Life Actuarial Challenges: An FSA perspective
Speech by Clive Briault, Managing Director, Retail Markets, FSA
Actuarial Profession Life Convention,
22 November 2005
It is a pleasure to be able to address such a large and distinguished gathering of life actuaries - and at such an interesting time in your Profession’s development. I am conscious, as I am sure are you, that between now and the next Life Convention there will be a new arrival in the actuarial world in the shape of the Board of Actuarial Standards. It is a good moment to reflect on how we perceive the work of life actuaries, and to survey some current topics on which your input is of great importance to us.
I intend to talk briefly about how we see the life industry today, the impact of our recent regulatory changes, and how we intend to work with the new Standards Board. And then I will make some more detailed remarks on our progress in implementing ICAS – Individual Capital Adequacy Standards - and some key technical issues for us in the development of Solvency 2.
State of the life industry
Let me start with some observations on how we regard the life insurance industry today and on our regulatory reforms, focusing in particular on the contribution of life actuaries. There has been extraordinary change in the last few years. We have seen the steep decline in new with-profits business; the reduction in Equity Backing Ratios at many with-profits funds, open as well as closed; and pressures to continue to reduce capital supporting with-profits. But there have not been the further significant fund closures in the last two years that some predicted; and there have been some new smoothed equity-based products coming onto the markets.
Other business has been more buoyant. Unit-linked continues to flourish, largely offsetting in terms of volume sales the decline in with-profits. Pensions business is growing strongly, in part in anticipation of the A-Day tax reforms in April. There is growing interest in annuities, including the opportunities in bulk purchase business. All this reflects continued strong consumer demand for the life companies’ services. But with low inflation, competition from other savings providers, new entrants and the uncertain impact of pension reform, life company managements clearly face some key challenges. In response to these challenges they will need to continue to address high cost bases, to improve investment performance, and to develop risk management to help deal with the continued uncertainties over longevity and of course mortality risk, not least given all the talk of a possible future flu pandemic.
Changes in FSA regulation
There have of course also been major changes in FSA regulation in recent years. The headlines have been dominated by our realistic reporting regime for with-profits business. Like many of you, we held our breath over the early months of this year while the auditors were having a look at the first audited FSA returns based on the new approach. In practice, there were no qualified returns, all directors’ certificates were signed and all firms comfortably met their new capital requirements. I am pleased to say that the end-June private submissions show a similar positive picture – a reflection again on all the industry’s hard work in this area. But we know that fully bedding in realistic balance sheets, including the systems and controls required to produce numbers to a high standard of accuracy and being clear in statements of the Principles and Practices of Financial Management about management actions, has further to go. We are already following this up our supervisory work.
One regulatory reform this year that has been less widely commented on, but is in many ways just as significant, is the change to life actuarial governance. We have said farewell to the appointed actuary and welcomed the head of actuarial function and the with-profits actuary. In practice, the nameplates on most of the desks of senior actuaries have not changed. But we do perceive a gradual but significant development in the engagement of actuaries in regulatory issues. Whereas in the past we have seen life actuaries leading the debate with us, we are now more likely to see them using their technical expertise to help general management make the best possible presentation of the firm’s case. This has been particularly evident in the discussions on Individual Capital Adequacy Standards, as I am sure you can imagine.
This development is welcome. It suggests that senior management are responding to our objective that they take responsibility for actuarial issues. We are aware that senior managers have been supported, as have boards, by actuaries providing training on realistic reporting, Individual Capital Assessments and other technical issues. One of the concerns expressed when we consulted was that the governance reforms might result in actuaries focusing only on issues relating to the fair treatment of customers in with-profits business, whereas the appointed actuary had a wider remit in this area. But this concern has proven to be unfounded.
One particularly pertinent issue on our Treating Customers Fairly agenda is defining the relative responsibilities of product providers and distributors, against the background of a market in which provision and distribution show few signs of being reunited. We do think that product providers, because they design the products sold in retail markets and maintain much of the day-to-day relationship with policyholders after the point of sale, have responsibilities in this area. We are planning further work to identify where the product provider can contribute to delivering our objectives – such as helping to improve consumer understanding and improving the quality of advice, not least through the provision of clearer information to advisers. We accept that alongside this work, we need to develop our understanding of the value chain in product creation and distribution in the life market so that we really understand the economics of the market and can identify the best approaches to delivering Treating Customers Fairly.
One area we want to focus on is the information which product providers give to distributors – to support new business sales, transfers and continuing advice. While we do not have detailed requirements in this area, it is clearly important that advisers are adequately supported when guiding consumers through such difficult decisions as whether to surrender a with-profits contract or run it to maturity. We know that many life offices are concerned themselves about the limited advice that seems to be available to policyholders in this area – and that they appreciate the contribution that improvements here could make to generating new business, improved persistency and so on.
