A Short History of the Risk-Based Capital (RBC) New Bond Factors

Thoughtware Article Published: Jul 19, 2021
Connie Jasper Woodroof, CJW Associates
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After 10 years of work, the NAIC has finally adopted new bond factors for all of the RBC formulas. This was a difficult process and involved more than a little bit of controversy. Factors applicable to a company’s bond portfolio were first put into place for the Life RBC (LRBC) (also referred to as the Asset Valuation Reserve (AVR) companies’ RBC) in 1991, using data mainly from the 1970s and 1980s. Bond factors for both the Property RBC (PRBC) and Health RBC (HRBC) followed by making slight adjustments to the Life factors. Those same factors have been used since that time. The recent adoption of new factors is to be implemented for the year-end 2021 reporting. 

Chapter 1 – In the Beginning

In 2011, the NAIC decided it was time to review the RBC treatment of all invested assets, not just bonds. Work began with the formation of the C-1 Factor Review Subgroup. (C-1 refers to the LRBC section handling most unaffiliated assets). The American Academy of Actuaries (Academy) was brought on board to handle the technical aspects of the project. It was a rocky beginning. The Academy found that the original work was not well documented and consequently had to “recreate the wheel” before moving into new territory. 

Although the Subgroup was to review most invested assets, the main area of focus quickly became the reporting of bonds. The review was applicable to not only the bond factors used but the granularity of reporting, including the possibility of expanding the NAIC designations used. Early on, the decision was made that the Academy work would involve only the bond portfolios of AVR (Life) companies and, within those portfolios, only corporate bonds. Once the corporate bonds were completed, the original idea was to then address municipal and government bonds. 

The work and discussions began.

Chapter 2 – A New Name, a New Status, & Controversy

Moving into 2013, the group was renamed and upgraded in status to the Investment RBC Working Group. Controversy began to surface in 2014. What controversy? The idea of consistency across business types—that is, the concept that the work being done by the Academy would ultimately be applied to all the RBC formulas. That approach was viewed by many as problematic since the work only used information from AVR companies. The objections were not just from industry. Many regulators that were involved with the other RBC formulas also questioned the consistency concept. The Academy asked if it should provide a separate bond analysis of the PRBC and HRBC formulas, but regulators couldn’t seem to make a decision. It was at this point (2014) that very preliminary base factors were presented to the Working Group. That really heated up the separate analysis conversation. 

The discussions continued. In 2015, bond “bucket” (classification) discussions were added to the agenda. How many bond classifications should be used? Things seemed to be picking up speed, and many thought new bond classifications and factors might be adopted by the end of the year. That didn’t happen. 

Chapter 3 – Moving Forward?

In 2016 the Investment RBC WG released its “A Way Forward” document, attempting to create a baseline for moving forward with the asset risk component of RBC. The document proposed an aggressive timeline with factors to be in place for year-end 2017. That didn’t happen. The Working Group also stressed that after four years of work, it was time to make decisions on several outstanding issues, including consistency between formulas. No decision was made. Both the PRBC and HRBC Working Groups were looking at implementing different factors from what was being developed for the LRBC. And the talks continued. 

By the end of 2017, the Working Group had not acted upon the Academy’s recommendations that were submitted in 2015 or the revised 2017 reports. Instead, a new implementation goal of 2019 was set. That didn’t happen. 

The Academy expanded the scope of its work to include the bond portfolio adjustment or bond size factor and appeared to be recommending separating the PRBC and HRBC formulas from its current work. No separation occurred. While all of this was occurring, the American Council of Life Insurers (ACLI) submitted a proposal to the Working Group suggesting factors for 20 bond categories that were different from the Academy’s recommendations. And then along came the federal Tax Cuts and Jobs Act of 2017 throwing a wrench into not only the work on bond factors but the rest of the RBC factors as well. 

By 2018 the Academy was once again asking for guidance on what assumptions should be included in its work. The guidance didn’t come, although everyone seemed to agree it was needed. But the Investment RBC Working Group did reach out to the Financial Condition (E) Committee (E Committee) indicating its work would probably expand the bond reporting categories to 20 and suggesting the NAIC should approve needed IT work to be ready for such a change. A report from the Academy’s Joint P&C/Health Bond Factor Analysis Working Group recommending specific differentiation for the bond factors for those two formulas was exposed for comment. And the talks continued.

In 2019, the Academy presented its third iteration of proposed bond factors for the LRBC, which also pushed for 20 bond reporting categories for year-end 2019 reporting. That didn’t happen, but work on NAIC IT system changes to accommodate the reporting was approved. 

