Risk Based Capital Discussion Document

Centre for Actuarial Research (CARe)

A Research Unit of the University of Cape Town

The Effect of Risk-Based Capital Formulae on South African Medical Scheme Solvency

CARe Discussion Paper prepared for the Council for Medical Schemes by John Kendal, supervised and edited by Heather McLeod May 2004

Centre for Actuarial Research University of Cape Town Private Bag Rondebosch 7701 SOUTH AFRICA Telephone: +27 (21) 650-2475 Telephone for Professor McLeod : +27 (28) 572-1933 Fax: +27 (21) 689-7580 E-mail: [email protected] E-mail for Professor McLeod : [email protected]

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Editor’s Note John Kendal submitted this work as his Honours research project in the Actuarial Science Department at the University of Cape Town in 2003. John obtained a first for his project (a rarity in Actuarial Science) and his work was submitted as one of the best national actuarial projects in that year. The purpose of his research was to ‘compare and explain’ the Australian and USA risk based capital (RBC) systems and investigate, using the 2000 statutory returns from the Office of the Registrar of Medical Schemes, the impact of application of these systems in South Africa. The most valuable and long-lasting part of this work is the definition of the data items in the statutory returns to the Registrar that should be used in the RBC formulae from the USA and Australia. This mapping was no small feat and this diligent work will provide a valuable platform for the development of recommendations on a possible RBC formula for South Africa. In areas where there was no equivalent data item in South Africa, the author has suggested an appropriate definition or indicated whether it is a meaningful omission. This work was placed in Appendices C, D and E but should probably have merited a chapter in its own right. This is a very useful research report which will lay the foundations for RBC work in medical schemes in the years to come. The most important research work now needed is to determine the required overall level of solvency for South African medical schemes. Work also needs to be done on how the solvency standard for healthcare funds differs from the standard for managed care organisations (the NAIC formula) in the USA and how this might be applied in South Africa. Once agreement is reached on the overall solvency needed in South African medical schemes and managed care organisations, it will then be possible to undertake further research on the appropriate level of certain key parameters in the formulae, based on South African evidence. Professor Heather McLeod May 2004

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Synopsis Risk-based capital (RBC) is a level of capital that enables a medical scheme to withstand certain adverse fluctuations in results. It is determined by the risks facing a scheme. This report examines two foreign methods for calculating RBC requirements and estimates the impact a RBC system would have on South African medical scheme solvency.

The USA and Australian RBC systems The USA RBC system for Managed Care Organisations (MCO’s) is incredibly detailed, but remarkably simple. It is based on a certain probability of ruin and determines the RBC for an MCO, known as risk-based capital after covariance, by multiplying its various balance sheet and income statement items by risk factors. A special feature of this system is its allowance for risk-transfer through managed care arrangements and reinsurance contracts. The Australian system requires insurers to hold capital to meet certain circumstances. This system resembles the current RBC system for South African life insurers and would probably be similar to any RBC system developed for South African medical schemes. It requires insurers to hold an amount of capital (i.e. the solvency reserve) that will enable the fund to meet its current obligations if the fund was closed to new business and run-off. It also requires the fund to hold sufficient capital (i.e. the capital adequacy reserve) to meet its obligations as a going concern. Special features of this system are its interaction with the Australian risk-equalisation system and its specification of a method to estimate outstanding claims.

Impact of RBC on South African medical scheme solvency Since no RBC system has been developed specifically for the South African medical scheme industry, the impact of RBC on South African medical scheme solvency was estimated by calculating the USA and Australian RBC requirements for South African medical schemes using 2000 statutory returns data. At the industry level, it is unclear whether a RBC system would require the industry to hold more or less capital than the current 25% of gross contributions rule. The USA RBC after covariance is less than 25% of gross contributions, while the Australian solvency and capital adequacy reserves straddle the current requirement. The figure below shows the USA and Australian RBC requirements as a percentage of gross contributions for individual schemes.

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0

10

20

30

40

50

60

70

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% More

Percentage of gross contributions

Nu

mb

er

of

sc

he

me

s

Risk-based capital after covariance

Solvency reserve

Capital adequacy reserve

Accumulated funds

Under both systems, some schemes are allowed to hold less than 25% of gross contributions while others are required to hold significantly more. This implies that some schemes would be strongly against a RBC system while others (especially the larger schemes) would support it.

Conclusions Despite the differences between the two foreign systems, they each have features that could be useful in the South African environment. They also suggest what changes should be made to the life insurance standards to make them applicable to medical schemes. In addition, it appears that each RBC system will have a unique effect on solvency at the industry level.

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Table of Contents

Editor’s Note ............................................................................................................ ii

Synopsis .................................................................................................................. iii

Table of Contents .................................................................................................... v

Glossary ................................................................................................................ viii

1. Introduction ..................................................................................................... 1

1.1 Background to Research Project ................................................................. 1 1.2 Statement of Research Project .................................................................... 1 1.3 Objectives of Research Project ................................................................... 1 1.4 Sources of Information ............................................................................... 1 1.5 Scope and Limitations of Project ................................................................ 2 1.6 Plan of Development .................................................................................. 2 1.7 Acknowledgements .................................................................................... 2

2. Risk-Based Capital .......................................................................................... 3

2.1 Introduction to Risk-Based Capital ............................................................. 3 2.2 Medical Scheme Risk ................................................................................. 4 2.3 Calculation of RBC Requirements ............................................................. 5 2.4 Desirable Features of a RBC System .......................................................... 6

3. The USA RBC system for Managed Care Organisations .............................. 8

3.1 Introduction to the USA RBC System ........................................................ 8 3.2 Asset Risk – Affiliates ............................................................................... 9 3.3 Asset Risk – Other .................................................................................... 10

3.3.1 Fixed income assets ........................................................................... 11 3.3.2 Replication transactions .................................................................... 11 3.3.3 Equity ................................................................................................ 12 3.3.4 Property and equipment assets .......................................................... 12 3.3.5 Asset concentration ........................................................................... 13

3.4 Underwriting Risk ..................................................................................... 15 3.4.1 Base Underwriting risk RBC ............................................................. 15 3.4.2 Underwriting risk RBC after managed care discount ......................... 15 3.4.3 Alternative risk charge ...................................................................... 17

3.5 Credit Risk ................................................................................................ 18 3.6 Business Risk ............................................................................................ 21 3.7 Risk-Based Capital After Covariance ........................................................ 23 3.8 Transitional Arrangements ........................................................................ 25

4. The Australian RBC System for Private Health Insurers ............................. 27

4.1 Introduction to the Australian RBC System ............................................... 27 4.2 Solvency Liability ..................................................................................... 29 4.3 Expense Reserve ....................................................................................... 31 4.4 Inadmissible Assets Reserve ..................................................................... 32

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4.5 Resilience Reserve .................................................................................... 34 4.6 Management Capital Amount .................................................................... 35 4.7 Capital Adequacy Liability ....................................................................... 36 4.8 Renewal Option Reserve ........................................................................... 39 4.9 Business Funding Reserve......................................................................... 40 4.10 Subordinated Debt Allowance ................................................................... 40 4.11 Solvency and Capital Adequacy Reserves ................................................. 42 4.12 Transitional Arrangements ........................................................................ 42

5. The effect of RBC on South African Medical Scheme Solvency ................... 44

5.1 Methodology ............................................................................................. 44 5.2 Industry Level ........................................................................................... 44

5.2.1 Aggregate solvency ........................................................................... 44 5.2.2 Aggregate solvency by scheme type ................................................... 45 5.2.3 Aggregate solvency by scheme size .................................................... 47

5.3 Individual Scheme Level ........................................................................... 48 5.3.1 Range of individual scheme capital requirements .............................. 48 5.3.2 Individual scheme solvency by scheme type ....................................... 49 5.3.3 Individual scheme solvency by scheme size ........................................ 49

5.4 Summary .................................................................................................. 50

6. A Comparison of the Australian and USA RBC Systems ............................. 52

6.1 Conceptual Framework ............................................................................. 52 6.1.1 Probability of ruin ............................................................................. 52 6.1.2 Capital to meet specific circumstances .............................................. 52 6.1.3 Suitable conceptual framework for a South African RBC system ........ 53

6.2 Components of Each Formula ................................................................... 53 6.2.1 Omissions from the USA formula ....................................................... 54 6.2.2 Omissions from the Australian formulae ............................................ 54 6.2.3 Relative sizes of the different components .......................................... 54

6.3 Special features of each formula ................................................................ 55 6.3.1 Special features of the USA formula .................................................. 55 6.3.2 Special features of the Australian formulae ....................................... 57

6.4 Meeting the requirements .......................................................................... 57 6.5 Basis for intervention ................................................................................ 57

7. Conclusions and Further Research ................................................................ 58

8. References and Bibliography ......................................................................... 59

8.1 Australia ................................................................................................... 59 8.2 United States of America .......................................................................... 60 8.3 South Africa .............................................................................................. 61 8.4 General ..................................................................................................... 62

Appendix A: Data Files Submitted to the Council for Medical Schemes ............. 63

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Appendix B: RBC Theory ...................................................................................... 64

B1. Calculation of RBC requirements using the EPD and probability of ruin approaches ............................................................................................................ 64

B1.1 Ruin Approach.......................................................................................... 64 B1.2 Expected policyholder deficit (EPD) approach ......................................... 65 B1.3 More complicated situations ..................................................................... 66

B2. Estimating factors by simulation .................................................................... 66 B3. Solvency liability margin ............................................................................... 67

Appendix C: Method used to calculate the USA RBC Requirement ................... 69

C1. Statutory returns data used in the calculation .................................................. 69 C2. Treatment of the different types of guarantee ................................................. 71 C3. Assumptions and adjustments to the formula .................................................. 72

C3.1 Premium tiers ........................................................................................... 72 C3.2 Alternative risk charge ............................................................................. 73

Appendix D: Method used to calculate the Australian Solvency Reserve ............ 74

D1. Statutory returns data used in the calculation .................................................. 74 D2. Assumptions and adjustments to the formula .................................................. 75

D2.1 Asset concentration risk ........................................................................... 75 D2.2 Resilience reserve .................................................................................... 75 D2.3 Management capital amount .................................................................... 77

Appendix E: Method used to calculate the Australian Capital Adequacy Reserve ................................................................................................................................. 78

E1. Statutory returns data used in the calculation .................................................. 78 E2. Assumptions and adjustments to the formula .................................................. 79

E2.1 General .................................................................................................... 79 E2.2 Capital adequacy margin .......................................................................... 79 E2.3 Renewal option reserve ............................................................................. 81

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Glossary Accumulated funds The net asset value of a medical scheme, excluding funds set aside for specific purposes and unrealised non-distributable reserves. Affiliates “A person or entity that directly, or indirectly through one or more other persons or entities, controls, is controlled by, or is under common control with the reporting entity.” (NAIC, 2001, 33) Capital (also equity or net asset value) For the purposes of this report, capital is defined to be total assets minus total liabilities. Therefore, the terms capital, equity and net asset value will be used interchangeably throughout this report. Gross contributions “Gross contributions are amounts (premiums) payable by members and/or employers, in terms of the rules of the medical scheme, for the purchase of healthcare benefits. Gross contributions include, savings plan contributions.” (SAICA, 2003, p.53) Healthcare receivables “Fee-for-service, coordination of benefits and subrogations, co-payments, and other health balances.” (NAIC, 2001, p.34) IBNR claims liability This is the liability for future payments in respect of claims that have already been incurred by the medical scheme but not yet reported in the scheme’s records, as well as the expected future development on reported claims (ASSA, 2003). Managed care Refers to the use of management techniques to deliver appropriate healthcare in a cost-effective manner, through the use of risk-sharing contractual arrangements with healthcare providers and various other healthcare expenditure management techniques. Managed care healthcare benefits This is the cost of healthcare services under payment systems such as capitations and other contractual arrangements (SAICA, 2003) Managed care management services expenses This is the cost to the medical scheme of healthcare expenditure management services such as disease and case management, pre-authorisation and bill review. This does not include the cost of any healthcare services. (SAICA, 2003)

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Managed care organisation “Any person, corporation or other entity which enters into arrangements or agreements with licensed medical providers or intermediaries for the purpose of providing, or offering to provide, a plan of health benefits directly to individuals or employer groups in consideration for an advance periodic charge (premium) per member covered.” (NAIC, 2001, p.34) National Association of Insurance Commissioners The regulator of, inter alia, USA MCO’s Net contributions “Net contributions represent contributions for which the medical scheme is at risk, and are calculated as gross contributions less savings contributions, during the accounting period.” (SAICA, 2003, p.54) Outstanding claims Outstanding claims consist of claims that have been: Incurred but not reported (IBNR); Reported but not yet settled or approved for payment; Reported and administratively finalised but which may be reopened. (ASSA,

2002). Private Health Insurance Administration Council The regulator of Australian private health insurers Probability of ruin The probability of insolvency Registered medical scheme Any medical scheme that is or will be in full compliance with the Medical Schemes Act of 1998, and is registered with the Council for Medical Schemes (Dreyer, 2001). The Registrar The Registrar of medical schemes, appointed under section 18 of the Medical Schemes Act of 1998 Reinsurance A contractual arrangement under which some of the risk of the medical scheme is transferred to a reinsurer in return for some consideration (ASSA, 2002) Risk Risk is the possibility of adverse deviations in results. Risk-Based Capital Risk-based capital is the minimum amount of capital a medical scheme must hold to ensure that the danger of insolvency is acceptably low. It is an amount of capital that enables an entity to survive certain adverse fluctuations in results.

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Risk charge The amount of risk-based capital required by a risk element or collection of risk elements. Risk element Distinct, quantifiable elements that differ in their level of risk are known as different risk elements (Butsic, 1994). For example, bonds, equities and property are three different risk elements. Risk factor (also RBC factor) The risk factor for a certain risk element is the ratio of its risk charge to the value of that risk element. They are related to risk charges and the value of a risk element by the following equation:

Risk charge = Value of Risk element Risk factor. Technical insolvency (also insolvency or ruin) Technical insolvency occurs when a scheme’s liabilities exceed its assets.

Abbreviations ASC Administrative services contract ASO Administrative services only ASSA Actuarial Society of South Africa HBFCAR Health benefits fund capital adequacy requirement HBFSR Health benefits fund solvency requirement IBNR Incurred But Not Received MCO Managed Care Organisation NAIC National Association of Insurance Commissioners PHIAC Private Health Insurance Administration Council RBC Risk-Based Capital RBCAC Risk-Based Capital After Covariance RBCBC Risk-Based Capital Before Covariance SAICA South African Institute of Chartered Accountants SEU Single Equivalent Unit

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1. Introduction

1.1 Background to Research Project

A medical scheme is solvent if its assets exceed its liabilities. For the purpose of regulation, a more stringent definition of solvency is used. This is meant to expose schemes that might become insolvent or experience financial distress in the future so that the regulator may take appropriate corrective action. In SA, for a scheme to be solvent under the regulator’s definition of solvency, it must hold accumulated funds in excess of 25% of gross contributions. In a study of solvency requirements for medical schemes, Cooper (2001) points out a number of problems with this regulatory solvency measure. For instance, it ignores the transfer of risk through managed care contracts and reinsurance agreements. It also ignores scheme size and variability in claims experience. In short, it makes no allowance for the differing risk profiles of medical schemes. Cooper concluded that the current solvency approach is inappropriate. He recommended the adoption of a risk-based approach, which would consider the specific risks faced by each scheme. He also recommended that the solvency definition allow for the transfer of risk.

1.2 Statement of Research Project

In light of Cooper’s recommendations, this project will examine two foreign risk-based capital systems and attempt to establish the effect a risk-based capital system would have on South African medical scheme solvency.

1.3 Objectives of Research Project

The objectives of this project are to: 1. Explain and compare the RBC systems of Australian Health Insurers and USA

Managed Care Organisations. 2. Use 2000 statutory returns data to establish the effect a RBC system would

have on South African medical scheme solvency.

1.4 Sources of Information

Legislative and regulatory documents provided the basic detail of the Australian and USA RBC systems, while journal articles on risk-based capital systems proved useful in understanding the formulae and RBC in general. Email was used to contact foreign RBC experts who were extremely helpful in explaining certain parts of the formulae and providing reference papers. The Registrar’s 2000 statutory returns provided the data to estimate the effect a RBC system would have on South African medical scheme solvency.


1.5 Scope and Limitations of Project

This report explains the Australian and USA RBC formulae and establishes the effect those RBC systems would have on South African medical scheme solvency if implemented without adaptation. It does not aim to develop a RBC system for South African medical schemes or to adapt the foreign systems for use in the South African medical scheme industry. The project was limited in places by data availability and international differences. Some of the data required by the Australian and USA RBC formulae was not available from the Registrar’s 2000 returns, which meant that assumptions and approximations were necessary. Furthermore, of the 146 schemes that were registered in 2000, only 144 submitted their 2000 returns. In addition, the report only considers the effect a RBC system would have on Registered scheme solvency. It ignores Bargaining Council scheme solvency.

1.6 Plan of Development

The report begins with an introduction to risk-based capital in general. It then looks at two foreign risk-based capital systems in detail. Chapter 3 gives an account of the USA RBC formula for Managed Care Organisations, while Chapter 4 explains the Australian solvency and capital adequacy standards for private health insurers. In Chapter 5, data from the 2000 statutory returns is used to estimate the impact of RBC on South African medical scheme solvency. This is achieved by calculating the USA and Australian RBC requirements for South African medical schemes. Chapter 6 then compares the Australian and USA systems. Finally, conclusions are reached and recommendations are made for further research.

1.7 Acknowledgements

The author wishes to thank his supervisor, Professor McLeod of the University of Cape Town, for her expertise, enthusiasm and supervision of this project. Thanks must also go to: Alan Ford of the American Academy of Actuaries; David Watson of the Health Practice Committee of the Institute of Actuaries of

Australia; Paul Groenewegen and Gayle Ginnane of the Australian Private Health Insurance

Administration Council; Maggie Grobler of the Council for Medical Schemes; and Mahesh Cooper for their selfless assistance and valuable insights. The author is also grateful to Yura Kaliazin for his comments on an earlier version of this report.


