Capital adequacy - is it the future of insurance regulation?
Implementing Risk-based Integrated Prudential Regulation
David Strachan
Financial Services Authority
1 December 2003
1. I am very pleased to be here this morning, to launch what will no doubt prove to be a fascinating foray into the most recent developments in prudential regulation for insurance firms. I suppose that it’s a bit late to avoid accusations of misrepresentation being slung at me, so I’d like to come clean at the outset and tell you that I’ve decided to exercise my keynote speaker rights and tweak the title of my remarks to you this morning.
2. My rephrased title for today, Capital adequacy – is it the future of insurance regulation? - does not, you’ll be relieved to hear, denote a regulator in a state of confused perplexity, or indeed one having a crisis of faith in the wisdom of our most recent prudential proposals. Quite the contrary. It alludes instead to the fact that if we are talking about the future of insurance regulation, capital adequacy – or to be more accurate, prudential regulation as a broader discipline - is not the whole picture. Indeed, it is only part of the whole picture, and as such should not be discussed in isolation.
3. As an organisation, the FSA has pushed through a massive programme of reform for the regulation of financial services as a whole. For insurance in particular the regulatory landscape has undergone a major change: to such a degree that some would argue it is now barely recognisable from that which we inherited in 1999. Through our package of reforms, brigaded under the Tiner project, very little in our approach to insurance regulation has escaped scrutiny and/or review. And as such, we are making great strides in the modernisation of both prudential and conduct of business requirements.
4. Hardly surprisingly then, we view these two regulatory disciplines as interdependent – and believe that a regime where one suffers at the expense of the other is a regime that is fraught with difficulty. Similarly, we expect firms’ senior management to espouse this view too.
5. Some of you will have come along this morning expecting to focus entirely on the new prudential requirements – and from the programme that the conference organisers have lined up, I am confident that that desire will be sated. That is all well and good. But the future of regulation cannot and will not reside only in prudential regulation. If the future of the insurance industry is to be the robust one that we intend it to be, then it is important that together, we get the ground work right now. This is why we embarked upon such an intensive programme of reform. We recognise the tremendous effort that this has required on your behalf in terms of listening, analysing and, in many cases, offering us your well-considered views. And, as a result, that period of consultation is coming to a close and we are now well into the next challenging phase – that of implementation and delivery. Our objective of developing and then embedding sound and sensible regulatory requirements for both prudential and conduct of business will provide the secure foundation on which to construct a stable future for the industry - one that will serve both firms’ and consumers’ interests alike.
6. This morning then I am going to spend time on each – looking in particular at one aspect of our new proposals for prudential regulation and one aspect of our approach to conduct of business requirements. So as well as updating you on our proposals for capital adequacy, and giving you a flavour of the types of responses that we have received in response to consultations 190 and 195, I am also going to preview some of the more prominent aspects of our forthcoming CP, Treating Policyholders Fairly, which will be published later this week.
Prudential Reform
7. Respecting the basis on which the invitation to speak to you this morning was extended though, I will begin with our proposals on capital adequacy. The rationale for CPs 190 and 195 is well rehearsed, but I think it’s worth taking a few minutes to remind ourselves of the context.
8. Shortcomings of the current capital requirements for life insurers have led regulators in the UK and elsewhere to adapt the existing approach in different ways to deliver more prudent regulation. Here, we generally expect firms to hold a multiple of at least two times the EU requirements, and in some cases a higher multiple, depending on the nature of business written. Elsewhere in Europe, some regulators expect insurers to make more stringent provisions for claims. While this may help achieve a better prudential outcome, questions of transparency and international consistency inevitably arise. I am hopeful, though, that some of these disparities will be eased by the introduction of Solvency II.
9. Given that is still some way off, in the meantime we decided to introduce our own domestic proposals for capital requirements for life insurers. The proposals develop what we term the “twin peaks” approach. This requires life firms to make a realistic assessment of their with-profits liabilities to determine whether they need additional capital on top of mathematical reserves to cover expected discretionary bonus payments.
10. Although we have only just reached the end of the consultation phase, we have actually been collecting data from firms on a “realistic” basis for well over a year. In fact the third set of data from firms – as at June 2003 – and which we have just finished analysing, covered 98% of the total UK with-profits business and showed that the quality of reporting had improved markedly from previous rounds.
