Younger Members Convention - 1 & 2 December 2003 - GLASGOW

Presenter: James Mulrooney, FSA

Topic: CP195 and regulatory developments in Life Insurance

Main Issues in CP 195

• Original proposals in CP 143 - “twin peaks” approach for life insurers

• Recent stockmarket falls put pressure on statutory solvency while insurers claimed realistic basis still strong

• “Tiner” Waivers - FSA needed reassurance before granting these waivers- realistic basis was able to provide evidence of financial strength

Problems with current regime

• Capital not very risk-sensitive

• With-profits constructive liabilities (accrued final bonus) not in balance sheet

• Capital hidden within prudent reserves

• Approach may undervalue options– eg guaranteed annuities, MVA-free dates

• Capital rules-based, not based on circumstances of the firm

• No allowance for smoothing costs

Criteria for Realistic Reporting

• Only applies to firms that are realistic reporters - with profit funds > £500m

• Smaller firms can opt in if they wish

• “Tiner” waivers now proposed to be codified into Integ Pru Sourcebook for realistic reporting firms

• Only realistic reporters can use all amended (i.e. less onerous) valn rules

• Other waivers will be available to all firms - e.g. restriction on equity yield

“Tiner” Waivers - Overview

• Original intention was to allow WP firms to retain equities and to avoid a downward spiral in equity prices

• Weakened Rules must still meet EU Directive minima - UK can go no lower

• Waivers should not create a risk to security of policyholder benefits

• Full publicity of firms with waivers on FSA website creates a positive image - seen as a “badge of strength”

Rules Changed: Statutory Reserves

• Gross Premium Valuation for WP

• Inclusion of prudent lapse assumption where justified

• Removal of cap on maximum valn reinvestment yield

• GAO reserving guidance weakened

• Restriction on Earnings Yield for equity assets removed

• Resilience reserve can now be held as a capital requirement: no RMM element

Realistic Reporting - Overview

• Applies to WP liabilities or firms with similar liabilities - deposit admin, etc.

• Designed to better identify risks in firms and to determine strength of firms

• Also should capitalise costs & risks that currently are not included in stat

• Will combine with stat valuation to ensure that adequate reserves are held

• Uses of techniques used internally by firms - asset shares, stochastic models

Realistic Valuation Methods

• Both asset share and prospective methods (e.g. bonus reserve valn) are acceptable for basic realistic reserve

• For option reserves, 1 of 3 methods should be used - 1). Stochastic projection, 2). Replicating portfolio of derivatives assets or 3). Range of deterministic projections with assigned probabilities

• Either asset share or BRV method is acceptable for basic policy benefits

Realistic Valn Methods - continued

• Realistic reserves can factor in future management actions - changes to investment mix, bonus rate reductions

• All future management actions must be consistent with treating customer fairly and the firm’s published PPFM

• All bases, parameters documented

• For option reserves, stochastic projections are preferred but

Realistic Valn Methods - continued

• Replicating portfolio of derivatives can be effective in certain circumstances - known future benefits, fixed maturity date(s), little variation in asset mix, etc

• Range of deterministic projections is least favoured option as option/g’tee costs often understated using deterministic methods v stochastic

• Size & complexity of w-p business also a factor in which model to adopt

“Twin Peaks” Calculation - Reserves

• Free assets on statutory basis cannot exceed free assets calculated on realistic basis

• Statutory reserves are WP policy reserves, WP portion of resilience reserve and WP portion of RMM - with benefit of less onerous reserving rules

• Realistic reserves are realistic reserves (incl. g’tee & smoothing costs) and RCM - risk capital margin

“Twin Peaks” Calculation - Assets 1

• Statutory value of assets unchanged - asset admissibility rules as before

• Realistic value of assets = statutory value of assets (for w-p pols)+ assets (of admissible type) above counterparty and/or exposure limits+ realistic value of any NP business in firm’s WP fund: e.g. EV of NP business

• Example: Value of Individual Property above 5% - OK; Antiques - no value

“Twin Peaks” Calculation: Other Issues

• Implicit items are still valid (up to 2007/9) in stat surplus calculation but have no value in realistic surplus calcs

• Cashless financing reinsurance (based on future WP surplus emerging) are proposed to have no value in stat valn

• Fin re based on WP s/h transfers or np profits may still be permitted in stat

• Each WP fund must meet WP realistic liabs from resources within WP fund

“Twin Peaks” Calculation - WPICC

• WPICC - WP Insurance Capital Component

• Designed to overlay realistic financial strength calcs on published (i.e. stat) financial strength - especially for firms that appear strong on statutory basis

• WPICC = Max(0, Statutory Surplus - Realistic Surplus)

• Positive WPICC must then be held as part of the firm’s capital requirement

Resilience Reserve & Risk Capital Margin (RCM)

• Resilience reserve - similar basis of calculation as before

• Required Capital Margin made up of 3 elements:

• Market Risk - assumed equity & property falls & interest rate shockCredit Risk component - increase in spreads (versus gilts) and defaults upPersistency Risk component - less people lapsing policies

Risk Capital Margin (RCM)

• Market risk test is designed to assess capital required to guard against market shock/crash

• Credit risk test used to assess capital needs for a deterioration in credit standing - “flight to quality”, recession

• Persistency risk designed to model p/holder behaviour of selectively NOT lapsing - increasing realistic reserves

Practical issues

• Forward swap rate or current gilt yield for discounting future option liability costs (e.g. GAOs) - different approaches are being taken. Gilt yield may possibly be more correct but swap rates are based on a deeper market - issue still to be resolved

• Approved Securities - definition of these assets includes some securities that are, arguably, not risk-free (unlike gilts) in CP97.

