ICAS refreshed: an FSA perspective
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Speech by Sarah Wilson, Director Retail Firms Division, FSA
6 March, 2007
I am delighted to be participating, with a number of my FSA colleagues, in this event today. And my thanks to the ABI for the initiative. As I think they are aware, we are particularly pleased that there is an event on ICAS at this time - as we wanted to update the industry on what is now two years experience of ICA reviews and to mark of course the publication of the new ICAS sub-principles and industry guidance. It is also an excellent time to be looking forward from ICAS to the related issues in the Solvency 2 work. But I intend to focus this morning, as requested, on ICAS to date and ICAS to come.
It is never a bad idea, when contemplating the results of a number of years work, to remind ourselves of objectives and intended outcomes. There were, and remain, three dimensions to this for us with ICAS.
First, we wanted to give firms an incentive to improve risk management generally. We were conscious that this was not as developed in insurance as in other parts of the financial services sector. We looked to ICAS to help in this area, mainly by stimulating improved risk measurement. We also address risk management directly, of course, with firms individually and through thematic reviews including our publication in November last year. But past weaknesses such as the life industry’s experience with providing for guarantees and the limited engagement with operational risk across the sector had made particularly clear the gaps on the measurement side.
Second, we wanted to reinforce the responsibility of senior management to manage the capital resources of the firm in line with its risks. It should no longer be acceptable, allowing of course for the scale and complexity of the business, for a firm to rely simply on compliance with regulatory minimum requirements, which may not adequately capture all the risks in the individual firm’s business.
Third however, as regulators, we still need – subject of course to existing directive requirements - to take our own view on the overall capital adequacy of the firm. So we wanted ICAS to help us in this, the attraction of ICAS being that it is risk-based and takes account of the firm's own view of its key risks. By combining that with our wider supervisory view of the firm, derived from the ARROW risk assessment, we aimed to create a powerful tool for evaluating – and then expressing in Individual Capital Guidance (or ICG) – the level and quality of capital we think it appropriate for a firm to hold. Of course many firms then choose for hold more than this regulatory minimum (reflecting for example their own risk appetite), but our work sharpens understanding of the baseline from which they can choose to move.
You will not be surprised to hear that we think the work of the last two years has delivered in spades on these objectives – mainly, I should say, thanks to the industry’s own efforts but also, I would argue, because of the robustly challenging approach which we have taken to the review work. And as a result the UK insurance sector is more stable and consumers using UK insurers are better protected than would otherwise be the case.
But before expanding on the lessons, let me remind you of the process and give you some facts on where we are. As you know, our ICAS work revolves around the firm’s ICA submission. Once this is received, we have detailed discussions with the firm, formulate our views on the required capital and after an internal challenge process aimed at promoting consistency of judgement, we communicate the ICG to the firm. In doing that we also highlight the links to our ARROW assessment whether or not that is being done at the same time. The whole process is now nearly always complete within six months and often within three or four.
Our most recent internal six monthly review of the ICAS programme, which looked at our work up to the end of January, showed that we have now given ICG to general insurers representing as much as 97% of total market net premium income and to life insurers representing 95% of market liabilities.
More specifically it is important to look at the sectors in turn.
On general insurance, we have given ICG to 102 general insurance companies - and to the Society of Lloyd's. On average, the extent to which our ICG has exceeded the firm’s own ICA, which I know is a matter of great interest and occasional concern, has reduced sharply. The average ICG of those issued during 2006 and in January 2007 is just 10% in excess of the firm's submitted ICA. This compares with 18% for reviews completed prior to 2006. So ICG and ICA are converging.
The two most significant issues in this sector that have resulted in capital add-ons, that is in ICG exceeding the ICA, have been: operational risk, including concerns with validation and lack of understanding by firms of their models; and lack of evidence from firms in support of the choice of assumptions used within their ICA. (For example, in the latter case, a lack of supporting evidence on assumptions used on the volatility of reserving and underwriting risks and/or the extent of correlations under stressed conditions.)
On the life insurance side, we have now given ICG to 53 companies. The average ICG has been 14% in excess of the firm's ICA. In this case, a comparison of the average add-on pre-2006 with that for more recent reviews does not show a decline as suggested by the general insurance numbers. However, there is more dispersion here - the range, barring one or two outliers, is between 170% and 100% of ICA; and there are more firms now at the lower end albeit a continued number of higher outliers.
In the life sector, the most significant areas of difference are similar - operational risk and aggregation (that is diversification, stressed correlation assumptions and the approach to non-linearity). But we also quite regularly add on capital for the quality of capital resources (especially where firms use intra-group loans) and credit risk, particularly in corporate bonds.
