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9th November 2004
Speech by John Tiner

1. Good afternoon. As ever it is a real pleasure to be travelling north of the border, particularly when my reason for doing so is to address delegates at the close of this year's life convention. Sadly, I have only been able to travel up for today's session, but colleagues from the FSA have confirmed that once again the Profession has excelled in providing a forum for practitioners to convene for a lively and stimulating debate, on the many issues facing your profession. And what a splendid location.
   
   
2. To say that 2004 has been a challenging year for your profession – and indeed for the sector as a whole - would be an understatement of gross proportions. You will, I'm sure, be pleased to hear that I do not propose to pick over events of the past year. Although I am a firm believer of the maxim that those who do not understand the mistakes of the past are condemned to repeat them, today is not the day for post mortems. I prefer instead to focus my remarks on the future.
   
   
3. As a prelude to that, I would first like to register my sincere thanks for the considerable and sustained effort that has been expended by all parts of the industry and the profession in helping shape and deliver a modernised regulatory regime that is fit for purpose and reflects the realities of today's insurance world. In particular, I would like to acknowledge the number of impromptu working parties led by the Profession that made a significant contribution in the early stages of moulding and then refining the requirements of our new capital adequacy regime. Without question, the modernisation programme for the insurance sector has been all encompassing and, some might argue, all consuming. Having carried out a detailed critique of the regime we inherited, set out our ideological stall with proposed new policies, consulted extensively and then finalised the respective strands of the new regime, we are now on the brink of a new regulatory era as the new regime for the insurance industry begins to unfurl.
   
   
4. Taking account of the fact that I had been given the post lunch slot, when preparing my remarks for today I concluded that it would be unwise to spend my time with you cataloguing each and every reform and their respective milestones, followed by a detailed exegesis of the nuances of respondents' views to our many consultation papers. Instead, I decided a more prudent course of action would be to focus on two broad themes: future infrastructure and future influence. The two are, I think, closely linked with the changes in the former inevitably giving way to a shift in the latter. So, in exploring the new infrastructural arrangements, I will briefly sketch out the changes that will begin to bite at the close of this year and point to some of the issues arising from the ongoing Morris Review. Then, to help illustrate the shifting dynamic in terms of actuarial influence, I will then spend some time on a subject which I know at the moment can never be too far from your thoughts: ICAS.
   

   
   Actuarial regime

5. I remember very well addressing your Annual Life Convention in Birmingham in late 2002. I remember it for three reasons - First, my train was 1 ½ hours late arriving in Birmingham; second, in what I recall was a rather long speech - I set out our proposals and thinking in respect of the reform of the Appointed Actuaries Regime and thirdly, I recall being faced by not just a friendly audience, but one refreshingly open minded on our proposals. So now in looking at the structural questions faced by top actuaries it makes sense, two years on, to take as our starting point the appointed actuary regime. Having evolved over the last 20 years or so under the predecessor regulatory bodies, the role of appointed actuary was rather an unusual one, at least in the context of the FSA as a whole, in that specific regulatory responsibilities were conferred on the holder of the role as opposed to the firm itself. I would of course stress here that being unusual in the financial services industry does not of itself provide cause for regulatory alarm! But, in addition to being a regulatory curiosity, we felt that the appointed actuary regime displayed a number of flaws, including the potential for conflicts of interest and the exclusion of the valuation of policyholder liabilities from both sign off by the directors and the external auditors. In addition to these, the onus of regulatory responsibilities that the regime placed on the appointed actuary revealed an awkward and, quite frankly, untenable dissonance with one of our core principles: that of senior management responsibility.
   
   
6. So we proposed the dissolution of the appointed actuary regime, replacing it with two new advisory functions: the actuarial function and the with-profits actuary function. In essence, the holder of the actuarial function will calculate, monitor and advise on policyholder liabilities as well as advising on how much capital a firm needs to support its business. To complement this, the with-profits actuary will be primarily responsible for advising the governing body on its use of discretion as this relates to the fair treatment of with-profits policyholders. Practitioners assuming this role will be required to report to the governing body at least annually on the use of discretion and also, importantly, to produce an annual report, available to policyholders, on whether the firms has taken policyholder interests into account when exercising this discretion. As you know, the same individual will be able to perform both functions, but individuals will be prohibited from performing the new functions and being chairman or chief executive, or indeed any other role within the firm which could lead to a significant conflict of interest. In addition, in keeping with the responsibilities of that role in respect to policyholders' interests, the with-profits actuary is prohibited from being a member of the board.
   
