14 October 2004
Speech by David Strachan

  1. Good morning. I am delighted to be here today to address delegates at what has been an excellent conference so far. Our hosts, the Wall Street Journal, are to be commended for their foresight in the timing of this two day summit, particularly in light of our theme of capital adequacy and the reinvigoration of the Solvency 2 project. The EU Insurance Committee's recent endorsement of the Commission's roadmap for Solvency 2 has given the project a new lease of life. And it is clear to me that the resolve and will to establish a pan-European capital adequacy framework are now palpable. Not wanting to get too carried away though, we are of course still only at the beginning of our journey towards a common solvency framework. Clearly that journey will take time and will not always be a smooth one. But I don't think for one minute that anyone in this room underestimates the determination and stamina that will be required from all parties to reach our desired destination. This morning then, as well as making some comments on Solvency 2 itself, I will describe the FSA's experience of introducing a new domestic capital adequacy framework for the UK insurance industry.

  2. The FSA has pushed through a massive programme of reform for the regulation of insurance firms. The regulatory landscape is, I would argue, barely recognisable from that which we inherited when the FSA became responsible for insurance regulation. But, before embarking upon my main subject I do want to emphasise that from the FSA's perspective, prudential requirements actually tell only half the regulatory story in the UK. In addition to the wholesale reform of capital adequacy our modernisation programme has also focused on conduct of business regulation; in other words, the interface between insurance companies and their customers. In the interests of balance then, you will forgive me I'm sure, for also pointing to some of our conduct of business reforms which we believe neatly complement our prudential reforms.

Reform of capital adequacy

  1. I will begin though by reminding ourselves why reform was so sorely needed. Under the existing regime, life insurance companies have not been required to back all of their promises with hard financial resources. The current state of play effectively allows insurance firms to ignore some significant non-contractual promises, including policyholders’ expectations that they would receive a fair terminal or final bonus. Even for contractual options or guarantees to pay minimum annuities, in the past firms' measurement approaches have not been as robust as might be expected. Common sense dictates therefore that the introduction - and delivery - of a regime that ensures firms have sufficient reserves to cover all of their liabilities, guaranteed or otherwise is hardly the stuff of controversy and dispute.

  2. However, I think it is also fair to say that the inadequacies of the current insurance directives do not manifest themselves solely in the UK. Shortcomings of the current capital requirements for life insurers have led regulators in the UK and beyond to adapt the existing approach in different ways to deliver more prudent insurance regulation. In the UK, we generally expect life insurance firms to hold a minimum of around two times the EU requirement, and in some cases a higher multiple, depending on the nature of business written. Regulatory counterparts in Europe expect insurers to make more stringent provisions for claims. One regrettable consequence of this is that a veritable patchwork of approaches has emerged across the EU. Consistency will, we hope, win the day with the introduction of Solvency 2. But given the weaknesses in the statutory valuation methods so exposed during the recent bear market we felt that it was essential to get our own house in order as soon as possible. This is why we introduced our own domestic proposals for capital requirements for life insurers ahead of the Solvency 2 timetable.

  3. Our new capital adequacy regime for life insurers is built upon what we term the “twin peaks” approach. Broadly speaking, this requires life firms with with-profits liabilities in excess of £500m to make a realistic assessment of their with-profits liabilities (including stress and scenario testing), to determine whether they need additional capital on top of mathematical reserves to cover expected discretionary bonus payments. Life offices with with-profits liabilities of less than £500m have the option of adopting the "twin peaks" approach, but are not obliged to do so. Regardless though, they are of course still subject to the EC minimum capital requirements.

  4. Although the new regime will not take effect until the end of this year, to help them prepare for the new world we have been collecting data from firms on a “realistic” basis since year-end June 2002. It is clear from this data that the deterministic approach of valuation for options and guarantees that had been used by most UK firms was largely inadequate. And so the recent shift towards adopting market consistent stochastic modelling by the majority of firms is greatly encouraging and will result in more accurate and appropriate measurement of firms’ liabilities. Progress that has been made will also help ensure a smooth the transition when the FSA's Integrated Prudential Sourcebook is switched on for insurers at the end of 2004.

  5. Although I have focused so far on changes afoot for UK life insurers, our reform package naturally encompasses change for general insurers and reinsurers as well. Here our new approach is again, as you might expect, more risk sensitive. Essentially, the new regime will require firms to hold capital at least equivalent to the higher of the Minimum Capital Requirement (MCR), which is dictated by Solvency 1, and the Enhanced Capital Requirement (ECR). For some, these new requirements will have only a modest effect because the firm may already hold 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.

  6. The new approach to capital adequacy for both life and general insurance firms produces a baseline of capital that we expect all insurers to hold. Clearly though, this is just the starting point as, in the new risk-based world, the amount of capital required to match an individual firm’s particular circumstances could be higher, or less frequently, lower than this generic minimum requirement. Moving away from a crude 'one size fits all' model, to capture this spectrum of idiosyncrasies we are introducing a framework of individual capital adequacy standards. In essence, this requires the senior management of a firm to carry out its own assessment of how much capital a firm needs given its business model and risk appetite. These are then submitted to the FSA and then we do our own assessment of whether this is an appropriate level. We will then issue Individual Capital Guidance reflecting our own views of how much capital is required to support a firm's individual risk profile.

