What is Capital At Risk (CaR)
Capital at risk (CaR) is the amount of capital that is set aside to cover risks. CaR applies to the self-insured, as well as insurance companies that underwrite insurance policies. It is used to pay losses. Similarly, an investor is required to have capital at risk in an investment in order to get certain tax treatments.
BREAKING DOWN Capital At Risk (CaR)
Insurance companies collect premiums for the policies that they underwrite. The amount of premium 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 the amount of premiums earned from underwriting policies. Because this is excess capital it can be used as collateral. It is an important indicator of an insurance company’s health due to the fact that having sufficient capital available to pay for claims is what prevents an insurer from becoming insolvent.
The amount of capital that must be held by an insurance company is calculated according to the type of policies that the insurer underwrites. For non-life insurance policies, the capital at risk is based off of estimated claims and the amount of premiums that policyholders pay, while life insurance companies base their calculations off of the total benefits that would have to be paid.
Regulators may set an insolvency margin for insurance companies, based on their size and the types of risks that they are covering in the policies that the underwrite. For non-life insurance companies, this is often based off of 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 does not apply to the type or riskiness of the capital holding itself.
Capital at Risk and Taxes
CaR is also relevant to federal income taxes. The 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 that 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 needed to have capital at risk.