The Regulatory Effect of Risk-Based Capital in Property-Liability Insurance

This study investigates how U.S. property-liability insurers changed their behavior response to the risk-based capital (RBC) requirements implemented in 1994. We posit that We posit that insurers may have acted to manage their operations and/or exploit anomalies in the RBC may have acted to manage their operations and/or exploit anomalies in the RBC formula so as to improve the RBC result. The sample consists of pooled, cross-sectional data of U.S. property property-liability insurers included in the NAIC’s database for the period 1991 to 2007. Simultaneous equations with partial adjustment models are estimated with change in a firm's operating risk characteristic (change in leverage ratio, change in proportion of premiums written in high-risk lines and change in proportion of stock real estate investment) as the dependent variable. First, regressions are estimated by year for 1991-1996. Then, pooled pooled regressions are estimated with dummy variables reflecting insurers’ financial strength added in the estimation. Two time dummy variables (1994 and 1991-1993 dummy) are also added to study whether or how insurers adjust their behaviors over time. We find that insurers adjust to We find that insurers adjust to We find that insurers adjust to We find that insurers adjust to We find that insurers adjust to We find that insurers adjust to their target ratio of leverage, proportion premiums written in high risk lines and proportion of stock and real estate investment simultaneously. We find that insurers in weaker financial positions may have a larger response to the imposition of RBC requirements. Results indicate that insurers in different financial conditions responded to RBC differently. Further, insurers have adjusted their behaviors over time, and a new regulatory rule plays a role in affecting these adjustments.