What Is Capital at Risk (CaR)?
Capital at risk (CaR) refers to the amount of capital set aside to cover risks. It applies to entities and people who are self-insured, as well as to insurance companies that underwrite insurance policies. Capital at risk can be used to pay losses or it can be used by investors who are required to have capital in an investment in order to get certain tax treatments.
Key Takeaways
- The term capital at risk refers to the amount of capital set aside to cover risks.
- Capital at risk is used as a buffer by insurance companies in excess of premiums earned from underwriting policies.
- Capital at risk helps pay for claims or expenses in the event that premiums collected by the company aren’t enough to cover them.
- Capital at risk is relevant when filing federal income taxes because the Internal Revenue Service (IRS) requires investors to retain capital at risk in an investment in order to get certain tax treatments.
- One of the requirements of taking a capital gain is that the investor needs to have capital at risk.
Understanding Capital at Risk (CaR)
Capital at risk can be used to describe several different scenarios for the insurance industry and for investors with respect to their taxes. Insurance companies collect premiums for policies they underwrite. The amount of premium they can collect is determined based on the risk profile of the policyholder, the type of risk being covered, and the likelihood that a loss will be incurred after providing coverage. The insurance company uses this premium to fund its operations, as well as to earn investment income.
Capital at risk is used as a buffer in excess of premiums earned from underwriting policies. In essence, the capital at risk helps pay for any claims or expenses in the event that the premiums the company collects aren’t enough to cover them. As such, capital at risk can also be referred to as risk-bearing capital or surplus funds. Because capital at risk is excess capital, it can be used as collateral. Capital at risk is an important indicator of an insurance company’s health because having sufficient capital available to pay for claims is what prevents an insurer from becoming insolvent.
The amount of capital that must be held in reserves by an insurance company is calculated according to the type of policies that the insurer underwrites. For non-life insurance policies, the amount of capital at risk required is based on estimated claims and the number of premiums that policyholders pay. For life insurance companies, the amount is based on their calculations of the total benefits that would have to be paid.
Capital at risk is also relevant to federal income taxes. The Internal Revenue Service (IRS) requires an investor to have capital at risk in an investment in order to get certain tax treatments. Many tax shelters used to be structured so the investor could not lose money, but could take income and turn it into unrealized capital gains to be taxed at a later time and a lower rate. That’s why one of the requirements of taking a capital gain is that you need to have capital at risk.
Special Considerations
Regulators may set an insolvency margin for insurance companies based on their size and the types of risks they cover in the policies that they underwrite. For non-life insurance companies, this is often based on the loss experienced over a period of time. Life insurance companies use a percentage of the total value of policies less technical provisions. These regulations typically apply to the amount of capital that must be set aside and do not apply to the type or riskiness of the capital holding itself.