1. 20 September 2004
Economic capital: Notes from the UK Canadian Institute of Actuaries Appointed Actuary seminar
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C O N F I D E N T I A L

2. Contents 1. Summary of Financial Services Authority (‘FSA’) objectives
2. The story so far
3. Individual capital assessment
4. Implications for UK Life
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3. Summary of Financial Services Authority (‘FSA’) objectives
Section 1
Summary of Financial Services Authority (‘FSA’) objectives
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4. 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’
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5. Section 2
The story so far
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6. 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
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7. The EU is moving towards harmonisation of Solvency regulation across Europe, using Basle as a template
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8. 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
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9. 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
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10. 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
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11. 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
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12. Individual capital assessment
Section 3
Individual capital assessment
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13. 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’
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14. 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’
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15. 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)
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16. 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)
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17. Implications for UK Life
Section 4
Implications for UK Life
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18. 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
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19. 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