2. Risk-Based Capital

The aim of this chapter is to introduce the idea of risk-based capital. This will set the scene for the next two chapters where two foreign RBC systems are discussed.

2.1 Introduction to Risk-Based Capital

Capital provides a cushion that allows a medical scheme to remain solvent through certain adverse fluctuations in results. The more capital a scheme holds, the less likely it is to go insolvent. The following diagram takes this relationship one step further by introducing risk.

Capital

Probability of ruinRisk

Source: Van Den Heever (1998)

Figure 2.1: The relationship between capital, risk and probability of ruin

A medical scheme’s probability of ruin (or probability of insolvency) depends on the risks that it faces as well as the amount of capital it holds. Two schemes facing the same risks but holding different quantities of capital will have different ruin probabilities. By changing the amount of risk and/or capital held, schemes can influence their probability of ruin, making this a three-way relationship. Under a risk-based capital (RBC) system, the relationship is simpler. The regulator would choose the maximum probability of ruin and then, by examining a scheme’s risk profile, determine the minimum amount of capital required by that scheme to achieve that probability of ruin. The figure below shows the relationship from the regulator’s point of view.


Minimum Capital

Requirement

Probability of ruinRisk

Figure 2.2: The relationship between risk, capital and probability of ruin from the regulator’s

point of view

Risk-based capital is the minimum amount of capital a medical scheme must hold to ensure that the probability of ruin is acceptably low. This minimum amount of capital is determined by the risks affecting the medical scheme. Under a risk-based capital system, medical schemes would be required to hold capital in excess of some minimum capital requirement (the RBC requirement) determined by the regulator. If a scheme’s capital fell below the required level, it would be subject to regulatory action of some kind.

2.2 Medical Scheme Risk

If each medical scheme were required to hold a minimum amount of capital determined by its risk profile, it would be natural to ask: “what risks should be taken into account when setting these minimum capital requirements?” This section looks at the various risks affecting medical schemes and will provide a point of reference for the risks considered by the foreign RBC formulae in the coming chapters. Hooker (1996), Cooper (2001) and the Council For Medical Schemes (2003) provided valuable input to this section. The main risks affecting medical schemes are: Uncertainty in claims costs; and Asset risk. Uncertainty in claims costs relates to the potential error in estimates of incurred claims for business already written and the potential error in estimates of future claims used to price new business. For instance, the outstanding claims liability on the balance sheet may be understated because incurred claims have been underestimated. Restating the liabilities will reduce the scheme’s capital and may result in insolvency. Also, new business may be under-priced because actual claims turn out to be higher than was expected when contributions were set. The resulting losses will reduce the scheme’s capital and could, if severe enough, cause insolvency.


Asset risk is another major risk for a medical scheme. The scheme assets are invested in the financial markets, so their capital values and income returns (e.g. dividends) are likely to fluctuate. A decline in capital value will reduce the equity on a scheme’s balance sheet and may lead to insolvency. Also, if the income from the assets is lower than expected, the scheme may have to sell other assets to meet claim payments. This will also reduce the scheme’s equity and could potentially cause insolvency. Poor liquidity of assets, caused by poor asset structure, may render the scheme unable to pay claims as they arise. Asset risk is intensified by excessive concentration of assets in particular asset classes or with particular issuers. Apart from the main risks already mentioned, medical schemes face many other risks, including: The risk of catastrophic losses; Expense risk; Managed care risk; Reinsurance risk; Credit risk; Management risk; and Growth risk. The first two risks are self-explanatory. Managed care risk is the risk that a Managed Care Organisation (MCO) defaults on its obligations to the scheme. This could happen if the scheme paid capitations to an MCO which went insolvent before providing the agreed care to the scheme members. Reinsurance risk relates to the possibility that the reinsurer will not pay future reinsurance claims in full. It includes the risk that the reinsurer may not pay those claims currently outstanding in full. Credit risk is similar and refers to the risk of other creditors defaulting on their obligations to the scheme. Management risk relates to the possibility that a scheme’s management is incompetent to run the scheme effectively. Areas that could be mismanaged include claims processing, investment, benefit design and financial reporting. Growth risk is present when a scheme grows quicker than its resources. In the UK general insurance context, Hooker (1996) highlights inadequate infrastructure and expertise as possible consequences of rapid growth into a new geographical area.

2.3 Calculation of RBC Requirements

Once the regulator has identified the risks affecting a particular scheme, that information can be used to calculate its RBC requirement. The next two chapters will describe exactly how this is done in the United States and Australia.


At a theoretical level, there are three possible approaches: The probability of ruin approach (used by the USA RBC system); The expected policyholder deficit approach; and The approach whereby schemes are required to hold capital to meet certain

circumstances (used by the Australian RBC system). Appendix B1 gives an example of how the first two methods work. Section 2.1 introduced the idea of RBC using the probability of ruin approach for ease of explanation.

2.4 Desirable Features of a RBC System

Hooker (1996) and Cummins et al (1992) suggest that a RBC system should be: An incentive for weak companies to hold more capital and/or reduce risks without

distorting the behaviour of financially sound schemes; Comprehensive; Based on a solid theoretical foundation; Free of unnecessary complexity; Robust; and Unlikely to cause adverse behavioural changes such as manipulation of financial

results. They also acknowledge that some of these qualities are conflicting. The coming paragraphs will expand on these points. The main aim of a risk-based capital system is to give financially weak schemes an incentive to reduce the danger of insolvency. It should encourage those schemes for which market incentives are insufficient, to reduce risk and/or hold more capital. More often than not this will cause the schemes to increase contribution rates. To avoid distorting the behaviour of financially sound insurers, the level of the RBC requirement must be set carefully. A high requirement will reduce insolvencies, but distort the behaviour of financially sound insurers and cause large increases in contribution rates. If the requirement is set too low, it will have no impact on insolvencies. The formula should be “comprehensive” or complete in that it includes as many different risks as possible. It should allow for the various steps schemes can take to mitigate risks, such as reinsurance arrangements and managed care arrangements. Likewise, the formula should recognise how schemes can exacerbate these risks, such as excessive concentration of assets in a certain asset class or with a certain issuer. Examples of solid theoretical foundations are the probability of ruin approach and the newer expected policyholder deficit approach. These approaches were both mentioned in the previous section.


Any RBC formula should be free from complexity that only marginally increases the accuracy of the formula. This will make the formula easier to explain, understand and use. Cummins et al (1993) point out that the more complex the formula, the more difficult it will be for schemes to determine the effect of their actions on their required capital. A complex formula could also lead to unintended side effects when the formula is put into practice, since it is harder to predict the effect of a complicated formula than the effect of a simple formula. Practically speaking, the benefits and costs of additional data reporting under a complex system need to be evaluated. The formula should also be “robust” in the sense that a minor change in a firm’s risk profile should cause no more than a minor change to that firm’s RBC requirement. Robustness helps ensure that the RBC system does not cause undesirable changes to scheme behaviour by creating incentives to manipulate financial results. Furthermore, the RBC requirement should not cause schemes to take unnecessary additional risks.


3. The USA RBC system for Managed Care Organisations

This chapter explains the USA RBC system for Managed Care Organisations (MCO’s).

3.1 Introduction to the USA RBC System

The USA RBC system calculates the amount of capital an MCO needs to ensure its probability of ruin is sufficiently low. This capital will enable the MCO to withstand certain adverse fluctuations in results. Although quite detailed, the formula is conceptually simple. The following example (ASSA, n.d.) will give an initial feel. Suppose an MCO invests all its assets in bonds and that the current value of this investment is $100 million. Next, assume that there is a 5% probability that the value of this investment will be less than $75 million in one year’s time and that the MCO has liabilities of $75 million. This implies that the MCO must hold at least $25 million in capital to have a 95% probability of remaining solvent over the coming year (assuming asset risk is the only risk faced by the scheme). If capital requirements are based on a 5% probability of ruin, the MCO will have a $25 million RBC requirement. In this example, a risk factor of 0.25 (i.e. 25/100) would be appropriate for bonds. In other words, the risk charge for bonds equals 0.25 multiplied by the value of the MCO’s bond portfolio. The USA RBC formula uses this risk factor approach to specifying the various risk charges. Most risk charges in the USA formula are of the form:

Risk charge = Value of Risk element Risk factor.

Risk elements are items that differ in their riskiness. In the above example, bonds are the risk element. Common stock, preferred stock and equities are other risk elements that would each require a different factor, the riskier the risk element, the larger the risk factor. Appendix B2 explains how these factors would be estimated in practice. The formula is divided into five sections, each one corresponding to a different risk. This structure is illustrated below.

H0: Asset risk - affiliates H1: Asset risk - other

Asset risk

H2: Underwriting risk

Liability risk

H3: Credit risk H4: Business risk

Other risks

RBC requirement

Source: NAIC (2001)

Figure 3.1: Structure of USA RBC formula


Each section contains the various risk elements relating to that risk. These risk elements require different risk factors to determine their risk charges. The total risk charges for each section of the formula are combined to give the risk-based capital after covariance (RBCAC) for an MCO. If an MCO’s total equity exceeds its RBCAC, the MCO is not subject to any regulatory action. However, if an MCO’s equity falls below one of four thresholds, the organisation will be subject to regulatory action. These different thresholds and their corresponding regulatory actions are shown in the table below. Authorised Control Level (ACL) is defined as 50% of an organisation’s RBCAC.

Table 3.1: RBC thresholds and their corresponding regulatory actions

RBC level Regulatory action

Company Action Level

(CAL=200% ACL)

The company must notify the insurance commissioner of the corrective actions it plans to take to increase capital.

Regulatory Action Level

(RAL=150% ACL)

The company must submit or resubmit a corrective plan of action to remedy the situation. After examining the company, the insurance commissioner will issue an order specifying the corrective actions to be taken.

Authorised Control Level

(ACL)

The insurance commissioner is authorised to take whatever regulatory action is necessary to protect the interests of the policyholders, including taking control of the company.

Mandatory Control Level

(MCL=70% ACL)

The insurance commissioner is required to place the company under regulatory control.

Source: Milliman (1998, p.2)

The following sections will explain each of the five sections of the USA formula; the calculation of risk-based capital after covariance; and the transitional arrangements used to phase in this RBC requirement. Data from South African medical schemes’ 2000 statutory returns are used throughout these sections to give a feel for how much RBC the formula would have required registered South African medical schemes to hold at 31 December 2000. This will also demonstrate the relative importance of the different sections.

3.2 Asset Risk – Affiliates

This section of the RBC formula allows for the risk that the value of investments in affiliates will decrease. Therefore, this section only affects MCO’s that have ownership in affiliates. South African medical schemes are essentially mutual organisations, so they cannot have a parent. They could however have a subsidiary, but this is rare.


The risk charge for ownership in affiliated entities depends on whether those entities are themselves subject to a RBC requirement. For affiliates that are not subject to RBC, holdings in non-USA insurance subsidiaries receive a risk factor of 1.0, while other affiliates have a risk factor of 0.3. For affiliates that are subject to RBC, the risk charge is more complicated. Since it has little relevance to the South African environment, its full detail will not be set out here and the reader is referred to NAIC (2001, pp.1-6). Suffice it to say, the aim of the risk charge for investment in affiliated entities is to ensure that the assets held in respect of the affiliate’s capital requirements are not counted in meeting the capital requirements of its owner. The asset risk – affiliates section also makes allowance for off balance sheet risk such as contingent liabilities that are disclosed in the notes to the financial statements. It calculates the risk charge by applying a 0.01 factor to the value of the contingent liability. By holding extra capital in respect of these contingent liabilities it reduces the risk of the MCO going insolvent, were it required to make any payments in terms of these contingent liabilities. The estimated value of the asset risk – affiliates charge for registered South African medical schemes is shown below.

Table 3.2: Estimate of asset risk – affiliates RBC

Rands

Off-balance sheet items 189,718H0: Asset risk - affiliates RBC 189,718Gross contributions 29,884,077,939% of gross contributions 0.001%

Clearly, the asset risk – affiliates charge would not impose a significant capital requirement on South African medical schemes.

3.3 Asset Risk – Other

Figure 3.2 shows the structure of the Asset risk – other section.

Fixed income assets Replication transactions Equity Property and equipment Asset concentration

Asset risk - other

Source: NAIC (2001)

Figure 3.2: Structure of asset risk – other charge

This section reserves against reductions in the market value of assets as well as the possibility of default of principal or interest. It only deals with unaffiliated investments. This part of the formula is very detailed because it differentiates between many different types of assets. For instance, it recognises seven different bond classes, and assigns each one a different risk factor.


This can make the formula appear more complex than it actually is. It also makes estimation of these risk factors (i.e. calibrating the formula) time consuming and expensive. Despite the level of detail in this section, all the risk charges are of the form:

Risk charge = Value of Risk element Risk factor.

The total risk charge for the asset risk – other section of the RBC formula is found by summing the risk charges for each of its five subsections. 3.3.1 Fixed income assets

The NAIC Security Valuations Office (SVO) classifies bonds into six different classes based on their risk of default of principal and interest. These bond ratings are used in the formula. The riskier bonds are allocated to the higher classes, so the higher the bond class, the higher the risk factor for that bond. The figure below shows the risk factors used for fixed income assets.

0.000 0.0030.010

0.020

0.045

0.100

0.300

0.003 0.003

0.200

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

Governmentbonds

Class 1 bonds Class 2 bonds Class 3 bonds Class 4 bonds Class 5 bonds Class 6 bonds Cash Other shortterm

investments

Other longterm

investments

Risk element

Ris

k f

ac

tor

Source: NAIC (2001)

Figure 3.3: Fixed income asset risk factors

3.3.2 Replication transactions

The formula recognises that some assets are held for the purposes of replicating the payoffs from derivatives. It handles these assets differently from normal holdings. The reader is referred to NAIC (2001, p.9) for the detail of this part of the formula.


3.3.3 Equity

The formula distinguishes between common stock and preferred stock. As for bonds, preferred stock is divided into six categories. Because there was no experience data available to determine the preferred stock factors, they were set at the bond factor level plus 2%, subject to a maximum of 30%. This was based on the assumption that preferred stocks are more likely to default than bonds and that the losses on preferred stock default would be higher than that on bonds (NAIC, 2001). Problems such as lack of data to estimate factors are made more likely by the level of detail in the formula. The resulting preferred stock and common stock factors are shown in the figure below.

0.0230.030

0.040

0.065

0.120

0.300

0.150

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

Class 1 preferredstock






Common stock

Risk element

Ris

k f

ac

tor

Source: NAIC (2001)

Figure 3.4: Equity risk factors

The factor for common stock lies between the factors for class five and six preferred stock. On the whole, the formula recognises that common stock is more risky than preferred stock, as one would expect 3.3.4 Property and equipment assets

Milliman (1998) state that one of the unique characteristics of MCO’s is investment in property, such as hospitals, that are used for the provision of care and may give the MCO greater control over healthcare costs. The formula appears to take this into account by dividing properties into: “Properties occupied by the company; Properties held for the production of income; and Properties held for sale.” (NAIC, 2001, p.12)


However, each category has a risk factor of 0.1, so for asset risk RBC purposes, it doesn’t matter which category the MCO’s property falls into. Furthermore, the underwriting risk section of the formula (see section 3.4) is unaffected by these property categories. This implies that the formula ignores any increased control over healthcare costs that an MCO enjoys from owning property. Furniture and equipment are divided into: Heath care delivery assets and Other furniture and equipment. Vehicles would be included in the second category (A. Ford, personal communication, May 2, 2003). As for property, both categories have a risk factor of 0.1. It is surprising that this risk factor is lower than the common stock factor (0.150). This seems to suggest that investment in furniture and equipment is less risky than investment in common stock. At first glance it may seem pointless to distinguish between different types of assets and then treat them in the same way. It is the author’s opinion that the NAIC plan to assign different risk factors to the various equipment and property types in the future, but have not yet decided what these factors should be (perhaps due to lack of data). 3.3.5 Asset concentration

The asset concentration section of the formula imposes an additional charge for high concentrations of certain types of assets with single issuers. This is because there is increased risk of insolvency if one of these issuers should default. An issuer is “a single entity, such as IBM or Ford Motor Company” (NAIC, 2001, p.13). Concentrated investments in certain types of assets are not expected to increase the risk of insolvency significantly. Such assets are exempt from the asset concentration charge. Assets subject to the concentration charge include: Bonds (class 2-5); Preferred stock (class 1-5); Other long-term invested assets; and Common stock. The asset concentration charge effectively doubles the risk factor (up to a maximum of 0.3) for assets held with the ten largest issuers. The ten largest issuers are determined based on the total value of the assets that are subject to the concentration charge invested with each issuer. By doubling the risk charge for these issuers, we decrease the probability that reductions in the value of these assets will cause insolvency. Estimated values of the different components of the asset risk – other charge for registered South African medical schemes are shown below.


Table 3.3: Estimate of asset risk – other RBC

Rands

Fixed income assets 465,973,565Equity 350,013,388Property and equipment 26,262,894Asset concentration 512,443,800

H1: Asset risk - other RBC 1,354,693,647Gross contributions 29,884,077,939% of gross contributions 4.5%

The contributions of the different subsections of the asset risk – other charge are shown in Figure 3.5.

37.8%

34.4%

25.8%

1.9%

Asset concentration

Fixed income assets

Equity

Property and equipment

Figure 3.5: Components of asset risk – other charge

The asset concentration charge is the largest contributor to asset risk – other. This is because many schemes were not invested across more than ten issuers, so the asset concentration charge made up almost half of their asset – risk other charges. Fixed income assets and equity assets are the other main contributors. Schemes hold very little property and equipment, so these components were not significant.


