RBC Action Levels, Dividend, and Adverse Reserve Trend
Lakeside Mutual Insurance Company writes commercial auto and general liability. At December 31, 2023, its total adjusted capital (TAC) is $58.0 million and its authorized control level RBC (ACL) is $32.0 million, producing an RBC ratio of 181%. The company's 2023 IRIS ratio 2 (change in surplus) is negative 12%, and its net written premium is projected to grow 25% in 2024. The appointed actuary estimates that a 10% adverse development in loss reserves would reduce TAC by $9.0 million over the next year. Management also wants to pay a $5.0 million dividend to its members in June 2024. The domiciliary commissioner has taken no action yet. Lakeside's board believes the company is adequately capitalized because the ratio is above 150% and because the trend test has never been triggered. The company has no outstanding surplus notes and no reinsurance collectability issues.
1. Determine Lakeside's RBC action level at December 31, 2023, and describe the regulatory consequences. Is the board's statement that the company is 'adequately capitalized' correct?
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RBC ratio = TAC / ACL = $58.0M / $32.0M = 181.25%. The NAIC RBC action levels are: Company Action Level (CAL) below 200% but at or above 150%; Regulatory Action Level (RAL) below 150% but at or above 100%; Authorized Control Level below 100% but at or above 70%; Mandatory Control Level below 70%. At 181.25%, Lakeside is at the Company Action Level.
At CAL, the insurer must submit an RBC plan to the domiciliary commissioner within 45 days, or the period specified by state law, identifying the sources of the ratio decline, corrective actions, and financial projections. The commissioner may examine the company, require additional reporting, and must review the plan. The board's statement is not correct in RBC terms: a ratio below 200% is not 'adequate' for RBC purposes, even though it is above 150%. The company is above the Regulatory Action Level, so it has not yet crossed into the level where the commissioner may order corrective action, but it is on the CAL and must act. The negative IRIS ratio 2 and planned 25% growth are warning signs that the ratio could deteriorate further.
2. Assume the $9.0 million adverse development occurs and the $5.0 million dividend is paid. Compute the pro forma RBC ratio and identify the new action level. Show the calculation.
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Pro forma TAC = $58.0M - $9.0M adverse development - $5.0M dividend = $44.0M. Pro forma RBC ratio = $44.0M / $32.0M = 137.5%. This falls below 150% but remains above 100%, so Lakeside would move from the Company Action Level to the Regulatory Action Level. At the Regulatory Action Level, the commissioner may require the company to file a corrective plan, may examine the company, and may issue an order specifying corrective actions. The company must also submit a new or revised RBC plan.
The calculation assumes the dividend is legally permissible and actually paid; if the dividend is paid while the company is at CAL, the commissioner may challenge it. The adverse development also increases reserve risk and may increase ACL, which would make the ratio even worse. If the company has any reinsurance collectability problems, TAC could be lower. A 137.5% ratio is a serious regulatory event and should be modeled before the dividend is declared.
3. Evaluate the relevance of the trend test and IRIS ratio 2 to Lakeside's situation. What should management do before paying the dividend?
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The RBC trend test is designed to catch companies whose RBC ratio is at or above 200% but whose recent trend suggests it will fall below 200% within a year. It is not the operative test once the ratio is already below 200%; Lakeside's 181.25% ratio already places it at CAL. The board's reliance on 'the trend test has never been triggered' is therefore misplaced. The trend test may still matter for projections, but it does not cure the current CAL.
IRIS ratio 2, change in surplus, of negative 12% is a warning that surplus is declining faster than premium or reserves. Combined with 25% planned growth and the actuary's $9M adverse-development estimate, it suggests the company may be growing into a capital problem. Management should not pay the $5M dividend without first preparing a revised capital plan, stress-testing the 25% growth, and discussing the RBC plan with the commissioner. It should consider suspending or reducing the dividend, obtaining capital, purchasing reinsurance, or slowing growth. The dividend may also require regulatory notice or approval depending on state law and the company's surplus. The company should document the board's risk assessment and update its ORSA/ERM analysis.