Practical issues - continued

• For the credit risk test under CP195, should non risk-free assets that are “approved securities” be included?

Risk Management

• New regime is akin to what best practice should be for insurers

• Firms may re-assess a number of aspects of their business - reinsurance, capital (support), hedging, bonus policy, etc.

• Systems and control weaknesses may be addressed by Enhanced Cap Req’t

• Sometimes capital may not be appropriate - systems overhaul, etc

FSA Annual Returns - Forms 18 & 19

• Two new forms are proposed to be included in FSA Annual Returns - Form s 18 & 19 are only required to be completed for realistic reporting firms

• Form 18 is the realistic balance sheet

• Form 19 compares statutory and realistic surplus to determine if the value for WPICC - I.e. zero or higher

• Any requirement to hold a (>0) WPICC will be a capital requirement on Form 9

Stage 1: standard regulatory basis - all life business

Admissible assets

750

RMM 25

Free capital25

Resilience reserve 20

Non-profit liabilities 100

With-profit liabilities

580

Stage 2: With-profits business only

Admissible assets644

Free capital 95

RMM 21

Resilience reserve

18

With-profits

liabilities 510

Realistic assets

675

Realistic liabilities

570

Market, credit and

persistency risk capital

29

Free capital- realistic basis 76

Peak 1 Peak 2

Final presentation under proposed approach

All life business- ECA

Free capital 76

WPICC 19

RMM 25

Market risk capital 20

Policyholder liabilities 610

ECRMCR

Capital measures for life insurers

MCR ICASCER

EU minimum + resilience

capital component

EU minimum + with-profits capital component + resilience capital component

Stress and scenario testing

Capital Requirements - Pillars 1 & 2

• Increases to Pillar 1 capital being implemented from 1 Jan 2004 - PS181

• Enhanced Pillar 1 - Realistic Reporting and requirement to hold WPICC (>0) - end 2004

• Pillar 2: Individual Capital Requirement - based on intrinsic risks individually assessed on firm-by-firm basis - should be more risk-sensitive

• Much of this information not public

Individual Capital Adequacy Standards

• Firms assess own capital requirement

– based on own business and risks

• Incentive for better risk management

• To enhance consumer protection and market confidence through reduced risk of financial failure

• Applies to all insurers

• Firms to carry out stress and scenario testing

• Firms to hold adequate fin resources

Terminology

• CRR: Capital Resource Requirement

• MCR: Min Capital Requirement - I.e.

• Capital Req,ment based on Stat Valn

• LTICR: RMM + resilience reserve (RCR) for both WP & NP liabs

• ECR: Enhanced Capital Requirement = LTICR + RCR + WPICC (which may be 0)

• ICA: Individual Capital Assessment

• ICG: Individual Capital Guidance

ICAS: areas to be considered

• Guidance in Handbook on factors to be taken into consideration

• Business risk factors– market and credit risk– securitisation risk– residual risk– concentration risk– high impact, low probability risk– cyclical and business planning

• Control risks factors: systems & controls

ICAS: Reporting

• No regular requirement

• Firm to retain analysis/reports for possible review by FSA

• FSA review as part of supervisory programme

• Not public information - between FSA and regulated firm; exclusions may apply - auditors, (external) appointed actuary, etc

Individual Capital Guidance (ICG)

• Initial exercise

– review of firms’ ICA

– issue ICG to firms

• Thereafter

– part of Arrow process

– frequency of review based on risk assessment

Content of ICA

• Amount of ICA

• Background of firm

• Environment, business strategy, plan and sources of new capital

• Risk assessment

• Stress and scenario tests

• Other risks

• Capital models

Results of ICG process

• May– confirm pillar 1 capital (not public);– give guidance for increased capital (not

public); or– allow waiver to reduce capital

requirements

• May impose requirement if guidance not accepted (in public domain) - variation of permission(s), in extreme

Change to Appointed Actuary regime

• Next year, appointed actuary replaced by actuarial function head and with profits actuary (for WP)

• Head of Act Fn carries on many of the roles of AA previously

• WP Actuary must certify that realistic reserves for WP business have been calculated consistent with TCF

• Reviewing Actuary must also certify being content with realistic basis calcs

Reporting and audit- realistic basis

• New forms to show realistic liabilities plus disclosure of basis on which assessed

• Audit scope to include realistic basis

• Reviewing actuary’s opinion to include realistic liabilities and capital requirement

• Directors certificate will cover realistic basis capital requirements

• All in public domain with rest of annual returns

Audit requirements & Role of Actuaries

• FSA Annual Returns - directors must now have regard to opinion of reviewing actuary

• Reviewing actuary must be independent of firm but may be an employee of audit firm

• With profit actuary also required to produce report to w-p policyholders - WP actuary can be “in-house”