Let me mention one other unsung but successful regulatory reform – the bringing together of actuarial and audit work through the new regulatory requirement for auditors of life companies to make use of a reviewing actuary. One of the most quoted parts of Lord Penrose’s Report on the events at Equitable Life was his likening of the separation of audit and actuarial work to commissioning two legs of a pair of trousers from different tailors. While we are satisfied that the new audit and reviewing actuary requirements are delivering improved standards of regulatory reporting, we remain open to any future initiatives to move to joint actuarial and auditor opinions on insurance companies' statutory accounts.
The FSA’s life actuaries
We have also been developing the work of our own life actuarial teams at the FSA. We have increased our strength in life supervision from 13 to 18 actuaries, mainly in response to the challenges of Individual Capital Adequacy Standards, and have increased the numbers of actuaries working in policy-making. We have grown our expertise in techniques such as stochastic modelling. We have made arrangements with the consultant actuaries for senior staff to spend time on secondment with the FSA. And I am pleased to say that we have also just taken on the first trainee life actuary to work in life insurance regulation for some years.
We are also adapting and developing the style of our actuarial work in supervision – seeking to be more challenging and more engaged in wider industry debate, as evidenced for instance by the level of participation from our team at the Convention this year. Just as we expect firms to integrate actuarial and wider management work, so our actuaries are now working much more to the agenda developed and managed by our frontline supervisors. There is further to go on this. But as the Morris Review acknowledged, the old separation of supervisors and actuaries in regulation is a thing of the past.
The Board of Actuarial Standards
We are looking forward to working closely with the Financial Reporting Council and its new Board of Actuarial Standards. We did of course work closely with the Morris Review team, supported the recommendations in the final report, and have recently been working with the Treasury and Financial Reporting Council on their implementation. The objectives and benefits of the new Board are clear: a wider range of external involvement and greater transparency in the standard-setting process should give much greater authority to actuarial standards than the Profession alone, notwithstanding recent reforms, can deliver.
The FSA will be a member of the new Board and we expect to work closely with Board staff. In fact, close co-operation between the Board and regulators is going to be critical to its success. To the extent that the Board’s work is mainly about technical standards, then much of the focus of its work will be on elaborating and interpreting regulatory standards. We welcome the input which we can see the Board making on difficult but important issues such as longevity risk and capital modelling, including developing a response to the actuarial issues coming out of the implementation of Individual Capital Adequacy Standards.
In addition to working with the Board of Actuarial Standards on the standards themselves, the FSA’s role, at least in the start up phase, will be to give effect to those standards as they apply to life companies. We can do this in two ways. First, to the extent that the standards will be applied by the Board to members of the Profession, as currently envisaged, we could in effect require firms to have regard to those standards when they take advice from the head of actuarial function. Second, we could continue to require life companies to have regard to “generally accepted actuarial practice” in the context of their work on complying with our valuation and other prudential requirements, and to refer specifically to the Board's standards here.
Our preference, longer term at least, is for the second of these approaches. Relying on actuaries employed by firms to implement standards in those firms because of professional obligations is somewhat indirect and out of line with the accounting framework and with our emphasis on senior management responsibilities. We are also concerned that at some stage we will want – in line with separate recommendations of the Morris Review – to move away from the current reserved roles for actuaries, when we can see that experts other than qualified actuaries can deliver the required advice.
So it would be better for the Board’s standards to be addressed directly to firms, with the Profession setting out how its members should implement these in practice. However, I do not want to labour these issues of form, important as they are, when the major focus should be on the substance, that is what the standards are going to say.
Individual Capital Adequacy Standards (ICAS)
I have already implied at least that ICAS is at the heart of many of the changes we are seeing in actuarial work. We have three main objectives for the new regime. First, to give firms an incentive to improve risk management – which we still think is not as developed as in other parts of the financial services sector. The contribution of ICAS lies, initially at least, in improving risk measurement – the clear gaps in which have been exposed in recent years by the experience of the life industry with providing for guarantees and by the limited engagement with operational risk across the sector.
Second, we want to reinforce the responsibility of senior management to manage capital resources in line with risks. Too many firms have been running the business simply on the basis of compliance with regulatory minimum requirements. Of course, the FSA still needs to take a view on the overall capital adequacy of the firm. So – and this is our third objective - we want ICAS to deliver the insights into the capital needs of insurance companies that will help us form this overall view of what is adequate capital. By combining the firm's own Individual Capital Assessment with our wider supervisory view of the firm, we have a powerful tool for evaluating the level and quality of capital we think it appropriate for a firm to hold.