It is important that we continue to feed back these raw numbers. Equally, I don’t believe they tell anything like the full story of the work so far. To an extent Goodhart’s Law has been operating – a variable once targeted inevitably becomes subject to distortion. Clearly, some firms have been managing their ICA to come closer to their expectations of our likely response. But I would prefer to express this more positively: lessons are being learned and firms are developing their models in response to improving market practice as we all gain greater experience in this area. We very much welcome that and expect to see add-ons reduce further as we move towards Solvency 2.
So what wider lessons would I highlight?
First, I think we have all shown that internal capital models can be integrated within a regulatory capital framework for insurance companies to good effect - by which I mean that ICAS has complemented the statutory measures by stimulating improvements both in supervisory understanding of risk and capital and in the underlying management and governance of risk. We have lost count, for example, of how often we have been told about - or observed for ourselves - the far greater understanding of risk at board level which ICAS has engendered. And this is of course all excellent preparation for Solvency 2. (On this latter point, firms must also be realistic. ICAS has given us a head start along the risk and capital journey, but use of a model to provide an ICA in our current regulatory approach is not the same as achieving Internal Model Approval under Solvency 2. We will work with the industry to prepare for approval ahead of Directive implementation.)
Second, ICAS has, we think, shown the value of a principles-based approach - of which, together with our work on Treating Customers Fairly, it has been a key pilot. We specified little more than that firms must hold capital sufficient over a one year time horizon at a 99.5% confidence level. Firms have developed models and frameworks to establish the level of capital that this implies in their case. We have now taken ICAS even further into the territory of principles-based regulation through co-operation with the ABI and other trade bodies on our new ICAS sub-principles and the industry code launched a few weeks ago. We feel that ICAS has underlined the value of high level standards to guide firms and the regulator without undermining the essential individuality of the approach. And we are fortunate that in the insurance world, we can look not just to proactive trade bodies but also to the new Board for Actuarial Standards to take a lead on standards in future.
Third, it is worth also reflecting on the contribution which our management of ICA reviews has made to resolving the issues over what are acceptable standards – and, we think, raising those standards in the process. Our approach has not always been comfortable for firms. And we have acknowledged before that we did not manage either industry expectations before the event or some of the individual firm discussions we had early in the process as effectively as we might have. But we have learned from early experiences, and do think our ICAS work bears out that robust supervisory challenge, with a commitment to good listening and constructive debate alongside it, has a key part to play in making a success of more principles-based regulation.
Let me finally look to the future. Our immediate priority is to complete the first round of our reviews of ICAs. We have covered much of the market by value, as I have said, but there are still many smaller firms awaiting ICG. To date, our impression is that there is some high quality work being done by such firms but also some poorer efforts. As ever, we hold all regulated firms to the same standards but are proportionate in our expectations of how they deliver in practice.
Beyond that, we are focused on three main challenges:
Meeting the need to extend our ICG to diversified groups – ie to give ICG that reflects assumptions on diversification benefits across sectors and countries as well as across the risks in individual firms. We don’t have all the answers. But we are working on practical approaches and will make good use of our learning in the context of the Solvency 2 preparations.
Second, we are looking at how best to add real value to the next round of reviews of ICAs, some of which have already taken place. We want, of course, to focus on areas where the firm’s approach has developed and on outstanding issues from the first review, especially where there were capital add-ons. But beyond that, we can see the opportunity and the scope for added value from taking a more qualitative approach – challenging firms on how they are using their ICA in practice to make better business decisions and improve risk and general governance; and how in practice it reflects and delivers on their risk appetite. While often impressed in our first round reviews by the extent of change in this area, we emphasise that there is more – sometimes considerably more - that firms can and should do. This is a key message in our recent publication on wider risks management in insurers that I mentioned earlier.
Third, we owe it to you and to ourselves to be smarter about combining our ICA review conclusions, qualitative and quantitative, with our ARROW risk assessment. This can be logistically challenging. But where we have done it, we think it has enabled a clearer more consistent message to the boards of directors, to whom our ARROW and ICAS reports are addressed. So we plan to do it more and, although this will happen over time rather than all at once, we invite you to challenge us when we do not succeed.
In conclusion, I would like to thank the ABI again for staging this event. I hope that if the broad theme is improving capital modelling and its contribution to regulatory capital, you will conclude there are many positive lessons to be drawn from ICAS. That is certainly our position and one we continue to reflect in our Solvency 2 discussions.