Development of UK Capital Adequacy Standards

1

• Development of UK Capital Adequacy Standards
• ARIA Conference, Washington DC
• 7 August 2006
• Ian Tower
• The Financial Services Authority

2
Scope of Presentation

• The need for reform
• Minimum capital
• Individual Capital
• Objectives
• Approach
• What we have found
• The future the EUs Solvency 2

3
The Need for Reform

• Risk management techniques were not as well
  developed and less objective in insurance than
  elsewhere in financial services
• Boards/senior management not sufficiently engaged
  with risk management process
• Statutory capital levels were not sufficiently
  risk sensitive
• Wanted to give firms incentive to improve their
  risk management techniques
• Needed to develop risk-based approach well before
  Solvency II reforms

4
UK insurance sector regulatory reform overview

• With-profits realistic reporting Principles
  Practices of Financial Management governance
• Financial governance abolition of the appointed
  actuary role
• Audit of FSA life returns with actuarial
  review
• New risk-based prudential capital for general
  insurance
• New approach to group capital adequacy
• Individual Capital Assessments - ICAS
• New framework for reporting to FSA
• Emphasis on treating customers fairly

5
Minimum capital (Pillar 1) life firms

• Two solvency tests (twin peaks) for
  with-profits (participating) business
• statutory (based on EU directives) and
• realistic (FSAs own test)
• different approaches to both reserves/valuation
  and capital
• realistic approach applies only for largest 37
  firms (with-profit liabilities over 500 mn)
• Realistic peak more sensitive to economic
  conditions, but provides no incentive for good
  risk management.
• Non-profit (non-participating) business subject
  to single statutory test.
• At 31/12/2005 the realistic peak was higher than
  regulatory peak for 32 of 37 realistic reporters.
• For the 32 an extra requirement (WPICC) is added
  to the regulatory requirement to ensure
  regulatory surplus does not exceed realistic
  surplus.

6
The Twin Peaks
Regulatory Peak
Realistic peak
WPICC
Risk Capital Margin (RCM)
Resilience capital requirement
ECR
MCR
Long Term Insurance Capital Requirement (LTICR)
Realistic reserves
Mathematical reserves
WPICC brings regulatory peak up to realistic peak
7
Minimum capital (Pillar 1) general/PC

• Formula charges based on
• asset values
• technical provisions
• premiums
• Limited to current accounting classes
• Not intended to be a risk based capital role
  of individual capital standards
• It is intended to be better than EU solvency
  standard and reflect risks better

8
Pillar 1 - General Insurance
MinimumCapitalRequirement
EnhancedCapitalRequirement
IndividualCapitalAssessment
IndividualCapitalGuidance
ICA
ICG
ECR
Directiveminimum
MCR
Can be less than 100 of ECR in certain cases
May be equal to or higher than firms ICA
9
ICAS individual capital overview

• Insurance firms are required to assess what level
  and quality of capital they need to maintain
• Should be no significant risk that they are
  unable to pay liabilities as they fall due
• FSA reviews ICA, taking into account other
  information, forms view of the capital adequate
  for the firm's risk profile
• FSA gives individual capital guidance (ICG) -
  both quantitative and qualitative
• ICAs are being reviewed over 2 1/2 years 2005-2007

10
Individual Capital - Objectives

• Emphasis on better risk management - as
  management problems or governance are at the root
  of insurer failures
• Capital modelling should improve understanding of
  risk as the interactions and causal links have
  not been well understood
• Risk based capital more relevant to the way
  businesses are run
• Emphasise senior management responsibility
• Enhance consumer protection and market confidence
  by reducing the risk of financial failure

11
ICAS Approach - Modelling framework

• Firms must undertake an assessment of the
  adequacy of their capital resources
• consistent with the activities and
  responsibilities of the firm
• to quantify the risk of the firm not being able
  to meet all its financial obligations as they
  fall due and
• to demonstrate a level of solvency which can be
  compared to a 99.5 probability of failure over
  one year.
• The assessment must
• reflect the nature of the firm's assets,
  liabilities, management practice and systems and
  controls and
• use methods of valuation in a consistent fashion
  throughout the assessment.

12
Governance, Use test etc

• The ICA framework should be embedded in the
  firms business
• We ask three principal questions
• Is there senior management engagement, including
  the Board?
• How are the ICA principles and models being used
  for ongoing management purposes?
• How are ICA results used to influence risk
  management goals and prioritise activity?

13
A typical review process
Internal Planning
Submission Request
Initial Review
FSA Initial View
Discussion with Firm
Written Questions
Formal Notification
FSA Panel Process
Preview to Firm
14
ICAS What we have found

• Variety of approaches taken and ICA numbers vary
  across similar firms on same issues
• The quantification of operational risk remains a
  challenge for almost all firms
• Measurement of diversification benefit taking
  credit for spread of risks a common issue
• Major improvement in firms - and supervisors -
  understanding of the key drivers of risk and
  capital
• Risk measurement improvements feeding through to
  better risk management.

15
The Future - Solvency 2

• EU project to reform insurance prudential
  regulation based on the three pillar structure
• Aims to incentivise better risk management and
  integrate regulatory capital assessment with
  firms capital management processes
• Supervisory adjustment to capital requirements
  where justified
• Quantitative Impact study in progress an
  important checkpoint in the design of the new
  regime
• Framework Directive proposal due mid 2007
• Implementation 2010?

16
Summary

• Firms have responded well to new UK framework
• More emphasis on risk management and spreading
  good practice with ICAS than statutory approach
• Beneficial for both firms and FSA as both getting
  a better understanding of the business and the
  risks
• Keys challenges for future include improving risk
  and capital management and development of
  Solvency 2.