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Speech by Sarah Wilson, Director and Insurance Sector Leader, FSA
Westminster and City conference on Rethinking Life Insurance: Capital, Risk and Strategy
6 November 2008

Thank you to Westminster and City for inviting me to speak today. A conference focused around capital, risk and strategy is always relevant – and certainly so in today's turbulent markets – so I am very pleased to have the opportunity to offer some thoughts from a regulatory perspective on these three important topics. In doing so, I will comment on:

• the unprecedented turbulence in the financial markets and the sectors' ability to deal with these challenges;
• the future of risk and capital management under Solvency II;
• the longer term strategic challenges for insurers arising from social, political and economic change; and
• the enduring need to put the fair treatment of customers at the heart of the business.

And to manage your expectations, I should also say up front that my agenda does not cover the Retail Distribution Review.  I hope you will understand that, as this is due to report in full later this month, I can only remind you of its importance to the efficient working of the retail investment market.  We will be launching the results at our own conference on 25 November which is the publication date of the Feedback Statement. 

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Turbulent markets

As you well know, since August 2007 there has been a sea change in the environment for financial services. Although many market commentators expected a downturn, the events that have unfolded are unprecedented, and the impact is being felt around the world and in different parts of the economy.

While the banking sector has been at the heart of the storm, the insurance sector – and the life insurance sector in particular – is increasingly coming under the spotlight. This is understandable; life insurers are investors, and on behalf of their policyholders they manage very significant portfolios of assets. So the recent falls and volatility in the equity markets, and the continued widening of corporate bond spreads has naturally captured people's interest and attention.

But it is also important to remember that:

• the insurance industry is in a very different place than in the last bear market of 2003; and
• this means it is better prepared to deal with stressed market conditions.

Reform of the capital regime for insurers

Let me start by saying that as a whole the industry is in a stronger position than it was in the early part of the decade when equity markets fell dramatically. Back in 2003 we had a regulatory regime that was not risk-sensitive, did not require insurers to hold capital to meet all their promises to policyholders and did not encourage good standards of risk management. In short, it was not fit for purpose, and the reforms we introduced in 2004 transformed the capital regime for insurers. This is an extremely important point, and it is sometimes overlooked or forgotten.

First, insurers are now subject to a strengthened Pillar 1 capital regime – the enhanced capital requirement for general insurers and the realistic balance sheet for the larger with-profits companies. Second, insurers are also subject to the Individual Capital Adequacy Standards (ICAS) regime, which requires insurers to calculate the capital requirements that reflect their own business risks and hold capital commensurate with this. Thirdly, we have introduced a number of changes designed to improve governance and the fairness of insurance contracts – particularly for with-profits.

The outcome of all of this is that the current capital regime is far more sophisticated and, importantly – in the context of current markets – is designed to deal with extreme market conditions. Alongside this, insurers should be much more aware of the capital consequences of the risks they are running within their business. Specifically, insurers already carry out resilience testing against a range of rigorous stress and scenarios relevant to the individual risks they face. And – unlike in 2003 – elements of the regime are counter-cyclical. Naturally, we are also keeping a close eye on market developments to ensure these elements continue to have the desired effect.

So I think the new regime is serving us well, and means that the industry is well placed to deal with the present difficulties. And I have seen nothing to convince me that the key tenets of the regime – market consistency, risk-sensitive capital requirements and good governance – need to change. But of course should we conclude that the present conditions demand a rethink of any aspects of the capital regime, or in their application to individual firms, this would be done in the usual way and with the normal approach to transparency.

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Risk management

To your credit, the industry embraced the changes to the capital regime – even where it meant having to raise additional financial resources – and responded by taking on the challenge of integrating risk and capital management. As a result, as well as having a stronger capital regime, insurers' standards of risk management are also significantly stronger, and we have seen:

• a better understanding of risk and the capital implications of those risks;
• the development of more sophisticated risk management techniques to mitigate risk; and
• evidence of resilience against a range of robust stress tests and scenario analyses.

