Younger Members Convention - 1 & 2 December GLASGOW Presenter: James Mulrooney, FSA Topic: CP195 and regulatory developments in Life Insurance

Main Issues in CP 195 Original proposals in CP “twin peaks” approach for life insurers Recent stockmarket falls put pressure on statutory solvency while insurers claimed realistic basis still strong “Tiner” Waivers - FSA needed reassurance before granting these waivers- realistic basis was able to provide evidence of financial strength

Problems with current regime Capital not very risk-sensitive With-profits constructive liabilities (accrued final bonus) not in balance sheet Capital hidden within prudent reserves Approach may undervalue options –eg guaranteed annuities, MVA-free dates Capital rules-based, not based on circumstances of the firm No allowance for smoothing costs

Criteria for Realistic Reporting Only applies to firms that are realistic reporters - with profit funds > £500m Smaller firms can opt in if they wish “Tiner” waivers now proposed to be codified into Integ Pru Sourcebook for realistic reporting firms Only realistic reporters can use all amended (i.e. less onerous) valn rules Other waivers will be available to all firms - e.g. restriction on equity yield

“Tiner” Waivers - Overview Original intention was to allow WP firms to retain equities and to avoid a downward spiral in equity prices Weakened Rules must still meet EU Directive minima - UK can go no lower Waivers should not create a risk to security of policyholder benefits Full publicity of firms with waivers on FSA website creates a positive image - seen as a “badge of strength”

Rules Changed: Statutory Reserves Gross Premium Valuation for WP Inclusion of prudent lapse assumption where justified Removal of cap on maximum valn reinvestment yield GAO reserving guidance weakened Restriction on Earnings Yield for equity assets removed Resilience reserve can now be held as a capital requirement: no RMM element

Realistic Reporting - Overview Applies to WP liabilities or firms with similar liabilities - deposit admin, etc. Designed to better identify risks in firms and to determine strength of firms Also should capitalise costs & risks that currently are not included in stat Will combine with stat valuation to ensure that adequate reserves are held Uses of techniques used internally by firms - asset shares, stochastic models

Realistic Valuation Methods Both asset share and prospective methods (e.g. bonus reserve valn) are acceptable for basic realistic reserve For option reserves, 1 of 3 methods should be used - 1). Stochastic projection, 2). Replicating portfolio of derivatives assets or 3). Range of deterministic projections with assigned probabilities Either asset share or BRV method is acceptable for basic policy benefits

Realistic Valn Methods - continued Realistic reserves can factor in future management actions - changes to investment mix, bonus rate reductions All future management actions must be consistent with treating customer fairly and the firm’s published PPFM All bases, parameters documented For option reserves, stochastic projections are preferred but

Realistic Valn Methods - continued Replicating portfolio of derivatives can be effective in certain circumstances - known future benefits, fixed maturity date(s), little variation in asset mix, etc Range of deterministic projections is least favoured option as option/g’tee costs often understated using deterministic methods v stochastic Size & complexity of w-p business also a factor in which model to adopt

“Twin Peaks” Calculation - Reserves Free assets on statutory basis cannot exceed free assets calculated on realistic basis Statutory reserves are WP policy reserves, WP portion of resilience reserve and WP portion of RMM - with benefit of less onerous reserving rules Realistic reserves are realistic reserves (incl. g’tee & smoothing costs) and RCM - risk capital margin

“Twin Peaks” Calculation - Assets 1 Statutory value of assets unchanged - asset admissibility rules as before Realistic value of assets = statutory value of assets (for w-p pols) + assets (of admissible type) above counterparty and/or exposure limits + realistic value of any NP business in firm’s WP fund: e.g. EV of NP business Example: Value of Individual Property above 5% - OK; Antiques - no value

“Twin Peaks” Calculation: Other Issues Implicit items are still valid (up to 2007/9) in stat surplus calculation but have no value in realistic surplus calcs Cashless financing reinsurance (based on future WP surplus emerging) are proposed to have no value in stat valn Fin re based on WP s/h transfers or np profits may still be permitted in stat Each WP fund must meet WP realistic liabs from resources within WP fund

“Twin Peaks” Calculation - WPICC WPICC - WP Insurance Capital Component Designed to overlay realistic financial strength calcs on published (i.e. stat) financial strength - especially for firms that appear strong on statutory basis WPICC = Max(0, Statutory Surplus - Realistic Surplus) Positive WPICC must then be held as part of the firm’s capital requirement

Resilience Reserve & Risk Capital Margin (RCM) Resilience reserve - similar basis of calculation as before Required Capital Margin made up of 3 elements: Market Risk - assumed equity & property falls & interest rate shock Credit Risk component - increase in spreads (versus gilts) and defaults up Persistency Risk component - less people lapsing policies

Risk Capital Margin (RCM) Market risk test is designed to assess capital required to guard against market shock/crash Credit risk test used to assess capital needs for a deterioration in credit standing - “flight to quality”, recession Persistency risk designed to model p/holder behaviour of selectively NOT lapsing - increasing realistic reserves

Practical issues Forward swap rate or current gilt yield for discounting future option liability costs (e.g. GAOs) - different approaches are being taken. Gilt yield may possibly be more correct but swap rates are based on a deeper market - issue still to be resolved Approved Securities - definition of these assets includes some securities that are, arguably, not risk-free (unlike gilts) in CP97.

