial sophistication, you may rightly ask: “If insurance companies need to set up capital to ward-off the risky business they have written, why was the capital required not related to the level of risk taken?” In the same vein you may ask: “How can the same level of Fixed Capital Standard be required of a two-year old startup company with a trickle of business on its books and a well-established company that has diverse blocks of risky business which date back decades, and also between Life and General Insurance?”
The Form of Insurance Companies: Prior to the 1980s, most of the insurance companies around the world were formed under the mutual company system. The company’s capital supporting the business was provided by its policyholders through loaded premiums. The companies used their dividend scales to effectively provide adequate capital beyond the Fixed Capital Standards. Since the capital was being provided by the policyholders – whose objectives were accident, fire, theft, mortality and morbidity coverage – there was no requirement for the companies to produce a certain amount of earnings in line with the capital provided to the company.
Products in the Era: The products on the market 40 years ago were mostly non-interest rate sensitive. That is, the risks written by the insurance companies were mostly on accident, fire, morbidity, mortality and general business. Interest rate volatility was minimal enough around the globe for companies to consider it not a material risk.
The advent of high rates of inflation and interest in the 1970s caused by the soaring oil prices led insurance companies to design and sell interest-sensitive products such as Universal Life, Variable Life etc. The companies also incorporated the volatile interest income to be earned in the premium rates for all products, in order to stay competitive with the bond, stock and savings products in the financial markets. These competitive premium rates led to the demutualisation of practically all the insurance companies, since it became difficult for them to sell their loaded premium products. After the demutualisation exercises, the insurance companies had to raise capital from the public capital markets.
Return on Equity (Capital and Surplus): The raising of public capital to support an insurance company is accompanied by periodic provision of returns on the capital to shareholders. The shareholders can then make the comparison of their returns on the capital to other similarly situated risky investments and the risk-free Treasury rates. This measurement is called the return on equity or its acronym ROE. Note, equity equals the total investment in the business, which is capital and surplus.
The return on equity (ROE) is calculated as follows:
ROE = Operational Net Income* + Earned Interest Income on Equity
Total Equity Invested in the Business
The issue with the above formula is the drag of ‘Earned Interest Income on Equity’ on the ratio. This is so because the capital backing the business for unexpected claims and losses is generally required to be invested in very liquid instruments – such as Treasuries, which earn less than the earnings on other invested assets of the insurance company. It is understood that real estate and other illiquid properties that earn next to nothing in investment income are allowed as part of capital and surplus by the NIC. It may be so, but hopefully they are accepted as capital on heavily discounted basis (30% to 50% discount), for them to be easily sold within three months to meet insurance claim payments, when needed.
The research behind insurance companies’ ROE requirements in developed economies – wherein 1-year Treasury rates are less than 2% – supports ROE requirements in the range of ‘1-year Treasury rate plus 10 to 15%’. The range may be quadrupled in a country like Ghana, where the 1-year Treasury rate hovers around 15%. Excess required capital from Fixed Capital Standards over RBC, which is not born out of any relation to the insurance company’s risk profile, leads to lower ROEs due to lower earnings on the capital. Let’s see an example:
- 1-year Treasury rate 17%
- ROE required 1-year Treasury + 30% = 47%
- Average earned rate by Capital & Surplus = 17%
- Fixed Standard Capital and Surplus Equity GH¢50million
- Risk Based Capital and Surplus GH¢30million
- Operating Net Income* GH¢10million
*Operating Net Income is after-tax and not including after-tax investment income on capital and surplus
Fixed Standard Capital/Surplus ROE = 10 + 17%*50 = 37%
Risk Based Capital/Surplus ROE = 10 + 17%*30 = 50%
Therefore, as stated earlier, having more of Fixed Capital Standards capital than necessary for the risk taken can be a drag on ROE and lead to a possible exit from the industry, or even prevent entry into the industry when ROEs are lower than can be found elsewhere. Premiums will possibly be raised to meet the ROE targets. Also, there is a possibility that for some companies the Fixed Capital Standards requirement may be less than the RBC, given the risk profile of the company. This can lead to insolvency.
Moreover, when RBC is instituted the pricing of products can incorporate the cost of the capital charges in there for the ROE target to be earned, with everything else being equal.
Conclusion: The Ghanaian insurance industry needs to jump onto the RBC ‘trotro’ with seatbelts and airbags that has been plying the ‘Capital Station’ for more than 30 years since the Fixed Capital Standards broke down a long time ago. The basic research to derive the RBC figures have been done around the world already. So, a little research and hard work can produce a suitable set of factors for the Ghanaian market without need to continue taking the easy but wrong route of a Fixed Capital Standard.
A Fixed Capital Standard may even lead to insolvencies since the big risk takers might take risks that exceed the Fixed Standard Capital requirements, whereas an RBC one will capture all the underlying risks and require appropriate levels of adequate capital to be set up. RBC requirements may even dissuade companies from taking on volatile risks they are not too well-versed in which also cost too much in RBC.
The NIC should do the hard and right thing for the industry instead of the easy and wrong thing. To those without much fundamental understanding of insurance risks, raising the Fixed Capital Standard to about three times the previous level may look good in the midst of recent banking failures, but it will potentially lead to the failure of insurance companies. This is akin to a medical doctor refusing to study and keep abreast with the modern and efficacious antibiotics of today for infections, but rather keeps prescribing increasing doses of penicillin – because that is the antibiotic he knows from his medical-school days some 50 years ago.
Finally, even the rating agencies such as A.M. Best, Moody’s and S&P have all joined the RBC ‘trotro’. Going forward, if the growing Ghanaian insurance industry is to receive any future ratings from them, the NIC should assist by putting the industry on the right path immediately.
- The tripling of the Fixed Capital Standard requirements may appear to be safely guarding the industry, but in reality it may ruin the insurance industry in the long run.
- The companies may have to raise their premium rates to meet their ROE requirements.
- The potential excess capital from Fixed Capital Standard can be deployed elsewhere in the Ghanaian economy, instead of being tied-up in the insurance industry for no economic reason but for a false sense of security.
- The RBC system can be planned for, worked on, and implemented by early 2020. So, there is no need to tamper with the current Fixed Capital Standard. It will impose unnecessary angst and useless work on the industry.
By F. Yaw Berkoh Nketia, FASG, FSA, MAAA for Actuarial Society of Ghana (ASG)