But this does not mean we are complacent. So with this in mind I want to share some thoughts on three areas where we are pressing insurers to ensure they are prepared for the challenges of operating in uncertain market conditions. We published these in an Insurance Sector Briefing in September, and I think they remain relevant today.

The first is on ICAS, and in encouraging continuing progress towards fully integrating risk and capital management. Based on our observations, the firms making the most progress share three things in common:

• the greatest level of senior management oversight and governance in the ICA process;
• the use of the ICA in wider decision-making – including exploring strategies for mitigating risks that exceed risk appetite; and
• keeping the ICA model up-to-date with significant firm or market events.

These kinds of developments have even more value in less benign market conditions and will be important as a means of understanding both the risks associated with the present difficulties and the general economic outlook. They will also be useful to insurers in their preparations for Solvency 2, which I will come back to later.

The second issue is the highly relevant one of managing risk in less benign market conditions. As you know, this kind of environment reduces the room for error; but it is also exactly the time when all kinds of risks may be exacerbated. And in making these comments I am thinking very much in terms of non-financial risks such as strategic risk, business models, financial crime – including data security and employee fraud – as well as operational risks. I am also thinking in terms of how prepared firms are for managing risk in sharply changing market conditions. When I say 'prepared' I mean practical arrangements; the systems and controls firms have in place for measuring and managing risks and the governance framework around this.  In our discussions with firms it is clear that in at least some cases they have more to do.

Another important aspect of managing risk in less benign market conditions is managing the risk of uncertainty in the valuations of assets and liabilities. Following visits this year to some insurers we found evidence of systems and controls weaknesses of potential relevance to the pricing and management of less liquid assets, including ABS. And while most of the insurers we visited had limited exposure to ABS as a percentage of total assets, all insurers need to ensure that they have appropriate systems and controls – including staff with relevant market knowledge – to enable them to manage the risks resulting from different instrument classes. On valuing liabilities, one of the consequences of the market turbulence is a widening in corporate bond spreads. As most life insurers hold corporate bonds to back various classes of business, analysis of this development should be a key consideration for them in determining the discount rate used to value long-term liabilities.  So senior management need to challenge themselves and are responsible for reaching careful and well-considered judgements in this area.

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The third issue is stress testing and scenario analysis, which insurers need to fully utilize so that they understand their resilience to both the current financial market dislocation and a more challenging economic environment. There are several areas where insurers might consider developing their approaches, including:

• re-examining stress test and scenario analyses, particularly for market and credit risk and correlation assumptions;
• taking into account ripple effects, whereby, in stressed conditions, one event could lead to multiple and unusual knock-on effects;
• identifying the low probability and high impact scenarios they would wish to survive; and
• identifying scenarios that would give senior management a clear understanding of events that would lead their firm to financial failure.

This last point is an important one, and will be explored more fully in a Consultation Paper published before the end of the year.

So I hope I have offered a strong argument for why insurers are well prepared to deal with the current challenges, as well as highlighting some important areas where we are actively pressing insurers to remain focussed. But of course risk and capital management are not just domestic issues, and ultimately Solvency II will have the greatest influence on the long-term landscape of the insurance sector. Importantly it will contribute to a greater consistency of approach internationally – as you will know, international insurance groups currently operate under a variety of regimes, not all of which are risk-sensitive. So I want to spend a few minutes reflecting on progress to date and the challenges that lie ahead.

Solvency II

The vision of Solvency II is of consistent requirements for capitalisation, supported by a supervisory regime that encourages – and rewards – improved risk management.