3.4 Underwriting Risk

The underwriting risk charge is usually the largest single component of the RBC requirement and it is based on the risk that incurred claims may be higher than expected. The underwriting risk charge is the maximum of the underwriting risk RBC after managed care discount and the alternative risk charge. 3.4.1 Base Underwriting risk RBC

Base underwriting risk RBC is calculated separately for each line of business. It is determined by the following equation:

Underwriting risk revenueClaims ratioRisk factor. Underwriting risk revenue is essentially contributions net of reinsurance premiums, so the formula allows for the transfer of risk through reinsurance. The credit risk (H3) section of the formula allows for the possibility that the reinsurer may default on its obligations to the MCO. The claims ratio has the effect of reducing the underwriting risk charge for schemes with better claims experience than others. Furthermore, it separates out the part of premiums that are meant to cover claims from the part meant to pay expenses (ASSA, n.d.). Expenses are dealt with separately in the business risk (H4) section of the formula. The risk factor is a premium weighted average of 0.15 and 0.09. The first $25 million of premiums are used to weight the 0.15 factor while the rest apply to the 0.09 factor. Other things equal, the risk factor and consequently the risk charge is lower for schemes with larger total premiums. Barth (1999) suggested this tiered approach in his article “Applying the Law of Large Numbers to P&C Risk-Based Capital”. He argued that the variability of a loss ratio is lower for insurers with larger risk pools. He quantified this relationship by regressing loss ratio standard deviation on earned premium. The tiered factors were then chosen based on this relationship. 3.4.2 Underwriting risk RBC after managed care discount

This section of the formula adjusts the base underwriting risk RBC for the transfer of risk from the MCO to the healthcare provider through managed care contracts. Underwriting risk RBC after managed care discount is:

Base Underwriting Risk RBCManaged care discount factor. The following table shows the different managed care categories and discount factors.


Table 3.4: Managed care credit categories

Category Description Factor

0 Fee-for-service, discounted fee-for-service and other non-managed care arrangements.

0.00

1 Payments made under contractual arrangements such as hospital per diems, physician fee schedules, DRG-based payments, case rates, and other contractual arrangements that would not apply to category 0.

0.15

2 Payments made subject to withholds and bonuses. The managed care credit factor is presented as a range based on the proportion of withholds and bonuses paid. The minimum factor is the managed care credit factor for category 0 or 1, depending on the reimbursement method to which the withholds pertain. The maximum managed care credit factor is 0.25.

0.00-0.25

3 Capitation payments made directly to providers of medical care and capitations paid to intermediaries, such as an IPA, who, in turn, make payments to providers who contract independently with the intermediary (not including employment contracts). This includes payments to physicians and nurses for utilisation review.

0.60

4 Owned facility expenses and salaries paid directly to medical care providers and noncontingent salaries or aggregate cost payments to licensed providers.

0.75

Source: Milliman (1998, p.6)

The total paid claims in each category are used as weights to determine the weighted average of the discount factors in the third column. Paid claims are used instead of incurred claims because of the variability in estimates of outstanding claims included in incurred claims as well as the difficulty in allocating estimated outstanding claims to the different managed care categories. The managed care discount factor is then defined as one minus this weighted average. It lies between zero and one. It is important to realise that this reduction in the risk charge is based on a reduction in the variability of claim payments caused by risk sharing agreements. It is not due to any reduction in the size of claims. Notice how the managed care arrangements that pass on more risk to the providers are assigned higher factors, which imply a smaller underwriting risk charge. As with reinsurance, the credit risk section allows for the possibility that the counter-parties to these contracts default on their obligations to the MCO. The figure below shows the breakdown of registered South African medical schemes’ paid claims between managed care and non-managed care arrangements. The 99% of paid claims that were paid under non-managed care arrangements would be grouped into category zero. Most of the 1% of paid claims made under managed care arrangements would probably be grouped into categories zero or one.


99.0%

1.0%

Non-managed care claims

Managed care claims

Figure 3.6: Managed care claims as a percentage of paid claims

Many of the managed care initiatives used by South African schemes have been found not to transfer any risk at all. Doherty and McLeod (2002) found that in 2001, only 13% of medical schemes used risk-sharing managed care arrangements. All this suggests that the managed care discount would currently have very little effect on South African medical schemes at present. [Editor’s Note: the use of risk-sharing arrangements is changing rapidly and the conclusion above is made too lightly. An allowance for managed care risk transfer makes sense IF managed care organisations in South Africa become regulated for solvency. They could be required to hold reserves using a similar RBC approach.] 3.4.3 Alternative risk charge

The other component of the underwriting risk section of the formula is the alternative risk charge. This reduces the probability that an MCO will be ruined by large individual claims. The alternative risk charge is twice the maximum after reinsurance payout on any individual claim. The underwriting risk section of the formula also makes allowance for many different types of business that USA MCO’s write that fall under the umbrella of medical insurance and are not the business of a medical scheme. An estimate of the underwriting risk charge for registered South African medical schemes is shown below.


Table 3.5: Estimate of underwriting risk RBC

RandsBase underwriting risk RBC 2,700,546,872Base underwriting risk RBC after managed care discount

2,695,639,592

Alternate risk charge 247,160,000

H2: Underwriting risk RBC 2,713,030,121Gross contributions 29,884,077,939

% of gross contributions 9.1% Notice how small the effect of the managed care discount is. The underwriting risk charge would impose a capital requirement of 9.1% of gross contributions on medical schemes. One of the author’s initial, but incorrect, criticisms of the USA RBC formula was that it did not allow for the risk of misestimating outstanding claims. Mr. Alan Ford, one of the creators of the formula, explained via email that the underwriting risk charge implicitly includes a reserve against misestimating outstanding claims. An extract from that email is included below.

“The answer to your question is that the H2 Factor includes provision for the misestimating of outstanding claims. RBC represents a level of capital that indicates a MCO's ability to withstand adverse fluctuation in results. For MCO's the H2 risk is primarily for the adverse deviation of incurred claims, which includes the change in estimates for outstanding claims over the valuation period as well as paid claims. Generally, outstanding claims are estimated as a function of the paid claims over the valuation period, adjusted for changes in claim backlog and other known factors. The estimates of outstanding claims and the paid claims are intimately related, so providing separate risk factors for the components would introduce unnecessary complexity into the determination of RBC.”

Alan Ford, personal communication, 27 February, 2003

3.5 Credit Risk

The credit risk section of the formula is divided into three subsections as shown in Figure 3.7.

Reinsurance Capitations Other receivables

Credit risk

Source: NAIC (2001)

Figure 3.7: Structure of credit risk charge


Reinsurance risk is the possibility that the reinsurer will not pay the amounts it currently owes the MCO, as well as the possibility that it will not provide the future cover already paid for by the portion of the reinsurance premium that is currently unearned. The reinsurance risk factor is 0.005, which is applied to amounts due from reinsurers and premiums paid in advance to reinsurers. This risk factor is only marginally higher than the cash factor of 0.003, suggesting that banks and reinsurers have similar security. As for property, the reinsurance section divides reinsurance receivables into various categories, but then assigns them all the same 0.005 factor. Presumably, the NAIC intends to assign different factors to these different receivables in future. Capitation risk is present when an MCO pays capitations to providers or intermediaries. It is possible that the provider or intermediary will not provide the agreed upon services and the MCO will be forced to pay other providers to provide these services. Withholds and letters of credit from providers can mitigate this risk. The formula takes this into account by making some capitations exempt from the risk charge when these measures are in place. The example in the table below shows how the risk charge is calculated for capitations paid directly to providers. The risk charge for capitations paid to intermediaries is calculated similarly.

Table 3.6: Example of calculation of capitation credit risk charge

A B C D=(B+C)/A E=A*Min(1,D/8%) F=A-E G=F*0.02

Name of provider

Paid

capitations

during the

year

Letter of

credit

amount

Funds

witheld

Protection

percentage

Exempt

capitations

Capitation to

providers

subject to risk

charge

Risk

charge

Dr. A 125,000 5,000 0 4% 62,500 62,500 1,250Dr. B 50,000 5,000 0 10% 50,000 0 0Dr. C 750,000 5,000 50,000 7% 687,500 62,500 1,250Dr. D 25,000 0 0 0% 0 25,000 500Total risk charge 3,000

Source: NAIC (2001, p.26)

If the capitations are secured by letters of credit and withholds equal to 8% of paid capitations, the entire capitation is exempt. Where less protection is provided, the exempt capitation is prorated. A risk factor of 0.02, which is equivalent to one week’s paid capitations, is applied to the remaining capitations. This seems to imply that some mixture of withholds and letters of credit equal to 8% of the paid capitation provides similar security to capital equal to 2% of the paid capitation. It is the author’s opinion that this risk charge and its concessions are based more on experience and judgement than statistics and data analysis. The other receivables risk charge reserves against the risk that certain receivables will be irrecoverable. It applies a 0.01 factor to investment income receivable and a 0.05 factor to health care receivables and amounts due from affiliates. A notable omission from this section is any allowance for arrear contributions. When questioned on this, Mr. Ford gave the following response.


“Due and unpaid (arrear) premiums are not included in the RBC calculation. Generally speaking, (in my opinion) this is not a large risk. The aging of this receivable item is included in a separate exhibit on the blank, so the regulator can readily discern where assets are ‘optimistic’ with respect to the aging. Also, this receivable is only admitted if it is under 90 days.”

Alan Ford, personal communication, 2 May, 2003 In the year 2000, some of the arrear contributions included in South African medical schemes accounts receivable were more than 120 days in arrears. This suggests that South African medical schemes are more exposed to this risk than are USA MCO’s. Estimates of the different components of the credit risk charge for registered South African medical schemes are shown in the table below.

Table 3.7: Estimate of credit risk RBC

Rands

Reinsurance RBC 1,774,818

Other receivables RBC 14,080,589

H3: Credit risk RBC 15,855,407

Gross contributions 29,884,077,939

% of gross contributions 0.1% The credit risk charge is only 0.1% of gross contributions, so it would not impose a significant capital requirement on medical schemes. The pie chart below shows the relative importance of its two components.

88.8%

11.2%

Other receivables RBC

Reinsurance RBC

Figure 3.8: Components of credit risk charge


The other receivables charge, based mainly on co-payments due from members, dominates the credit risk charge. Capitation risk is absent since this data was unavailable. Since only 13% of medical schemes used risk sharing managed care arrangements in 2001 (Doherty & McLeod, 2002) it is not expected to be significant.

3.6 Business Risk

The business risk section of the formula is divided into three subsections as illustrated below.

Administrative expense risk Non-underwritten and limited risk Excessive growth risk

Business risk

Source: NAIC (2001)

Figure 3.9: Structure of business risk section

When premiums are set they include an assumption about the level of future administrative (i.e. non-claims) expenses. These expenses are unknown at the time premiums are set, so their variability leads to a risk charge. The administrative expense charge is of the form:

Previous year’s administrative expensesRisk factor. The risk factor is a tiered factor, similar to the underwriting risk factor. It is a weighted average of 0.07 and 0.04, where the first $25 million of premiums is used to weight the 0.07 factor while premiums in excess of $25 million weight the 0.04 factor. The effect of this is to reduce the administrative expense risk charge for larger schemes, which are expected to have less fluctuation in their administration expenses. USA MCO’s can act as administrators for third parties, performing administrative services such as claims processing. This type of business is known as “non-underwritten and limited-risk business”. In this regard, the RBC formula differentiates between administrative services only (ASO) and administrative services contracts (ASC). Under an ASO contract, the MCO only pays claims once the third party has paid the MCO enough money to fully cover the claims. Under an ASC contract, the MCO would pay claims first and seek reimbursement from the third party afterwards. Administrative expenses relating to ASC and ASO contracts are assigned a risk factor of 0.02. This is lower than the factor for the MCO’s own administrative expenses. This is probably because the MCO is only concerned with claims administration under these contracts, allowing less scope for variability in expenses. Furthermore, a 0.01 factor is applied to total claims payments made under ASC contracts on behalf of third parties. This risk charge stems from the risk that the counter party to the ASC contract may be unable or unwilling to reimburse the MCO for claims payments made under the contract.


This risk charge has implications for South African medical scheme administrators. If a RBC formula similar to the USA formula were introduced in South Africa, third party administrators, as well as MCO’s and medical schemes, would be obliged to hold minimum amounts of capital. The final part of the business risk section is the excessive growth charge, which aims to penalise uncontrolled growth. It does this by comparing the underwriting risk RBC to a notional “safe level”. The formula sets the maximum safe level of underwriting risk RBC by growing the previous year’s underwriting risk RBC for one year at the one-year growth rate in premiums plus 10%. The excessive growth charge is then defined as 50% of the difference between the current underwriting risk RBC and the maximum safe level, subject to a minimum of zero. Professor McLeod pointed out a problem with this method of reserving against excessive growth (personal communication, April 3, 2003). If a scheme has a large increase in membership shortly before the date on which the RBC requirement is calculated, the extra premiums from these new members will not be fully visible at the calculation date. Therefore, the underwriting risk RBC will not have increased sufficiently to generate an excessive growth charge. An estimate of the business risk charge for registered South African medical schemes is shown in the table below.

Table 3.8: Estimate of business risk RBC

Rands

Administrative expense RBC 124,379,325Excessive growth RBC 177,549,064H4: Business risk RBC 301,928,389

Gross contributions 29,884,077,939

% of gross contributions 1.0% The business risk charge would impose a capital requirement of roughly one percent of gross contributions. The relative sizes of the different subsections of the business risk charge are shown below. The excessive growth charge and administrative expense charge both contribute significantly to the business risk charge. The non-underwritten and limited risk business charge was not applicable to South African medical schemes. Such risk charges relate more to the business of scheme administrators than medical schemes.


58.8%

41.2%

Excessive growth RBC

Administrative expense RBC

Figure 3.10: Components of business risk charge

3.7 Risk-Based Capital After Covariance

The risk-based capital after covariance (RBCAC) is a level of capital that allows the MCO to withstand various adverse circumstances, as defined by the earlier five sections of the formula. Since it is unlikely that these five circumstances coincide, the RBCAC is less than the sum of these five sections. RBCAC is determined by the following formula:

2222 43210 HHHHHRBCAC . It assumes that the H1, H2, H3 and H4 risks are uncorrelated, while the H0 (affiliates) risk is highly correlated with the other four risks. The following example (ASSA, n.d.) will show how these assumptions are used. Suppose an MCO has two risk elements, A and B, with risk charges of R3 million and R4 million respectively. Assume that the risk charge for a given element is set so that if the MCO faced only that risk and held exactly that amount of capital it would have a 5% probability of ruin. Therefore, if an MCO had risk element A only and exactly R3 million in capital, it would have a 5% probability of ruin.


For a scheme with both risk elements, the capital requirement for a 5% probability of ruin would be

43),(243 22 RiskBRiskAnCorrelatio .

Case 1: If A and B are perfectly positively correlated, the capital requirement for a 5% probability of ruin is R7million (i.e. 3+4). Case 2: If A and B are uncorrelated, the capital requirement is R5 million (i.e.

22 43 ). The covariance adjustment is the cause of much debate. Van den Heever (1998) wrote that there should be a covariance adjustment but that this square root rule is somewhat arbitrary. On the other hand, Butsic (1994) has derived this square root rule exactly by assuming that the values of the risk elements are normally distributed. In addition, Hooker (1996) recommended that there should be no overall covariance adjustment, but there should be an adjustment for covariance within the asset risk charge. Hooker based this recommendation on his opinion that the absolute level of a RBC requirement is a political decision based on what the market can handle. The table below shows the total RBC after covariance and its components for registered South African medical schemes.

Table 3.9: Analysis of estimated RBCAC

Risk category Risk charge% of RBC before

covariance

RBCAC' excluding

Hx as % of RBCAC'

H0: Asset risk - affiliates 189,718 0.0% 100.0%H1: Asset risk - other 1,354,693,647 30.9% 89.6%H2: Underwriting risk 2,713,030,121 61.9% 45.5%H3: Credit risk 15,855,407 0.4% 100.0%H4: Business risk 301,928,389 6.9% 99.5%RBC before covariance 4,385,697,281 100.0%

RBC after covariance 3,338,115,241Gross contributions 29,884,077,939

% of gross contributions 11.2%

RBC after covariance' 3,047,670,556 Source: Based on ASSA (n.d.)

The total RBCAC for registered medical schemes was estimated at 11.2% of gross contributions. To arrive at this figure, the covariance adjustment was applied separately to each scheme, giving each individual scheme’s RBCAC, which were summed to get the total RBCAC for registered schemes.


The covariance adjustment increases the importance of larger risk charges and decreases the importance of smaller sections (ASSA, n.d.). To illustrate this effect, the RBC after covariance’ was calculated by applying the covariance adjustment to the total H0-H4 components, as if the registered schemes were one big scheme. This is merely for explanatory purposes and doesn’t represent any extension to the formula. The total figures were used to avoid introducing a second set of numbers. The effect of the covariance adjustment can be seen by comparing the sum of the different sections of the formula i.e. risk-based capital before covariance to the RBCAC’. It is clear that the RBCAC’ is less than the RBCBC. In addition, the risk categories that form a large proportion of RBCBC have even greater influence on the RBCAC’. The opposite is true of risk categories that form a small proportion of RBCBC. Figure 3.11 shows the relative importance of the different risk charges.

61.9%

30.9%

6.9%

0.4%0.0%

H2: Underwriting risk

H1: Asset risk - other

H4: Business risk

H3: Credit risk

H0: Asset risk - affiliates

Figure 3.11: Components of RBCBC

The underwriting risk charge is the largest risk charge, followed by the asset risk – other charge. The business risk charge is the third largest charge while the other charges are negligible.

3.8 Transitional Arrangements

The RBC requirement was phased in over the calendar years 1998, 1999 and 2000. Figure 3.12 illustrates the transitional arrangements.


50% 50% 50% 50%

40%

45%

50% 50%

20%

25%

30%

35%

40%

45%

50%

55%

1998 1999 2000 2001

Calendar year

Perc

en

tag

e o

f R

BC

AC

Full ACL

Transitional ACL

Source: NAIC (2001)

Figure 3.12: Transitional arrangements

When fully implemented, the ACL is set at 50% of RBCAC. During the phase-in period, it is set lower than that. In 1998 the ACL was 40% of RBCAC, in 1999 it was 45% of RBCAC and from 2000 onwards, ACL is set at 50% of RBCAC. Since all the other RBC thresholds are defined in terms of the ACL, this has the desired effect of slowly raising the capital requirements to their full levels.