So, how is the implementation of ICAS going? Good in parts, I would say. We have completed the review process with only 12 life firms so far, although we are at an advanced stage in our discussions with 12 more. If you recall that we plan to review the Individual Capital Assessments of 120 life companies before the middle of 2007, you don’t need an actuarial qualification to see that we have to speed up. We need your submissions to be better in some cases. But we also accept that we were not adequately prepared for the range of issues that faced us in considering the Individual Capital Assessments submitted to us by firms, or the length of time it would take us to resolve these with the firms concerned. And our communication has not always been as it should be. We are learning lessons – and feeding back more, as in the Insurance Sector Briefing on ICAS that we published last Friday.
What about the substance of what we have found? We have been impressed by most submissions – and we judge them for these purposes on both technical content and the way in which the process has been handled at the firm. We do expect the right functions within the firm to have been involved in developing and signing off the work – particularly that the firm's Individual Capital Assessment is not just the product of the Actuarial Department but has risk management and front line business involvement too. We expect senior management and board involvement at the appropriate level.
By and large, while there is further to go, we are reassured on these issues. It is particularly encouraging that in many cases boards have clearly been involved, at some firms at quite a detailed level, in considering and signing off Individual Capital Assessments. And we have seen evidence that these Assessments are actually being used by the firm in their day to day business – an article of faith for us as it increases the confidence we have in the quality of the process if the firm itself has a real stake in the outcome.
There have been some questions and concerns about our process in setting Individual Capital Guidance and we are keen to receive more feedback as the work develops. There are three key points we are making now to our teams, actuaries and supervisors, in our setting of Individual Capital Guidance. First, in considering areas where we feel the need for firms to hold capital over and above what firms propose in their Individual Capital Assessment, we will focus only on material issues in terms of the overall risk to the firm. It is not our intention to add on capital for every area where we think the firm could do better or where we have found another firm with a more prudent approach.
Second, we are trying to strike a balance between delivering consistent outcomes in our decisions across the industry and recognising that Individual Capital Guidance should be specific to the firm and not simply an alternative form of Pillar 1 capital requirement. We use benchmarks to trigger further enquiry and discussion rather than taking us automatically to a particular number. Where good arguments can be made, we are open to these and we have a tolerance of results that come in around the benchmark. But we are also faced with some Capital Assessment numbers that vary significantly across firms in respect of the same risks. Diversification assumptions are one area to highlight. Mortality risk is another. There are limits to flexibility if we are not to be inconsistent – and not to leave ourselves with concerns about whether the 99.5% confidence interval is being met.
Third, we do want to give credit for areas where the firm has taken a particularly prudent approach, for example reflecting uncertainty in its estimates of a particular risk. There are various ways in which we can deal with these. We may simply in effect net off the areas of over and under provision – focusing on the overall adequacy of the approach. In other cases, we may invite the firm to recalculate some elements of its Capital Assessment if it feels there is material over-provision – leaving us to concentrate our resources on the Individual Capital Guidance appropriate to the areas of potential under-provision.
Where are we coming out in terms of actual Individual Capital Guidance numbers? So far all of the Individual Capital Guidance numbers we have issued to life firms, or are working on with firms, are higher than the firm's submitted Capital Assessment. This outcome should be expected.
The range of our Guidance numbers is interesting, however. Looking at the 10 groups where the process is most advanced, the range is between around 110% and 170% of the Individual Capital Assessment. But for only four of these is our Guidance more constraining than the Pillar 1 requirements. And in no case have we set Individual Capital Guidance at a level that exceeds a firm's actual capital.
Our priorities now are to press ahead, learning the lessons of experience so far. We will soon be issuing our first group Individual Capital Guidance, with the need to take a view on diversification across businesses. We recognise the need to raise our game somewhat. But we should also not lose sight of the high quality technical discussions that have been held with firms so far, and the real progress in risk measurement and in senior management and board level engagement in risk and capital issues.
Solvency 2
Finally, a word on Solvency 2. As you know, we have been advocating the need for new thinking on insurance solvency rules within Europe. The existing EU arrangements – already supplemented and in effect superseded on a national basis by a growing number of countries – rely on an outdated mixture of opaque prudence in the quantification of the technical provisions, inflexible asset allocation limits, and a simplistic volume-based capital requirements formula. Their inadequacy is now widely recognised and there is growing convergence on the way forward. As the negotiations move into the next key phase, I wanted to take this opportunity to make clear our overall vision for the new regime.
Our objectives for Solvency 2 are clear – we want a Solvency 2 regime which is proportionate, and more transparent, robust and risk-sensitive than Solvency 1; a regime which is implemented in a more consistent manner across the EU than currently; we need to let firms decide how to run their businesses, how they should respond to market demand, and how they may best provide cost-effective products that address policyholders' needs; and we need a regulatory regime that encourages and rewards good risk management.
