Future of life assurance: Managing risks
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Speech by Sarah Wilson, Director and Insurance Sector Leader, FSA
Institute of Economic Affairs
15 May 2008
Thank you to the Institute of Economic Affairs and Marketforce for inviting me to speak today. Thinking back to my early days as Sector Leader for Insurance, one of my first speeches was at this very conference when I offered some thoughts on how the industry was progressing in embedding the new insurance regime – one that, as you know, requires senior management to understand and control the risks that they run, so that they comply with our Principles and so that those risks fall within their pre-determined risk appetite. Today I would like to focus on the continuing importance of robust risk management, looking in particular at the new insights gained by looking at recent market events; the need to start planning for a changed prudential regime under Solvency 2; and the need to measure and manage the risks that exist in respect of the fair treatment of customers.
Strategic challenges
But first, and given the title of this conference, it would be re-miss if I did not observe that all this happens against a back-drop where the strategic challenges for life company senior management are significant and probably growing. These challenges are of several kinds. There are social and political challenges such as changes to longevity (where firms need to ensure that capital reserving reflects the true extent of the uncertainty behind future longevity estimates); and changes in approaches to pension provision and the tax regime. There are changes to market structure such as the creation of new approaches to distribution via, for example, platforms; and the establishment of new specialist bulk annuity players. There are changes to regulatory arrangements such as might occur as a result of the Retail Distribution Review where we published our interim report last week. And there are behavioural changes, including most obviously the declining interest on the part of consumers and their advisers in with-profits products over the past decade. Senior management are having to manage their risks therefore in circumstances where their own strategies are under review and changing in response to a particularly rapidly changing business environment for the sector. They can expect their supervisors to take a strong interest in their ability to do this.
More-over, recent market events have tended to reduce the room for error. We said in our Financial Risk Outlook published in January that we expect uncertain and turbulent market conditions to continue for the foreseeable future. And, irrespective of holdings of structured products (which you tell us are generally minimal), falls in the value of equity, bond and property portfolios, rating downgrades on some investments and lower (total) returns on investment can be expected to affect profits in 2007/08.
Given the challenges that lie ahead, it is important to note that during the last few years there has been substantial and encouraging progress in the quality and robustness of insurers' risk management practices. These improvements, which we reported on in some detail at the end of 2006, have stemmed not only from the introduction of the new individual capital adequacy or ICAS regime, but also from firms' greater appreciation of the commercial benefits of good risk management practices. As a result we have seen a move away from risk management as a set of self-contained activities, carried out solely with the regulator in mind, towards a world where insurers’ senior management often have a much better appreciation of their risks and of the actions needed to manage them. In talking about risk management we are therefore talking of a much improved baseline – and of the need to further enhance existing practices and embed change.
Risk management challenges
I said I would look in turn at three challenges in risk management today – first, new insights gained by looking at recent market events; second, the need to start planning for a changed prudential regime under Solvency 2; and third, the need to measure and manage the risks that exist around the fair treatment of customers.
(i) Recent market events
Recent market events have brought into sharp focus the need for firms, in doing their own capital modelling (as they must under our ICAS regime), to think ‘outside the box’ in terms of plausible stress tests and sensible scenarios to run on their portfolios and businesses. We have seen a fundamental repricing of risk, and the simultaneous fall, for example, of equity prices and bond yields. The last nine months has taught us all that the unlikely can become reality and that a whole sector of financial services can be affected by exactly the same issue. And the downside risks have increased making the financial sector as a whole more vulnerable to future shocks. All this means that if firms' ICAS modelling is to stay up to date and as useful as it should be, firms need to review their assumptions and, in particular, their stress and scenario tests.
On stress testing, insurers should now be considering whether there is a need to recalibrate their models. Most obviously, recent events might cause life companies to re-examine and strengthen stress tests for market and credit risk and for changes in correlation assumptions.
On the last of these, and as we have previously reported, during the roll-out of our ICAS regime in 2005-07 one of the most common add-ons we imposed was in respect of weak correlation assumptions. In other words, firms were assuming greater diversification benefits than we thought were reasonable. Recent events have provided some evidence of an increased correlation of risks in the tails of distributions, so we expect firms to be considering the implications. .
On scenario testing also, insurers should be reviewing the adequacy of their work to date. In the light of recent events, we are encouraging firms to consider whether they need to carry out a more extensive range of scenario analyses than hitherto - thinking carefully about the 'ripple effect' whereby in stressed conditions one event could lead to multiple and unusual knock-on effects. The key of course is that the scenarios are 'sensible'. Firms should be using their own judgements, applying them to their own business and ensuring that their ICAS calculations encapsulate these plausible scenarios. We expect firms to be thinking through for themselves the scenarios that they feel they would need to survive, as well as identifying those scenarios that would lead to financial failure. By contrast, in the past some firms appear to choose scenarios that simply validate the capital answer that they have already arrived at, whereas we expect a mindset that allows for scenario modelling changing the result.