  7. With self assessment playing such a dominant role in the new regime, the heightened importance of effective risk management practices should come as no surprise. Assessing and managing risks is a fundamental part of a firm's good business management practice and features strongly in all of our requirements for firms. However, beyond simply keeping the regulator happy, our new approach to capital requirements provides an additional incentive for firms to develop good risk management practices: in a recent survey of European P&C insurers, an overwhelming 95 per cent of respondents agreed that effective and competent risk management can reduce solvency capital requirements. So we can be seen to be pushing on an open door here.

  8. Last year we carried out our own research into the risk management practices and procedures in the UK insurance industry. Although this research is now a year old its findings bear a few moments of consideration. Encouragingly, it is clear that since we began carrying out risk assessments in 2001, many insurance firms have improved the way they manage risk. Our review identified a number of positive developments – for example, most firms had made good progress in putting in place processes that will enable better identification, assessment and control of risk, such as senior management committees, risk assessment functions and management information. Against this steady improvement, there were however, pockets of weakness. These included: lack of independent and objective assessment of risks; under-developed or in some cases un-defined risk appetites; poor quality of management information; a lack of consideration of risks arising from the operations of other group companies; and a lack of co-ordination between internal audit, risk assessment functions and those responsible for assessing capital requirements.

  9. Of course, these findings provide a snapshot of risk management practices and procedures from over 12 months ago and as such I would expect there to have been incremental improvements in all of these areas as firms get to grips with the requirements of the new regime and appreciate the correlative benefits of sound risk management practice. And by sound practice, I mean risk management that is rooted deep within the culture and business model of the firm, as opposed to changes on the surface that seek to do little more than demonstrate compliance with our guidance.

  10. It is I think fair to say that voices of dissent have only been notable by their absence, with our new approach to capital adequacy enjoying the wide ranging support and advocacy of trade associations, analysts, commentators and indeed firms themselves. It is undoubtedly a radical departure for firms. And for some this new approach brings with it significant challenges. Against this background, I for one have been very impressed with the way in which the industry has focused on preparing for the new regime. The next pressing challenge is to ensure that the regime is fully embedded and that ICAs become enshrined in the way that firms' senior management run their businesses. We are confident that in time the new regime will result in an industry whose collective financial health is more robust and capable of withstanding the shocks and strains which inevitably emerge in our sector.

Solvency II

  1. The case for a thorough root-and-branch reform of solvency in Europe is clear. The existing regime is outmoded, it unduly restricts methods of business, it is not sufficiently risk sensitive and market developments have made the system begin to creak at the joints. Our decision to go ahead and introduce a more risk-sensitive regime in the UK underlines the importance and urgency we attach to modernising insurance regulation. Not surprisingly then, we are fully behind the resolution to introduce and deliver Solvency 2 in Europe and are committed to taking an active role in driving the work forward. It is critical that progress is made to a rapid, but credible timetable; momentum is important but not at any cost, particularly if that cost is intellectual rigour or curtailed consultation periods.

  2. We believe that the three-pillar approach adopted in Basel for banking is also suitable for the insurance sector. As such, we advocate the importance of risk responsive pillar 1 capital requirements, the pillar 2 supervisory review (including the ability to set individual capital requirements above the pillar 1 requirement as necessary), and the pillar 3 disclosures to harness market discipline. Flexibility is, however, key. Without wishing to be accused of stating the obvious, insurers are different to banks and although we support the adoption of a similar framework, it needs to be adapted to the particulars of the insurance world. What the EU should be aiming for is a framework of risk responsive capital requirements that addresses both asset and liability risks (and their interactions), and one which sets the right incentives for good risk management. There should also be scope for firms to use their internal models, as an alternative to the formula or factor based 'standard' calculation.

  3. With the Lamfalussy principles now firmly established and CEIOPS finally fully functional, we think there is a clear case for the EU to take advantage of this flexible machinery and apply it to Solvency 2. Staying true to the Lamfalussy ideology will mean hard-coding only the high level objectives and guiding principles into the framework Directive while leaving the technical detail for regulators. Provided we succeed in this, the EU will have a more adaptable solvency regime that will remain relevant for longer, and can better respond to future market and risk management developments.

  4. We strongly support an explicit link between financial accounting, based on IAS, and regulatory accounting. This would improve transparency of firms' financial positions, assist in the achievement of a more risk responsive distribution of capital between firms, and reduce the cost burden on firms of employing different accounting and reporting systems. So, what we should aim for is greater harmonisation of regulatory accounting. The existing EU legislation is not based on a common accounting practice and there is considerable variation in the calculation of technical provisions and in accounting for assets. The consequence is opacity of results and differences in the levels of 'prudent' margins over the value of expected liabilities, and ultimately an uneven playing field for EU firms. The crucial point about accounting for solvency is that liabilities should be reported at fair value; the management of an insurance firm must be able to say what they are expecting to pay out to their policyholders. Furthermore, firms should hold an explicit additional risk capital margin to address specific contingencies to an agreed confidence level. This all sounds well and good said here in a conference in Vienna, but we must not forget that, crucially, we do not yet have IAS Phase 2 – accounting for insurance contracts. Were this project to lose its way, we would have to think again. The much-needed EU solvency reform cannot wait for IAS Phase 2 forever.

