Economic capital: Notes from the UK Canadian Institute of Actuaries Appointed Actuary seminar

1. 20 September 2004 Economic capital: Notes from the UKCanadian Institute of ActuariesAppointed 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

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

3. Section 1 Summary of Financial Services Authority (‘FSA’) objectives

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’

5. Section 2 The story so far

6. The previous ‘rules-based’ approach was ‘dilapidated and deficient’ Inadmissibleassets Admissible assets Availablecapital EU minimum required capital = x% stat reserves Statutory reserves including resilience Conservative assumptions Valuation interest rate

7. The EU is moving towards harmonisation of Solvency regulation across Europe, using Basle as a template

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

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 XSadmissibles Risk capital margin EV of NP Other Required Capital WPICC SolvencyStandard Required Capital in Par Fund Realistic Liabilities LTICR Resilience Mathematical Reserves Economic Capital Enhanced Capital Requirement Regulatory Peak Realistic Peak

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

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

12. Section 3 Individual capital assessment

13. 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’

14. Individual Capital Assessment can take a numberof 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’

15. Individual Capital Assessment has wider scopethan RCM Included in 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 Implicit target of BBB rating (99.5% over 1 year)

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)

17. Section 4 Implications for UK Life

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

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