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The Patient Protection and Affordable Care Act (ACA) brought new risks and volatility to the world of health insurance. The prospect of insuring a previously uninsured population with restrictive market rules has obviously created unprecedented challenges. Furthermore, the estimation required for assets and liabilities associated with ACA risk adjustment has concerned insurers and regulators alike. Rapid insolvency of many new health organizations has renewed the focus on insurers being adequately capitalized.

Adequate capitalization has always been a crucial requirement for the sustainability and operating ability of insurance organizations. As organizations who are primarily in the business of accepting risk, insurance companies require sufficient levels of surplus funds to assure that obligations to consumers can be met and that such organizations have the financial strength to withstand volatility and fluctuation in a competitive market environment.

Adequacy is usually characterized in two realms. Minimum capital is defined in the regulatory realm and is largely formulaic in nature. Optimal capital (or “surplus”) reflects corporate-specific objectives and is generally expressed as a preferred range to maximize corporate security, financial efficiency, and furtherance of corporate goals. As each insurance company is unique, determination of an optimal surplus range is specific to the unique circumstances of each organization. In addition to its deep ACA expertise, Axene Health Partners, LLC (AHP) has developed proprietary modeling designed to help organizations determine their optimal surplus range; a sample report highlighting our modeling capability is included here.

How Much Surplus is Needed? / RBC History

Companies need surplus for many reasons, including support for loss reserves, protection from adverse cash flow shocks, funding future capital investments (e.g., administrative systems, buildings) and growth. The primary method currently used in the United States to measure required surplus is based on Risk-Based Capital (RBC) metrics.

RBC was developed in the 1990s as an early warning system to detect financial distress and to signal potential trouble to regulatory authorities. The calculations inherent in the methodology are designed to provide varying levels of authoritative action depending on the ratio of a company’s capital level to the authorized control level (ACL) calculated in the RBC formula. As results are tracked and reported, the process leads to RBC being a conveniently used internally tracking measure as well.

Historically, various standards have been developed to determine required minimum surplus levels. An early method was simply a fixed dollar surplus requirement. As this standard does not appropriately adjust to an insurance company’s size, it was replaced in many jurisdictions by a ratio of surplus to annual revenue. A consideration of “surplus as a percentage of revenue” is commonly known as SAPOR and offers a transparent calculation with surplus requirements varying by insurer size. Unfortunately, the SAPOR statistic is overly simplistic and doesn’t consider an individual insurer’s risk profile.

Insurance company insolvencies in the late 1980s and early 1990s led the National Association of Insurance Commissioners (NAIC) to establish a working group to consider a more rigorous calculation reflecting the inherent risk of an insurer’s business to determine a minimum capital level; specifically, the working group believed companies with greater risks should be expected to hold higher amounts of capital. The group studied companies that had failed or exhibited weak financial condition to better understand indicators of potential financial trouble.

The resulting RBC construct was developed to be an early warning system for insurance regulators and to require a provision of capital adequacy determined formulaically by insurer risk levels. RBC is more refined than earlier assessments of capital adequacy, which were purely based on fixed amounts or simple comparisons of surplus levels to annual premiums. RBC measures consider not only an insurer’s size, but also its growth rate and various risk exposures.

Health insurance was a bit of an afterthought in the initial RBC models. The NAIC initially adopted different formulas for life insurers and property & casualty (P&C) insurers; depending on organizational structure and mix of business, health insurers were differentially categorized with life or P&C insurers. As both life and P&C insurers are more subject to long-term risks and asset/investment risks (distinct from the primary health insurance risk of “underwriting”), a new model specific to health insurance was adopted in 1998.The majority of the risk in the Health RBC model is often associated with “underwriting risk” and largely reflects the risk of pricing inadequacy.

The ACA Impact

In addition to new market rules and a changing population, the ACA “single risk pool” concentrates all pricing exercises into an annual decision well in advance of when premiums become effective. This concentration diminishes opportunities to offset losses through other products with various rate filings throughout the year. In the early years of the ACA, regulatory changes were unpredictable and often occurred mid-year, which did not allow insurers to reflect changes in prices.

Rebates subject to the minimum loss ratio requirement act as a one-sided risk corridor; smaller insurers and others subject to larger fluctuations are risk. Risk adjustment continues to be a challenge to predict, particularly for insurers with small market share. A review of aggregate RBC levels reveals a significant drop in surplus amount and more companies below the regulatory thresholds in 2014.