11. Our analysis shows that the financial health of the sector has stabilised with the aggregate financial strength of with-profits funds remaining largely unchanged. Undeniably, the deterministic approach to valuing guarantees that had been used by many firms had significant drawbacks. And the recent shift towards adopting market consistent stochastic modelling by the majority of firms is to be applauded, and should result in more accurate and appropriate reporting of firms’ liabilities. The progress that is being made now will also help ensure a smooth transition when the Integrated Prudential Sourcebook is switched on for insurers in 2004.
12. The drawbacks of the existing approach for life insurers find their mirror image in the current requirements for general insurers. Our new approach, as you might expect, is again more risk sensitive. CP 190 proposes that firms hold capital at least equivalent to the higher of the Minimum Capital Requirement (MCR), which is dictated by Solvency I, and the Enhanced Capital Requirement (ECR). For some, these new requirements will have only a modest effect because the firm already holds capital in excess of the proposed requirements. For others it could require them to respond by either raising new capital or by reducing the risks they face or underwrite.
13. So, to recap, the new approach to capital adequacy for both life and general insurance firms produces a minimum level of capital that we expect firms to hold. However, the amount of capital required to match an individual firm’s circumstances and business mix could be higher – or less frequently, lower – than this generic minimum requirement. To deal with this spectrum of idiosyncrasies, we have also proposed a framework of Individual Capital Adequacy Standards for both life and general insurers. Central to this bespoke approach is the role of senior management in ensuring that their firm holds financial resources that appropriately match its particular business mix and plans and take account of its risk profile and control structure. It is critical that firms’ senior management take responsibility for this assessment of the amount of capital they need to hold. And we aim to road test our approach to ICAS for general insurers in spring 2004 with a handful of firms on a voluntary basis. We will start to apply the full methodology from the second quarter of 2004.
Feedback on CP 190 and 195
14. Although, we are still in the midst of wading through the responses that have flooded in, I thought it would be useful to give you my initial take on some of the views and issues raised.
15. The consultation period on CP195 closed last week. As is typical, many responses have come in at the last minute. It is also worth saying that we have not yet received responses from all the bodies that we might expect, and I would encourage any stragglers to send their response in soon. Given that we now need to spend some time analysing these, my comments are largely based on the useful and progressive discussions we have had with members of the actuarial profession, the auditing profession and the ABI throughout the consultation period, as well as some early drafts of written responses.
16. I think I can say though that, almost without exception, proposals for a realistic assessment of with-profits business have been positively received. The results are considered to be both more risk responsive, and more transparent. As you might expect for a CP of this nature, there are also a number of detailed and technical issues on which respondents have commented. You will be relieved to hear though that I do not intend to catalogue these today - but a few general observations may prove interesting.
17. First, it would seem that some have been so struck by the bright new light of realistic reporting that they have undergone something of a Damascene conversion, wishing to extend realistic reporting to all life business and scrapping mathematical reserving requirements entirely. It is certainly encouraging to note such unbridled enthusiasm for realistic reporting, including amongst the actuarial profession. But there are two factors which underpin our belief that pared back mathematical reserving requirements for with-profits and non-profit business must continue for the time being.
18. First, the EU Life Directive, which specifically requires mathematical reserves to cover guaranteed benefits, including guaranteed bonuses. And second, a desire for a period of 'parallel running' of the old and the new systems, while the performance of the new system is tested in practice, and firms have time to gain more experience of it. While both the firms involved and the FSA have made great strides in understanding the significance of realistic reporting, this is still, to some extent “work in progress”. Hence some period of parallel reporting would be important, even without the directive constraints.
19. The second comment I want to make is that we agree with some respondents that our requirements need clarification in certain areas. And in the coming period we will work to deliver this, including refining our Handbook text on the treatment of reversionary bonuses and subordinated debt.
20. Third, we are also in agreement that there are other areas where more could be done to advance our thinking and spread good practice, and that other stakeholders could play a useful role here. We are encouraged by the willingness of the actuarial profession to drive forward some of this work, and, in particular, welcome the work and planned consultation on an actuarial guidance note on the calibration of market consistent models.
21. Fourth, some respondents raised concerns about the challenging timetable of bringing their with-profits realistic reporting up to audit standard for 2004. I certainly agree that this is a challenge, but one that we think that firms should be able to meet, with the appropriate planning and preparation. We have already had some helpful preliminary discussions with the audit profession, and we expect these to continue over next year.