   
7. In addition to the actuarial function and the with-profits actuary, auditors (who of course will now have to cover the full balance sheet in their audit work) will be required to seek actuarial advice from a third new role - the reviewing actuary - who must be independent from the firm. In effect, this means that the valuation of liabilities will be subject to independent actuarial peer review as well as professional challenge from the auditors. The reviewing actuary will also be required to give advice on the realistic liabilities.
   
   
8. Clearly, these changes radically overhaul what had become an increasingly antiquated regime. I think it is fair to say that they reflect the reality that the opacity of the actuary's 'black box' has had it day– though I should recognise of course that the issue of eroded trust is true of professions beyond that of just actuaries. One need only look towards the operating environment of professionals in the fields of accountancy, medicine, law - and even education and the clergy - to see that trust has become a rarified commodity. Once on the wane, trust is extremely difficult to rebuild. Rebuilding is achievable, though only once firm foundations have been laid. But I for one am confident that the key tenets of the new actuarial regime - clarity of responsibilities and accountability; greater transparency; and enhanced disclosure – will help provide that robust starting point. I think it is important to be clear here that the new regime will not ultimately herald the demise of discretion. Indeed, this is equally applicable for another component of the reform package: PPFM. What we are talking about here are acceptable degrees of discretion flanked by clear disclosure; in sum, moving to a world in which the disclosure of discretion has usurped discretionary disclosure.
   

   
   Morris Review

9. As I said at the outset, following what has often felt like an elephantine gestation period, we are now on the brink of implementation. While there is still some tweaking being done at the margins with regards to the new functions, including for example the addressee of the with-profits actuary's report, I am confident that the reforms to the actuarial regime will address the shortfalls of the previous arrangements and provide a regulatory framework that is fit and proper for the modern operating climate. However, following Lord Penrose's report into Equitable Life, as you all know the then Financial Secretary to the Treasury tasked Sir Derek Morris with a review into the actuarial profession, with a particular focus on considering how best to modernise the profession and see that high standards are delivered in a more open, challenging and accountable professional culture. I would stress here that although we feel these seams have been extensively mined in the process of developing our own reforms for with-profits business, should Sir Derek suggest some additional reforms that will enhance the effectiveness of our new regime, then we will of course approach these with an open mind.
   
   
10. The Morris Review is, I believe, due to publish an interim assessment in the next month or so, and as such it would be improper of me to comment extensively on this subject. That said, I would like to pause just briefly to share a few observations on issues that strike me as particularly pertinent: the reserving of certain roles to actuaries; standard setting; and peer review.
    
    
11. I have talked already about the reforms that we have made to the appointed actuary arrangements and the new roles for an actuarial function and with-profits actuary. In the context of some broader thinking about the role of the actuary in modern financial services, Sir Derek's review has rightly raised the question of whether these roles should still be reserved to members of the Profession – as they will be under our new requirements. I have to say that we are open-minded about this issue. In principle, it is not formal qualifications that matter so much as the availability of expert staff with skills and experience relevant to the task. We can, for example, see benefits in individuals with capital markets expertise being brought into the insurance world. And there is much greater experience in that world of running complex financial models and the risk management methodologies associated with them. But we also recognise that here and now it is qualified actuaries who combine the knowledge of insurance products and markets with the quantitative skills. We will watch and learn from the debate which Sir Derek has kicked off.
    