4. The Australian RBC System for Private Health Insurers

This chapter explains the Australian RBC system for Private Health Insurers.

4.1 Introduction to the Australian RBC System

The Australian RBC system for Private Health Insurers (“insurers”) requires insurers to hold capital to meet certain circumstances. The solvency standard requires insurers to hold an amount of capital (i.e. the solvency reserve) that will enable the fund to meet its current obligations if the fund was closed to new business and run-off. The capital adequacy standard requires the fund to hold sufficient capital (i.e. the capital adequacy reserve) to continue to meet its obligations as a going concern. The capital adequacy reserve is expected to exceed the solvency reserve. PHIAC (2001) sets out the likely steps that the PHIAC would take in the event of a breach of one of the standards. The RBC thresholds and regulatory responses in the table below are based on Torrance (2001), who gives an interpretation of the PHIAC paper.

Table 4.1: RBC thresholds and their corresponding regulatory actions

Capital level Regulatory action

Capital Adequacy ReserveIncreased PHIAC monitoring and potential direction to the insurer to improve its position.

Solvency ReserveDirect PHIAC action to protect the insurer's obligations to its policyholders. Source: Torrance (2001)

An insurer with capital in excess of the capital adequacy requirement is likely to suffer no intervention from the regulator. Before looking at the detail of the solvency and capital adequacy formulae, it is helpful to understand their logic. Figure 4.1 illustrates the method used to calculate the solvency reserve; the capital adequacy reserve is calculated similarly. The solvency reserve is not calculated directly; a figure called the solvency requirement is calculated first. The difference between the solvency requirement and the reported liabilities of the fund is the solvency reserve, which is the minimum amount of capital an insurer is required to hold under the solvency standard.


Total Assets Capital and Liabilities

Solvency Requirement

Reported Liabilities

Solvency Reserve

Figure 4.1: Relationship between the solvency reserve and the solvency requirement

The structure of the solvency requirement is illustrated below.

Solvencyliability

Liability risk

Inadmissibleassetsreserve

Resiliencereserve

Asset risk

Expensereserve

Managementcapitalamount

Additional obligations

Solvency requirement

Source: PHIAC (2000a, p.6)

Figure 4.2: Structure of solvency requirement

The solvency requirement ensures that the insurer can meets its obligations in a run-off situation under a range of adverse circumstances affecting assets as well as liabilities. The solvency liability is the value of the insurer’s liabilities on a conservative basis (this basis is specified in the standards). The inadmissible assets reserve; resilience reserve; expense reserve and management capital amount can be thought of as risk charges that require the insurer to hold extra capital on top of the solvency liability as a buffer against adverse circumstances. The sum of these five components is called the health benefits fund solvency requirement (HBFSR). The HBFSR less subordinated debt is the solvency requirement. The logic behind this subordinated debt allowance will be made clear in Section 4.10.


The structure of the capital adequacy requirement is illustrated in Figure 4.3.

Capitaladequacy

liability

Renewaloptionreserve

Liability risk

Inadmissibleassetsreserve

Resiliencereserve

Asset risk

Businessfundingreserve

Managementcapitalamount

Ongoing fund

Capital adequacy requirement

Source: PHIAC (2000b, p.6)

Figure 4.3: Structure of capital adequacy requirement

As with the solvency requirement, summing the six components at the bottom of the diagram and making an adjustment for subordinated debt will generate the capital adequacy requirement for a given scheme. The rest of this chapter will describe the workings of each section of the solvency and capital adequacy standards. At the time of writing, the standards were being changed. The changes come into effect on 1 July 2003. Where relevant, the detail of these changes will be included. Furthermore, data from South African medical schemes’ 2000 statutory returns will be used throughout these sections to estimate how much RBC the formula would have required registered South African medical schemes to hold at 31 December 2000. This will also show the relative importance of the different sections of the standards.

4.2 Solvency Liability

The solvency liability is equal to the reported liabilities of the insurer plus a loading for those components of the insurer’s liabilities that are unknown and had to be estimated. The structure of the solvency liability is illustrated below.

Solvency net claimsliability

Solvency reinsuranceaccrued liability

Solvency otherliabilities

Solvency liability

Source: PHIAC (2000c, p.9)

Figure 4.4: Structure of solvency liability

The solvency net claims liability is the sum of two quantities: 1) 1.1 (Outstanding claims) 2) The maximum of

a) 1.1 (Contributions received in advance) (Loss ratio) b) Contributions received in advance.


The first quantity allows for the risk of underestimating outstanding claims. It adds a ten percent margin in recognition of that risk, ensuring that in a run-off situation it is likely that the insurer would be able to pay outstanding claims already incurred. The basis for this 10% margin is outlined in Appendix B3. The second quantity recognises that the insurer may be required to make claims (and other) payments in excess of the contributions received in advance when providing the cover paid for by those contributions. It requires the insurer to hold enough capital to absorb such payments. The loss ratio is the ratio of expected claims and expenses to contributions. Therefore, the product in line 2a is the value of the expected payments relating to the contributions received in advance plus a ten percent loading for adverse experience. David Watson of the Australian Institute of Actuaries confirmed via email that any reference to “reinsurance” in the Australian standards actually refers to their risk-equalisation system. An extract from that email is given below.

“Reinsurance is a retrospective benefit equalisation arrangement, administered by PHIAC. Its primary purpose is to support the community rating system that is in place by virtue of the legislation governing the operations of health insurers.”

David Watson, personal communication, 22 March, 2003 The parts of the solvency liability relating to these “reinsurance” arrangements will be ignored in this report as they would involve a rather lengthy detour into the Australian risk-equalisation system. The reader is referred to PHIAC (2000c, p.9 & pp.45-48) for the details of this part of the calculation. However, with a South African risk equalisation system currently being developed, it should be noted that such a system would interact with a health RBC system. Solvency Other Liabilities is the total balance sheet value of all other liabilities. The solvency liability is the sum of the three components in Figure 4.4. It provides a cushion of capital over and above the value of liabilities in recognition of the possibility that liabilities are understated. This increases the likelihood that an insurer can meet its obligations in a run-off situation. The table below shows the solvency liability for registered South African medical schemes. The solvency liability turns out to be 5.4% larger than balance sheet total liabilities. Therefore, the solvency liability alone generates a solvency reserve of 5.4% of liabilities.


Table 4.2: Estimate of solvency liability

RandsAs % of total

liabilitiesSolvency net claims liability 3,650,978,408Solvency other liabilities 3,152,775,597

Solvency liability 6,803,754,005 105.4%Less: Total liabilities 6,453,059,082"Contribution" to solvency reserve 350,694,923Gross contributions 29,884,077,939As % of gross contributions 1.2%

Contribution to the solvency reserve is the difference between the solvency liability and total liabilities. It shows how much of the solvency reserve is generated by the solvency liability section. The solvency liability generates a solvency reserve of 1.2% of gross contributions.

4.3 Expense Reserve

In a run-off situation, contributions will cease, but the insurer will continue to incur certain expenses. These expenses could erode the resources of the insurer, leaving it unable to meet its obligations to policyholders and other creditors. The solvency standard requires insurers to hold capital to meet these expenses and prevent such an outcome. The formula for this reserve is

5.0reserveExpense (Total expenses – Allowable deductions).

The reasoning behind it is quite straightforward. It starts off with the fund’s total non-claims expenses for the year prior to the valuation date and subtracts those expenses that the fund can immediately terminate (such as marketing and broker commissions) without extra cost to the fund. Then, under the assumption that the leftover expenses decrease to zero linearly over the course of one year, it multiplies the leftover expenses by 0.5. Regulation 6(1)(a) in terms of the Medical Schemes Act of 1998 holds that South African medical schemes are not obligated to pay claims that are reported over four months after the date on which the last medical service was rendered to the member or dependant. This implies that a South African medical scheme, which is closed to new business, will have few claims to process four to five months after its closure. Therefore, a South African medical scheme’s expenses may decrease to zero in less than one year, and a factor of less than 0.5 could be used in the South African environment. At the time of writing, the PHIAC were adjusting this part of the formula. From 1 July 2003, the expense reserve will be 40% of total non-claims expenses (with no deductions) for the year prior to the valuation date (P. Groenewegen, personal communication, May 2, 2003). This is equivalent to the old requirement with 20% of non-claims expenses being deductible.


Table 4.3 shows the expense reserve for registered South African medical schemes.

Table 4.3: Estimate of expense reserve

RandsAs % of total

expensesTotal expenses 3,705,122,360Total allowable deductions 1,209,641,858Expense reserve 1,247,740,251 33.7%Gross contributions 29,884,077,939As % of gross contributions 4.2%

The expense reserve equals 33.7% of total expenses and generates a solvency reserve of 4.2% of gross contributions.

4.4 Inadmissible Assets Reserve

The inadmissible assets reserve has three components as illustrated below.

Assets used inconduct of business

Holdings in prudentiallyregulated institutions

Asset concentrationreserve

Inadmissible assetsreserve

Source: PHIAC (2000c)

Figure 4.5: Structure of inadmissible assets reserve

If the inadmissible assets reserve is being calculated as a component of the solvency requirement, it equals the sum of all three components in Figure 4.5. However, for inclusion in the capital adequacy requirement it should not include the reserve in respect of assets used in the conduct of business. If a fund closes to new business, it may need to sell some of its assets to fund its expenses during the run-off period. For some assets, it will be difficult to recover their full balance sheet value on sale. On a run-off basis, these assets are effectively worth less than their normal balance sheet values. Therefore, the solvency standard requires the insurer to hold reserves to the extent that these assets are over valued. It defines the size of this reserve by specifying the value to be assigned to various assets in a run-off situation. For instance, arrear contributions, computer software, and prepaid expenses are all assigned zero values. So, the insurer must hold reserves equal to these assets’ balance sheet values.


If an insurer has holdings in an entity that is required to hold a minimum quantity of capital (i.e. a prudentially regulated entity), that insurer will be required to hold a reserve to the extent that the balance sheet value of that holding includes part of the entity’s capital requirement. This ensures that the assets supporting the capital requirement of the subsidiary entity are not used to meet the capital requirement of the insurer that owns it. Similar allowances were made for affiliates subject to RBC in the USA formula. In general, the assets supporting the capital requirements of one entity cannot be used to meet the capital requirements of another entity at the same time. The asset concentration reserve imposes a capital requirement based on the risk from excess concentration of assets with one obligor. It does this by defining an acceptable level of investment with each obligor and then imposing a capital requirement to the extent that investment with each obligor exceeds the acceptable level. For most assets, the maximum acceptable level of investment with a particular obligor is 10% of the total assets of the insurer. An example of an exception to this rule is investment in government bonds where the maximum acceptable investment is 100% of the insurer’s total assets. Although the 10% limit seemed rather harsh to the author, the Australian Government Actuary has indicated that it may be too lenient and that a 5% limit may be more appropriate (P. Groenewegen, personal communication, May 2, 2003). If this were implemented, insurers would have to hold over 20 different assets to avoid an asset concentration charge. Table 4.4 shows the value of the inadmissible assets reserve for registered South African medical schemes.

Table 4.4: Estimate of inadmissible assets reserves

RandsAs % of total

assetsTotal assets 12,972,132,222

Assets used in conduct of business 1,523,412,290 11.7%Asset concentration risk 2,579,028,277 19.9%

Inadmissible assets reserve (solvency) 4,102,440,567 31.6%Gross contributions 29,884,077,939As % of gross contributions 13.7%

Asset concentration risk 2,579,028,277 19.9%

Inadmissible assets reserve (capital adequacy) 2,579,028,277 19.9%Gross contributions 29,884,077,939As % of gross contributions 8.6%

For solvency purposes, 31.6% of total assets were inadmissible, while 19.9% of total assets were inadmissible for capital adequacy purposes. This can be interpreted as imposing a solvency reserve of 31.6% of assets and a capital adequacy reserve of 19.9% of assets. The inadmissible assets reserve generates a solvency reserve of 13.7% of gross contributions and a capital adequacy reserve of 8.6% of gross contributions.


4.5 Resilience Reserve

The resilience reserve establishes a reserve against adverse movements in asset values relative to liability values. In other words, the resilience reserve is that quantity of capital that ensures an insurer’s assets still exceed its liabilities after an economic shock that decreases the value of the insurer’s assets relative to its liabilities. The explanation of this reserve requires some notation, as used in PHIAC (2000c, p.23). Let: RR be the resilience reserve; A and A’ be the value of the insurer’s assets before and after the shock; L and L’ be the value of the insurer’s liabilities before and after the shock. Assets that are worth one rand before the shock will be worth A’/A rand after the shock. The resilience reserve is defined so that assets worth RR+L before the shock are worth L’ after the shock. In other words, the assets supporting liabilities and the capital cushion provided by the resilience reserve before the shock, should be enough to meet liabilities after the shock. Therefore the resilience reserve satisfies

''

LA

ALRR .

This implies that

LA

ALRR

'' .

The prescribed economic changes that determine A’ are listed in Table 4.5.

Table 4.5: Economic shocks assumed in resilience reserve

Asset classShock for

solvency

Shock for capital

adequacy

EquitiesFall in capital value of (25% times DF)

Fall in capital value of (35% times DF)

PropertyFall in capital value of (15% times DF)

Fall in capital value of (25% times DF)

Interest bearing

securities

Rise in yield of (1.5% times DF)


Indexed bondsRise in yield of (0.5% times DF)


Source: PHIAC (2000c, p. 23)


In the above table, DF is the diversification factor as defined in PHIAC (2000c, p.24). It reduces the severity of the economic shocks (and hence the resilience reserve) for insurers that spread their assets across the different asset classes. With effect from 1 July 2003, the fall in capital value of property for solvency purposes will be increased to 25% times DF (P. Groenewegen, personal communication, May 2, 2003). This is because of the difficulty in determining the value of properties in a wind-up situation. Table 4.6 shows an estimate of the resilience reserve for registered South African medical schemes.

Table 4.6: Estimate of resilience reserves

RandsAs % of total

assets

Total assets 12,972,132,222

Resilience reserve (solvency) 307,614,756 2.4%Gross contributions 29,884,077,939As % of gross contributions 1.0%

Resilience reserve (capital adequacy) 739,138,071 5.7%Gross contributions 29,884,077,939As % of gross contributions 2.5%

The resilience reserve imposes a solvency reserve of 2.4% of assets and a capital adequacy reserve of 5.7% of assets. Furthermore, the resilience reserve adds 1.0% of gross contributions to the solvency reserve and 2.5% of gross contributions to the capital adequacy reserve.

4.6 Management Capital Amount

At a practical level, the management capital amount imposes a fixed dollar minimum on both the solvency and capital adequacy reserves. The minimum solvency reserve is $1.0 million while the minimum capital adequacy reserve is $1.5 million. Torrance (2001) explains that many of the other components of the solvency and capital adequacy requirements are proportional to the sizes of the insurer’s balance sheet items or the size of the insurer. In contrast, management risks are often not proportional to the size of the fund and are best handled by imposing a minimum capital requirement. The minimum capital requirement also gives the public a minimum assurance of the financial soundness of health insurers. Table 4.7 shows the management capital amounts for registered South African medical schemes. [Editor’s Note: in future work, this should be contrasted with the capital needed to start a medical scheme in South Africa.]


Table 4.7: Estimate of management capital amounts

Rands

Management capital amount (solvency) 89,465,276Gross contributions 29,884,077,939As % of gross contributions 0.3%

Management capital amount (capital adequacy) 67,034,376Gross contributions 29,884,077,939As % of gross contributions 0.2%

It seems clear that the management capital amount is small, adding 0.3% of gross contributions to the solvency reserve and 0.2% of gross contributions to the capital adequacy reserve.

4.7 Capital Adequacy Liability

The capital adequacy liability is very similar to the solvency liability. It has the following structure.

Capital adequacy netclaims liability

Capital adequacyreinsurance accrued

liability

Capital adequacyother liabilities

Capital adequacyliability

Source: PHIAC (2000c, p.30)

Figure 4.6: Structure of capital adequacy liability

Capital adequacy other liabilities is the value of all other liabilities at their balance sheet values. It is identical to solvency other liabilities. The capital adequacy net claims liability is the sum of the following two quantities: 1) {1+Margin} (Outstanding claims)

2) The maximum of a) {1+Margin} (Contributions received in advance) (Loss ratio) b) Contributions received in advance.

With effect from 1 July 2003, the “Margin” will be removed from part 2a, making it contributions received in advance times the loss ratio (P. Groenewegen, personal communication, May 2, 2003). This will reduce the capital adequacy liability for some insurers. The capital adequacy net claims liability is essentially the solvency net claims liability with the 10% figure replaced by “Margin”. “Margin” is the “capital adequacy margin” and it is determined by the characteristics of the insurer in question.


It has a minimum value of 12.5% to which two additions are made, namely: The fund size addition and The membership and claims experience stability addition. The additions for various fund sizes are shown in the figure below.

200,000 SEU's

20,000 SEU's

4,000 SEU's

0%

1%

2%

3%

4%

5%

6%

7%

8%

0 50,000 100,000 150,000 200,000 250,000

Number of SEU's

Fu

nd

siz

e a

dd

itio

n

Source: PHIAC (2000c)

Figure 4.7: Fund size addition to capital adequacy margin

The standards use “Single Equivalent Units” (SEU’s) as the measure of insurer size. This measure has its origins in the Australian risk-equalisation system (PHIAC, 2000c). Parkin (2001) explains that a single member is classified as one SEU, while all other classes of membership (married, family etc) are classified as two SEU’s. The relative sizes of the additions suggest that risk is reduced more by growth from 4,000 SEU’s to 20,000 SEU’s, than growth from 20,000 SEU’s to 200,000 SEU’s. The addition for membership and claims stability requires judgement from the person completing the calculations. It cannot be negative and 5% would be a large addition. The more the following conditions exist, the closer the addition should be to 5%: Membership numbers vary significantly; Incurred claims vary significantly; Loss ratios have been increasing over recent years; and A new product has been introduced which is expected to affect the fund’s finances

significantly, but about which little is known. Walker (2003) suggests a way to determine the capital adequacy margin for a given insurer based on stability of past claims only. He proposes calculating the incurred claims per SEU per day for each month over some sufficiently long period (18 months in his example).