We expect the European institutions to approve the Solvency II Directive by early 2009.  It has been a huge effort, and an even greater achievement, for the 27 Member States to get close to final agreement on the principles of Solvency II.  Some people have questioned the relevancy of Solvency II in light of recent market events.  We have supported Solvency II from the beginning and recent events only reinforce the need for strong risk-management and an adequately capitalised insurance industry, and Solvency II, if adopted in line with the Commission’s Proposal, will deliver just that.  Market consistency, risk-sensitive capital requirements reflecting economic reality, adequate systems of governance including the forward-looking risk identification and solvency analysis through the Own Risk and Solvency Assessment are key building blocks of Solvency II that will be an important part of ensuring the future stability of the industry. 

Solvency II will require insurers to operate risk management from the boardroom and throughout the firm.  It introduces a new, risk sensitive regulatory capital measure, and provides for increased scrutiny of firms’ internal models through a formal process of approving models for use in calculating regulatory capital requirements.  UK firms are in a strong position to take the additional steps necessary to prepare for Solvency II, given their experience of our existing ICAS regime, which combines a principles-based framework with risk-based capital requirements. 

In September, we published a Discussion Paper that represents the start of a programme of preparation for Solvency II for the UK insurance market.  It highlights and explains key elements of the Solvency II regime, and identifies the actions that insurers need to take. A simple but important step is to identify an individual responsible for preparing a plan for Solvency II implementation. Another is to get Solvency II preparations onto boards' agendas, and the key messages chapter of the DP is designed to facilitate this. We are also asking firms to review their overall governance framework, including risk management, and to assess the impact of the new 'standard formula' for capital calculation, as tested in the recent QIS4 exercise.

On internal models, the DP indicates how firms might progress their development towards Solvency II requirements.  It also lays out a timeline for the internal model approval process, and by June next year we are asking firms to confirm whether they intend to follow the internal model route.  This is an important decision for firms and those wishing to use internal models under Solvency II will need to further evolve their risk management so that it is effective and fully integrated with capital management. Approval of an internal model under Solvency II will only occur if the supervisor is confident that the firms’ risk management function is adequate. 

For many firms there is still a great deal to be done and they should not underestimate the level of effort that will be required.

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Longer term strategic challenges

Aside from the clear challenges posed by the present market difficulties, there is a wider strategic context for the focus on risk and capital management. Life insurers are operating in an environment in which the longer term challenges are also significant – and probably growing – which means that a strong culture of risk and capital management, coupled with clear strategic leadership, are key to success.

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. And there are behavioural changes, including the fall in consumer (and adviser) confidence in with-profits products and the corresponding rise in popularity of unit-linked products.

Senior management are therefore having to manage their risks (and their capital) in circumstances where both the short and the long-term landscapes are uncertain. We will be taking a close interest in their ability to do this.

TCF

Finally, I would like to share some thoughts on an issue that will endure long after the present difficulties have diminished; will help shape insurers' response to the strategic challenges; and should affect the very way in which risk is managed: TCF.

By the end of December 2008 we expect all firms to be able to demonstrate to themselves – and to us – that they are consistently treating their customers fairly. To be clear about what this means, I will unpack some of the statements we made in the June about culture and performance, and highlight the issues we are expecting firms to resolve in order to meet that deadline.

In June this year, we said that by December firms should be able to demonstrate four things. First, they should demonstrate that senior management have instilled a culture whereby they understand what the fair treatment of customers means; where they expect their staff to achieve this at all times; and where (a relatively small number of) errors are promptly found, put right and learned from.

We explained what we meant by ‘culture’ in the context of TCF last year, when we published a ‘culture tool’ – designed to help senior management identify areas of risk to TCF outcomes in the culture of the firm. Leadership is central - where there is strong leadership with a clear vision of what treating customers fairly means for the firm, it is more likely to have a culture which is geared towards delivering fair consumer outcomes. The firm's strategy is relevant – and insofar as current market conditions cause firms to alter their strategic direction – senior management should consider the implications for customers as an integral part of their planning. Decision-making at all levels within the firm will also impact. And controls, including management information, are important so that senior management in the firm can satisfy themselves that the customer is being treated fairly. And then there are the people issues. Recruitment, training and competence - firms can influence the delivery of fairer outcomes by recruiting staff with appropriate values and skills; training staff effectively; and assessing and monitoring their competence. And very topically at present of course, reward strategy is key. Those firms that showed good practice against the March deadline had treated TCF as something which needed to be built into the firm's culture.