    
12. To my mind, any move to enhance actuarial standards is to be applauded. So long as there is the distinct possibility that advice given by Actuary A could differ substantially from advice on the same set of conditions given by Actuary B, the question of restoring trust remains an issue. Again, I want to emphasise that this need not herald the death of discretion; the objective of improving standards is to be clear about the parameters within which professional discretion can be exercised – and where necessary narrowing these parameters. Encouraging progress in that direction has, in our view, already been made through the work the Profession has been doing on updating the Guidance Notes to reflect the new capital adequacy standards. We also welcome the Profession's proposal to establish an Actuarial Standards Board, although here too, Sir Derek and his team have started an important debate about the best way for standards to be set in the future and the governance arrangements surrounding such a Board. On this latter point we would hope that the membership of the Board would include non-actuaries and users of actuarial reports. Perhaps just as the FSA has a seat on the accounting Professions’ Finance Reporting Council, it may be appropriate for the FSA to be a member of an Actuarial Standards Board. Again, we are adopting something of a watching brief here. To be clear, while welcoming ideas for improving the standard setting process, I should add that we are not bidding for an enhanced monitoring role ourselves.
    
    
13. The third issue on Sir Derek’s review I want to turn to briefly is that of peer review. Now, I suspect that I may well be swimming against the tide of delegate opinion today on this particular topic, but we have always been clear on our position that the peer review work which we have identified as necessary should be carried out by the new reviewing actuary who will have a clear line of accountability to the auditor. Of course, should firms choose to put in place wider peer review arrangements then this is a decision for the senior management of individual firms themselves and not something we would object to per se. But all things considered – including for example the costs to firms, especially smaller firms and our new guidance on strengthening governance arrangements for with-profits business – we feel that regulatory prescription for peer review over and above that provided for in the new arrangements would be overkill and would not pass a cost/benefit test.
    

    
    ICAS

14. Having spent a good portion of my time on changes to the infrastructure, and the consequent impact that will have on the influence that members of the Profession enjoy, I would now like to move on to focus on one particular area where this re-defined influence will be felt most keenly felt in practice: ICAS. But before exploring the role of actuaries in the new ICAS world, it is worth spending a few moments reminding ourselves of the mechanics that underpin this framework.
    
    
15. When I last addressed the Profession back in February 2003 – happily, again in Edinburgh - we had just started to point up the increased emphasis that we place on a life insurer’s realistic financial position. At the end of next month – just 22 months later - the introduction of the Integrated Prudential Sourcebook will enshrine that emphasis in our rules. Policy development and implementation have been swift and effective – this has only been possible due to the collaborative approach adopted by the industry, the profession, the trade associations and ourselves.
    
    
16. Despite this significant collective achievement, it is fair to say that to some extent the Pillar I twin peaks approach only covers part of the life industry, i.e. with profits. We are now extending our risk-based approach to capital across all life firms subject to the EU Directives, with the introduction of the Individual Capital Assessment regime on 1 January 2005.
    
    
17. The thinking underpinning the ICAS regime is that even after the introduction of the Integrated Prudential Sourcebook, the Pillar I capital requirement is still only the starting point: a broadbrush tool that is unlikely to address all aspects of an important, but individual life insurer’s business and the specific risks that it faces. This is why the Pillar II requirement we have introduced with the concept of ICA which takes account of the idiosyncratic nature of firms' business models, is such an essential part of the overall architecture. As such the introduction of the new framework has four main objectives:

• first, that each firm holds capital that is appropriate to its business and to the quality of the controls it applies in its risk management;

• second, to emphasise the responsibility of a firm's senior management for ensuring that the firm has adequate financial resources (and to be clear, by senior management we do of course include the Board);

• third, to provide incentives for better risk management and consequently disincentives for poor risk management; and lastly

• fourth; to enhance consumer protection and market confidence through a reduced, but not a zero, risk of failure.

18. ICAs will be reviewed over the next two and a half year period starting with those firms that are highest impact, or where the business or risk profile warrants early attention – or simply where we are doing a risk assessment of the firm, a process that puts us in the best position to assess the ICA in the context of our understanding of the risks to which the firm is exposed. Wherever possible, we will aim to conduct this review at the same time as the firm’s Arrow assessment.
    
