Development of UK Capital Adequacy Standards ARIA Conference, Washington DC 7 August 2006 Ian Tower The Financial Servi

1. Development of UK Capital Adequacy Standards ARIA Conference, Washington DC 7 August 2006 Ian Tower The Financial Services Authority

2. Scope of Presentation • The need for reform • Minimum capital • Individual Capital: • Objectives • Approach • What we have found • The future – the EU’s Solvency 2

3. The Need for Reform • Risk management techniques were not as well developed and less objective in insurance than elsewhere in financial services • Boards/senior management not sufficiently engaged with risk management process • Statutory capital levels were not sufficiently risk sensitive • Wanted to give firms incentive to improve their risk management techniques • Needed to develop risk-based approach well before Solvency II reforms

4. UK insurance sector regulatory reform – overview • With-profits: “realistic reporting”; Principles & Practices of Financial Management; governance • Financial governance: abolition of the “appointed actuary” role • Audit of FSA life returns – with actuarial review • New risk-based prudential capital for general insurance • New approach to group capital adequacy • Individual Capital Assessments - ICAS • New framework for reporting to FSA • Emphasis on treating customers fairly

5. Minimum capital (Pillar 1): life firms • Two solvency tests (“twin peaks”) for with-profits (participating) business – • statutory (based on EU directives) and • realistic (FSA’s own test) • different approaches to both reserves/valuation and capital • realistic approach applies only for largest 37 firms (with-profit liabilities over £500 mn) • Realistic peak more sensitive to economic conditions, but provides no incentive for good risk management. • Non-profit (non-participating) business subject to single statutory test. • At 31/12/2005 the realistic peak was higher than regulatory peak for 32 of 37 realistic reporters. • For the 32 an extra requirement (WPICC) is added to the regulatory requirement to ensure regulatory surplus does not exceed realistic surplus.

6. The Twin Peaks Regulatory Peak Realistic peak WPICC Risk Capital Margin (RCM) Resilience capital requirement ECR MCR Long Term Insurance Capital Requirement (LTICR) Realistic reserves Mathematical reserves WPICC brings regulatory peak up to realistic peak

7. Minimum capital (Pillar 1): general/P&C • Formula: charges based on: • asset values + • technical provisions + • premiums • Limited to current accounting classes • Not intended to be a risk based capital – role of individual capital standards • It is intended to be better than EU solvency standard and reflect risks better

8. Pillar 1 - General Insurance MinimumCapitalRequirement EnhancedCapitalRequirement IndividualCapitalAssessment IndividualCapitalGuidance ICA ICG ECR Directiveminimum MCR Can be less than 100% of ECR in certain cases May be equal to or higher than firm’s ICA

9. ICAS – individual capital: overview • Insurance firms are required to assess what level and quality of capital they need to maintain • Should be no significant risk that they are unable to pay liabilities as they fall due • FSA reviews ICA, taking into account other information, forms view of the capital adequate for the firm's risk profile • FSA gives individual capital guidance (ICG) - both quantitative and qualitative • ICAs are being reviewed over 2 1/2 years 2005-2007

10. Individual Capital - Objectives • Emphasis on better risk management - as management problems or governance are at the root of insurer failures • Capital modelling should improve understanding of risk as the interactions and causal links have not been well understood • Risk based capital more relevant to the way businesses are run • Emphasise senior management responsibility • Enhance consumer protection and market confidence by reducing the risk of financial failure

11. ICAS Approach - Modelling framework • Firms must undertake an assessment of the adequacy of their capital resources: • consistent with the activities and responsibilities of the firm; • to quantify the risk of the firm not being able to meet all its financial obligations as they fall due; and • to demonstrate a level of solvency which can be compared to a 99.5% probability of failure over one year. • The assessment must: • reflect the nature of the firm's assets, liabilities, management practice and systems and controls; and • use methods of valuation in a consistent fashion throughout the assessment.

12. Governance, “Use test” etc • The ICA framework should be embedded in the firm’s business • We ask three principal questions: • Is there senior management engagement, including the Board? • How are the ICA principles and models being used for ongoing management purposes? • How are ICA results used to influence risk management goals and prioritise activity?

13. A typical review process Internal Planning Submission Request Initial Review FSA Initial View Discussion with Firm Written Questions Preview to Firm FSA Panel Process Formal Notification

14. ICAS – What we have found • Variety of approaches taken and ICA numbers vary across similar firms on same issues • The quantification of operational risk remains a challenge for almost all firms • Measurement of diversification benefit – taking credit for spread of risks – a common issue • Major improvement in firms’ - and supervisors’ - understanding of the key drivers of risk and capital • Risk measurement improvements feeding through to better risk management.

15. The Future - Solvency 2 • EU project to reform insurance prudential regulation based on the three pillar structure • Aims to incentivise better risk management and integrate regulatory capital assessment with firms capital management processes • Supervisory adjustment to capital requirements where justified • Quantitative Impact study in progress – an important checkpoint in the design of the new regime • Framework Directive proposal – due mid 2007 • Implementation 2010?

16. Summary • Firms have responded well to new UK framework • More emphasis on risk management and spreading good practice with ICAS than statutory approach • Beneficial for both firms and FSA as both getting a better understanding of the business and the risks • Keys challenges for future include improving risk and capital management and development of Solvency 2.