FSA: The new approach to insurance regulation and the implementation of Solvency II

Speech by Julian Adams, Director of Insurance Supervision, Prudential Business Unit, the FSA, at the City & Financial Conference, London.

The title ‘The new approach to insurance regulation and the implementation of Solvency II’ seems to imply that these are two separate issues. It is my belief, however, that the two are in fact one and the same, and I would like to spend my time with you this morning exploring what I mean by that and what both of those things will mean in practice over the next 12 months and beyond.

It is worth recapping at this point what the main features are of the government’s regulatory reform programme, and how these affect the existing institutions. As you’ll be aware, the proposal is to make the Bank of England responsible for so-called macro-prudential supervision. Alongside this responsibility, the Bank – through a new subsidiary called the Prudential Regulation Authority (the PRA) – will also have responsibility for the micro-prudential supervision of individual firms which undertake deposit-taking and insurance activities. There will be clear linkages between the two so that, for instance, the outputs of macro-prudential analysis will influence the agenda in relation to the supervision of individual firms.

There will also be a separate body – the Financial Conduct Authority. This will be responsible for supervision of the conduct activities of firms which are prudentially regulated by the PRA, and it will be responsible for all aspects of supervision of all of the other firms currently supervised by the FSA. This will include responsibility for markets oversight and acting as the Listing Authority, as well as issues relating to the fair treatment of retail and commercial customers.

My own responsibilities are on the prudential side, and it is the PRA’s future approach which I will be talking about.

We expect that the PRA will assume its statutory responsibilities in the spring of 2013. In order to make the change more manageable, and to allow us to benefit from it more quickly, we have recently reorganised the FSA to reflect the future split in its responsibilities, and anticipate to some extent the future approaches of its successor bodies. This means that we are now operating in an environment known as ‘internal twin peaks’, and I will talk a little more later about what this will mean for you as regulated firms.

As you know, the PRA will have two statutory objectives: first, there will be the PRA’s general objective of safety and soundness of firms, minimising the potential impact of a firm’s activities on the stability of the UK financial system; and, second, there will be the more specific insurance objective of contributing to the securing of an appropriate degree of protection for policyholders. These complementary objectives recognise the differences between different parts of the financial sector, and the different ways in which firm failure can affect counterparties and other stakeholders, as well as the real economy.

We perceive the principal benefits of the new arrangements as being two-fold. First, the clear combination of macro- and micro-prudential responsibilities within the Bank of England group will put us in a much better position to understand and deal with the nature and extent of cross-sectoral risk transfer, and the potential effects this may have on the overall system.

An example of this would be the way in which stock-lending transactions between insurers and banks are treated on both sides of the trade. Second, supervising insurers and banks together also ensures consistency of treatment between the two sectors, meaning that transactions will be treated in the same way if they are the same in substance, irrespective of their legal form.

From the point of view of firms, the PRA’s much more tightly-defined objectives will mean that there will be a clearer focus from supervisors, concentrating on matters which go to the heart of the financial viability of firms, and thus their ability to meet commitments made to policyholders. This is a particularly important issue when dealing with insurers, as policyholders’ premiums are paid up-front, often many years before any entitlement under the policy may materialise.

Supervisors will be expected to be able to answer 30 questions about the firms which they supervise; these answers will put them in a position to be confident that they understand

• whether a firm is financially sound;
• whether the business model works and is reasonably robust;
• what the vulnerabilities of the business model are;
• what stress testing (including reverse stress testing) has been carried out – what would break the company; and
• what the potential is for harm to be caused by failure of the firm.

None of this is completely new, and much of what you see will be an evolution of the prudential approach the FSA has taken to insurance supervision in recent years. In 2005, we introduced individual capital adequacy standards – ICAS – a risk-based capital regime for insurers, and we are now working to implement the Solvency II Directive, which will modernise the risk management, governance and capital regime for insurers on a consistent basis across Europe. These developments are entirely consistent with the PRA’s intended approach.