    
19. Having reviewed a firm's own assessment, we will then issue individual capital guidance, or ICG, reflecting our own view of what the minimum level and quality of capital would be for that firm. As we have said previously, ICG represents the regulatory intervention point. And as such, we fully recognise the importance of applying our approach in a way that delivers consistency of treatment across the industry as far as possible.
    
    
20. ICG will be set taking into consideration capital consistent with a 99.5% confidence level over a one year period or, if appropriate to the firm’s business, a lower confidence level over a longer period, and as such firms should prepare their ICAs on the same basis. But regardless of the period adopted, firms should ensure that their projected assets are sufficient to meet their projected liabilities to be paid as they fall due throughout the duration. Whilst the concept of a 99.5% confidence level over one year may be a relatively easy concept for certain risks where historic data are readily available such as equity market risk, we appreciate that it is more difficult and subjective for others, such as mortality risk for annuity business.
    
    
21. Being a realist, I recognise that there is not always a perfect alignment of interests between FSA and firms: firms are focused on achieving financial success whereas our primary driver is in reducing the risk of financial failure - recognising of course that ours is not a zero failure regime. So whilst firms will want to understand the opportunity costs of certain downside events, our interest is limited to the impact of those events on a firm’s capital base.
    
    
22. However, it is important that where future outcomes are uncertain firms understand the risks being taken on and hence how sensitive the future financial condition of the firm is to those risks. Assigning probabilities to outcomes may be a difficult exercise but from the discussions we have had to date with firms, they have found some of the results from the modelling of risks informative and helpful to their understanding – and management – of the risks that they are running.
    
    
23. ICAS is about focusing on the downside risk and on the tails of distributions. This will often involve working with distributions derived from few, if any, data points, and inevitably judgement calls abound. This is not uncharted territory for members of the Profession.
    
    
24. Preparation of a firm's ICA requires a coordinated multi-disciplinary approach– actuaries working both with the risk management area and business unit managers to understand more fully the risks the firm is exposed to and the quality of controls a firm has in place to mitigate those risks. And as such, while actuaries should be integral to a firm's ICAS project team, the ICA should not be seen by the senior management of firms as just another “job for the actuaries”. The integration of actuarial influence into a much broader team needs to become the norm. For ICAS to work effectively – and successfully – it is essential that a mix of skill sets are involved, with individuals pooling their knowledge of the firm. Similarly, risks can emerge from right across the business and it is neither right nor fair to expect the actuaries to be expert in all of those fields.
    
    
25. Where you really do come into your own, is in ensuring that the models underlying the ICA calculations are developed and implemented in a controlled, documented environment. For our part, understanding the quality of the modelling environment is essential to us as this will directly impact on the credibility we can ascribe to firms’ ICA calculations. That is not to say that we expect all firms to have developed new models for their ICA calculations as our rules require that the processes and systems required to carry out assessments should be proportionate to the nature, scale and complexity of the firm’s business.
    
    
26. Before moving on to cover some of the more thorny issues that have emerged along the pathway to making the new regime a reality, at risk of being repetitive, I would like to stress again that we view a firm's governance procedures as critical – the Board should not just be involved in sign-off of the ICA. Let me repeat that: the Board should not just be involved in sign-off of the ICA. Ultimately, senior management are responsible for the whole process, and so the Board should be involved at all stages of development as they need to have sufficient understanding of the methodology adopted in order to be confident to provide that sign-off. It is here that actuaries have an additional role to play – that of pedagogue in educating the Board and senior management to a level where they are able to have justifiable confidence in the process and its results.
    
    
27. So what are some of the issues that have emerged in our work with firms on the ICAS framework?
    
    
28. First, consistency with our ICG standard. We appreciate that even firms that derive their ICA using gross risks with a 99.5% confidence level over one year will find it difficult to fully justify all their assumptions. Naturally then, firms that have taken a different approach - for example run-off, or immediate stress to their balance sheet - will find it even more difficult to prove consistency with our standard. While we will adopt a pragmatic stance with regards the question of how firms have arrived at their ICA, we will still expect a firm's senior management to justify the approach taken.
    