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Second, and integral to a good culture, we expect firms to be appropriately and accurately measuring performance against all customer fairness issues materially relevant to their business, and be acting on the results. The key is development of evidence and measures that are really used by senior management. We don't want to see firms generating management information just to satisfy a visit from the regulator. We understand completely that a file badged as TCF MI is not worth anything unless it really is used by senior management as a way of measuring how the firm is behaving and whether outcomes are being met. Just as we did in March, senior management can usefully check whether they are measuring performance against the outcomes rather than simply conformity with internal processes; and whether they are measuring fairness rather than customer satisfaction. And, as with any other information relied upon, senior management will want to satisfy itself that information on performance against TCF outcomes has integrity – for example, that those measuring suitability of advice are qualified to do so, and that their work is overseen or checked at least periodically in some way.

Third, the measures are just one part. We also expect firms to be demonstrating through those measures that they are delivering fair outcomes. After many years of work, we would expect you to be delivering a very strong performance. This does not mean 100% delivery on all occasions, but – on rare occasions when things go wrong – we would expect senior management to have put in place clear accountabilities and timelines for taking action.

Finally, we expect firms to have no serious failings – whether seen through MI or known to us directly– including in areas of particular regulatory interest previously publicised by the FSA.

I know that firms are keen to meet the deadline, and that a huge amount of work is on-going with a great deal of commitment.  Equally, I would like to draw your attention to two very significant issues in the marketplace which, were they are allowed to persist, will demonstrably mean that the firms in question have not met the December deadline. These will be familiar to you, so I will not spend long on them here, but they are critical to your success in delivering on TCF.

• The first area is with-profits, where insurers need to ensure that they properly manage conflicts of interest and employ truly independent judgement in assessing their success in doing so. You will know that thematic work in this area has identified weaknesses, and that public perception is that insurers' governance arrangements are simply not delivering the protection to policyholders which they were designed to provide. We are aware of improvements in some cases, and expect changes to have been made where-ever necessary by the end of December.  Not only will progress here be critical to our assessment of whether these firms have met the deadline, but it is an area where progress – and visible progress – might help restore confidence in the market.
• The second area is policyholder communications, which particularly applies to with-profits, but is also applicable more generally. Thematic reviews have again found failings in this area, in relation to: Key Features Documents; and post-sale communications on both with-profits policies and Open Market Options. Providing clear and timely policyholder communications is a key aspect of firms' treatment of consumers and we have a high expectation that insurers will have made the necessary changes by no later than the end of December.

I also want to add that, in current market conditions, some insurers will face tough decisions: on investment strategy; on new business growth; and, in the case of with-profits insurers, on bonus rates and MVRs. These are always tough decisions, and is it extremely important that at the same time as taking timely and decisive action, senior management seek the necessary independent input and act in accordance with our rules and guidance.

In our view meeting the December deadline provided 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. We continue to believe strongly, not least in current market conditions, that progress is both essential and hugely in the interests of the industry. I hope you do too.

Conclusion

In conclusion, I started by noting the significance of current market conditions for the life sector, but also the reasons for believing that individual insurers are better placed to manage the consequences for their balance sheets – a change arising out of a fundamentally different regulatory regime combined with improvements in insurers’ own risk management.  Continuing to enhance risk and capital management will be key – to managing in stressed markets; to successful implementation of Solvency 2; and to management of the medium and longer-term strategic challenges facing the sector.  And throughout we expect firms to take their customers into account and to treat them fairly.

Thank you.

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