The RBC ratio is a retrospective calculation based upon historical enrollment, premiums, and other measures. It does not appropriately capture changing dynamics in the marketplace, such as existing business becoming subject to new market rules or minimum loss ratio requirements.

Insurance companies need surplus levels to withstand difficult times, protect consumers and
ultimately prevent corporate insolvency

Factors That Impact Optimal Surplus Range

The business of insurance involves a collection of various risks. Insurance companies are particularly vulnerable to risks that not only take time to recognize, but also require time to respond and implement corrections. As sustained periods of adverse conditions can cause significant losses, insurance companies need surplus levels to withstand difficult times, protect consumers and ultimately prevent corporate insolvency.

Each corporation is inherently different, and AHP recognizes that capital needs are determined by each insurer’s unique circumstances, business requirements, and management objectives. The insurers’ analytical capabilities, its business distribution, and the regulatory environment will influence an insurers’ corrective timeline. Accuracy in trend projection, pricing products and assessment of financial assets and liabilities (e.g. incurred but not reported claims) allows insurers to be properly capitalized with lower levels of surplus.

Risk Tolerance impacts development of an optimal surplus range and is largely at management discretion. As insurance is the business of risk, it would be impractical for an insurance company to obtain and maintain a level of surplus that would result in absolute immunity of financial danger. At the same time, insurance companies should have prudent surplus levels that minimize the possibility of ever falling below minimum levels of necessary capitalization.

Corporate structure plays a large role in determining an optimal surplus range. Aggressive companies with access to outside capital may have a lower optimal surplus range and utilize surplus to aggressively pursue new opportunities. Non-profit companies with less access to capital generally need and prefer a safer level of capital.

Third parties can influence optimal surplus range determination. Some states, notably Pennsylvania, have taken an active role, in informing companies of their appropriate range. The Blue Cross and Blue Shield Association requires its licensed companies to meet certain thresholds.

Reasons to Assess Optimal Surplus Range

Assessing an organization’s optimal surplus range is a prudent exercise for obvious and less intuitive reasons:

  • Public Interest – An overlooked benefit of operating within an optimal surplus range is public sentiment. The public interest is well served by a periodic reassessment of an optimal surplus range and continuous maintenance of surplus levels within that range.
  • Risk Assessment – Many insurance organizations don’t have a strong sense of what their optimal surplus range is, nor do they understand the likelihood and magnitude of a significant loss over a multiple-year period. An optimal surplus range determination necessarily assesses the loss probability over multiple time horizons.
  • Risk Tolerance Discernment – An optimal surplus range is dependent on the risk tolerance of corporate management. Every company has a different risk tolerance. Many companies have never explored what their tolerance is or sought to discern management agreement. Defining a risk tolerance in term of probabilities of being in a financially challenged position crystallizes understanding of what that tolerance is.
  • Tangential Learnings – A proper determination of an optimal surplus range investigates corporate processes and assesses strengths and weaknesses. The comprehensive process may reveal opportunities to enhance certain function that are tangentially related to the project scope.
  • Understanding of Risk Components – An external review of risk components often reveals items that are not on the short list of managements’ concerns.


Health insurance companies require adequate capitalization to maintain operations, achieve their goals in competitive marketplaces, and ensure against insolvency risk. Adequate capitalization is primary to every company’s viability and operations. It is required to ensure that promises and commitments to its members to offer financial protection from health care costs can be kept. Adequate capitalization is also needed to support membership growth, introduce new products, build and maintain technology and infrastructure, pursue new opportunities, and operate effectively as market conditions and the regulatory environment change over time.

Health insurers also have an interest in optimizing capital levels. As each company is unique in a multitude of ways, it is worthwhile to periodically assess an appropriate surplus range. With the implementation of the ACA, insurance companies should reassess their optimal surplus range. This can be determined by incorporating new market rules and corporate specific factors into a stochastic model.

Periodic reassessment of an optimal surplus range is a healthy exercise for insurance organizations. With changing market conditions and fluid corporate dynamics, a decennial assessment is usually appropriate. More frequent assessments are necessary when significant changes or merger and acquisition activity occurs.

As the health insurance environment has become more complicated and volatile with the ACA, many companies have sensed an immediate need to reassess their optimal surplus range. Other companies have elected to do perform this assessment for the first time. If your organization has not assessed its optimal surplus range in an ACA context, we would welcome the opportunity to have an exploratory conversation with you.

About the Author

Greg Fann, FSA, FCA, MAAA, is a Consulting Actuary with Axene Health Partners, LLC and is based in AHP’s Temecula, CA office.