Select Committee on Treasury Minutes of Evidence



ParaRecommendation FSA Response
7.2Solvency standards
7.2Required minimum capital reflects all the risks in the business, pending the future introduction of fair value accounting. We have announced our commitment to radically improving prudential requirements for insurance firms within a framework consistent with the "three pillar" approach being adopted in the revision of the Basel Capital Accord. A start has been made in our June 2001 consultation paper on the Integrated Prudential Sourcebook (CP97), which proposed:

—  moving to a more dynamic, risk-based approach to capital adequacy for insurance companies; and

—  changes to the reserves which life insurers are required to maintain, thus moving towards a more realistic measure of solvency for with-profit funds.
7.2.1Guarantees and options should be valued stochastically and consistently with traded options prices. Current rules are inadequate. The June 2001 consultation paper on the Integrated Prudential Sourcebook included proposals to require insurers to "market test" the value of such options against external reinsurers or capital market providers. This essentially provides for values to be assessed in a manner akin to that used by the capital markets.
The insurance regulation project will discuss with the industry and professions how a market-based approach to provisioning for options and guarantees can be achieved by firms and introduced at the earliest opportunity.
7.2.2Review exercise of discretion over the use of implicit profits items. Current EC Directives currently allow implicit profits items to count towards solvency, within limits. Under the new Financial Services & Markets Act (FSMA) regime FSA rules will continue to prohibit implicit profit items unless a waiver has been obtained. The FSMA process for granting waivers will involve a more rigorous decision-making process than has applied in the past.
We are re-drafting the out-of-date guidance on the information we expect to be given and factors which will be considered when granting waivers for implicit items. Greater emphasis will now be placed on firms' management to demonstrate the overall solvency position of the firm and that there has been no double counting of the future margins. This draft guidance will be consulted on during November 2001, along with other guidance on asset valuation.
In the longer-term the use of implicit items will be restricted under changes to the EU Directives agreed this year.
7.2.3Review extent of industry's reliance on financial reinsurance and consider how much this erodes its strength, since its use undermines the margins of prudence in the current solvency framework. Financial reinsurance does not always erode a company's strength. In some cases it may be a genuine and appropriate form of financing. The key problem is the difficulty in identifying situations where such reinsurance has been taken out.
In the longer-term the key to addressing these issues will lie in more realistic solvency measures and clearer reporting of the financial position. In the meantime we are working on gaining improved disclosure so that readers of insurance companies' accounts and regulatory returns can see how financial reinsurance affects the financial condition of specific insurers.
In particular, we have been working with the ABI (Association of British Insurers) and the Accounting Standards Board to seek improvements to the disclosure of such reinsurance contracts in the Companies Act accounts of insurers. As part of the with-profits review we are also suggesting an alternative form of solvency statements for with-profit offices which explicitly shows financial reinsurance on the primary solvency statement.
In addition, we will carry out a review of financial reinsurance (including that which is in effect regulatory arbitrage) and the extent to which the industry's strength is affected by its use.
The insurance regulation project will also consider whether any further interim measures are needed to address the treatment of financial reinsurance.
Financial reinsurance arrangements, including material contingencies to them, should be disclosed in the regulatory returns. There is already a requirement for life insurers to disclose certain details of these arrangements in their regulatory returns. However, as noted above, in practice this disclosure is not always sufficient.
We have been involved since April this year in a review of the ABI SORP (insurance accounting guideline for Companies Act accounts). This is expected to include strengthening of the disclosure requirements for both financial reinsurance and contingencies.
We will also consider financial reinsurance and contingency disclosures when we consult on the changes to the regulatory reporting requirements necessary to implement the new prudential standards proposed in CP97. This consultation is expected to be in May 2002.

7.2.4Review the possibility of introducing multiple control levels as a basis for triggering proportionate regulatory action, eg including requiring reports at certain non-statutory trigger points. From 1 December, under FSMA, FSA will have much clearer grounds to intervene in an insurance company if the firm's management, business or internal controls give rise to a material risk to the FSA's objectives.

