What it means
In the United States, insurance is regulated mainly by individual states, and each state has its own commissioner or director. The NAIC brings these regulators together so that they can share information and agree on common approaches.
Its output includes model laws and regulations that states may adopt in whole or in part. One of its most important contributions is statutory accounting.
Insurers must file financial statements using rules designed to show whether they can pay claims, which differ in several ways from the accounting used for investor reporting. The NAIC maintains these rules in a manual that states generally follow.
It also developed risk-based capital requirements. These set the minimum capital an insurer should hold based on the risks it takes, such as insurance, investment and credit risks.
Regulators compare the company's actual capital with the required amount and take action when the ratio falls below set levels. The NAIC also provides databases, financial analysis tools, rating of securities held by insurers and a system for sharing information on market conduct and complaints.
Insurers, auditors and investors use its public information to understand an insurer's position. Companies that operate in many states benefit from consistent rules, though differences remain.
Because the NAIC is a membership association, its model laws do not take effect on their own. A state has to pass the law or adopt the regulation, so rules can differ across states and adoption can take years.
A finance professional working with a US insurer should check the rule that applies in the insurer's home state.
In practice
Real-world examples.
Example
A state insurance department adopts an NAIC model law on how insurers manage their investments. Local insurers must follow the new requirements from the following year. The department uses NAIC guidance to train its examiners.
Example
An auditor reviewing a life insurer checks that its financial statements follow the NAIC accounting manual. She notes differences from the company's investor reporting figures and prepares a reconciliation. Her report goes to the regulator.
Example
A corporate finance team considering buying a small insurer reviews its risk-based capital ratio filed with its state regulator. The ratio of 310% is comfortable, which gives the buyer confidence about its capital strength. The team still asks for a detailed review of reserves.
Formula
Calculation
Risk-based capital ratio = Total adjusted capital / Authorised control level risk-based capital x 100
Under the NAIC model framework, regulators take action at defined points: company action level at 200% of the authorised control level, regulatory action level at 150%, authorised control level at 100% and mandatory control level at 70%. Suppose an insurer has total adjusted capital of $60,000,000 and an authorised control level of $25,000,000. Ratio = 60,000,000 / 25,000,000 = 2.4, or 240%. This is above the 200% company action level, so no action is triggered. If capital fell to $45,000,000, the ratio would be 45,000,000 / 25,000,000 = 180%, below 200%, and the company would have to submit a plan.Case study
Seen in the real world.
Heartland Mutual is an illustrative, fictional property insurer operating in six states. Following a year of severe storms, its claims rose sharply and its total adjusted capital fell from $80,000,000 to $48,000,000, while the authorised control level was $26,000,000. The risk-based capital ratio fell from 80 / 26 = 308% to 48 / 26 = 185%.
The new ratio was below the 200% company action level, which required the insurer to prepare a plan for restoring capital and submit it to its regulator. The finance team proposed a reinsurance arrangement to cut its exposure to storm losses and a capital contribution of $10,000,000 from its parent.
With the extra capital, the ratio rose to 58 / 26 = 223%, back above the action level. The illustrative lesson is that the capital thresholds work as an early warning system, giving regulators and management time to act before the insurer is in serious difficulty.
Watch out
Common mistakes.
- Treating the NAIC as a government regulator, when it is an association whose standards only apply once states adopt them.
- Assuming that statutory accounting gives the same numbers as the accounting used for investors, when the two sets of rules differ.
- Believing the rules are identical in every state, when states adopt model laws at different times and in different forms.
Questions
People also ask.
What does the NAIC do?
It helps state regulators coordinate by writing model laws, maintaining statutory accounting rules, running solvency tools and sharing data.
What is risk-based capital?
It is a method that sets the minimum capital an insurer should hold according to the risks in its business, with regulators acting when the ratio falls below set levels.
Why does the NAIC matter to non-insurance businesses?
Its standards affect the financial strength of insurers that provide a company's cover, so they help judge whether an insurer is likely to pay claims.
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