He then recommends a capital adequacy margin based on the standard deviation of these monthly figures divided by ten. If this statistic exceeds 5%, a margin of 5% is recommended. If it lies between 4.5% and 5%, a margin of 4.5% is recommended, etc. Walker argues that it is sufficient to base the margin on this standard deviation only, because it picks up membership variability, claims variability and changing loss ratios. The results of his calculations support this argument. The margins recommended using this approach were similar to the margins that the insurers participating in the study had recommended independently using their own judgement. In response to Walker’s paper, Watson (2003) comments that the determination of the stability addition requires judgement and can never be reduced to a formula alone. However, Watson believes that Walker’s method does give a good indication of experience stability. A histogram of the capital adequacy margins for registered South African medical schemes is shown below.

0

10

20

30

40

50

60

70

12% 14% 16% 18% 20% 22% 24% 26% More

Capital adequacy margin

Fre

qu

en

cy

0%

20%

40%

60%

80%

100%

120%Frequency

Cumulative %

Figure 4.8: Histogram of capital adequacy margins

The histogram shows that 70% of the margins are between 16% and 22%. Furthermore, none of the margins exceed 26%. Due to the 12.5% minimum, all the margins exceed the 10% value used in the solvency liability. The capital adequacy liability for registered South African medical schemes is shown in Table 4.8.


Table 4.8: Estimate of capital adequacy liability

RandsAs % of total

liabilitiesCapital adequacy net claims liability 3,820,566,610Capital adequacy other liabilities 3,152,775,597

Capital adequacy liability 6,973,342,207 108.1%Less: Total liabilities 6,453,059,082"Contribution" to capital adequacy reserve 520,283,125Gross contributions 29,884,077,939As % of gross contributions 1.7%

As expected, the capital adequacy liability (108.1% of liabilities) was found to be greater than the solvency liability (105.4% of liabilities). The capital adequacy liability added 1.7% of gross contributions to the capital adequacy reserve.

4.8 Renewal Option Reserve

Current contribution levels may be insufficient to cover claims and expenses over the coming year. It may take some time for the insurer to realise this and adjust premiums. In the mean time, the insurer will need sufficient capital to absorb the losses from this under pricing and/or adverse experience if it is to avoid insolvency. The renewal option reserve requires insurers to hold a quantity of capital to absorb such losses. The renewal option reserve is the NPV of cash outflows less cash inflows over the twelve months following the valuation date, subject to a minimum value of zero. These cash flows are based on a conservative projection of results and the insurer’s current business plan. More specifically, this conservative projection uses: Contributions as in the current business plan; Expected benefits increased by the capital adequacy margin; Expected expenses increased by half the capital adequacy margin; and Investment income on contributions received in advance and projected net cash

flows equal to the return on one-year Government treasury bonds less 1%. This rate is also used as the discount rate to calculate the NPV.

From 1 July 2003, investment income on outstanding claims provision must also be recognised (P. Groenewegen, personal communication, May 2, 2003). The table below shows the value of the renewal option reserve for registered South African medical schemes.


Table 4.9: Estimate of renewal option reserve

Rands

Renewal option reserve 4,551,783,444Gross contributions 29,884,077,939As % of gross contributions 15.2%

The renewal option reserve contributes significantly to the total capital adequacy reserve, imposing a capital adequacy reserve of 15.2% of gross contributions.

4.9 Business Funding Reserve

The insurer’s future business plan may (say) aim to grow the business by attracting new policyholders through increased advertising and/or by expanding into new markets. This strategy will impose marketing and advertising expenses on the insurer, which will reduce the scheme’s capital. This expansion should not reduce the security of existing policyholders’ claims against the insurer. Therefore, the insurer must hold extra capital, to the value of the business funding reserve, if its business plan is likely to reduce the scheme’s current level of capital. The business funding reserve is basically the extra quantity of capital required to ensure that the fund will meet the solvency requirement over the three years following the valuation date, less any capital that the insurer has entered into binding arrangements to raise externally in the future. It was not possible to calculate this reserve using data from the South African medical schemes’ 2000 statutory returns. Each scheme’s business plan for the three years following the valuation date, as well as the expected impact of that business plan on the scheme’s capital would be needed to calculate the business funding reserve.

4.10 Subordinated Debt Allowance

Throughout this chapter we have focused on the solvency (capital adequacy) reserves as quantities of capital that the scheme is required to hold. To understand the subordinated debt allowance, we need to focus on the solvency (capital adequacy) requirements as quantities of assets that the scheme is required to hold. The coming paragraphs will explain the subordinated debt allowance as it applies to the solvency requirement. The allowance works similarly for the capital adequacy requirement. The subordinated debt allowance allows the insurer to use subordinated debt as well as equity to fund its solvency requirement. This allowance leads to the difference between the HBFSR and the solvency requirement. That is

trequiremenSolvencydebtedSubordinatHBFSR .


The following example should clarify this.

Table 4.10: Balance sheet of a hypothetical insurer under various scenarios ($ millions)

Scenario A: Base case Scenario B: Equity issue

Assets 40 Capital 5 Assets 50 Capital 15Liabilities 35 Liabilities 35

40 40 50 50

HBFSR 50 HBFSR 50Less: Subordinated debt 0 Less: Subordinated debt 0Solvency requirement 50 Solvency requirement 50

Scenario C: Subordinated debt issue Scenario D: Subordinated debt issue (with subordinated debt allowance) (without subordinated debt allowance)

Assets 50 Capital 5 Assets 50 Capital 5Liabilities 45 Liabilities 45

50 50 50 50

HBFSR 60 HBFSR 60Less: Subordinated debt 10 Less: Subordinated debt 10Solvency requirement 50 Solvency requirement 60

Suppose an insurer with a HBFSR of $50 million has total assets of $40 million (Scenario A in Table 4.10). There are various options to fund the extra $10 million of assets that it needs: debt, equity or some combination of the two. If it uses equity (Scenario B), the insurer’s total assets will increase by $10 million, its solvency requirement will remain at $50 million and its solvency requirement will be met. If it uses subordinated debt (Scenario C), its total assets will increase by $10 million. Its HBFSR will increase by $10 million, since solvency other liabilities increases by $10 million, but its solvency requirement will remain the same, thanks to the subordinated debt allowance. Therefore, the scheme will have met its solvency requirement. If the solvency standard had no subordinated debt allowance (Scenario D), the insurer in the above example could not have used subordinated debt to fund the extra $10 million of assets and meet the solvency requirement. The $10 million of subordinated debt would increase assets by $10 million, to a total of $50 million. However, it would increase the solvency requirement to $60 million. Any increase in assets funded by subordinated debt would lead to an equal increase in the solvency requirement. Therefore, subordinated debt could not be used to meet the insurer’s solvency requirement.


4.11 Solvency and Capital Adequacy Reserves

The first section of this chapter explained how the solvency and capital adequacy reserves are calculated. The table below shows their values for registered South African medical schemes.

Table 4.11: Estimate of solvency and capital adequacy reserves

RandsAs % of

reserveRands

As % of

reserveSolvency liability 6,803,754,005 5.8% Capital adequacy liability 6,973,342,207 6.2%Expense reserve 1,247,740,251 20.5% Renewal option reserve 4,551,783,444 53.8%Inadmissible assets reserve 4,102,440,567 67.3% Business funding reserve 0 0.0%Resilience reserve 307,614,756 5.0% Inadmissible assets reserve 2,579,028,277 30.5%Management capital amount 89,465,276 1.5% Resilience reserve 739,138,071 8.7%HBFSR 12,551,014,854 Management capital amount 67,034,376 0.8%Less: Subordinated debt 0 HBFCAR 14,910,326,375Solvency requirement 12,551,014,854 Less: Subordinated debt 0Less: Reported liabilities 6,453,059,082 Capital adequacy requirement 14,910,326,375Solvency reserve 6,097,955,772 Less: Reported liabilities 6,453,059,082

Gross contributions 29,884,077,939 Capital adequacy reserve 8,457,267,293

As % of gross contributions 20.4% Gross contributions 29,884,077,939

As % of gross contributions 28.3%

The solvency and capital adequacy reserves were estimated to be 20.4% and 28.3% of gross contributions respectively. The “percentage of reserve column” shows how much each component contributes to the final reserve. For the solvency and capital adequacy liabilities, reported liabilities were subtracted first before evaluating their contributions to the reserves. The inadmissible assets reserve and the expense reserve together make up nearly 90% of the solvency reserve. Similarly, the renewal option reserve and the inadmissible assets reserve together make up nearly 85% of the capital adequacy reserve. These components appear to be the critical parts of each formula.

4.12 Transitional Arrangements

The Australian solvency requirement is being phased in over the calendar years 2001 to 2005. As for the subordinated debt allowance, the solvency requirement must be interpreted as a minimum quantity of assets to understand the transitional arrangements. Figure 4.9 shows how this transition is taking place.


2000 2001 2002 2003 2004 2005 2006 2006

Old requirement

HBFSR

Transitional requirements

0%

17%

33%

50%

67%

83%

100% 100%

Source: PHIAC (2000a)

Figure 4.9: Transitional arrangements

In 2001, insurers were required to hold assets in excess of the old capital requirement plus 17% of the difference between the HBFSR and the old requirement. Over the years 2002 to 2006, this 17% will increase by 17% each year until the full HBFSR is reached and the new solvency requirement is fully implemented. The health benefits fund capital adequacy requirement (HBFCAR) is being phased in similarly.


5. The effect of RBC on South African Medical Scheme Solvency

This chapter will estimate the effect of RBC on South African medical scheme solvency both at the industry level and at the individual scheme level. In doing so it will also compare the size and effect of the USA and Australian RBC requirements.

5.1 Methodology

Ideally, to estimate the effect a RBC system would have on South African medical scheme solvency, a RBC system developed for South African medical schemes should be applied to South African data. Since no such RBC system existed at the time of writing, foreign RBC systems were applied to South African data. The results of these calculations were used to estimate the effect a RBC system would have on South African medical scheme solvency. More precisely, the USA and Australian RBC requirements were estimated for South African medical schemes at 31 December 2000, using data from their 2000 statutory returns. Some of the results of these calculations have already appeared in the previous two chapters. Appendices C, D and E set out exactly what data was used to calculate each part of the USA RBC requirement, the Australian solvency reserve, and the Australian capital adequacy reserve respectively. International differences and data availability meant that approximations and assumptions were sometimes necessary. These approximations and assumptions are also recorded in the relevant appendices.

5.2 Industry Level

This section estimates the impact of a RBC system on South African medical scheme solvency at the industry level. It does this by comparing the RBC requirements of different aggregates of schemes to the accumulated funds of those aggregates. 5.2.1 Aggregate solvency

Figure 5.1 shows the total value of the four different capital requirements for registered schemes.


3,338

6,098

7,471

8,457

5,127

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

Risk-based capital aftercovariance

Solvency reserve 25% of gross contributions Capital adequacy reserve Accumulated funds

R m

illi

on

s

Figure 5.1: Accumulated funds and capital requirements for registered schemes

Comparing the capital requirements to accumulated funds, we see that the USA RBC system finds the industry adequately capitalised. However, both the Australian solvency standard and the South African 25% rule suggest that registered schemes should be holding more accumulated funds. The capital requirements can also be compared to one another. Both the USA RBC requirement and the Australian solvency reserve are lower than the current 25% of gross contributions requirement, whereas the capital adequacy reserve is R1 billion higher than the 25% requirement. This implies that the USA system would allow registered medical schemes to hold less capital than the current requirement. On the other hand, the Australian system would require registered medical schemes to hold more reserves than the current requirement. 5.2.2 Aggregate solvency by scheme type

Figure 5.2 shows the total capital requirements, as a percentage of gross contributions, for different scheme types. The capital requirements are expressed as a percentage of gross contributions for ease of comparison.


11.2%

20.4%

28.3%

17.2%

9.1%

18.3%

13.3%

15.6%

38.2%

25.3%

23.7%

25.0%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

Risk-based capital after covariance Solvency reserve Capital adequacy reserve Accumulated funds

Pe

rce

nta

ge

of

gro

ss

co

ntr

ibu

tio

ns

Registered

Registered - open

Registered - restricted

Figure 5.2: Capital requirements as a percentage of gross contributions (by scheme type)

Comparing the capital requirements to accumulated funds, we see that the USA RBC system would find that both scheme types are holding sufficient accumulated funds. The Australian system would find that neither scheme type is adequately capitalised, since neither scheme type satisfies the capital adequacy reserve. Only the restricted schemes meet the Australian solvency requirement. Comparing the capital requirements for different scheme types, we see that both the USA and Australian systems require restricted schemes to hold a larger percentage of gross contributions as reserves than open schemes. This implies that the RBC systems find the restricted schemes “riskier” than the open schemes. The restricted schemes tend to have lower membership than the open schemes, so this is probably a scheme size effect rather than a scheme type effect. In reality, open schemes face a greater risk of adverse claims fluctuations due to their open enrolment and restricted underwriting (ASSA, 2002). This suggests that a South African RBC system may need to include an indicator that somehow increases the requirement for open schemes (Professor McLeod, personal communication, April 10, 2003). Another way to handle this would be to set up different requirements for open and restricted schemes. In other words, use different RBC factors for open and restricted schemes respectively. The horizontal black line shows the current 25% of gross contributions requirement. On the whole, the USA system would allow registered schemes to hold less than 25% of gross contributions as reserves, while the Australian system would require registered schemes to hold more than 25% of gross contributions as reserves.


5.2.3 Aggregate solvency by scheme size

Figure 5.3 shows the total RBC requirements, as a percentage of gross contributions, for registered schemes by scheme size.

18.5%

34.0%

47.0%

40.0%

19.4%

31.3%

46.8%

34.9%

9.5%

17.7%

24.3%

12.7%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Risk-based capital after covariance Solvency reserve Capital adequacy reserve Accumulated funds

Pe

rce

nta

ge

of

gro

ss

co

ntr

ibu

tio

ns

Small Medium Large

Figure 5.3: Capital requirements as a percentage of gross contributions (by scheme size)

The size classifications small (<6000 members), medium (>6000 members and <30000 beneficiaries) and large (>30000 beneficiaries) are based on the Annual Report of the Registrar of Medical Schemes (2001). Comparing the capital requirements to accumulated funds shows that the small and medium schemes meet the USA requirement and the Australian solvency reserve, but not the capital adequacy reserve. Large schemes meet the USA RBC requirement but neither of the Australian reserve requirements. Comparing the capital requirements for different scheme sizes shows that the RBC systems require small and medium schemes to hold roughly the same proportion of gross contributions as reserves. However, they allow large schemes to hold a significantly smaller percentage of gross contributions as reserves. Both Australian reserves require small and medium schemes to hold more than 25% of gross contributions as reserves. For large schemes, the Australian solvency reserve is less than 25% while the capital adequacy reserve is approximately 25%. The USA RBC requirement is lower than 25% for all three scheme sizes.


5.3 Individual Scheme Level

This section estimates the effect of a RBC system on South African medical scheme solvency at the individual scheme level. It does this by showing the range of capital requirements that schemes would be required to hold under a RBC system and by reporting the proportions of schemes that meet the various capital requirements. 5.3.1 Range of individual scheme capital requirements

Figure 5.4 shows the distribution of the different capital requirements, as well as the distribution of accumulated funds.

0

10

20

30

40

50

60

70

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% More

Percentage of gross contributions

Nu

mb

er

of

sc

he

me

s

Risk-based capital after covariance

Solvency reserve

Capital adequacy reserve

Accumulated funds

Figure 5.4: Histogram of capital requirements for registered schemes

The main feature of this graph is the large range in capital requirements. If a RBC system were introduced in South Africa, some schemes would be allowed to hold less than the current 25% of gross contributions, while others would be required to hold substantially more. Schemes with very small annual contributions are often required to hold more than 25% of gross contributions. Under the Australian system, the inadmissible assets charge (which makes up 67.3% of the solvency reserve and 30.5% of the capital adequacy reserve, see Table 4.11) is often behind these large capital requirements. Some schemes have large outstanding contributions, which add significantly to the assets used in the conduct of business charge. Other schemes have large asset concentration charges.


5.3.2 Individual scheme solvency by scheme type

Figure 5.5 shows the percentages of each type of scheme that meet the various capital requirements.

68.9%

54.7%52.0%

37.8%

68.1%

40.4%38.3%

34.0%

69.3%

61.4%

58.4%

39.6%

0%

10%

20%

30%

40%

50%

60%

70%

80%

US risk-based capital standard Solvency standard 25% of gross contributions rule Capital adequacy standard

Pe

rce

nta

ge

of

sc

he

me

s t

ha

t a

re s

olv

en

t

Registered

Registered - open

Registered - restricted

Figure 5.5: Percentages of schemes that are solvent (by scheme type)

Comparing the RBC standards to the current requirement, we see that more schemes are solvent under the USA RBC standard and the Australian solvency standard than under the current 25% of gross contributions rule. On the other hand, a smaller percentage of each scheme type is solvent under the Australian capital adequacy standard than under the current 25% of gross contributions rule. We can also compare the solvency of the different scheme types. Under each RBC standard, the proportion of restricted schemes that are solvent is larger than the proportion of open schemes that are solvent. 5.3.3 Individual scheme solvency by scheme size

Figure 5.6 shows the percentages of registered schemes that meet the various capital requirements, by scheme size.