The tools that can be used for intervention have also been extended significantly, eg an improved right to obtain information, ability to request reports from experts, and provision to limit a firm's activities in line with a "scheme of operations" it has submitted. (This latter tool includes a requirement to demonstrate capital is sufficient to support a prospective assessment of financial and operational resources, after stress and scenario testing.)

The insurance regulation project will consider this recommendation.
7.3Role of Appointed Actuary
7.3Appointed Actuaries should be subject to independent external review, carried out by the FSA or independent firms, to a standard equivalent to an external audit. Changes have already been made to the role of the Appointed Actuary under the new FSMA regime which comes into effect from 1 December. In particular the individuals performing this function will have to be approved by the FSA. The new regime also places more emphasis on the responsibilities of firms' senior management to allocate clearly and document responsibilities and to ensure that systems and controls, including segregation of duties, are appropriate.

We are considering whether Appointed Actuaries should be subject to external review and, if so, how best to achieve this. The cost-benefit implications will need to be carefully considered.
7.4Review the purpose, content and frequency of the regulatory returns. The regulatory returns are to be reviewed so that reporting is consistent with the proposed new prudential rules and guidance in CP97. We plan to consult on these changes in May next year.

This review will look at the full range of issues including content of "standard" items; how much will be obtained through general information gathering as part of the normal supervisory process; which elements should remain on the public record and which items should be private to the regulator; which elements will be subject to self-certification, external audit or actuarial or other forms of certification; and the frequency of reporting.

In addition one of the workstreams under the with-profits review is considering what improvements can be made to the regulatory returns in the meantime to provide more effective and transparent disclosure of information about the financial condition of with-profits offices. An issue paper is due to be published at the end of October and we hope to be able to bring these changes to disclosure into effect as of the end of 2002.
The assessed financial risk must be an integral part of an overall risk assessment that is consistent across the FSA Financial risk is clearly a key input to the overall identification of risk. This is reflected in our new risk-based approach to regulation, which uses a single, FSA-wide model to assess risk and make judgements about the appropriate regulatory response.

In addition, as announced in June 2001, we are working on an integrated approach to prudential standards which includes systems and controls relating to areas such as operational risk, credit risk, market risk, group risk, as well as the main financial risk measures such as insurance solvency and liquidity. We plan to consult on the supervisory processes by which these standards will be assessed in May next year.
The FSA must have the ability to obtain further information, perhaps routinely for higher risk firms, and to conduct its own review where necessary. The changes introduced by FSMA (eg additional powers to require information and use experts) increase the FSA's ability to do this.

The insurance regulation project will consider how we should use these powers and whether any further enhancements in FSA rules are needed.
7.5Industry Review
7.5Consider producing a regular review of issues and trends that may pose a regulatory risk to the industry. We have already started to improve our understanding of industry and environmental trends.

Our Risk Assessment Division, established in June 2001 to consolidate risk assessment work across the FSA, will provide enhanced environmental analyses to help supervisors to be more fully informed about key trends and developments across all relevant sectors.
7.7The FSA should:
Be prepared to be more proactive in pursuit of its statutory objectives to protect policyholders. This is a fundamental part of our new risk-based approach to regulation. We have already carried out extensive training for regulators throughout the FSA about the new regime and conducted successful pilot exercises.
Review its use of powers of investigation, influence and intervention so that its actions are proportionate to the preceived risks. We recognise, however, that we still have much to do in this area. The Chairman's Committee is taking the lead in driving through the cultural change throughout the organisation. However, fully achieving change on this scale will take time.
Adopt a more proactive, risk-based approach that relates the contact with a firm to its risk category. Specific cultural issues related to insurance supervision will be addressed as part of the insurance regulation project.
Form and articulate a clear view of what are the permissible boundaries of proactive regulation. This will be considered as part of the insurance regulation project.
In addition, the FSA should devote more resources to developing awareness between teams about what each other does and needs. Welcome integrated insurance regulation. Integrating prudential and conduct of business regulation has already helped in this area, as has integrated supervision of the largest financial groups. Addressing any outstanding issues relating to effective co-ordination and communication will be part of the insurance regulation project.