Practical issues - continued For the credit risk test under CP195, should non risk-free assets that are “approved securities” be included?

Risk Management New regime is akin to what best practice should be for insurers Firms may re-assess a number of aspects of their business - reinsurance, capital (support), hedging, bonus policy, etc. Systems and control weaknesses may be addressed by Enhanced Cap Req’t Sometimes capital may not be appropriate - systems overhaul, etc

FSA Annual Returns - Forms 18 & 19 Two new forms are proposed to be included in FSA Annual Returns - Form s 18 & 19 are only required to be completed for realistic reporting firms Form 18 is the realistic balance sheet Form 19 compares statutory and realistic surplus to determine if the value for WPICC - I.e. zero or higher Any requirement to hold a (>0) WPICC will be a capital requirement on Form 9

Stage 1: standard regulatory basis - all life business Admissible assets 750 RMM 25 Free capital 25 Resilience reserve 20 Non-profit liabilities 100 With-profit liabilities 580

Stage 2: With-profits business only Admissible assets 644 Free capital 95 RMM 21 Resilience reserve 18 With- profits liabilities 510 Realistic assets 675 Realistic liabilities 570 Market, credit and persistency risk capital 29 Free capital- realistic basis 76 Peak 1Peak 2

Final presentation under proposed approach All life business- ECA Free capital 76 WPICC 19 RMM 25 Market risk capital 20 Policyholder liabilities 610 ECR MCR

Capital measures for life insurers MCRICASCER EU minimum + resilience capital component EU minimum + with-profits capital component + resilience capital component Stress and scenario testing

Capital Requirements - Pillars 1 & 2 Increases to Pillar 1 capital being implemented from 1 Jan PS181 Enhanced Pillar 1 - Realistic Reporting and requirement to hold WPICC (>0) - end 2004 Pillar 2: Individual Capital Requirement - based on intrinsic risks individually assessed on firm-by-firm basis - should be more risk-sensitive Much of this information not public

Individual Capital Adequacy Standards Firms assess own capital requirement –based on own business and risks Incentive for better risk management To enhance consumer protection and market confidence through reduced risk of financial failure Applies to all insurers Firms to carry out stress and scenario testing Firms to hold adequate fin resources

Terminology CRR: Capital Resource Requirement MCR: Min Capital Requirement - I.e. Capital Req,ment based on Stat Valn LTICR: RMM + resilience reserve (RCR) for both WP & NP liabs ECR: Enhanced Capital Requirement = LTICR + RCR + WPICC (which may be 0) ICA: Individual Capital Assessment ICG: Individual Capital Guidance

ICAS: areas to be considered Guidance in Handbook on factors to be taken into consideration Business risk factors –market and credit risk –securitisation risk –residual risk –concentration risk –high impact, low probability risk –cyclical and business planning Control risks factors: systems & controls

ICAS: Reporting No regular requirement Firm to retain analysis/reports for possible review by FSA FSA review as part of supervisory programme Not public information - between FSA and regulated firm; exclusions may apply - auditors, (external) appointed actuary, etc

Individual Capital Guidance (ICG) Initial exercise –review of firms’ ICA –issue ICG to firms Thereafter –part of Arrow process –frequency of review based on risk assessment

Content of ICA Amount of ICA Background of firm Environment, business strategy, plan and sources of new capital Risk assessment Stress and scenario tests Other risks Capital models

Results of ICG process May –confirm pillar 1 capital (not public); –give guidance for increased capital (not public); or –allow waiver to reduce capital requirements May impose requirement if guidance not accepted (in public domain) - variation of permission(s), in extreme

Change to Appointed Actuary regime Next year, appointed actuary replaced by actuarial function head and with profits actuary (for WP) Head of Act Fn carries on many of the roles of AA previously WP Actuary must certify that realistic reserves for WP business have been calculated consistent with TCF Reviewing Actuary must also certify being content with realistic basis calcs

Reporting and audit- realistic basis New forms to show realistic liabilities plus disclosure of basis on which assessed Audit scope to include realistic basis Reviewing actuary’s opinion to include realistic liabilities and capital requirement Directors certificate will cover realistic basis capital requirements All in public domain with rest of annual returns

Audit requirements & Role of Actuaries FSA Annual Returns - directors must now have regard to opinion of reviewing actuary Reviewing actuary must be independent of firm but may be an employee of audit firm With profit actuary also required to produce report to w-p policyholders - WP actuary can be “in-house”