New rules for a new era

The UK's new rules designed to implement a risk-based regime for regulating the insurance industry are due to come into place at the end of the year. John Ferry talks to the Financial Services Authority about what this means in practice for insurance companies.

The introduction of new rules to bring about risk-based regulation of the UK insurance industry was not a case of a busybody regulator imposing unnecessary market restrictions, but a much-needed modernisation of rules that were well past their sell-by date, according to Iain Wright, the Financial Services Authority’s (FSA) head of department responsible for insurance issues in the major retail groups division. “In reviewing the whole of the insurance regulatory structure it was fairly evident that it’s outdated and needs improving,” he says.

The rules, which will affect companies from the beginning of next year, will require UK insurers to build risk models to see how much capital they need to set aside to cover their daily operations. The FSA wants them to take account of risks – market, credit and operational – that traditionally insurers would not give much regard to.

The way that UK insurance regulations, and related capital requirements, are set is based on European Union (EU) directives that date back to the 1970s. These stipulated that insurers had to hold capital based on the volume of business they wrote and the amount of claims they expected to pay.

“The risk capital charges that were applied to those figures were determined in 1978, and there were some minimum levels of capital that had to be held,” says Melanie McLaren, a partner and insurance regulatory expert at PricewaterhouseCoopers (PWC) in London. “The minimum guarantee, for example, was something like e250,000, which in today’s money is nothing.”

She continues: “The capital charges didn’t take account of things such as the type of business that you were writing. So if you’re writing a standard personal motor book, you’re running a very different risk profile than if you are writing long-term employers’ liability covering asbestos risk, for example.”

These rules did not take account of the level of risk that an insurance company is actually facing. And the rules also ignored a host of other major risk categories, such as credit risk and market risk.

The EU knew that things had to change, and so in early 2000 began a review called Solvency I. This resulted in some limited modifications, such as an increase in the level of the minimum guarantee fund (the smallest amount to be maintained by the insurance company over and above the capital and retained earnings to meet technical reserves).

Solvency I also tried to link the minimum guarantee fund to inflation, required the holding of increased capital for higher risk liability business, and adjusted the methodology for calculating the available and required solvency margins. “But basically it just tinkered with things,” says McLaren.

The second phase of this review, called Solvency II, is meant to introduce a more risk-based capital regime across the EU. But this is still a work in progress, and a draft of these new rules is not expected until around 2006.

The FSA, however, has taken the lead in risk-based regulation, and aims to have its own set of rules in place by the end of this year. “We decided to move on with this quite quickly as it’s such a significant issue for the UK,” says Wright. “There’s always the risk that EU processes can slip. But there is also the tangential benefit that we will be in the position where we have actually done this [risk-based regulation] and thought about it, and so we can influence the agenda in Europe.”

The area of the financial markets that is leading the way when it comes to risk-based regulation is the banking sector, with the new Basel capital Accord. So how much of an influence has Basel been on the FSA’s new rules?

“As an integrated regulator we have a lot of banking experience, so it [the Basel process] has had some input,” says Wright. “It is important to us that we regulate different sectors in as similar way as possible. Although we are taking the philosophy that risk-based capital is the right approach and we are trying to use the lessons from Basel, to avoid re-creating the wheel, we did recognise that there are differences between insurance and banking.”

Wright gives the example of underwriting risk, which insurers engage in but banks don’t. “And the way in which credit risk affects insurers is different to banks. We did look in detail at the different risks that insurers face. And, for example, different risk weightings apply to insurers than to banks.”

The broad approach that Basel takes, in trying to apply risk-based capital charges to operational, credit and market risks, is similar to what is happening in insurance, although the latter must also account for idiosyncratic risks associated with the sector.

PwC’s McLaren says: “Previously, UK insurers would not have had a requirement to have an independent risk assessment function. But you would never go to a UK bank and find that they did not have a risk department. Insurers have not had that, principally because their business is about risk, but they’ve focused on insurance risk. The FSA’s new rules makes them focus on the other risks that are in place.”