73.3%

59.3%

65.1%

38.4%

68.2%

63.6%

59.1%

50.0%

60.0%

40.0%

20.0%

30.0%

0%

10%

20%

30%

40%

50%

60%

70%

80%

US risk-based capital standard Solvency standard 25% of gross contributions rule Capital adequacy standard

Pe

rce

nta

ge

of

sc

he

me

s t

ha

t a

re s

olv

en

t

Small Medium Large

Figure 5.6: Percentages of schemes that are solvent (by scheme size)

More large schemes are solvent under the three RBC standards than under the current 25% of gross contributions rule. This suggests that the current capital requirement for large schemes is quite conservative. A larger percentage of medium schemes are solvent under the USA RBC standard and the Australian solvency standard than under the current 25% of gross contributions rule. A larger percentage of small schemes are solvent under the USA RBC standard than under the current 25% of gross contributions rule. Comparing the solvency of the different scheme types shows that under each of the four solvency standards, the percentage of small and medium schemes that are solvent is higher than the percentage of large schemes that are solvent.

5.4 Summary

This section summarises the estimated effect of the various RBC systems on South African medical scheme solvency. Industry level: Registered schemes are solvent under the USA RBC system but insolvent under

all others. The USA RBC system and Australian solvency standard allow registered schemes

to hold less than 25% of gross contributions, whereas the Australian capital adequacy standard requires registered schemes to hold more than 25% of gross contributions.

Restricted schemes are required to hold a larger percentage of contributions as reserves than open schemes.


Small and medium schemes are required to hold a larger percentage of contributions as reserves than large schemes.

Individual scheme level: Under a RBC system, some schemes are allowed to hold less than 25% of gross

contributions as reserves; others are required to hold significantly more. More registered schemes are solvent under the USA RBC system and the

Australian solvency standard than under the current 25% of gross contributions rule. In contrast, fewer registered schemes are solvent under the Australian capital adequacy standard than under the current 25% of gross contributions rule.

A larger proportion of restricted schemes than open schemes are solvent. A larger proportion of small and medium schemes than large schemes are solvent.


6. A Comparison of the Australian and USA RBC

Systems

This chapter will compare the Australian and USA RBC systems. Where possible, it will highlight issues that may be relevant to the development of a RBC system for South African medical schemes.

6.1 Conceptual Framework

The USA and Australian RBC systems are based on different conceptual frameworks. The USA system is based on a particular probability of ruin, while the Australian system requires insurers to hold capital to meet certain circumstances. The following paragraphs will discuss the merits of each framework. 6.1.1 Probability of ruin

The probability of ruin approach is closely related to the underlying stochastic model. This enables the use of statistical techniques to estimate the risk factors in the USA RBC formula. Such techniques support the level of detail and the number of different factors in the standards. 6.1.2 Capital to meet specific circumstances

The Australian solvency and capital adequacy standards require insurers to hold enough capital to meet their current obligations if the fund was closed to new business and to continue to meet their obligations as a going concern. This form of capital requirement is easily understood by a layperson, but it is more difficult to use statistics to estimate this type of capital requirement. The two-tier solvency and capital adequacy requirement is equivalent to Campagne’s notion of static and dynamic solvency. Cooper (2001) explains that static solvency refers to an insurer’s ability to meet current outstanding claims and existing obligations in a run-off situation. Dynamic solvency requires the insurer to hold sufficient capital to have a high probability of remaining solvent while it writes new business and continues to grow. The South African capital adequacy standard for life insurers also requires insurers to hold capital to meet certain circumstances. The Actuarial Society of South Africa (2001) explains that the insurer is required to hold the greater of the “termination capital adequacy requirement” and the “ordinary capital adequacy requirement.” The first of these requires the insurer to hold enough capital to pay the lapse and surrender values on all its policies, while the second requires the insurer to hold sufficient capital to withstand adverse experience and continue doing business as a going concern


6.1.3 Suitable conceptual framework for a South African RBC system

In the USA and Australia, the health RBC systems were both based on RBC systems already developed for other types of insurers in those countries. Therefore, one possibility for a South African RBC system for medical schemes would be to consider the RBC system currently in use for South African life offices. This implies requiring schemes to hold capital to meet certain circumstances. The Australian system will thus provide an understanding of this approach in the context of South African medical schemes.

6.2 Components of Each Formula

The table below shows what risks the various sections of each RBC system reserve against. A question mark indicates a possible omission from the RBC system.

Table 6.1: Risks and corresponding sections of RBC standards

Risk US RBC standardAustralian solvency

standard

Australian capital

adequacy standard

Asset riskAdverse systematic market

movements

Asset risk - affiliates and

otherResilience reserve Resilience reserve

Asset concentration and non-systematic risk

Asset risk - other, asset concentration

Inadmissible assets reserve, asset concentration risk

Inadmissible assets reserve, asset concentration risk

Asset realisation/liquidity NAInadmissible assets reserve, assets used in the conduct of business

NA

Holdings in institutions

required to hold RBC

Asset risk - affiliates, affiliates

subject to RBC

Inadmissible assets reserve, holdings in prudentially

regulated institutions

Inadmissible assets reserve, holdings in prudentially

regulated institutions

Liability risk

Reserve adequacyUnderwriting risk, base underwriting risk RBC

Solvency liability Capital adequacy liability

UnderpricingUnderwriting risk, base underwriting risk RBC

NA Renewal option reserve

Catastrophic lossesUnderwriting risk, alternative risk charge ? ?

Other risks

Expense riskBusiness risk, administration expense charge

Expense reserve Renewal option reserve

Management and business risk

Business risk Management capital amount Management capital amount

Credit and counter party riskCredit risk, reinsurance and

capitation riskImplied Implied

Growth riskBusiness risk, excessive growth charge

NA Business funding reserve

The Australian solvency standard is based on a run-off view of the fund, while the USA RBC formula and the Australian capital adequacy standard view the fund as a going concern. This is why some risks in Table 6.1 are not applicable to the various capital requirements.


Furthermore, although no explicit provision is made, the Australian standards take credit risks and counter party risk into account implicitly. That is, they assume that the balance sheet values of individual assets reflect the default risk of those assets. Based on Table 6.1 and the developments of the earlier chapters, there appear to be one or two minor omissions from the standards. 6.2.1 Omissions from the USA formula

The USA RBC formula makes no allowance for the risk that arrear contributions are irrecoverable. As mentioned earlier, this is because USA MCO’s do not have significant exposure to this risk (A. Ford, personal communication, May 2, 2003). South African medical schemes do, however, face significant exposure to such bad debts. In the calendar year 2000, registered medical schemes wrote off R80.2 million in bad debts on their way to an overall net surplus of R242.3 million. Clearly, if a system like the USA were implemented in South Africa, it would need to include an allowance for bad debts. 6.2.2 Omissions from the Australian formulae

The Australian RBC formulae do not allow for The risk of catastrophic claims or Covariance between the different risks. The USA formula, through its alternative risk charge, allows for the risk of catastrophic claims, while the Australian formulae make no such allowance. Torrance (2001) writes that the risk from large individual claims was identified as a risk to be considered under the solvency and capital adequacy standards. It appears that this never actually happened. A South African RBC standard built along the lines of the Australian system should try to include such a risk charge. The Australian formulae make no allowance for covariance between the different risks. This is both a weakness and strength of the formula. Without a covariance adjustment, the formula is simpler and less intimidating. However, including an adjustment would be more theoretically correct. Covariance adjustments, the USA covariance adjustment in particular, are the subject of much debate (Section 3.7 touched on some of the different viewpoints). It is the author’s opinion that any South African RBC formula would be better off without such an adjustment. A complicated adjustment would make the industry suspicious of the formula and less likely to support its implementation. 6.2.3 Relative sizes of the different components

Figure 6.1 shows the contribution of the different risk charges to each of the RBC requirements.


30.9%

72.3%

39.2%

61.9%

5.8%

60.0%

7.2%

21.9%

0.8%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Risk-based capital before covariance Solvency reserve Capital adequacy reserve

Pro

po

rtio

n o

f c

ap

ita

l re

qu

ire

me

nt

Asset risk Liability risk Other risk

Figure 6.1: Components of capital requirements for registered schemes

There is some similarity between the relative importance of the Australian capital adequacy reserve’s constituent risk charges and those of the risk-based capital before covariance. The liability risks are of very similar importance. The importance of the components of the solvency reserve is quite different to the other two requirements. This is because the solvency reserve is based on a run-off view of the fund while the other requirements aim to secure the fund’s future as a going concern. When a scheme is closed to new business and run-off, its only liability risk is that technical reserves are insufficient. An ongoing operation faces this risk as well as the risk that future claims are higher than expected. This suggests that liability risk is more important for a going concern than for a scheme that is closed to new business. A scheme that is closed to new business also faces the risk that its assets are not realisable at their balance sheet values, as well as the risk of market fluctuations. An ongoing operation would have less exposure to these asset realisation risks and would be able to realise the value of its assets over their useful lives. This suggests that asset risk is less important for an ongoing operation than for a scheme that is closed to new business.

6.3 Special features of each formula

6.3.1 Special features of the USA formula

Special features of the USA formula are its allowance for transfer of risk through Reinsurance and Managed care. The Australian formulae do not have these features.


The transfer of risk through reinsurance is allowed for implicitly by basing the underwriting risk charge on contributions and claims net of reinsurance premiums and recoveries. Likewise, the alternative risk charge is based on claims after reinsurance recoveries. The credit risk section of the formula allows for the risk that the reinsurer will default on obligations to the MCO. As explained in Section 3.4.2, the MCO’s underwriting risk charge is reduced where the MCO shares risk with the providers of medical services. The reduction is larger when more risk is transferred to the provider. As for reinsurance, the credit risk section makes allowance for the possibility that the providers will default on their obligations to the MCO. Both of these features are based on the premise that reinsurance and managed care arrangements actually transfer risk away from the scheme and that reinsurers and MCO’s are also required to hold capital. In constructing a South African RBC system, the need for such allowances will be determined by the types of reinsurance and managed care arrangements in use, as well as the capital requirements of these other organisations. Section 20 of the Medical Schemes Act of 1998 (as amended) requires that all reinsurance contracts need to be approved by the registrar. Furthermore, the Actuarial Society of South Africa (2002) defines a reinsurance agreement as

“… any contractual arrangement whereby some element of risk contained in the rules of the medical scheme is transferred to a reinsurer in return for some consideration.” (ASSA, 2002, p.1)

This suggests that future medical scheme reinsurance arrangements are likely to transfer risk to the reinsurer. In addition, South African long-term insurers are required to hold minimum amounts of capital. Therefore, a South African RBC system should incorporate an allowance for risk transfer through reinsurance. Currently, South African medical schemes are obliged to hold 25% of gross contributions with no allowance for the transfer of risk through reinsurance. 2004 is the first full year of data that the Council for Medical Schemes will have on the effect of reinsurance on medical schemes. Therefore, late 2005 is the earliest that the council may consider incorporating a reinsurance offset in the current capital requirement (Professor McLeod, personal communication, May 14, 2003). The managed care allowance is a different story altogether. South African MCO’s are not required to hold minimum amounts of capital, so to reduce a scheme’s capital requirement because of contracts with an MCO would reduce the total amount of capital in the industry (Professor McLeod, personal communication, April 3, 2003). Furthermore, a managed care allowance would have little effect on the industry at present. Therefore, a South African RBC formula should not include a managed care allowance.


6.3.2 Special features of the Australian formulae

Noteworthy features of the Australian formulae are their Specification of a method to determine outstanding claims and Interaction with the Australian risk-equalisation system. The USA formula does not have these special features. The specification of a method to determine outstanding claims attempts to reduce the scope for an insurer to manipulate reserves in order to reduce its capital requirement and increase the capital on its balance sheet. The ASSA and the South African Institute of Chartered Accountants (2003) brought out professional guidelines on the estimation of IBNR claim liabilities for South African medical schemes, which list a number of factors that need to be considered when estimating these liabilities. Since guidance is already available, it would be unnecessary for a South African RBC system to specify a method for calculating IBNR liabilities. Although this report paid very little attention to the parts of the Australian standards relating to their risk-equalisation system, it recognises that the two systems interact. The standards treat amounts payable and receivable in terms of the risk-equalisation system differently to other payables and receivables, see PHIAC (2000c, p.9 & pp.47-48) for the details. A risk-equalisation system is currently being developed for South African medical schemes. Any RBC system for medical schemes should be consistent with this risk-equalisation system.

6.4 Meeting the requirements

The USA standard requires an MCO to hold a minimum quantity of equity. The Australian standards require insurers to hold a quantity of assets, in addition to those supporting the liabilities, which may be financed by either equity or subordinated debt. A South African RBC system would probably require schemes to hold a minimum quantity of accumulated funds. A disadvantage of accumulated funds is that its definition allows more scope for interpretation than equity or subordinated debt.

6.5 Basis for intervention

The USA standards are extremely clear on what action the regulator should take for every possible level of MCO equity. This makes regulation transparent and brings certainty to the industry, but it can be quite restrictive for the regulator. The regulatory responses under the Australian standards are less prescriptive than under the US. For instance, it is not clear on exactly what actions are to be taken in the event of a breach of the standards. Furthermore, part VI, division 3 A & B of the Australian National Health Act (1953) gives the PHIAC the right to issue directions to insurers even if they meet the requirements of both the solvency standard and the capital adequacy standard. Although this provides flexibility to the regulator, it does not give insurers as much certainty as the USA system.


7. Conclusions and Further Research

Based on the findings of this report, the following conclusions may be drawn: 1. Both the USA and Australian RBC systems have features that may be useful

in the South African environment. The RBC systems studied in this report both have features that may be useful when developing a RBC system for South African medical schemes. They give insight into some of the adjustments that would need to be made to make them suitable for medical schemes. The USA system’s allowance for risk transfer through reinsurance contracts, as well as the Australian system’s interaction with the Australian risk-equalisation system, suggests issues to be considered in the development of a RBC system. 2. At the industry level, the effect of a RBC system on South African medical

scheme solvency is unclear. It is unclear whether a RBC system would require the industry to hold more or less capital than 25% of gross contributions. The USA system would allow the industry to hold substantially less, while the Australian requirements straddle the 25% of gross contributions requirement. It appears that each different RBC system would have a different effect on medical scheme solvency. 3. Differing individual scheme capital requirements would lead to winners and

losers under a RBC system Both RBC systems studied allowed some schemes to hold less than 25% of gross contributions, while other schemes were required to hold substantially more than 25%. Schemes required to hold more than 25% may feel that the system is biased against them and be opposed to the use of RBC. Schemes required to hold less than 25% of gross contributions, often the larger schemes, would probably support the introduction of RBC. It is recommended that the following be investigated: 1. Starting Points for a RBC system for South African Medical Schemes. The USA and Australian RBC systems provide insight into the features a RBC system for medical schemes could have. These systems and the current RBC system for South African life insurers provide possible starting points for the construction of a RBC system for South African medical schemes. The investment (asset) sections of the life insurance formula may not need major changes, while the liability sections will need to be reconstructed to suit medical schemes. [See Editor’s Note for research now needed]


8. References and Bibliography

8.1 Australia

Cumpston, J. R. (1992). Margins for Prudence in Outstanding Claims Provisions. Proceedings of Eighth General Insurance Seminar, Institute of Actuaries of Australia, 211-238. Macquarie Bank Limited website. (n.d.). Retrieved April 18, 2003 from http://www.macquarie.com.au. Office of Legislative Drafting, Attorney-General’s Department, Canberra. National Health Act (1953), [Online]. Available: http://scaleplus.law.gov.au. [2003, January 6]. Parkin, N. (2001). Risk Equalisation in practice. B.Bus.Sc. project. University of Cape Town. Private Health Insurance Administration Council. (2000a). Health Benefits Organizations – Solvency Standard 2000, [Online]. Available: http://www.phiac.gov.au. [2003, January 10] Private Health Insurance Administration Council. (2000b). Health Benefits Organizations – Capital Adequacy Standard 2000, [Online]. Available: http://www.phiac.gov.au. [2003, January 10] Private Health Insurance Administration Council. (2000c). Health Benefits Organizations – Interpretation Standard 2000, [Online]. Available: http://www.phiac.gov.au. [2003, January 10] Private Health Insurance Administration Council. (2001). Managing Supervision and Intervention March 2001 Guidelines, Received through personal communication with P. Groenewegen. [2003, May 5]. Private Health Insurance Administration Council. (2002). Review of the Solvency and Capital Adequacy Standards – Discussion Paper, August 2002, [Online]. Available: http://www.phiac.gov.au. [2003, January 10] Taylor, G. C. (1996). Risk, Capital and Profit in Insurance, University of Melbourne research paper number 39. [Online]. Available: http://www.economics.unimelb.edu.au/actwww/. [2003, April 14] The Institute of Actuaries of Australia. (2000). Comments on the solvency and capital adequacy standards exposure draft for the private health insurance industry, [Online]. Available: http://www.actuaries.asn.au. [2003, January 10].


The Institute of Actuaries of Australia. (1999). Guidance Note 650 – Actuarial reports and advice on outstanding claims in health insurance, [Online]. Available: http://www.actuaries.asn.au. [2003, January 10] The Institute of Actuaries of Australia. (2002). Guidance Note 660 – Financial projections for health insurers, [Online]. Available: http://www.actuaries.asn.au. [2003, January 10] The Institute of Actuaries of Australia. (n.d.). Submission on the draft solvency and capital adequacy standards for the private health insurance industry, [Online]. Available: http://www.actuaries.asn.au. [2003, January 10]. Torrance, D. (2001). The Development of Prudential Requirements for Private Health Insurers, Institute of Actuaries of Australia Biennial Convention, 2001. Received through personal communication with D. Watson. [2003, March 23]. Walker, B. (2003). Health Insurance Membership and Claims Experience Stability Margin, [Online]. Available: http://www.actuaries.asn.au. [2003, May 10]. Watson, D. (2003). Newsletter on Private Health Insurance in Australia, 107, [Online]. Available: http://www.actuaries.asn.au/PublicSite/about_us/hpcnewsletters.htm. [2003, June 11].