22. Turning to CP 190, I am encouraged to see that again most respondents think we are heading in the right direction and that there is a common appreciation that a risk sensitive approach to capital is the most sensible way to develop financial regulation.
23. There is virtually unanimous support for our Individual Capital Assessments approach, which is perhaps unsurprising given that this will allow firms the opportunity to make their case for their own, particular treatment. Although some firms have expressed concern about the speed with which we are proposing to introduce the requirements for firms to make their own assessment of capital adequacy and conduct appropriate stress and scenario tests to support their conclusions, good progress is already being made by many firms. Indeed, we will be starting to review capital adequacy on this basis in the first half of next year. But we will of course take into account any practical problems that firms may experience when introducing new systems and controls for risk management. This is a good illustration of how we are moving to a more proactive supervisory approach and extends what supervisors should already be doing in their efforts to get beneath the skin of how firms manage their capital.
24. On the ECR - we acknowledge that it is a simple formula which will not fit all business profiles. Responses to this proposal have focused on three main points: First, whether the formula is calibrated too high and the potential for super-equivalence to EU directive requirements. Second, whether the formula should be more complicated to reflect more precisely the theoretical benefits of diversification between classes of business underwritten and the lower volatility experienced in larger accounts. And third, whether the ECR should be introduced as a prudential requirement at all (ahead of Solvency II) or merely used as a benchmark against which firms own assessments can be compared and reconciled.
25. On diversification, we think the case would have been stronger had the industry provided us with empirical evidence to illustrate the benefits of diversification in stressed conditions. We remain to be convinced on a case by case basis that benefits over and above those already allowed for - which are considerable - in the ECR formula exist.
26. Finally, on the timing of introducing the ECR as a prudential requirement, we are not likely to decide this until towards the end of 2004, after we have published final integrated sourcebook rules for insurers. So, initially the ECR will represent a benchmark for the time being. The absence of any quantitative responses from firms to the consultation means that the best way of assessing whether it is useful as a minimum capital requirement is to use it in our planned reviews of individual capital assessments for both large and small firms during 2004.
27. In terms of concerns raised over why we are pushing ahead with our proposals ahead of the Brussels timetable and the perceived resultant disadvantage that UK firms would experience, our view is clear. First, while our proposals do indeed pre-empt Solvency II and the reinsurance directive, we consider it paramount that we start implementing them now, rather than await the conclusion of international discussions, which could take some considerable time. Second, to some extent the ECR does no more than formalise informal requirements – both in the UK and other EU member states – which are designed to overcome the low level and lack of risk sensitivity of the current minimum capital requirement. Third, our proposed changes are also consistent with the IMF’s modernisation recommendations made earlier in the year in its UK Financial System Stability Assessment.
28. As with all our consultations, we are genuinely interested to know what you think. Our proposals are just that, proposals. It goes without saying then, that it is important that we get this right and if strong arguments are put to us, then we will listen carefully and may modify our approach accordingly.
29. The remarks I have made just now should give you a flavour of the responses we have received. We now need to go away and give full consideration to the issues and questions that you have raised. Once we have done this, we will prepare our responses, with the aim of publishing a combined policy statement that will include feedback and near final rules for both CPs by summer 2004.
30. Our new capital adequacy proposals are a critical element of the foundations we are now laying to modernise insurance regulation. They will provide a more appropriate and sensitive calculation of regulatory capital requirements and will lead to greater transparency, earlier regulatory intervention where it is required and perhaps most importantly, a closer alignment of capital to the risks of the business.
Treating Policyholders Fairly CP
31. Given that the consultation periods for our new capital adequacy proposals have just closed, and given that the ink on your responses will only just be dry, it’s probably fair to assume that the ground I have just covered is still fairly fresh in your minds. What will be less familiar to you - though I hope in due course will become equally well-trod territory - is our forthcoming CP on Treating with-profits Policyholders Fairly, which we are publishing later this week.
32. I need not tell you of the considerable criticisms that with-profits products have been subject to in recent years. Neither do I need to remind you of the consequent impact on consumer and market confidence leading to diminishing sales of the products themselves. Our aim is to improve the quality of with-profits products, preserving some of their advantages whilst eliminating some of their defects. They should also give rise to an increase in quality and efficiency of competition.