    
29. Second, capital for what? In other words, on what basis are we expecting firms to assess liabilities in a year's time? As stated in PS 04/16, a firm should make its assessment of adequate financial resources on realistic valuation bases for assets and liabilities taking into account the actual amounts and timing of cash flows under realistic projections. In other words, after the adverse scenario the cash that is available from premium income, realised assets, etc should be sufficient to meet payments, bearing in mind TCF requirements, as they fall due to policyholders on a "best estimate" basis.
    
    
30. Third, appropriateness of capital. Firms may include subordinated debt (tier 2 capital as it is now called) as part of their capital resources in their ICA. This of course protects policyholders in the event of the firm being wound up insolvently and when we say "firms should ensure that they have sufficient capital to ensure that there is no significant risk that they cannot pay their liabilities as they fall due", it is liabilities to policyholders that we are mainly concerned with. However, 'liabilities' to repay subordinated debt and to service the interest is also obligation which firms should factor into their assessments and we would expect firms to plan for how such obligations or expectations will be met as part of their capital assessment. There are therefore practical floors to the quality of capital which it would be appropriate for firms to include in their ICA.
    
    
31. Fourth, group diversification. We will give ICG both in respect of the solo capital for individual entities within a group and in respect of the total capital within the group. Firms may argue that in addition to diversification benefits between risks within a single firm there are benefits arising from diversification between different firms within a group. We recognise that this may technically be the case for some risks but need to see evidence that such benefits arise in practice (and beyond the allowance made in the calibration of our minimum requirements) before giving credit for it. Where we do give credit, it is likely to be by reducing the group ICG rather than the solo ICG as this is in line with our aim to get the right capital in the right place and group diversification should be reflected at group level. One of our principal concerns centres on the mobility and availability of capital between sectors in stressed scenarios (for example between life and general insurance or between insurance and banking). We have concluded that firms are unlikely to satisfy us that there should be any allowance for diversification between sectors, and only within the life sector if the firm can satisfactorily demonstrate the mobility and availability of capital.
    
    
32. Fifth, pension Scheme deficits. For Pillar I we are consulting on a pragmatic approach based on excess contributions the employer expects to make in the next 5 years rather than the deficit within the scheme calculated on any particular basis. Pillar II is far more in firms' own hands and demands a realistic look at the costs and possible actions firms and trustees could take, in times of stress. But again the focus should be on the expected excess contributions that can be foreseen in present and stressed circumstances. So this does not necessarily mean that a deficit calculated, say, under FRS 17 assumptions should be directly brought into a firm's ICA; rather, that the firm should explore the commercial tensions between trustees' and pension regulators' needs to protect members of the scheme and the viability of the firm on whose continued business future funding of the scheme largely depends. I am aware, through correspondence with the ABI, that there is a concern that we are pushing through reforms on pension deficits for insurers ahead of other regulated firms, such as banks. The changes to pillar 1 requirements on which we are currently consulting apply equally to banks and insurers and take effect at the same time. It is debateable whether the pillar 2 regime for banks is ahead or behind insurers – banks have for many years had individual capital ratios set by us above the minimum requirements, and in theory these can allow for pension scheme risks. In practice, it is probably true that insurers' pillar 2 regime has leap-frogged that of banks in terms of its sophistication – for which the industry is to be commended – and it may not be until 2007 that the banks catch up. We will be consulting further on the banking regime in 2006.
    
    
33. Sixth, management actions. In assessing capital requirements in times of stress, firms can quite reasonably take account of management actions. It is, however, up to the firm to prove that the management actions assumed in times of stress have been considered from a legal viewpoint and are consistent with the PPFM, our forthcoming proposals on treating with-profits policyholders fairly and the broader obligation to treat customers fairly– and of course are only relied upon once!
    
    
34. And lastly seventh, new business. Again our approach is conditioned by pragmatism. What we do want to avoid is a scenario in which the strategy a firm has adopted means that it is unable to meet its own ICA requirements in a few months time without having to raise capital. In many cases, the inclusion of one year’s new business in the firm's submission will usually suffice (although only where it increases the ICA). Where new business is capital hungry and significant, firms need to bear in mind where the ICA is heading, and one way of allowing for this could be a plausible stress in increased new business volumes.
    
