Risk-Based Capital and Solvency Screening in Property-Liability Insurance: Hypotheses and Empirical Tests

Abstract

For a fixed probability of wrongly classifying a strong insurer as being weak (Type I error), this paper examines the classification power (the probability of correctly identifying a weak insurer as being weak) for two potential solvency detection methods. The first is to classify insurers using ratios based on risk-based capital (RBC) standards and the second is to use the Financial Analysis Tracking System (FAST) solvency screening mechanism created by the National Association of Insurance Commissioners (NAIC). We test the hypothesis that the RBC system has at least as much power for identifying financially weak insurers as the FAST scoring system does. Our empirical results are largely inconsistent with this hypothesis: RBC ratios are less powerful than FAST scores in identifying financially weak property-liability insurers during our sample periods. We also provide limited evidence that RBC ratios and FAST scores are jointly more powerful in identifying weak insurers than FAST scores alone, which suggests that RBC ratios may convey new information about insolvency risk despite their relatively low power on a univariate basis.