8.2 United States of America

Actuarial Society of South Africa Healthcare Committee. (n.d.). Demystifying the US Risk-Based Capital formula, Unpublished document provided to the Financial Soundness working group of the Council for Medical Schemes. Barth, M. M. (2000). A Comparison of Risk-Based Capital Standards Under the Expected Policyholder Deficit and the Probability of Ruin Approaches. The Journal of Risk and Insurance, 67(3), 397-414. Barth, M. M. (1999). Applying the Law of Large Numbers to P&C Risk-Based Capital. Journal of Insurance Regulation, 17(4), 438-477. Butsic, R. P. (1994). Solvency Measurement for Property-Liability Risk-based Capital Applications. The Journal of Risk and Insurance, 61(4), 656-690. Milliman & Robertson. (1998). Risk-Based Capital Requirements for Managed Care Organisations. [Online]. Available: http://www.milliman.com. [2003, January 10]. National Association of Insurance Commissioners (NAIC). (2001). Risk-Based Capital Report Including Overview and Instructions for Companies. Kansas City, Mo.: NAIC.


8.3 South Africa

Actuarial Society of South Africa (2001). PGN104: Life Offices – Financial Soundness Valuation, [Online]. Available: http://www.assa.organisation.za/guidance/pgn104.htm [2002, November 18] Actuarial Society of South Africa Healthcare Committee. (2002). Draft professional guidance note: Advice to South African Medical Schemes On Reinsurance, Circulated electronically by Healthcare Committee. Actuarial Society of South Africa and South African Institute of Chartered Accountants. (2003). Professional Guidelines: IBNR Liability Valuations of South African Medical Schemes, Circulated electronically to the Financial Soundness Working Group of the Council for Medical Schemes. Bodie, Z., Kane, A., & Marcus, A. (1999). Investments (4th ed.). Boston: McGraw-Hill. Bond Exchange of South Africa website. (n.d.). Retrieved April 16, 2003, from http://www.besa.org.za. Cooper, M. (2001). Extracts from Solvency and Medical Schemes in South Africa, Unpublished discussion document provided to the Financial Oversight Committee and the staff of the Council for Medical Schemes. Council for medical schemes. (2001). Annual report of the registrar of medical schemes 2001. [Online]. Available: http://www.medicalschemes.com. [2003, April 18]. Council for medical schemes. (2003). Review of the factors that influence financial soundness of medical schemes, [Online]. Available: http://www.medicalschemes.com. [2003, April 30]. Doherty, J., & McLeod, H. (2002). Are medical schemes becoming more affordable? In Health Systems Trust, South African Health Review 2002 (pp.41-66). Durban: Health Systems Trust. Dreyer, S. (2002). A study of the Exempt Medical Schemes. B.Bus.Sc. project. University of Cape Town. South African Government (1998) Medical Schemes Act, 1998 (Act No. 131 of 1998), Government Gazette No. 19545, Vol. 402, 2 December 1998. Also, Medical Schemes Amendment Act, 2001. South African Government (1999) Regulations in terms of the Medical Schemes Act, 1998, Government Notice, Regulation Gazette No. 6652, Vol. 412, 20 October 1999.


South African Government. (1998). Requirements & Guidelines to be complied with for registration of a medical scheme in terms of the medical schemes act, 1998 (Act No 131 of 1998), Government Gazette No. 19545, Vol. 402, 2 December 1998. The South African Institute of Chartered Accountants. (2003). Audit and Accounting Guide on Medical Schemes (Draft), [Online]. Available: http://www.saica.co.za. [2003, April 7]. Van Den Heever, R. J. (1998). Risk Adjusted Capital in a General Insurance Environment. Transactions of the Actuarial Society of South Africa, XII(1), 154-173.

8.4 General

Cummins, J., Harrington, S., & Niehaus, G. (1993). An Economic Overview of Risk-Based Capital for the Property-Liability Insurance Industry. Journal of Insurance Regulation, 11(4), 427-447. Hooker, N. D., Bulmer, J. R., Cooper, S. M., Green, P. A. G., & Hinton, P. H. (1996). Risk-Based Capital in General Insurance. British Actuarial Journal, 2(II), 265-323. Kongsveldt, P. R. (1996). The Managed Health Care Handbook (3rd ed.). Maryland: Aspen Publishers.


Appendix A: Data Files Submitted to the Council for Medical Schemes Report.doc Data/Australia.xls Data/US.xls Tables and figures/Tables and figures.xls Tables and figures/Figures.ppt Correspondence/Useful contacts.xls Correspondence/Various emails Electronic documents/…


Appendix B: RBC Theory

B1. Calculation of RBC requirements using the EPD and probability of ruin approaches Following the approach of Butsic (1994), a simplified version of a medical scheme is used to explain the two approaches. The scheme is assumed to have assets with a

fixed value (A) and liabilities with a random value ( L~

). B1.1 Ruin Approach

As long as the value of assets exceeds the value of liabilities ( LA~

) the scheme is

solvent. If the value of liabilities exceeds the value of assets ( LA~

) the scheme is insolvent or “ruined”. The ruin approach sets the minimum capital requirement for a

medical scheme by targeting a certain probability of ruin ( ]~

Pr[ LA ). The following numerical example will illustrate the ruin approach. Assume the regulator sets the minimum capital requirement to ensure a 5% probability of ruin.

Table B1: Balance sheet of a hypothetical medical scheme under various scenarios

ProbabilityAsset

Amount

Loss

Amount

Capital

AmountScenario 1 0.20 12,000 8,500

Scenario 2 0.60 12,000 10,000

Scenario 3 0.15 12,000 11,000

Scenario 4 0.05 12,000 13,000

Expectation 12,000 10,000 2,000 Source: Butsic (1994)

The scheme in Table B1 has assets of R12,000; liabilities with an expected value of R10,000 and capital of R2,000. The scheme is solvent under the first three scenarios but insolvent under the fourth. Since the probability of the fourth scenario is 5%, the scheme has a 5% probability of ruin. If the scheme held less capital than R1,000 (i.e. R11,000-R10,000), it would be insolvent under scenario three also, increasing its probability of ruin to 20%. Therefore, R1,000 is the minimum amount of capital required for this medical scheme to achieve a 5% ruin probability. R1,000 is this scheme’s RBC requirement. The scheme in Table B1 holds capital in excess of its RBC requirement, so it would not suffer any regulatory action. This minimum capital requirement is equivalent to 10% of the balance sheet value of liabilities. Therefore, the regulator could express the RBC requirement for the scheme as sLiabilitie1.0 . This observation may seem trivial, but it is crucial for understanding the USA RBC formula in Chapter 3The factor of 0.1 is known as a risk-based capital factor. It is the ratio of the risk charge to the value of the risk element. Here the risk element is the liability.


B1.2 Expected policyholder deficit (EPD) approach Butsic (1994) suggests that the probability of ruin approach is inappropriate and that the severity of ruin needs to be taken into account too. For this reason he supports the expected policyholder deficit approach to setting RBC requirements. He used a numerical example similar to the one below to explain his point of view:

Table B2: Two schemes with the same balance sheets but different loss distributions

Scheme A

ProbabilityAsset

Amount

Loss

Amount

Capital

Amount

Claim

PaymentDeficit

Scenario 1 0.20 12,000 8,500 8,500 0Scenario 2 0.60 12,000 10,000 10,000 0Scenario 3 0.15 12,000 11,000 11,000 0Scenario 4 0.05 12,000 13,000 12,000 1,000Expectation 12,000 10,000 2,000 9,950 50

Scheme B

ProbabilityAsset

Amount

Loss

Amount

Capital

Amount

Claim

PaymentDeficit

Scenario 1 0.20 12,000 8,000 8,000 0Scenario 2 0.60 12,000 10,000 10,000 0Scenario 3 0.15 12,000 11,000 11,000 0Scenario 4 0.05 12,000 15,000 12,000 3,000

Expectation 12,000 10,000 2,000 9,850 150 Source: Butsic (1994)

Schemes A and B both have R12,000 of assets, a R10,000 expected loss (liability) and capital of R2,000. However, the distributions of their losses differ. Both schemes are insolvent under scenario four and have a 5% probability of ruin, but scheme B’s policyholders have more unpaid claims than scheme A’s when the schemes are insolvent. Scheme A’s policyholders can expect R50 of unpaid claims while scheme B’s policyholders can expect R150. The probability of ruin alone doesn’t capture the full danger of insolvency for the policyholders; the severity of ruin needs to be considered too. This example suggests that the expected difference between the claims the insurer is obliged to pay and the actual payments made (i.e. the expected policyholder deficit) would be a good indication of the danger of insolvency. In fact, to adjust for different liability sizes, the ratio of expected policyholder deficit to expected losses (i.e. the EPD ratio) is used as the measure of the danger of insolvency. Continuing with the example in Table B2, if the regulator required a 0.01 ratio of EPD to expected loss (i.e. a 0.01 EPD ratio) the schemes would have to hold capital as in the following table:


Table B3: Calculation of minimum capital requirement

Scheme A Scheme B(1) Required EPD ratio 0.01 0.01

(2) Expected loss 10,000 10,000

(3) Required expected deficit [(1)*(2)] 100 100

(4) Required deficit - scenario 4 [(3)/.05] 2,000 2,000

(5) Loss amount - scenario 4 13,000 15,000

(6) Required claim payment - scenario 4 [(5)-(4)] 11,000 13,000

(7) Required assets [(6)] 11,000 13,000(8) Minimum capital requirement [(7)-(2)] 1,000 3,000

Source: Barth (2000)

Therefore, Scheme A has a RBC requirement of R1,000, while scheme B has a R3,000 RBC requirement. The capital requirement can be expressed per unit of liabilities (capital requirement/value of liabilities). That is, Scheme A is required to hold sLiabilitie1.0 , while scheme B is required to hold sLiabilitie3.0 . B1.3 More complicated situations Clearly the examples used to illustrate the ruin and EPD approaches are unrealistic; medical schemes face multiple risks – not just liability risk. Nevertheless, the techniques used in these unrealistic examples are also of value in more complicated situations involving multiple risks. This is because the capital requirement for a scheme facing multiple risks is calculated by evaluating the capital needed for each risk as if it was the only risk the scheme faced; and then combining the capital required for each risk. More precisely, to determine the total capital required for the entire scheme: calculate the amount of capital required for each risk element (i.e. the risk charge for each risk element) as if it was the only risk faced by the scheme and then combine the risk charges for all risk elements to get the total capital requirement for the scheme. When combining the capital for the different risk elements an allowance should be made for the covariance between the different risk elements. For further discussion of these approaches, see Butsic (1994) and Barth (2000). Butsic describes the expected policyholder deficit approach in great detail, while Barth gives a very readable comparison of the two approaches.

B2. Estimating factors by simulation In practice the RBC factors in the USA formula are estimated using stochastic simulation. ASSA (n.d.) explains this simulation approach in some detail. What follows is merely an introduction to the approach based on ASSA (n.d.). In essence, stochastic simulation is used to estimate the probability of ruin for a given initial level of surplus. The initial level of surplus is then changed until the desired probability of ruin is achieved. That optimal level of surplus determines the RBC factor.


The following (simplified) example shows how the underwriting risk section of the formula could be estimated. Surplus is expressed as a percentage of contributions, making it comparable to the loss ratio. The example uses a five-year modelling period. The table below shows the results of one simulation.

Table B4: One simulation of end of year surplus

YearLoss ratio

deviateActual loss ratio

Premium basis

loss ratio

End of year

surplus0 60% 65% 10%

1 5% 65% 65% 10%

2 7% 72% 65% 3%

3 -17% 55% 65% 13%

4 0% 55% 65% 23%5 16% 71% 65% 17%

Source: ASSA (n.d.)

The loss ratios (claims/contributions) for each of the five years are simulated first. This is done by adding a randomly generated loss ratio deviate to the previous year’s loss ratio. The distribution of this deviate could be based on medical schemes’ past experience. Then, the end of year surplus is generated. Ending surplus is the previous year’s ending surplus, plus the premium basis loss ratio minus the actual loss ratio. The simulation in the above table is not a ruin at the 10% initial surplus level. By running about 1,000 such simulations, the probability of ruin at the 10% surplus level could be estimated. If 10% surplus corresponds to the desired probability of ruin, a 0.1 risk factor may be chosen for underwriting risk. That is, 0.1 times contributions equals base underwriting risk RBC.

B3. Solvency liability margin Torrance (2001) explains the basis for the 10% solvency liability margin. He uses the risk structure below to estimate the standard deviation of outstanding claims liabilities, which he then uses to derive the 10% solvency margin. Variation in outstanding claims liability can be separated into two components. Systemic variation (Sv) measures the impact of environmental factors, external to

individual insurers, which affect the industry as a whole. Independent variation (Iv) refers to the impact of random claim variations on

individual insurers. This variation usually decreases with increasing size of the insurer.

The total variation (standard deviation) of outstanding claims is then given by:

22 IvSv .


Quarterly health fund data for the 19 quarters ending on 30 September 1999 were then analysed to estimate the above risk measures. The results of this analysis are shown below. Systematic variation = 1.5% Independent variation = 4.3% Total variation = 4.5% Based on the results of his analysis, the standard deviation of the outstanding claims liability of an insurer of average market share was estimated at 4.5%. Since PHIAC required a reserve of roughly two standard deviations to ensure a 2.5% probability of ruin, a margin of 10% was adopted. Torrance didn’t fully explain how he arrived at these results but referred the reader to Cumpston (1992) for an explanation. Cumpston carried out a similar analysis for general insurers and his paper gives some insight into how these risk measures are estimated. The reader is referred to Cumpston and Torrance’s articles for the details of this analysis.


Appendix C: Method used to calculate the USA RBC Requirement

C1. Statutory returns data used in the calculation The following table lists exactly what statutory returns data were used in the calculation of the USA RBC formula’s various risk charges. If there is no data next to a particular risk charge, that risk charge was not calculated.

Table C1: Data used to estimate RBCAC

H0 - Asset risk - affiliates

Off-Balance Sheet Items 0.010Guarantees and suretyships for third parties. See explanation of the different types of guarantees below.

Directly Owned Insurer Subject to RBCIndirectly Owned Insurer Subject to RBCDirectly Owned MCO Subject to RBCIndirectly Owned MCO Subject to RBC

Directly Owned Alien InsurerIndirectly Owned Alien Insurers

H1 - Asset risk - otherInvestment SubsidiaryHolding Company Excess of SubsidiariesInvestment in ParentOther AffiliatesFair Value Excess Affiliate Common StockFixed Income Assets

Bonds

Category 1 0.003 RSA government bondsCategory 2 0.010 Transnet, Post office, Eskom bondsCategory 3 0.020 Water board, Land bank bondsCategory 4

Category 5 0.100 Local government bondsCategory 6 0.300 Other bonds e.g. company bondsCash 0.003 Cash and cash equivalentsOther long term invested assets 0.200 All other investments

Replication & Mandatorily Convertible Securities Unaffiliated Preferred Stock 0.300 All preferred stockUnaffiliated Common Stock 0.150 All equitiesProperty & Equipment

Properties occupied by the company 0.100 Land and buildingsProperties held for the production of income 0.100Properties held for sale 0.100 Investment propertyFurniture and equipment 0.100 Office equipment and fittingsEDP equipment and software 0.100 Computer equipment and software

Asset Concentration

Section of US RBC formula FactorStatutory returns data used (data is at

31/12/2000 unless otherwise stated)


H2 - Underwriting riskNet Underwriting Risk (Basis 1) 0.090-0.150

Premium Gross contributions less reinsurance premiumsNet incurred claims Gross claims less reinsurance claimsManaged care claims payments

Category 0 0.000Direct benefits paid during the year for the period

and the previous period

Category 1 0.150Managed care benefits paid during the year for the period and the previous period

Category 2

Category 3Category 4

Rate Guaranty - 15-36 MonthsRate Guaranty - Over 36 MonthsAssessment Risk (Non-Guaranty Fund)

Stop LossDisability IncomeLong-Term CareLimited Benefit PlansPremium Stabilization Reserve

H3 - Credit riskTotal Reinsurance RBC

Reinsurance recoverables 0.005 Reinsurance claims recoveries outstandingUnearned premiums 0.005 Reinsurance premiums paid in advanceOther reserve credits

Intermediaries Credit Risk RBCTotal Other Receivables RBC

Investment income receivable

Health care receivables 0.050

Arrear contributions plus recoveries from

members for co-payments plus advance payments on savings plan

Amounts due from affiliates

Aggregate write-ins

H4 - Business riskAdministrative Expense RBC

General administrative expenses 0.040-0.070 Administration expenditureNon-Underwritten and Limited Risk Business RBC

Premiums Subject to Guaranty Fund AssessExcessive Growth RBC (Basis 1)

UW risk revenue, prior yearGross contributions less reinsurance premiums for the year ended 31/12/1999

UW risk revenue, current yearGross contributions less reinsurance premiums

for the year ended 31/12/2000

Net UW risk RBC, prior yearAs for H2 above, but using data for the year ended 31/12/1999

Net UW risk RBC, current yearAs for H2 above, using data for the year ended 31/12/2000


C2. Treatment of the different types of guarantee The statutory returns data distinguishes between: Guarantees supplied by a scheme to the registrar; Guarantees for third parties; and Suretyships for third parties. To calculate the USA RBC requirement, it was necessary to know if any of these guarantees and suretyships were contingent liabilities. For the avoidance of doubt, this question was put to the Council for Medical Schemes. The Council’s response is reproduced below.

“Legal basis supporting the different types of guarantees: Per section 35(6)(d) - A medical scheme shall not by means of suretyship or any other form of personal security, whether under a primary or accessory obligation, give security in relation to obligations between other persons without the prior approval of the Council or subject to such directives as the Council may issue. Per section 24(5) - The Registrar may demand from the person who manages the business of a medical scheme which is in the process of being established, such financial guarantees will in the opinion of the Council ensure the financial stability of the medical scheme Per Regulation 2(j) - the guarantees and the guarantee deposit vouchers as the Registrar may require Per section 33(3) - The Registrar may demand from the principal officer such financial guarantees as will in the opinion of the Council ensure the financial soundness of benefit options. Per section 44(9)(b) - at any time demand from the medical scheme such financial guarantees and guarantee deposits as will in the opinion of the Registrar ensure the financial stability of the medical scheme Per Registration and accreditation two types of guarantees are required upon registration of a new scheme - guarantee deposit in to the bank account of the medical scheme and a guarantee with a recognized reputable bank Accounting treatment of the abovementioned: 1. Suretyship or guarantee provided by the scheme to a third party

Per AC 130.28 - an enterprise should not recognize a contingent liability


Per AC 130.87 - unless the possibility of any outflow in settlement is remote, an enterprise should disclose the following for each contingent liability in a note to the financial statements: (a) a brief description of the nature; (b) where practicable:

a. an estimate of its financial effect, b. an indication of the uncertainties regarding the amount or timing, and c. the possibility of any reimbursement.