Chapter 4 – The Investment RBC Working Group Disappears

In 2020, there were some strong signs that the work on RBC bond factors was moving forward. Early in the year, new bond reporting using 20 categories, replacing the current six categories, was adopted for use in the 2020 RBC, with the same format adopted for each of the formulas. Although the reporting format changed, there were no new factors for 2020. In the table below, the new reporting categories are indicated showing the corresponding PRBC factors. 

Table 1

Later in the year, the Investment RBC Working Group was disbanded. All of the action items that had been previously assigned to that Working Group were transferred to the Capital Adequacy Task Force or to the LRBC, PRBC, or HRBC Working Groups as appropriate. Now separate handling of revised bond factors for each of the formulas won. Discussions moved to the individual Working Groups, and as a consequence, the talks became more focused to that specific RBC type. Realizing that new factors needed to be finalized, the number of Working Group meetings increased to try to achieve that goal.

The E Committee was losing patience and sent a memorandum to the LRBC Working Group regarding getting the expanded bond factors in place, emphasizing the need to accomplish this for year-end 2021 RBC reporting. The memo also indicated the LRBC Working Group should consider analysis that would be prepared by the ACLI. (Recommendations from the E Committee are usually considered to be “orders.”) It was at this point that the ACLI brought in Moody’s Analytics (Moody’s) to analyze the suggested bond factors prepared by the Academy. Ultimately, the LRBC Working Group ended up with two different bond factor proposals to be considered. The PRBC and HRBC Working Groups were developing their own factors. The talks continued. 

Chapter 5 – The Final Product

(In the following discussion, referenced page numbers may change as all RBC revisions are finalized.)

Finally, on May 29, 2021, the HRBC Working Group became the first to adopt new bond factors beginning with 2021 reporting. It should be noted that the new factors affect not only the directly held bonds reported on page XR007.1 but also bonds listed on XR006 for securities lending collateral held and the asset concentration. The adopted factors are as follows: 

Table 2
Note: There is still a reporting category of “exempt” bonds, which have a factor of .000. 

Although the concept of adding a bond size adjustment to the HRBC was discussed, it was not adopted as a separate formula calculation but was instead incorporated into the adopted factors. 

The PRBC Working Group soon followed during its June 9 meeting. The factors will apply to the directly owned bonds reported on page PR006, the securities lending collateral on PR015, and the Asset Concentration as well. In addition, the PRBC Working Group adopted changes to the bond size factor and eliminated separate reporting and handling for hybrid securities. Hybrids will now be included with bonds. The factors are as follows. 

Table 3   
Note: There is still a reporting category of “exempt” bonds, which have a factor of .000. 

Table 4

On June 11, the LRBC Working Group locked in its factors. Remember, this group had been considering two different sets of bond factors: one set developed by the Academy and one set developed by Moody’s under the umbrella of the ACLI. The final decision was to adopt the approach developed by Moody’s. This was overwhelmingly the preference of industry, as witnessed by the comment letters that were received. For those who might not be familiar with the LRBC, it uses two sets of factors, a base factor and a tax factor. Both sets were revised. Factor changes also were applied to the hedged asset bond schedule (LR014), off-balance sheet securities lending collateral bonds (LR018), the Asset Concentration (LR010), and the bond size factor

Table 5
Note: There is still a reporting category of “exempt” bonds, which have a factor of .000.

Table 6

Besides the change in bond factors, the 2021 LRBC formula also will contain a change in the real estate reporting and factors, the addition of factors to the longevity risk, and investment income incorporated into the health underwriting factors, as well as a couple of other minor changes adopted for all of the formulas. Consequently, the LRBC Working Group will be preparing a guidance document to help regulators understand that because of the number of changes implemented in the 2021 LRBC formula, a company’s results may vary from previous years. In particular, Life companies may trigger the trend test. Regulators need to be aware that triggering the trend test this year may be a result of formula changes and not a result of underlying changes in the company’s risk exposure. 

In the NAIC hierarchy, changes to the RBC formulas are not considered “final” until adopted by a Working Group’s parent. In this case, that is the Capital Adequacy Task Force. The Task Force held a meeting on June 30, adopting all of the above, in addition to a few other formula revisions. All revisions will be posted to the Task Force’s webpage. 

Chapter 6 – Epilogue
As much as this narrative seems to resemble a comedy of errors, at least to a point, the work on the bonds was only part of a bigger picture. Yes, it took 10 years to complete the bond work. To most, that was way too long. But during that time, all groups involved also had other projects to complete. In fact, a lot of other projects. Will there be another project of such magnitude? Probably. Have all parties concerned learned from this experience? Let’s hope so. 

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