So, what will be the main features of the new regime? First, it is important to emphasise that – as with the FSA today – the PRA is not intending to implement a zero failure regime. It is questionable whether a regulator could ever genuinely bring about such a scenario, and it is certainly accepted that the costs associated with doing so – in terms of product affordability and availability, competitiveness and so on – would far outweigh the marginal benefits. What the PRA will seek to do is two things – first, to minimise the probability of firm failure, and second to bring about a situation where the impact of such a failure, both on policyholders and on the financial system, is also minimised.

The way we will go about this involves a number of stages, which will fit into an overall framework that will replace the FSA’s current ARROW framework, with which you will have become familiar over the years. This new framework will bring together all strands of regulatory activity into a single supervisory strategy. The size and shape of this strategy will be informed by our assessment of the firm’s overall impact on the PRA’s objectives, and will take into account whether we have responsibility only for an individual firm, or for an entire group as consolidated supervisor. This will be true of both insurance groups and groups which cut across the banking and insurance sectors.

The first stage in the new framework will be an assessment of the vulnerability of the firm’s business model. This assessment will take into account a number of different factors, including the macroeconomic and legal environment; the risks inherent in the portfolio of business underwritten and how these may change in the future; and concentrations on, or exposures to, certain types of risk or customer.

The second stage will be for us to consider whether there is a reasonable resolution approach which could be adopted in the event of firm failure. It is true that the nature of resolution in the insurance market is clearly very different from that available for banks, where there is now a special resolution regime set out in statute.

For insurers there are a number of long-standing and well-understood resolution mechanisms – for instance, solvent run-off and schemes of arrangement – for firms which have either failed or have closed to new business. We understand these mechanisms and are comfortable with the way they operate in practice.

What we will need to do, however, is consider whether these exit mechanisms would be viable in the circumstances of all firms, as there may be circumstances in which generally effective approaches do not necessarily respond well to an individual firm, portfolio of business or type of event. We have work in hand to consider this, and it may be that we need to develop new – and possibly mandated – resolution approaches for insurers in the future.

The third stage will be for us to undertake a detailed analysis of firms’ financial strength, and this is one of the areas where the preparatory work we are doing with the industry on Solvency II will achieve broader progress towards the PRA’s objectives, particularly in the case of those firms who are in our internal model approval process. As we get closer to the implementation date, we will also be working with those firms who have opted to use the standard formula, to understand better their position under Solvency II, and the appropriateness or otherwise of their chosen calculation method.

The fourth and final stage will be to consider the quality of the firm’s risk management and governance arrangements. This will clearly look at the structure and operation of the systems within firms, but will also consider the competence and quality of senior management, and the quality of information which is available to those people to enable them to manage risk effectively. Some of the questions we will want to consider are:

• Does the board truly understand what would break the business?
• How are such risks quantified and reflected in the firm’s risk appetite?
• What are the management actions which would be available should certain events occur, and how satisfied are senior management and the board that they would be genuinely effective?

I trust these questions give you assurance that our focus will be on the overall effectiveness of the system of governance and how it works in practice, rather than on the form and structure in and of itself. These are also questions which firms should be considering for themselves, not least as they continue to compile their Own Risk and Solvency Assessments, which will be an important component of Solvency II.

These four main areas will be of importance to us, but clearly the approach we will take will vary from firm to firm. As is the case today, we will deploy the greatest effort in dealing with firms and issues which pose the greatest risk to the PRA’s objectives.

The supervisory framework I have just outlined is designed to ensure that we can deliver the PRA’s overarching philosophy, which is that supervision should be forward-looking and judgement-based; be risk-based and proportionate; include tools for appropriate interventions when things go wrong; and be delivered by suitably qualified and empowered people with the right skills. All of these are also vital for our delivery of Solvency II, and I want to spend some time now talking about how we will work over the coming months to draw these two strands together.

As I mentioned earlier, we have recently reorganised the FSA into a model we have referred to as ‘internal twin peaks’. This is designed to mirror, in so far as is possible, the organisations which will be in place following the official legal cutover date, which we expect to be next spring. There are some practical advantages to this, such as allowing us to identify which staff will move to each of the successor organisations, but more importantly, it allows us to move in a gradual way to the PRA’s – and the FCA’s – new ways of working in the context of our existing organisation, meaning that there should be some continuity at legal cutover, and affording us the chance to experiment with aspects of the new regime in advance.

