Risk and the Capital of Insurance Companies

by Richard W. Kopcke
July/August 1996

Insurance companies, like other financial institutions, have been evolving from specialized businesses to enterprises offering a variety of financial services. Rising interest rates impelled this evolution during much of the past three decades as most insurers tried to remain competitive. However, as insurers' profit margins subsided and they attracted new business, their assets generally grew more rapidly than their capital. To maintain the safety and soundness of insurance companies, regulators increasingly are adopting risk-based capital requirements instead of rules that limit insurers' investments and contracts, but these standards measure neither the protection for policyholders embedded in insurers' portfolios nor the rate at which this protection might change with economic conditions.

The author suggests that risk managers and regulators might use the models behind value-at-risk calculations to isolate those economic conditions that threaten the solvency of insurance companies. A conservative policy might require that insurers adopt financial strategies that limit their maximum losses for all "feasible" conditions, a kind of minimax strategy. This version of risk-based capital requirements might reveal best the risks that insurance companies are bearing and, when necessary, might tie their need for capital more directly to these risks, rather than to their commitments to individual assets and liabilities.

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