Younger Members Convention 1

1
Younger Members Convention - 1 2 December 2003
- GLASGOW Presenter James Mulrooney, FSA

• Topic CP195 and regulatory developments in Life
  Insurance

2
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

3
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

4
Criteria for Realistic Reporting

• Only applies to firms that are realistic
  reporters - with profit funds gt 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

5
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

6
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

7
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

8
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

9
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 firms
  published PPFM
• All bases, parameters documented
• For option reserves, stochastic projections are
  preferred but

10
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/gtee costs often
  understated using deterministic methods v
  stochastic
• Size complexity of w-p business also a factor
  in which model to adopt

11
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.
  gtee smoothing costs) and RCM - risk capital
  margin

12
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 firms WP
  fund e.g. EV of NP business
• Example Value of Individual Property above 5 -
  OK Antiques - no value

13
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

14
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
  firms capital requirement

15
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

16
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

17
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.

18
Practical issues - continued

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

19
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 Reqt
• Sometimes capital may not be appropriate -
  systems overhaul, etc

20
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 (gt0) WPICC will be a
  capital requirement on Form 9

21
Stage 1 standard regulatory basis - all life
business
Free capital 25
RMM 25
Resilience reserve 20
Admissible assets 750
Non-profit liabilities 100
With-profit liabilities 580
22
Stage 2 With-profits business only
Peak 1
Peak 2
Free capital- realistic basis 76
Free capital 95
Market, credit and persistency risk capital 29
Admissible assets 644
Realistic assets 675
RMM 21
Resilience reserve 18
Realistic liabilities 570
With-profits liabilities 510
23
Final presentation under proposed approach
All life business- ECA
Free capital 76
WPICC 19
RMM 25
ECR
MCR
Market risk capital 20
Policyholder liabilities 610
24
Capital measures for life insurers
EU minimum with-profits capital component
resilience capital component
EU minimum resilience capital component
Stress and scenario testing
MCR
ICAS
CER
25
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 (gt0) - 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

26
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

27
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

28
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

29
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

30
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

31
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

32
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

33
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

34
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 actuarys 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

35
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