33. The CP essentially builds on what is already implicit in the existing regime – a codification, if you will, of the principles that have traditionally underpinned good practice in the with-profits sector. Our proposed rules in this area amplify some of our Principles for Businesses and so are more a reminder rather than new instruction. As ever, key to our proposals is the emphasis that we place on the role and unequivocal responsibility of firms’ senior management. That responsibility is very much reflected in the way that we have drawn up this approach.
34. The CP has three main sections: rules and guidance on treating with-profits policyholders fairly; our proposals on the consumer-friendly delivery of PPFMs; and proposed improvements in the process for reattribution of inherited estates.
35. I would like to cover, briefly, some of the main areas of our key proposals under the three headings. First, our proposed rules and guidance on treating with-profits policyholders fairly.
36. Those of you familiar with our Handbook will associate “treating customers fairly” with Principle 6 of our 11 Principles for Businesses. Some might go on to assume that treating policyholders fairly might therefore be mainly about conduct of business requirements for life insurers. That would not be a safe assumption in this case, since many of the aspects of this forthcoming CP will cover the approaches to smoothing, payouts and surrender values, as well as aspects of disclosure. It is therefore very much about the totality of regulation – bringing together the complementary frameworks for prudential and conduct of business.
37. Brigaded under this first part of the CP are several important with-profits issues. In practice, the most frequently voiced concerns about the way with-profits policyholders are treated centre on how payouts are determined. We believe more openness and consistency on the how payouts on maturity and surrender are calculated will bring indisputable benefits to both consumers and the industry. So we are proposing that firms set target payout ranges related to asset shares. These will be specified in PPFM and will minimise the risk that firms might underpay – or indeed overpay – in the shorter or longer term. That is not to say though, that we do not recognise that payouts may be affected and may fall as a result of other factors.
38. Our aim is that firms should manage their with-profits business in a way that is consistent with a genuine attempt to achieve these targets. The effectiveness of these proposals though, in terms of protecting policyholders’ interests, will depend on whether and how firms calculate asset share. We are proposing a slightly modified version of the retrospective method - which you will recall was one aspect that we consulted on in CP 195. We recognise, however, the significant costs for firms that do not currently use modern asset share techniques, including some of the largest firms. But we want to hear your views on whether our proposals for smaller firms being allowed to use alternative methods of asset share calculation are appropriate.
39. One issue which I’m sure we’d all be much happier not having to read about over the breakfast table, is that of surrender values. The use of Market Value Reductions and other techniques, has as we all know, been widespread in recent years to ensure that departing policyholders do not leave with more than their fair share of the fund.
40. We fully recognise the need to achieve an equilibrium of interests between departing and remaining policyholders. We are proposing that, as with maturity values, surrender values be based on smoothed asset share. From that base value, firms would only be allowed to make deductions for specific costs, including unrecovered costs, disinvestment costs and costs incurred in administering the surrender itself. Closed funds would be able to make specific provision for other deductions in their run-off plans, where these are underpinned by fairness to policyholders. Further, we would like to consult on proposals that MVRs could only be applied in the event that they are actually needed to protect the interests of remaining policyholders, for example. if there has been a significant and relevant change in the market value of the with-profits fund or high volumes of surrenders have occurred, or are likely to occur. Any deduction in value must be no more than is necessary to reflect the impact of these factors.
41. Another area I would like to touch on this morning is that of distribution. I said earlier that our proposals are designed to minimise the risk that firms might underpay policyholders over time (as well as the risk that they might overpay). Essentially this is an issue of fairness for current policyholders and can lead to build up of excess inherited estates. So we think that, when taking decisions on distribution of surplus, a firm's governing body should consider whether the surplus in a fund exceeds what is necessary to support its current and future business. If it concludes that it does, we think fairness to policyholders points towards distribution. On this point, I do want to stress though that we are not suggesting that firms must distribute surplus to the detriment of the fund's financial strength. This would be quite contrary to the objectives we are pursuing in CP195. So it is paramount that we strike the right balance, and the consultation process will help us do just that.
42. The CP also has some important things to say about closed funds. Whilst closure of a fund may not necessarily be against policyholders’ interests, we feel that some firms could do a lot more to keep their policyholders informed. We are therefore proposing that, when a firm closes its with-profits fund to new business, it must let its policyholders know within 28 days. Firms should also provide policyholders with information about the reason for closure, the reasonably foreseeable implications and the options open to them. As for communicating with us, firms will be required to submit a run-off plan, demonstrating how they will ensure a full and fair distribution of its closed with-profits fund, including any relevant inherited estate.
