Expect tighter solvency control

February 1, 2009

Measurement tools used by state regulatory bodies evaluate MCO capitalization and investment

At this juncture, we will review the current panoply of regulatory tools used to evaluate the financial condition of health insurers, HMOs and other MCOs. This oversight function is performed by state insurance regulatory bodies.

TOOLS OF THE TRADE

State regulators also look at various financial ratios and formulas for determining whether the company is adequately capitalized. One key financial ratio is the ratio of premiums to surplus. As a general rule, a company's net retained premiums on an annualized basis should not exceed 400% of its total capital and surplus.

The most common measurement of required capitalization now used by regulators is the National Association of Insurance Commissioners (NAIC) Risk-Based Capital (RBC) formula. This formula is now in effect in most states. It requires a company to compare its total capital and surplus, with certain prescribed adjustments, to a formulaic calculation of capital required for the company.

The RBC formula takes into consideration the company's asset mix, lines of business, and volume of business. The resulting calculation is referred to as the "Authorized Control Level" RBC. If the company's adjusted capital is less than 100% of the Authorized Control Level RBC, regulators may intervene and place the company under control. If the company's adjusted capital is between 100% and 150% of Authorized Control Level RBC, regulators will require the company to take corrective actions to improve its financial condition. In most cases, a company will be considered sufficiently capitalized if its adjusted capital in comparison to the Authorized Control Level RBC is 250% or above.

In addition to the tools regulators have to evaluate capitalization levels, there are significant limitations on the investments that are permitted for these regulated entities. Generally speaking, most of their assets must be invested in highly liquid securities.

Finally, regulators also have oversight on dividends and distributions and may disapprove of such payments that are deemed to be "extraordinary." In most states, annualized dividends that exceed the greater of 10% of capital and surplus or net income are deemed extraordinary. If determined to be extraordinary, such dividends require regulatory approval.

Barry Senterfitt is a partner in the insurance industry practice of Akin Gump Strauss Hauer & Feld LLP in the firm's Austin, Texas, office.