The first and most immediate change you will notice if you are from an insurance company – as opposed to a broker – will be that you will now have separate supervision arrangements for prudential and conduct issues. This in itself is a significant deviation from the FSA’s previous integrated approach, but one which is appropriate for us to make given the arrangements which will be in place in the future. The two sets of supervisors for each firm will work in a way which is independent – reflecting their different scope and responsibilities – but coordinated.

This means that you will be dealing with two sets of people who will make different judgements based on different objectives. Over time, the two supervisory bodies will move towards their new operating models and assess separately the impact on their objectives of the firms which they each supervise.

From a prudential point of view, over the coming months your supervisors will start to implement various aspects of the new regime, which I outlined at a high level earlier. This will involve some changes to our risk assessment process, changes to the nature of issues which are raised with you, and changes to levels of supervisory engagement. You will see your supervisors focusing on a smaller number of key issues than has been the case before. We will set out in more detail what the practicalities will be – both in the run-up to the legal cutover date and afterwards – at industry briefing events in June.

In the meantime of course, your supervisors will continue to work with you on your preparations for Solvency II, and I want to outline how this engagement will work in the context of the philosophy I outlined earlier.

Solvency II brings with it significant requirements for supervisors to exercise judgement when dealing with the firms which they supervise. This is especially true in the case of internal model approval, but also applies more generally across the full spectrum of the regime. Notwithstanding that it is a sensible and desirable way for us to behave in any case, the Directive also enshrines a principle of proportionality which cuts across all aspects of a supervisor’s work with firms. I want to explain first of all how we believe these principles apply in practice, and then go on to give some examples of how we propose to ensure that our work adheres to them.

The principle of proportionality does not give us or anyone else the scope to waive or otherwise disapply aspects of the regime for one group of firms or another. The Directive contains a set of requirements, which can be derived from the text of the Directive itself and the supporting implementing measures. For example, there are over 300 of these in relation to internal model approval, and any firm applying for such an approval should meet those requirements. Proportionality comes into play in the amount of work we will expect firms to do to demonstrate that a requirement has been met, and in the amount of supervisory time that we will devote to our own review of the evidence.

So, in the case of internal model approval, we have provided firms with a self-assessment template which includes all of those 300 or so requirements I just mentioned, but we should be clear that: first, we do not expect 300 separate pieces of evidence, one for each requirement; and second, our supervisors and actuaries will not carry out an in-depth review on the evidence which supports each and every requirement. Our review work will be organised into 15 themes, such as scope, use test, and validation, and the actual work carried out with each firm will be targeted on those issues which are of the greatest and most fundamental materiality to the firm’s overall solvency position.

We feel that this is the most appropriate way to discharge our overall obligation to be proportionate, whilst also, in accordance with the PRA’s general approach, focusing on a small number of key issues which are of highest impact.

Our approach to whether these requirements have been met will also be judgement-driven. What this means is that we will have to take a view on whether, for instance, something is ‘adequate’, ‘comprehensive’, ‘complete’ and a number of other, similar, requirements. This means that there may be times when our judgement differs from yours; we make no apology for this, and in fact it is an inevitable feature of a judgement-driven regime that there may well be circumstances when differences of opinion will arise. You will see this in your relationship with the PRA more generally, which we would expect to be more challenging than you may have been accustomed to previously.

The commitment which we have made, and which I make again, is that our judgements – even when they differ from your own – will be well-reasoned, and will have been subject to very significant senior management challenge within the PRA. This is every bit as true of our implementation work for Solvency II as it will in the more ‘business as usual’ environment under the PRA in the future.

The need to be robust is especially important in the case of model approval, as we need to be mindful of the limitations inherent within them, and the risks associated with their approval. We must not lose sight of the fact that models, by their nature, are only ever an approximate view of the world – and they’re only ever as good as the data and the assumptions which underpin them. This applies at the level of individual types of risk, such as the well-documented issues associated with catastrophe models, caused by the underestimation of demand surge, but also in the way in which different parts of a model interact with each other. This latter point is especially important in the context of correlation assumptions and diversification, and we are particularly conscious of the way in which correlations can in fact become stronger as events move closer to the extreme tails of the distribution.