This means that a lot of the controversy surrounding Basel, such as how to apply a meaningful charge to something as ill-defined as operational risk, applies equally to insurance.

“Operational risk is an area we’re looking at currently,” says Wright. “As with banking, that’s the least developed part. And it’s the area where there will be a lot of debate.”

But “a lot of debate” might be putting it mildly. “The FSA has given them [insurance companies] nothing,” says Hitesh Patel, a partner at consultant KPMG who specialises in risk-based insurance regulation. “There are no guidelines. The companies have to come up with their own model and then the FSA looks at it.”

Still, insurance companies can take some consolation in the fact that the FSA does not intend to start handing out fines at the end of the year to those that are not instantly complying with the new rules. There will be some leeway, says Wright.

“There will be a development process with this,” he says. “The rule will come in and it will say that a company must have performed its own individual capital assessment and submitted that to the FSA as a private submission. The bit that we do is take that, look at the risk framework, then issue individual capital guidance.”

McLaren adds: “The FSA is taking a sensible approach. It wants to see progress but doesn’t expect a perfect world. And also there’s the fact that the FSA won’t get around everybody to review them for 18 months to two years.”

When the new regulations come into place, insurance companies will have to do their own internal capital assessments, which means they have to build a capital model that takes account of all the risks that the organisation faces, then let the FSA review the model. The hope is that the FSA will agree with the numbers, but if it does not then it will issue individual capital guidance until sufficient improvements are made to the company’s risk and control modelling process.

Wright explains how the process works: “At the base level you take the lines of business that an insurer writes, and you assign a risk weighting based on how risky it is. You also look at the investments they hold and give them a risk weighting. You build that up and it gives you a number. But then you ask how soundly the business is actually managed, and what are the systems and controls to identify, monitor and mitigate risks. The business then makes a judgement and decides whether they manage themselves in a very industry-leading way. And then we come in with a team of people supported by actuaries, but also supervisors and policy people here, and we look at how well the company compares to industry standards, and how they compare to what we’d like to see in each risk area.”

All this means insurance companies will have a lot of work to do before and after the new rules are introduced. “There’s a wealth of work to be done in terms of getting documentation together and evidence of what the risks are and what their control processes are – how you document your appetite for a risk,” says McLaren. “And there’s quite a lot of work, particularly in the actuarial field in terms of building these capital models, and looking at how the risks are correlated, what adverse scenarios you can potentially test, what the parameters are, and so on.”

The overall aim, says Wright, is to increase the gross amount of capital levels held by UK insurers. At present, the FSA regards around twice the statutory minimum as being the appropriate level of capital to hold. “But what you will find in practice is that a number of firms, and not just the larger ones, will hold a buffer above the regulatory minimum,” says Wright. “A lot of them have moved, as we have moved, to actually holding more capital and having their own economic capital models.”

Hedging and risk-based capital requirements for insurers

Aside from the main issue of how risk-based regulation will change the way insurance companies operate, the new rules could have other unforeseen spin-off effects. One of these is an incentive for insurance companies to carry out more hedging to free regulatory capital. Hedging is taken account of when the FSA works out risk-based capital requirements. If a position is fully hedged, the net position of the trade will be looked at. So does this mean insurance companies, like banks, will be using derivatives to lower their capital requirements? Will they be going to the credit derivatives market to hedge the new credit risks that their models will have to take account of? “People are starting to understand how hedging can affect the result and the level of capital that they need to hold. But the difficulty is that industry rules on the use of derivatives are pretty archaic, and the FSA has yet to overhaul the rules,” says Melanie McLaren, a partner and insurance regulatory expert at PricewaterhouseCoopers. “So, on the one hand, they expect insurers to hold capital against adverse scenarios, which would lead them to look economically at some sort of hedging or risk transfer transaction. But on the other hand, the rules as to the sort of transaction that you can enter into are actually quite narrow.” In the meantime, the FSA is unrepentant. “This is not something we are looking into at the moment,” says Iain Wright, the FSA’s head of department responsible for insurance issues in the major retail groups division. “We have rules in the area of hedging and we are not aware that these cause the insurance industry a problem.”

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