How Does Minimum Capital Calculation Rule Affect Insurance Companies’ Risk-Taking Behavior

Abstract

This paper explores the impact of capital-adequacy-requirements on the investment behavior of insurance companies from a new perspective. We specifically investigate one important feature of Risk-Based Capital (RBC) system, the square root rule in aggregating risk categories. We test how the simple square root rule affects insurance companies’ risk-taking behavior in their fixed-income (FI) investment. The RBC calculation formula causes difference in the RBC cost of acquiring risky FI securities across different insurance companies and across time. We find that insurers facing lower RBC cost of FI securities have higher net purchase of risky FI securities than other insurers who face higher RBC cost. We use Hurricane Sandy and Hurricane Katrina as exogenous shock to RBC cost; we find that insurers suffered more in the two disasters take more risk in their FI investment in the following year, and their overall risk and probability of insolvency also increase. This special case highlights the side-effect of current RBC calculation rule and minimum capital calculation in other capital regulation regimes.

Keywords: capital requirement, covariance, insurance, regulation

JEL Classification: G11, G18, G22