Younger Members Convention - 1 & 2 December 2003 - GLASGOW Presenter: James Mulrooney, FSA

1. Younger Members Convention - 1 & 2 December 2003 - GLASGOWPresenter: James Mulrooney, FSA Topic: CP195 and regulatory developments in Life Insurance

2. Main Issues in CP 195 • Original proposals in CP 143 - “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

3. 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

4. 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

5. “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”

6. 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

7. 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

8. 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

9. 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

10. 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

11. “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

12. “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

13. “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

14. “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

15. 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 shockCredit Risk component - increase in spreads (versus gilts) and defaults upPersistency Risk component - less people lapsing policies

16. 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

17. 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.

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

19. 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

20. 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

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

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

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

24. Capital measures for life insurers EU minimum + with-profits capital component + resilience capital component Stress and scenario testing EU minimum + resilience capital component MCR CER ICAS

25. Capital Requirements - Pillars 1 & 2 • Increases to Pillar 1 capital being implemented from 1 Jan 2004 - 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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”