2. Guarantee deposit provided by the scheme to the Registrar

Per AC 000.49(a) - definition of an asset is complied with and thus form part of the bank account

3. Guarantee provided by the scheme to the Registrar with a

recognized reputable bank

Per AC 130.32,90 - Contingent assets should not be recognized. When an inflow of economic benefits is however probable, disclose:

(a) a brief description of the nature; (b) an estimate of the financial effect if possible.

Therefore it depends whether it is a guarantee deposit or just a guarantee.”

Maggie Grobler, personal communication, 8 April 2003 Based on this response, it was concluded that only the guarantees and suretyships for third parties are contingent liabilities, which should attract a risk charge in the off balance sheet items section of the formula.

C3. Assumptions and adjustments to the formula Two changes were made to the USA RBC formula when applying it to South African medical schemes. C3.1 Premium tiers The premium tiers in the underwriting risk charge and business risk charge were changed from $0 - $25 million to R0 - R135 million. This was an attempt to make the results of the calculation more relevant to the South African environment. The figure of R135 million is the average total gross contributions over the 2000 calendar year for a scheme with 30,000 beneficiaries. The average contribution per beneficiary per year in 2000 was R4,516. Therefore, the average annual contribution for 30,000 members was R135.48 million. This was rounded to R135 million for use in the premium tiers. The table below examines the sensitivity of the calculation to the size of the tier.


Table C2: Premium tier sensitivity analysis

R100 million R135 million R200 million

Underwriting risk RBC 2,636,065,606 2,713,030,121 2,810,098,943Business risk RBC 267,974,426 301,928,389 345,315,385RBCAC 3,267,551,759 3,338,115,241 3,430,260,399% of gross contributions 10.9% 11.2% 11.5%

RBCAC was calculated using a R100 million tier and a R200 million tier as well as the R135 million tier. In all three cases the results were similar. C3.2 Alternative risk charge The alternative risk charge was set at R1,670,000. As mentioned earlier, the alternative risk charge should be twice the maximum after reinsurance payout on an individual claim. The maximum individual claim payout was taken to be R835,000, which is the average of the top ten claims paid by medical schemes administered by Medscheme during the 2001 calendar year. The top ten claims and a description of their causes are shown below.

Table C3: Top ten claims

Description R

Malignant neoplasm of oesophagus unspecified 1,322,358 Aneurysm of heart 1,019,545 Unspecified injury of head 893,870 Unspecified appendicitis 844,463 Chronic obstructive pulmonary disease, unspecified 796,526 Fracture of first cervical vertebra 751,140 Other acute renal failure 714,111 Injury of heart 707,412 Malignant neoplasm of pancreas, unspecified 687,027 Shock, unspecified 601,411

RBCAC was calculated using two other alternative risk charges to check the sensitivity of the result to the alternative risk charge assumed. The table below shows the results of this sensitivity analysis.

Table C4: Alternative risk charge sensitivity analysis

R1 million R1.67 million R2 million

Underwriting risk RBC 2,702,486,167 2,713,030,121 2,720,318,957RBCAC 3,328,928,065 3,338,115,241 3,344,681,637% of gross contributions 11.1% 11.2% 11.2%

When the RBCAC was recalculated using R1 million and R2 million alternative risk charges, the results differed by less than 0.1% of gross contributions respectively. The result is robust because the base underwriting risk after managed care discount is larger than the alternative risk charge for most schemes, so the alternative risk charge has no impact on the RBCAC of most schemes.


Appendix D: Method used to calculate the Australian Solvency Reserve

D1. Statutory returns data used in the calculation The following table lists exactly what statutory returns data were used in the calculation of the Australian solvency reserve. If there is no data next to a particular risk charge, that risk charge was not calculated.

Table D1: Data used to estimate Australian solvency reserve

Solvency LiabilitySolvency net claims liability

Outstanding claims liability Provision for outstanding claims plus reportedclaims not yet paid

Reinsurance outstanding claims liability Relates to Australian risk equalisation system

Unexpired risk liability Loss ratio*contributions received in advancewhere Loss ratio = (Gross contribution income - savingscontribution income + admin expenses + managedcare: management services + broker fees) / netclaims incurred

Contributions in advance Contributions received in advanceSolvency reinsurance accrued liability Relates to Australian risk equalisation systemSolvency other liabilities All liabilities not mentioned above

Expense reserveTotal expenses Admin expenditure + managed care: management

services + own facility staff costs and expensesAllowable deductions Legal fees; actuarial fees; consultancy fees (not

the contracted administrator) + penalties + marketing expenses

Inadmissible assets reserveAssets used for the conduct of business Arrear contributions, recoveries from members for

advance payments on savings plan accounts, reinsurance premiums paid in advance, loans to members (capital and interest), computer equipmentand software, prepayments.

Holdings in associated prudentially regulated institutionsAsset concentration risks All assets

Section of Australian solvency standardStatutory returns data used (data is at

31/12/2000 unless otherwise stated)


Resilience reserveEquities Preference shares, ordinary shares, units in

equity unit trustProperties Land and buildings, also investments: Immovable

property, units in unit trusts that invest in propertyshares, shares in property companies, debenturesof property companies.

Interest bearing Cash and cash equivalents, also investments:bonds, debentures (convertible, listed & unlisted),units in unit trusts that invest mainly in income generating securities

Indexed bonds

Management capital No further data needed

D2. Assumptions and adjustments to the formula It was necessary to make the following assumptions and adjustments to the formula to apply it to South African data. D2.1 Asset concentration risk The maximum permissible investment in each asset type is listed below. 100% of scheme assets for SA government bonds. The maximum of 50% of total scheme assets and R5 million for cash and cash

equivalents. 10% of total assets for all other assets. D2.2 Resilience reserve The statutory returns data only record the market value of each scheme’s bond holdings. Since the prescribed change in bond values are specified in terms of a yield increase, it was necessary to use an approximation to convert this yield increase into a change in bond value. After consultation with Professor McLeod (personal communication, 10 April 2003) the following approximations and assumptions were used. Under the assumption that schemes, on average, hold the All Bond Index (ALBI), or other pooled bond investments that are benchmarked against the ALBI, the volatility of the ALBI was used to make an approximation. The proportionate increase in bond value was estimated using the equation below.

Proportionate increase in bond value -(Yield increase) (Volatility). This equation comes from Bodie, Kane and Marcus (1999). The table below contains average ALBI figures for the period 1 January 2003 to 16 April 2003. These figures and the equation above were used in calculating the resilience reserve for bonds.


Table D2: Average ALBI figures

ALBI quantity

Average modified duration (years) 4.64Average yield 11.05%Average volatility 4.40

The results were tested for sensitivity to the assumed volatility by calculating the solvency and capital adequacy reserves using volatility of 4.00 and 5.00 as well as the chosen 4.40. The table below shows the results of those calculations.

Table D3: ALBI volatility sensitivity analysis

4.00 4.40 5.00

Resilience reserve 287,093,068 307,614,756 338,663,328Management capital amount 89,920,974 89,465,276 88,773,306

Solvency reserve 6,077,889,782 6,097,955,772 6,128,312,375

As % of gross contributions 20.3% 20.4% 20.5%


Capital adequacy reserve 8,407,730,693 8,457,267,293 8,532,713,858As % of gross contributions 28.1% 28.3% 28.6%

The capital adequacy reserve is more sensitive to the volatility than the solvency reserve as the yield changes in the resilience reserve for capital adequacy are larger than for solvency. Both the solvency and capital adequacy reserves show little sensitivity to the volatility figure. The diversification factor also required approximation, being a function of the average term to maturity for the cash and fixed interest sectors combined. At 31 December 2000, 80% of Registered schemes’ cash and fixed interest investments were in cash and cash equivalents while the other 20% were in fixed interest investments. Using 0 years as the term of a cash investment and the average modified duration of the ALBI (4.64 years) as the average term of the fixed interest investments, gives a weighted average term of 0.93 years for the two sectors combined. The table below shows the value of the solvency and capital adequacy reserves when the fixed interest terms are 0 years, 0.93 years and 4.64 years.

Table D4: Average fixed interest term sensitivity analysis

0 years 0.93 years 4.64 years


Solvency reserve 5,978,675,040 6,097,955,772 6,092,737,705


Resilience reserve 474,334,908 739,138,071 728,222,230Management capital amount 76,958,876 67,034,376 67,139,224Capital adequacy reserve 8,202,388,630 8,457,267,293 8,446,456,299As % of gross contributions 27.4% 28.3% 28.3%


This appears to be the most significant assumption tested so far. The solvency reserve differs by up to 0.4% while the capital adequacy reserve differs by up to 0.9% as the assumption varies. D2.3 Management capital amount The management capital amount in the solvency standard imposes a minimum solvency reserve of $1 million on Australian private health insurers. Professor McLeod suggested the use of a R5 million minimum when calculating the solvency reserve for South African schemes (personal communication, April 10, 2003). This is based on the current rules for starting a medical scheme which require schemes to hold a minimum balance of R2.5 million in their bank account and submit a guarantee of R2.5 million to the registrar from a reputable bank (South African Government, 1998). The table below shows the value of the solvency and capital adequacy reserves calculated using R0, R5 million and R10 million minima.

Table D5: Management capital amount sensitivity analysis

R 0 R5 million R10 million

Management capital amount 0 89,465,276 325,757,543Solvency reserve 6,008,490,497 6,097,955,772 6,334,248,040


Management capital amount 0 67,034,376 239,996,044Capital adequacy reserve 8,390,232,917 8,457,267,293 8,630,228,961As % of gross contributions 28.1% 28.3% 28.9%

The solvency reserve was estimated to be 0.8% higher when a R10 million minimum was used, but 0.3% lower when no minimum was imposed. The capital adequacy reserve was slightly less sensitive to the assumed minimum.


Appendix E: Method used to calculate the Australian Capital Adequacy Reserve

E1. Statutory returns data used in the calculation The following table lists exactly what statutory returns data were used in the calculation of the Australian capital adequacy reserve. If there is no data next to a particular risk charge, that risk charge was not calculated.

Table E1: Data used to estimate Australian capital adequacy reserve

Capital adequacy liabilityCapital adequacy margin Monthly scheme membership for the year 2000.

See comments below.Capital adequacy net claims liability

Outstanding claims liability Provision for outstanding claims plus reportedclaims not yet paid

Reinsurance outstanding claims liability Relates to Australian risk equalisation system

Unexpired risk liability Loss ratio*contributions received in advancewhere Loss ratio = (Gross contribution income - savingscontribution income + admin expenses + managedcare: management services + broker fees) / netclaims incurred

Contributions in advance Contributions received in advanceCapital adequacy reinsurance accrued liability Relates to Australian risk equalisation systemCapital adequacy other liabilities All liabilities not mentioned above

Renewal option reserveContribution income Gross contributionsBenefit claims Gross claimsReinsuranceAdministration and other expenses Administration expenses; managed care

management services; broker fees; own facilitystaff costs; own facility expenses.

Investment earnings rateTaxation

Business funding reserve

Inadmissible assets reserveHoldings in associated prudentially regulated institutionsAsset concentration risks All assets

Section of Australian capital adequacy

standard

Statutory returns data used

(data is at 31/12/2000 unless otherwise stated)


Resilience reserveEquities Preference shares, ordinary shares, units in

equity unit trustProperties Land and buildings, also investments: Immovable

property, units in unit trusts that invest in propertyshares, shares in property companies, debenturesof property companies.

Interest bearing Cash and cash equivalents, also investments:bonds, debentures (convertible, listed & unlisted),units in unit trusts that invest mainly in income generating securities

Indexed bonds

Management capital No further data needed

E2. Assumptions and adjustments to the formula It was necessary to make the following assumptions and adjustments to the formula to apply it to South African data. E2.1 General The assumptions and adjustments made when calculating the solvency reserve, as outlined in Appendix D2, were also made when calculating the capital adequacy reserve. In particular, the management capital amount was assumed to impose a minimum capital adequacy reserve of R5 million, as for the solvency reserve. The sensitivity to these assumptions was tested in Appendix D2. E2.2 Capital adequacy margin No adjustments were made to this part of the formula but assumptions were made when calculating each scheme’s capital adequacy margin. The base (minimum) value for the margin was 12.5%, as in the capital adequacy standard, to which a fund size addition, as well as a membership and claims stability addition was added. To calculate the fund size addition it was necessary to convert each scheme’s membership at 31 December 2000 into a number of SEU’s. Each single member is counted as one SEU while all other members (married etc) are counted as two SEU’s. The marital status of each member was not in the data set so each member was counted as 1.5 SEU’s. This is equivalent to assuming that half the members are single. In evaluating the sensitivity of the results to this assumption, the results were recalculated twice: firstly, counting each member as one SEU and secondly, counting each member as two SEU’s i.e. assuming that all members are single and that no members are single. The table below shows the results of those calculations.


Table E2: SEU assumption sensitivity analysis

1 SEU 1.5 SEU's 2 SEU's

Capital adequacy liability 6,992,142,508 6,973,342,207 6,961,142,269Renewal option reserve 4,710,916,700 4,551,783,444 4,453,753,786Resilience reserve 750,349,550 739,138,071 731,335,295Management capital amount 65,967,513 67,034,376 67,709,337


Assuming one SEU gives the largest capital adequacy reserve while assuming two SEU’s gives the minimum reserve. The capital adequacy reserve changes by about 0.5% of gross contributions as the assumption is changed. No data on claims stability was available, but monthly membership for the year 2000 was included in the schemes’ 2000 returns. For each scheme the coefficient of variation of its monthly membership was calculated and used to determine its membership stability addition. The histogram below shows the distribution of those coefficients of variation.

0

5

10

15

20

25

30

35

40

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 20% 30% More

Membership coefficient of variation

Fre

qu

en

cy

0%

20%

40%

60%

80%

100%

120%

Frequency

Cumulative %

Figure E1: Histogram of membership coefficients of variation

Based on this diagram, it was decided to structure the membership variability addition in the following way.


Table E3: Membership and claims stability addition

Membership coefficient of variation (CV) Additional margin

Less than 1% 0%

Less than 20% but greater than 1% 5%*(CV-0.01)/0.19

Greater than 20% 5% Using the histogram to interpret this margin structure, one can see that the 20% of schemes with the lowest CV get a 0% a margin, while the 10% of schemes with the highest coefficient of variation get a 5% margin. The margin is allocated linearly between these two extremes. Figure 4.8 is a histogram of the resulting capital adequacy margins. The table below shows the results of using different methods to deal with the stability addition: either setting it to 0.0%, 2.5% or 5.0% for all schemes or using the coefficient of variation method described above.

Table E4: Stability addition sensitivity analysis

0.0%Coefficient of

variation2.5% 5.0%

Capital adequacy liability 6,946,022,061 6,973,342,207 7,028,857,670 7,111,732,569Renewal option reserve 4,364,702,554 4,551,783,444 5,011,696,580 5,685,330,876Resilience reserve 726,161,330 739,138,071 772,013,178 818,937,285Management capital amount 70,532,571 67,034,376 62,830,681 55,950,059

Capital adequacy reserve 8,233,387,711 8,457,267,293 9,001,367,305 9,797,919,984As % of gross contributions 27.6% 28.3% 30.1% 32.8% Overall, the coefficient of variation method produces results which are a mixture of the 0% and 2.5% approaches. However, it assigns a higher margin to schemes with more membership variability (typically the open schemes) than to schemes with less variability. E2.3 Renewal option reserve The basis used to calculate the renewal option reserve is taken from Torrance (2001, p.42). Torrance was the lead consultant on the development of the standards. He used this basis to approximate the renewal option reserve for the Australian private health insurance industry using only past data. Torrance assumed that: Next years claims are expected to be the same as this year’s claims.

Next years contributions are expected to be the same as this year’s contributions.

Torrance’s basis ignores investment earnings. The author chose to allow for investment earnings in the calculations in this report. This made it necessary to make an assumption about the incidence of cash flows over the year following the valuation date. It was assumed that all cash flows occur halfway through the year. The table below shows how the results would differ if cash flows were assumed to occur at the beginning and at the end of the year.


Table E5: Cash flow incidence sensitivity analysis

Beginning Middle End

Renewal option reserve 4,775,035,616 4,551,783,444 4,338,969,211Resilience reserve 753,740,365 739,138,071 725,218,493Management capital amount 65,499,093 67,034,376 68,656,895


The capital adequacy reserve differs by 0.8% either way if the cash flows are assumed to occur at the beginning or end of the year instead of the middle. In addition, the renewal option reserve uses the one-year yield on Commonwealth Government Treasury Bonds at the start of the date of the projection, less 1% as the rate of investment earnings. The yield on these bonds at 18 April 2003 was 4.64%. It is pure coincidence that this yield looks so similar to the average modified duration on the ALBI. The yield, and other information, on these bonds was found at the website of Macquarie Bank Limited. However, for consistency with the assumptions made in the resilience reserve and relevance to South African medical schemes, the average yield on the ALBI (11.05% per annum, see Table D2) was used as the rate of investment earnings. The table below shows the value of the capital adequacy reserve for the two different rates of investment return.

Table E6: Investment return sensitivty analysis

4.64% 11.05%

Renewal option reserve 4,712,422,307 4,551,783,444Resilience reserve 750,202,725 739,138,071Management capital amount 65,817,221 67,034,376

Capital adequacy reserve 8,627,753,655 8,457,267,293As % of gross contributions 28.9% 28.3%

The capital adequacy reserve is 0.6% higher when the lower 4.64% investment return is used.

Documents

Risk Based Capital Discussion Document