20 September 2004 Economic capital: Notes from the UK Canadian Institute of Actuaries Appointed Actuary seminar Client logo should align top with this guide Client logo should align bottom with this guide C O N F I D E N T I A L

Contents 1. Summary of Financial Services Authority (‘FSA’) objectives 2. The story so far 3. Individual capital assessment 4. Implications for UK Life Copyright © 2004 Mercer Oliver Wyman

Summary of Financial Services Authority (‘FSA’) objectives Section 1 Summary of Financial Services Authority (‘FSA’) objectives Copyright © 2004 Mercer Oliver Wyman

Summary of Financial Services Authority (‘FSA’) objectives Statutory objectives Consumer protection Maintaining confidence in the financial system Practical interpretation ‘Greater transparency and protection for consumers’ ‘Enough capital to be able to honour the promises they make to their customers’ ‘Reduce the risk of a firm’s financial failure . . . Not reduce the risk to zero’ Copyright © 2004 Mercer Oliver Wyman

Section 2 The story so far Copyright © 2004 Mercer Oliver Wyman

The previous ‘rules-based’ approach was ‘dilapidated and deficient’ Inadmissible assets Admissible assets Available capital EU minimum required capital = x% stat reserves Statutory reserves including resilience Conservative assumptions Valuation interest rate Copyright © 2004 Mercer Oliver Wyman

The EU is moving towards harmonisation of Solvency regulation across Europe, using Basle as a template Copyright © 2004 Mercer Oliver Wyman

The FSA has taken the lead in developing concrete proposals via its (draft) Integrated Prudential Sourcebook Pillar I – ‘Twin Peaks’ Technical reserves based on minimum requirements (peak 1) Realistic reserves based on market-consistent value of liabilities For participating (‘with-profits’) funds only Generally requires stochastic modelling Minimum capital requirement based on stress tests of both peaks Pillar II – Individual Capital Guidance FSA instructs each company to hold a certain amount of additional capital, based on its own risks Internal models are encouraged, and ICG will take results into account Copyright © 2004 Mercer Oliver Wyman

The FSA has taken the lead in developing concrete proposals via its (draft) Integrated Prudential Sourcebook Pillar I – Twin Peaks Pillar II – Individual Capital Assessment XS admissibles Risk capital margin EV of NP Other Required Capital WPICC Solvency Standard Required Capital in Par Fund Realistic Liabilities LTICR Resilience Mathematical Reserves Economic Capital Enhanced Capital Requirement Regulatory Peak Realistic Peak Copyright © 2004 Mercer Oliver Wyman

Main focus to date has been on realistic peak Realistic liabilities Risk capital margin Components of liability Asset share MC cost of guarantees & smoothing Charge for guarantees Requires a market-consistent asset model Calibrated to prices of available options (e.g. interest rates and equities) or historic volatilities (e.g. property) Dynamic algorithms for bonuses and policyholder behaviour Based on specified instantaneous market shocks Equity/property Interest rate Credit risk Dampeners applied in extreme circumstances Aimed at a BBB-level market shock 99.5% confidence interval over one year Proposed accounting standards will include publication of realistic liability and RCM Copyright © 2004 Mercer Oliver Wyman

A number of companies have published their RCM coverage for the 2003 year-end * Including external shareholder funds NB: All figures are based on ABI basis for determining realistic balance sheets Copyright © 2004 Mercer Oliver Wyman

Individual capital assessment Section 3 Individual capital assessment Copyright © 2004 Mercer Oliver Wyman

This provides the basis for ‘Individual Capital Guidance’ The FSA wants companies to assess their own capital requirements as a part of running the business Hold capital that is appropriate to the business Responsibility of senior management Better risk management Consumer protection and market confidence This provides the basis for ‘Individual Capital Guidance’ Copyright © 2004 Mercer Oliver Wyman

Individual Capital Assessment can take a number of forms Twin peaks RCM Stress and scenario testing Economic capital models Complexity Greater credit will be given for internal models where these are ‘adequately integrated into business management’ Copyright © 2004 Mercer Oliver Wyman

Individual Capital Assessment has wider scope than RCM Market risk Credit risk Liquidity risk Insurance risk claims persistency Operational risk Across the entire company, and allowing for interactions between risks and products Included in RCM Implicit target of BBB rating (99.5% over 1 year) Copyright © 2004 Mercer Oliver Wyman

The approach to Economic Capital modelling is deliberately not specified Scope for a wide variety of approaches ‘Cut-off’ vs. ‘run-off’ Inclusion of new business Choice of Economic Scenario Generator Risk metric Management actions vs. treating customers fairly Requirement to allow for material risks Longevity Expense/overheads Operational risk Allowance for diversification and aggregation (where justifiable) Copyright © 2004 Mercer Oliver Wyman

Implications for UK Life Section 4 Implications for UK Life Copyright © 2004 Mercer Oliver Wyman

The new regime has already led to industry action Standard Life to demutualise New rules are ‘fundamentally shifting the shape of with-profits’ Legal & General ‘We are considering guarantee charges on the NUL&P [participating] fund’ Norwich Union Copyright © 2004 Mercer Oliver Wyman

The new framework should result in a more intuitive capital regime and better managed companies Asset liability mismatches lead to greater capital requirement Use of derivatives for risk management is rewarded Subject to counterparty risk Management are required to ‘walk the walk’ Dynamic investment policy Smoothing Principals and Practices of Financial Management Natural hedges and diversification should reduce capital Sensible risk management is rewarded Copyright © 2004 Mercer Oliver Wyman