Finally in this regard, I should emphasis that we are not expecting firms to meet a standard for capital requirements going forward any higher than that already incorporated in ICAS – ie a 99.5% probability of survival within one year. (Of course many insurers choose to hold capital in excess of this requirement.) Instead, what might have altered is firms' understanding of the scale and nature of events that can happen with a greater than 1 in 200 frequency, and which capital should be sufficient to cover. Such changes in understanding should lead to modelling changes and might, in some instances, lead to some increase in individual capital assessments. But I emphasise that we have not at present concluded that current market conditions have revealed that insurers' previous stress and scenario tests have understated capital requirements; rather we are expecting insurers to keep their modelling up to date and consider its implications as would be normal good practice in risk management. As usual, the appropriate scale of this exercise will vary depending on the scale and complexity of a firm's business. And we are talking to insurers and will be feeding back to them lessons from this and other aspects of current market conditions.
(ii) Preparing for Solvency 2
Solvency 2, as set out in the current draft Directive, places great emphasis on risk management. Most particularly, and as we have already stressed, firms wishing to use internal models under Solvency 2 will need to further evolve their risk management so that it is fully integrated with capital management. We are also conscious of the growing interest in further information from the FSA on what will be needed to gain model approval under Solvency 2. In response, we will run some workshops in the summer inviting firms to discuss with us our preliminary thinking on planning for directive implementation; and these will be followed by a Discussion Paper in the Autumn.
In the meantime, firms are well advised to start thinking through the consequences of Solvency 2 for them. One of the ways in which many firms have already done this is through participating in QIS exercises that are designed to assess the financial impact, suitability and practicality of the Committee of European Insurance Supervisors (CEIOPS)' proposals.
As we reported in the UK QIS3 results, were Solvency 2 to be introduced now in line with that specification, there would be a substantial buffer of capital in the industry over the proposed standard capital requirement, but the effect varied between firms. Care is needed when interpreting these results in view of the provisional nature of the methodology and calibration in QIS3, and the fact that firms results were provided on a best efforts basis. However, by engaging in QIS exercises, firms are able to understand where and how Solvency 2 might lead to changed capital requirements in their case as compared with their own current ICAS calculations. Firms have a further opportunity to learn about possible implications, and to influence the outcome of the current discussions more generally, through participating in QIS4 - a very practical way to engage your Board on the subject and to start to anticipate the risks and issues for your business.
(iii) Treating Customers Fairly (TCF)
As you will be well aware, notwithstanding the important risk management issues in relation to capital outlined above, we believe that it is important for firms to continue to focus also on managing risks with respect to fair treatment of customers. In particular, we have set a deadline of December this year by which all firms must be able to demonstrate to themselves and to us that they consistently treat their customers fairly.
In our work on TCF we have for a long time pointed to the significance of management information as key to embedding change in firms. And I hope it is evident to you that such information is absolutely key to proper identification and management of risks to the fair treatment of your customers; and more-over, by being seen to use such information, senior management can drive change in staff behaviour such that improvements occur. So we are placing great emphasis now in the final stages of this initiative on firms having the right management information in place – MI that measures outcomes and not processes; and fairness rather than satisfaction.
It is also fair to say that, while there is no presumption that all firms have work to do to improve their treatment of customers, our thematic work over time has demonstrated that the industry as a whole has much to do – its risk measurement, management and control in this area needs to improve. For life insurers, I would like to draw attention to two issues - deficiencies in the quality of consumer information, and the importance of strong with-profits governance.
On consumer information, there are three pieces of thematic work that are directly relevant to life insurers, and therefore illustrate this point. The first two have been communicated within the past year - Key Features Documents and post-sale communications. The third, where I have headline results today but which will be published in full in July, is the findings from our review of the quality of firms' wake-up packs – the literature provided to those approaching retirement.
On key features documents (material that is fundamental at the point sale disclosure), we reported in September last year that only 15% of a sample of just over 200 documents complied with our Principles and rules. For these documents then, only a small proportion of firms were meeting TCF Outcome 3 – consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale. The main areas of concern were explanations of risk, charges and more general information about the product itself and its aims. Jargon was also a significant problem, and key information was not always prominently communicated.
On post-sale communication, work also published last year showed documents for life sector policyholders were of variable quality - we found some good examples, but also some significant failings. The main ones were failure to mention and/or explain Market Value Reduction free-dates or Guaranteed Annuity Rates; use of complex terminology without explanation; and a failure to explain how the actions of an insurer may affect the policyholder.