  5. There are still a number of technical issues that must be addressed before Solvency 2 hits the home straight – but owing to time constraints I do not propose to pick through these today. I would however just like to mention two key points made in the Commission's post-FSAP Insurance Expert Group Report that we particularly subscribe to:

    • first, that Solvency 2 needs to address issues for groups: home/host responsibilities, and inconsistencies between the IGD and FGD, for example; and

    • second, that the directive proposals should be developed under the guiding discipline of rigorous cost-benefit analysis: we shall be pressing the Commission on this, but we also look to the industry to engage actively and constructively, including participating in quantitative impact studies.

  6. Solvency 2 represents a fundamental and a wide-ranging review of the current EU solvency regime in light of developments in insurance, risk management, finance techniques and financial reporting. The future EU-wide solvency regime must be better geared towards the risks that today's insurance companies face and it should encourage and reward solid risk management. The FSA strongly supports this project as a crucial step in ensuring adequate consumer protection and stable markets and we look forward to sharing our experience in introducing a risk-based capital regime with our European partners. The project is undoubtedly challenging but, with CEIOPS now fully functional and poised to assist the Commission, there is much to be optimistic about. It is important though, not to lose sight of the fact that a set of rules can only ever be as effective as their implementation. Collectively, we must not neglect the need to identify ways in which to foster greater harmony of implementation too.

Conduct of business reform

  1. Having outlined the key tenets of the FSA's domestic reforms of capital adequacy and touched on some of the issues surrounding Solvency 2, before closing I think it is worth spending a few minutes highlighting some of our reforms on the way in which insurance companies interact with their customers. Indeed, given that we are discussing the future of insurance regulation, accusations of negligence would be well founded were I to conclude my remarks without commenting on this critical aspect of our regulatory approach.

  2. Complex products which allow for management discretion pose particular issues in terms of transparency and communication to policyholders. Clarity of such communication is clearly essential with these types of products, such as with-profits policies – a particularly British pre-occupation. Starting with our review of with-profits business in February 2001, changes to our conduct of business requirements have been just as important as prudential reforms.

  3. One key reform that we have introduced to address the concern over the wide-reaching discretion that has been available to the senior management of with-profits funds has been the introduction of something called the Principles and Practices of Financial Management (PPFM). Since the end of April this year all firms carrying on with-profits business have been required to publish a PPFM. The purpose of which is to set out how a firm's senior management plans to run its with-profits business. It includes key information on how payouts at maturity are calculated, the firm's bonus policy, investment strategy and the application of any relevant charges on early surrender.

  4. With-profits is a notoriously complex area and while the introduction of PPFMs was welcomed and has proved instructive in terms of setting out how a fund is governed, as lengthy and detailed documents they are not particularly accessible for the typical policyholder. As such, we are proposing that firms be required to select the most important information from their PPFM and include it in a consumer-friendly version. These should be written in plain, easily understood language and will be sent to existing and potential policyholders. We are still in the process of consulting on our proposals to introduce consumer-friendly PPFMs but research we carried out showed that this type of document helped increase consumer understanding of with-profits policies.

  5. You may conclude from my comments just now that our focus is fixed unswervingly on what firms are doing. While this is true, we must not overlook the central importance of policyholder engagement. With rights come responsibilities and as such consumers too have a critical part to play in ensuring that they understand what they are getting involved in. Clearly this cannot be achieved in isolation though and we hope that our work on consumer education – under the banner of our Financial Capability Strategy – will help bring about the much needed improvement in consumers' financial awareness.

Conclusion

  1. I've covered quite a bit of ground this morning, beginning with our domestic reforms to capital adequacy and some of the attendant issues of Solvency 2. The new prudential requirements that we will introduce at the end of this year are, I hope you will agree, conditioned by common sense. Although employing sophisticated modelling techniques, at their most fundamental the reforms are no more complex than ensuring that capital held is more closely aligned to the risks of the business that insurance companies write. They are a critical component of the reform package but in isolation they do not constitute the future of insurance regulation.

  2. The keen-eyed among you will have noted that the title of my remarks on the backdrop does not strictly tally with the advertised programme. That is not as some might suggest evidence of a regulator's natural propensity for awkwardness, but rather indicative of the fundamental importance of both prudential and conduct of business regulation: two struts that support the UK's regulatory regime. The future of regulation cannot - and will not - reside in capital adequacy alone. At the FSA we view prudential and conduct of business requirements as interdependent and believe that a regime in which one suffers at the expense of the other is a regime that would fall considerably short of our stated aim of maintaining market confidence and helping ensure that consumers get a fair deal.

  3. I'd be delighted to take any questions.

 

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