43. The second main section of the CP that I’d like to mention this morning is our proposals for the consumer-friendly delivery of PPFM. Most of you should by now be fairly well acquainted with our original set of proposals on PPFMs – otherwise fondly known as firms’ Principles and Practices of Financial Management. PPFM will become a prominent feature of the regulatory and consumer landscape for with-profits funds, and we envisage that their introduction will make the discretion that exists in with-profits funds and the way in which this is exercised by the Board and senior management more transparent thus helping ensure that consumers are treated fairly. Firms will be required to make these publicly available from March 2004 and as noted in my recent letter to CEOs, PPFM preparations should already be well under way.
44. In CP 167 we developed our thinking in this area, which manifested itself in the form of consumer-friendly PPFMs. The forthcoming CP contains our feedback to responses that we received and sets out our proposals for their introduction. From November 2004 firms will be required to extract key parts of their PPFM and make them available to consumers on request, free of charge. Because of the importance of getting this right for consumers, during the consultation period, we will be working with firms to do some consumer testing of the first drafts of these documents to see if the consumer friendly PPFM does, in practice, deliver better understanding of with-profits products. This is something that we will be seeking assistance on from a sample of firms.
45. You will, no doubt, be pleased to hear, that our proposals are not all about adding further weight to our Handbook. It is our view that the introduction of PPFM and its consumer-friendly counterpart, will render with-profits guides largely redundant. We are therefore proposing to abolish this requirement and along with it, a whole section of our ever-burgeoning Handbook.
46. The third section of the CP that I’d like to bring your attention to covers our proposals for improving the process for reattribution of inherited estates. Although reattributions - where a firm proposes buying out rights policyholders have over the pool of unallocated money, known as the inherited estate – are relatively uncommon, our proposals in this area will help bolster our drive to ensure consumers get a fair deal.
47. So what next? Well, we plan to consult for four months and on the basis that the new rules and guidance on treating with-profits customers fairly should not come into effect until 31 March 2005, in other words, a full year after firms are first required to publish their PPFMs – though firms they will be required to make their consumer friendly PPFMs available by November 2004.
48. The array of proposals on Treating Policyholders Fairly that I have laid before you this morning are critical to the foundation for the future as are the provisions set out in CPs 190 and 195. Indeed, these new conduct of business proposals ensure that the foundations are set that bit deeper than before. This, of course, makes it important that we integrate, as we are proposing to do, the detail of our conduct of business regulation with that of our prudential regime. The former sets out the minimum requirements as to how with-profits business is to be managed while the latter seeks to quantify the capital that is needed to support business which, or course, depends critically on how it is to be managed.
Conclusion
49. I’ve talked extensively this morning about how, with a solid foundation in place, the insurance industry can serve its customers well. The challenges ahead are significant, but, in my view, are certainly surmountable if we tackle them together to provide “responsible reform”. This morning I have stressed the importance of looking at the whole picture in terms of both prudential and conduct of business regulation. But, in closing, it is important to remind ourselves of the other necessary component to complete the picture: the consumer.
50. As regulator, we have ultimate responsibility for ensuring that the foundation we lay are set deep enough and are strong enough to support the overarching structure on top. As firms, your senior management have responsibility for compliance with our requirements – both in terms of financial soundness and how you treat your customers. The third aspect of this tri-partite relationship concerns the responsibility of the consumer.
51. The consumer’s right to protection from unfair practices and treatment is unquestionable and sacrosanct. But the sustainability of the relationship between firms and their consumers – and arguably the future success of the industry itself – is strengthened by consumers taking responsibility for their own actions. This will not happen overnight, or unaided. This is where regulator and regulated (along with others) have an additional role to play. This is but to scratch the surface of a huge issue, which is very high on our won agenda. But I do think it is important to note now, that each of us, consumers included, have a contribution to make if we are to have an industry that does indeed prosper and works for its customers. This is delivery of “responsible reform”.
52. And whilst not wanting to be quoted out of context, I hope that my remarks this morning have given you a clear sense of the inadequacy of capital adequacy alone. Prudential and conduct of business requirements are interdependent. Together, they form the foundation on which that prosperous, and sustainable, future for the industry can – and should – be built.