7.8Remain alert to the difficulties of implementing change and, in particular, be alive to the risk that structural change may facilitate better communication and co-ordination but will not necessarily achieve it. We fully accept this point and are taking steps to address it, including increasing incentives for FSA staff to behave in ways that are consistent with the new culture. These will include promoting more movement of staff within the organisation.
For matters of a certain size etc, the FSA should not assume that the existing team structures will deliver the required result. Part of our new approach involves greatly increased matrix working—pulling together teams from across the FSA to deal with specific issues.
FSA management should ensure that a special team is formed if the existing team does not encompass all those with a relevant interest or the necessary expertise. The insurance regulation project will consider whether this requires any enhancement.
The team must be properly constituted and work cohesively, exchanging information consistently and comprehensively.
Reinforce the "non zero failure" message by making clear to consumers that non-intervention or no comment from the FSA should not be taken as an endorsement of the company's financial well being. We constantly seek opportunities to do this, although in practice it is a message that is difficult to get across. We shall consider what more might be done.
There is uncertainty about the interpretation of Conduct of Business rules and standards of disclosure regarding significant operational risks. Consider what standards of disclosure should apply and the extent to which these can be codified. Work is already under way on improving disclosure, and we have announced a "rolling review" of conduct of business rules. There is a constant tension between our preference to set principles and the desire among some parts of the industry for detailed rules.
Rectify the shortcomings (of communication and shared learning between regulator and Enforcement) and ensure that information with Enforcement is made available to the regulator and vice versa in a timely way. While the integrity of enforcement information must be respected, we accept that all relevant information must be able to flow to the supervisors unimpeded. Guidelines for liaison between supervisors and Enforcement have already been developed and management will ensure that proper co-ordination is achieved.
In integrating insurance regulation, the FSA must ensure that responsibilities re Policyholders' Reasonable Expectations (PRE) are comprehensive and properly managed. Under the new FSMA regime, the concept of PRE disappears, to be replaced by the principle that customers should be treated fairly (Principle 6 of our core Principles for Businesses).

The integration of conduct of business with prudential supervision should help enable responsibilities relating to treating customers fairly to be more effectively managed.

The insurance regulation project will consider any further ways in which this can be more effectively addressed within integrated supervision.
7.9Consider how to apply a more rigorous risk assessment process to specific situations where certain risks have escalated or crystallised and all reasonably considered outcomes need to be planned for. The insurance regulation project will consider how risk assessment should be applied in such circumstances.
For concepts such as PRE, that are undefinable or capable of more than one interpretation, the FSA should develop policy templates to ensure consistency of interpretation and application. The FSA has already sought to provide extra clarity and guidance on the concept of treating customers fairly in the context of with-profit funds within the draft Integrated Prudential Sourcebook (CP97).

Our internal policy and procedural guidelines are also being updated to ensure consistent interpretation and application of the FSMA regime and the risk-based approach.

We will consider whether policy templates should be developed.
Carry through to completion the current work on clarifying PRE. Elaborating on the fair treatment of customers is one of the workstreams of the with-profits review. Amongst other things, the review is addressing the need to tell customers about the operation of discretion in with-profit funds. Other work is addressing the governance of these funds and other aspects of the fair treatment of customers.
The New Regulator for the New Millennium (NRNM) will require the FSA to consider the level of resources committed to life insurance and the mix of competencies and skills in order to give effect to the more proactive and interactive approach that is planned. Resources committed to life insurance supervision have already been increased and extensive training for the new regime is in progress.

The level and mix of resources, plus training requirements etc, will be considered as part of the insurance regulation project.
7.10Expect the FSA to progress the exercises and initiatives that have continued beyond the 8 December 2000 cut-off point. These are being taken forward.

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Prepared 17 December 2001