Marginal Cost of Risk-Based Capital and Risk-Taking

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 show that the simple square root rule of the RBC calculation formula causes difference in the marginal RBC cost of holding risky fixed-income securities across different insurance companies and across time. We find that insurers facing a lower RBC cost of fixed-income investment purchase more of risky fixed-income securities than those who face a higher RBC cost. Using Hurricane Sandy and Hurricane Katrina as exogenous shocks to RBC cost, we find that insurers suffered more in the two disasters took more risk in their fixed-income investment in the following year and that their overall risk and probability of insolvency also increased. These special cases highlight the side-effect of current US RBC calculation rule implicitly assuming independence between risk categories, and provide an important regulatory implication for minimum capital calculation in capital regulation regimes.

Keywords: Risk-based capital; Risk taking; Capital regulation; Insurance companies

JEL Classification: G18, G22, G32