As far as technical provisions are concerned, we are keen to move to measuring liabilities according to their market-consistent value. This is the closest to a measure of liabilities that it is possible to get that is both reliable in the sense of being set by reference to an objective market standard and also relevant to economic decision-making. A year ago, we said that in view of the significant practical difficulties in implementing a true market consistent valuation standard, it may be appropriate, as an interim measure until the International Accounting Standards Board's Phase 2 project completes, to set a soundness standard for technical provisions by reference to a defined confidence level. A confidence level of 75%, based on the precedent set in Australia, has now been incorporated in the European Commission's Framework for Consultation, as a 'working hypothesis'.
Since then, work on technical provisions, and dialogue with the industry, have continued. The Chief Risk Officers Forum has argued for a soundness standard that is more explicitly based on a market consistent value, such as the 'cost of capital' approach. They argue that within the timeframe of Solvency 2, they will be ready to implement such an approach. While we continue to believe, at least for the time being, that it is premature to use such a soundness standard for all insurance companies, we do believe that, with appropriate regulatory safeguards, some firms should be allowed to depart from a percentile based approach and adopt a purer market consistent standard.
Insurance companies that are likely to be best able to demonstrate their ability to adopt a market consistent standard are also those that are likely to be applying to their supervisory authority for permission to use an internal model to calculate their Solvency Capital Requirement. Permission would of course only be granted where a supervisory authority is satisfied that an applicant has demonstrated that it is able to implement a statistically robust and economically valid methodology.
We are also aware of the difficulties for firms that lack rich data histories in applying a stochastic methodology in a confidence level approach, especially if the confidence level were to be set at 75%, or higher. We see two complementary streams of work that could help to alleviate this problem. First, a confidence level soundness standard should permit reasonable approximations using deterministic methods, where appropriate. To alleviate the associated risk of inconsistent outcomes across firms, there would be a need for clear actuarial standards – defining, limiting and describing appropriate deterministic methods, how they should be calibrated and how and when they could be used. We welcome the recent initiative by the EU actuarial Groupe Consultatif to investigate how this might be done. The second would be for industry associations to look into collecting and collating data, to enable insurance companies to use industry, as well as their own, data.
The Committee of European Insurance and Occupational Pensions Supervisors is currently examining technical provisions and in particular the risk margin above expected (or mean) value. Firms are participating on a voluntary basis in a quantitative study, using not only the soundness standard of a 75% confidence level, as that is the Commission's working hypothesis, but also points around that. So firms are also invited to supply the 60 th and 90 th percentiles. This will help European supervisors to understand how the quantum of technical provisions changes as the confidence level is varied, and thus to answer the big remaining questions: should a defined percentile approach be used? If so, what percentile should be set as the standard? What risks should be included in the scope of the percentile? Are other approaches possible, at least for some firms? And should other limits, floors or restrictions be imposed on the quantification of technical provisions?
Technical provisions of course need to be matched by assets. At present the EU directives impose some asset admissibility limits. We think that asset limits are a blunt instrument. Risk below a certain level is ignored. Risk above that level is treated as fully realised. A better way of dealing with market and credit risk is by designing a solvency capital requirement that includes appropriate weighting for all types of market and credit risk. Only to the extent to which this proves not possible should we contemplate including asset admissibility limits in Solvency 2.
Which brings me finally to the solvency capital requirement. As I have said, our vision is that technical provisions should be set at the market consistent value, or by some close substitute to the market consistent value such as the defined-percentile approach appropriately calibrated. The solvency capital requirement should then measure the potential variability of the near-market-consistent technical provisions, along with potential changes in asset values, over a 12 month time horizon to a confidence level of 99.5%.
Overall, we think that the best way forward in designing Solvency 2 is to follow a broadly market-consistent approach, while making appropriate allowances for the difficulties in implementing that approach in some aspects. This view appears to be gaining good support from the industry, many insurance supervisors and other stakeholders.
Conclusion
In conclusion, we remain optimistic about prospects for the UK life insurance industry. There are challenges and risks, many of them not easy to quantify. But it seems to us that the regulatory reforms of the past few years, by delivering sounder finances, better governance and improved audit and actuarial review, have put the life industry in a much better shape to weather future storms, whatever they may be. And Individual Capital Adequacy Standards, while still to bed down, are already contributing both improved risk measurement and better capital modelling. While the outcome of Solvency 2 is uncertain, it holds out the prospect of a new coherence and consistent application of solvency standards across the European Union.
Like the life industry itself, actuaries find themselves increasingly challenged by other disciplines and areas of expertise. And the creation of the Board of Actuarial Standards oversight is sure to bring a wider range of interests into standard-setting. A certain amount of soul-searching about the future for actuaries is no doubt inevitable in these circumstances. But this should not cloud the high value that users, industry and regulators, continue to place on actuarial services. While individual actuaries continue to engage with new developments, and the Profession continues to develop its training for new actuaries, we see no reason why this should not continue to be the case in the future.