In each of these cases, we said that work to remedy the position needs to be complete as a part of an insurers’ TCF programme by December this year. I hope that work is now well in hand but, on the assumption that many firms have not yet completed it, I would expect senior management now to be receiving MI showing deficiencies in these areas and to be asking for evidence of remedial action.
On open market options, we are in the process of completing two strands of thematic work. One relates to assessing the quality of the literature issued to pension customers as they approach retirement age – the so-called 'wake-up' packs. The other examines the alleged delays by some firms in transferring open market option funds to another annuity provider. We will publish the full results in July once we have completed both aspects of our work, but we have made significant progress to date, so I wanted to spend a few moments outlining at high-level what we have found so far.
Importantly, we found that more than 60% of the 'wake-up' packs sent by 55 insurance companies provide information that complied with our Principles and rules – that is it was clear and enabled customers to make informed decisions about their retirement options. However, a disappointing 40% of the wake-up packs we reviewed failed to meet regulatory requirements. Combine this with research suggesting a gap of around 20% between the top and bottom annuity rates (not including enhanced and impaired annuity rates), and the potential for customer detriment is evident.
In a little more detail, there are three key areas for improvement. First, some insurers failed to explain the potential advantages of exercising the Open Market Option. For example, a significant number of firms stopped short of actually explaining that exercising the option can result in a higher pension. Similarly very few firms mentioned the advantages of shopping around for customers with health problems, who could be better off buying an annuity from providers offering impaired life or enhanced rate annuities.
Second, some insurers failed to give sufficient prominence to important information and key decisions. For example, where there is a guaranteed annuity rate (which is significantly higher than market rates) this should be prominent, making clear when it applies and in which circumstances it could be lost, such as exercising the OMO or deferring retirement.
Third, not all firms are using their guaranteed rates in their default annuity illustrations, even though they would result in significantly higher incomes for policyholders. This results in the policyholder getting a misleading view of the in-house pension and could lead them to underestimate the value of the guaranteed annuity rate and choose an option where it would be lost.
Other weaknesses we have identified were failing to link retirement options to the relevant consequences or giving lengthy explanations of technical points when they were unlikely to be relevant to most of their customers, mixing up the decision on the type of annuity with the best annuity rate, failing to make clear the value of seeking advice in making a decision, and inappropriate use of the FSA factsheet on buying a lifetime annuity.
While it is pleasing therefore that 60% of firms in this instance did comply with the Principles and rules, these results suggest that – at least in this aspect of their TCF work – a very significant minority of firms still have substantial work to do. Again we would expect the MI being received by senior management to be showing where this is the case.
Over the coming months of our TCF work – as we approach the December deadline – we will scrutinise how firms have responded to our feedback on all of these three specific areas of policyholder communications. As is usual, we will keep under review the use of varying types of supervisory action where change is not evident – including enforcement where there are examples of significant potential or actual consumer detriment.
TCF and with-profits governance
Before I leave TCF, I would like to mention one key life sector issue that is not amenable to analysis using management information, and that is the importance of managing conflicts in with-profits business through establishment of robust governance arrangements. I draw your attention to this because, notwithstanding the relative decline of new with-profits business, the size of the back-book means that treatment of with-profits policyholders remains key to the life sector’s reputation and to its credibility as a sector aiming to treat policyholders fairly. And fundamental to that treatment is the establishment of proper with-profits governance to ensure that there is independent judgement in assessing the firm's compliance with its Principles and Practices of Financial Management and in its management of any conflicts of interest between different groups of policyholders and between policyholders and shareholders.
I wrote to insurers on this issue last September, and I am pleased to say that we have since seen some improvements in governance arrangements. Nevertheless it is clear that further improvements are needed and, alongside scrutiny of other aspects of firms’ implementation of the new with-profits regime, we will continue to challenge firms on the effectiveness of their governance arrangements.
Overall on TCF, we continue to press firms to improve their risk identification, measurement and management – so enabling them to translate their good intentions into measurable improvements in the treatment of customers. This will requires focus and energy from senior management. We expect to publish a progress report in June assessing how far firms had got by March. We hope that the industry recognises that it has a unique opportunity to fundamentally shift consumer outcomes, bringing benefits to consumers, enhancing reputation, and increasing the prospect of market growth over the longer term. Not least given the strategic challenges mentioned at the beginning of my remarks, that would clearly be of benefit.
Conclusion
In conclusion, your conference title is the future of life assurance. From a regulatory perspective, in a rapidly changing business environment, I have focused on the need to continue to enhance and embed strong risk management – learning from changing market conditions; anticipating Solvency 2; and improving practices in the treatment of customers. I am very happy to answer your questions.