For this reason, over the coming weeks and months you will start to receive a much higher degree of feedback than has been the case to date. This is because we have now completed a significant part of our review work in the pre-application phase, and are now in a position to draw meaningful conclusions, not only at firm level, but also across peer groups. This feedback may well include points where our view as to your state of preparedness will differ from your own. You can expect us to be much clearer as to our views on your progress, and should bear in mind that – particularly in the case of model approval – this may result in us forming the view that you will not reach the required standard by a date which makes model approval viable before implementation, and, as a result, ceasing to work with you and exiting you from our process.

Judgements will apply in the future at the level of individual rules or requirements, but also at an over-arching level, looking at the financial position of the firm as a whole. This means that it will be incumbent on us to consider a firm’s financial position, not only in its current circumstances, but also in a range of future scenarios. The judgements which underpin the developments of these scenarios will be important and – again – even if you disagree with them you can be assured that they have been well-reasoned and will be applied in a consistent way to you and your peers.

The need for a framework for intervention is another aspect which is recognised both by the Solvency II Directive and by the PRA’s design. Last summer, we set out our intention to create a proactive intervention framework for the PRA, which will be an extension of the ‘ladder of intervention’ which is a feature of Solvency II, and which we already have in place for dealing with firms which have breached their individual capital guidance. This will set out a series of trigger points at which regulatory action will be presumed. This is not to say that the ability of supervisors to exercise judgement will be fettered by this, as the precise measures which will be taken in any set of circumstances will differ in accordance with the risk posed and the extent to which matters have the potential to deteriorate further.

The proactive intervention framework will set out the actions which will be expected of firms’ management and the PRA’s supervisors. These actions will clearly become more intensive as the firm’s position deteriorates, and will start to involve greater degrees of contingency planning, including not only the PRA but also the FCA and other bodies such as the FSCS.

The operation of such an intervention framework is to facilitate the achievement of the overall objective of minimising the potential for, and impact of, disorderly failure.

The need for suitably qualified people is key to the operation of any supervisory system, and increasingly so when we expect those supervisors to use a high degree of judgement in deciding how to address certain situations, and expect them to challenge firms’ senior management in a way which goes to the heart of the financial viability of firms. We have recruited heavily in the run-up to Solvency II implementation, both for front-line supervisors and for specialists to back them up, not just actuaries – central though they are to the Solvency II process – but also other specialists who can help our supervisors to form sound judgements when they are required to.

What has been clear in our implementation of Solvency II, and what will increasingly be the case under the PRA, is that there is significant scope for us to underpin our own work with good quality interactions with suitably qualified third parties. I am thinking here not only of consulting actuaries and the like, but also of firms’ auditors and also of skilled persons. We have set out previously our expectation that the use of skilled persons’ reports is likely to increase under the PRA, although still only making use of this tool where it is the most appropriate way to address a particular risk. It is clear that this form of regulatory action still carries with it a degree of stigma as far as firms are concerned, and we are keen to stress that this should not be the case.

One of the ways we will be making use of outside parties in the short term is in the review of technical provisions which we believe is vital to underpin our internal model approval work for Solvency II. Whilst not technically part of the internal model requirements, we believe that it would not be possible for us to approve a model without being satisfied as to the accuracy of the underlying balance sheet, with technical provisions forming the largest and most complex part of this for most insurers. As we have set out previously, we will be expecting a form of external review to be carried out on the technical provisions of all internal model firms prior to our approval of their model.

All of the foregoing – proportionality, judgement, intervention and informed delivery – will be dependent on our ability to collect and analyse high-quality and relevant data. The new data and reporting system for Solvency II will put us in an excellent position to deliver this, and we will be investing in systems which will enable us not only to receive the mandated data and disseminate it to EIOPA as required, but also to undertake informed and useful analysis of it and draw meaningful conclusions.