    
35. The framework is clearly still in its infancy, but in addition to it being a regulatory reporting tool, we expect, and indeed are pleased to see early evidence, that firms are using ICAS (or some variant of it) as part of their ongoing risk and capital management – both economic and regulatory.
    
    
36. Implementing the ICAS regime will be a (long) journey both for the industry and the FSA. In some areas, we are all still “feeling our way” and good practice will develop over time. And as such, it would be wholly unrealistic to expect firms' assessments to be perfect on 1 January 2005. An enormous amount of work has already been done, but we appreciate that most firms expect to develop and refine their models and assessments further in 2005 and beyond.
    
    
37. Before closing, it would be remiss of me not to at least nod to the other significant regulatory development that actuaries have been immersed in over the last few years: realistic reporting.
    
    
38. As you know, for some time now every six months we have been collating private submissions of realistic data from the largest with-profits firms to help smooth the full roll-out of realistic reporting. The latest set of submissions – as of 30 June- give a fairly clear indication that firms should be capable of producing realistic balance sheets to the required standard by the time the new rules come into force. The quality of submissions has continued to steadily improve as firms upgrade their systems and models to take account of recommendations from both ourselves and reviewing consultants. Nearly all have upgraded their valuation methods and are now using a stochastic approach. Now, while I clearly cannot get into specifics, I can tell you that the aggregate realistic surplus, excluding the RCM, was £23bn – broadly similar to that of December 2003. The more significant change has been in the reduction of the RCM from £17bn to £12bn, and I can also inform you that on the basis of these submissions, no firm is currently in breach of the capital requirements.
    
    
39. Given the accelerated timetable for realistic reporting, and taking account of the range of other significant issues with which the industry has had to grapple, this achievement should not be underplayed. In just two years, the key elements of financial reporting for with-profits have been successfully transformed, moving away from the current statutory regime with its inherent and well-known deficiencies towards to the more coherent – and almost universally well regarded – realistic approach.
    

    
    Conclusion

40. The modernisation programme has an extremely broad wingspan, requiring actuarial engagement at pretty much every point. You will forgive me, I’m sure, for restricting my remarks to a handful of areas so as to allow time for greater exploration.
    
    
41. 2004 has been an extremely busy period for the life industry and actuaries working in the life industry in particular. My view is that the introduction of the Integrated Prudential Sourcebook and ICA framework has given actuaries the reasons they needed to be able to spend time and buy resources to gain a deeper understanding of the risks involved in the firm’s business. The difficult part may be communicating clearly some of these complex results and associated methodologies to the Board. The prize however, is great, both for the well being of the firm and as an aside the level of debate and discussion with the FSA.
    
    
42. I am pleased to say that the FSA has long enjoyed a strong working relationship with the Profession, and I am delighted that this trend looks set to continue under your new president. We may not always see eye to eye on every issue, but all joking aside, I do believe that robust exchange and challenge are often characteristics of the most valuable relationships. I would like to close by coming full circle and reiterating my thanks for the tremendous effort that you have put in to meet the challenges of wholesale regulatory reform and to help make the reforms a reality. The Profession has proved itself to be real agents of change and I hope that going forward, you will continue to remain at the forefront of surfacing better practice as the new regime beds in and a steady state begins to emerge.
    However, it is important to recognise that regulation is only one component of the life insurance market, although you would be forgiven for thinking over the past two years, there was nothing else. You have businesses to run, customers to serve, people to motivate, systems and products to develop, competitors to fight and, ultimately, owners to satisfy. Successful modern businesses thrive on change and the UK life insurance industry is in the thick of change - - depolarisation to liberalise markets, introduction of the new basic advice regime, an increasing awareness by people of the need to provide for the longer term - - to mention a few. Our regulatory reforms will I believe contribute to a more trusted industry with new tools of financial economics and so will help businesses who treat their customers fairly to thrive and prosper and win in the marketplace.
    
    
43. I'd be delighted to take any questions.