As well as informing our own work, the Solvency II data requirements, and in particular the new disclosure regime, should have the effect of significantly enhancing the degree of market discipline to which firms are subject, through publication of reports which are compiled on a consistent basis across Europe.

I have talked a lot so far about what the future will hold, as well – I hope – as indicating ways in which what we are doing to day will start to take us there. I’d like to take the last part of my time to concentrate on what is happening right now with Solvency II, and what we are starting to see.

Those of you involved in our internal model work will be aware that we are continuing our pre-application work with most firms, and that some are now starting to move towards the submission phase, which is the next part of the process. At this stage, we would expect firms to be able to produce a reasonably complete set of application materials for submission to us in the landing slot which we have previously agreed with them. The first point to make is that we regard the move from pre-application to submission as one where we will make a substantive decision as to a firm’s progress. This means that if we do not believe that a firm has made sufficient progress during pre-application to be able to provide a reasonably viable submission to us – we will cease work with the firm and not allow it to continue in the internal model process in the run-up to implementation. This clearly is not a decision we will take lightly, not least because we are aware that the repercussions for some firms of not achieving model approval are potentially severe. But equally it is one which we are perfectly prepared to take, and we have been clear with firms that we expect them to have contingency plans in place to deal with a situation where their model is not approved.

We make no apology for being robust in our approach to internal model approval. We have to be conscious of the extent to which approval of a model has the potential to pose risk to us, and will only therefore approve one if we can be assured that it is appropriate and will remain so in a range of circumstances. I have already mentioned that our review work will focus on the main areas of materiality for an individual firm, and if we are not in a position to be satisfied on these aspects we will not approve it.

For this reason I thought it might be useful to highlight some of the points we have seen during our review work to date. I should start by noting that, in general, levels of engagement with the process have been good, both within firms and with us. What we are starting to see, though, is a number of firms falling behind on their own implementation plans, and this is beginning to cast doubt in some cases on their ability to achieve their submission slots.

More specifically, we have observed that validation workstreams seem to be significantly behind other workstreams within firms. In some cases, scope is too narrow, whilst in others work is simply incomplete. This has led to firms not being properly able to identify critical issues, which has in turn sometimes impeded our review work.

We would caution against a perception which seems to exist amongst some firms that expert judgement is a ‘magic bullet’ which can be used to explain away any aspects of a model which are not properly documented or justified. Clearly, making informed judgements is important – and, as I have already said, we will be making judgements of our own – but these still need to be explained and, in many cases, justified with evidence. The mere fact that a judgement has been made on a specific issue does not make it immune to challenge, and nor does it mean that normal standards do not apply.

In many cases, supporting documentation is weak or undeveloped. Whilst poor documentation is bad in and of itself, we are also concerned in some cases that it is an indicator of poor underlying thinking, or a lack of senior management engagement with a particular issue.

Finally, much of the work we are seeing on model change policies is weak. There seems to be little thought as to what the purpose of the model change policy is – namely, to provide the framework within which the model will be developed and controlled, and to provide the basis upon which we will have the opportunity to consider and approve changes to the model. Many of the examples we have seen to-date need more consideration of the division of changes into ‘major’ and ‘minor’, particularly needing to incorporate qualitative as well as quantitative aspects.

As I have already mentioned, you should start to receive much more direct feedback from your supervisors in the coming weeks and months, giving you clarity as to our views on your individual progress and issues which give rise to concern in relation to your own particular model.

I have concentrated here mainly on internal model work, as this has formed the bulk of our activities with firms to date. As we move into 2013, we will also turn our attention much more to those firms who are intending to use the standard formula, and will work with them to assess their approach, and the extent to which their use of the standard formula is appropriate. The principles I have already spoken about will be every bit as applicable to this work as it is to internal model approval.

I have sought to provide you with an insight into how we are developing the PRA, and how some of our recent developments fit into that overall design. I also hope to have demonstrated that Solvency II is not only consistent with the PRA’s design and philosophy, but in many ways actually provides the basis for the way we will work in the future. For this reason, it is my belief that the implementation of Solvency II is the new approach to insurance regulation, and it will be central to everything that we in the PRA do in the insurance sector.