Lessons from the new UK regulatory framework for life assurance

1. Lessons from the new UK regulatory framework for life assurance presented by Colm Fagan at the Life Strategies conference, Dublin, 2 March 2005

2. 3 months into the job … Significant prudential supervision changes in the UK: • Responsibility for solvency liabilities transferred to Board • Appointed Actuary role no longer exists (since 31/12/04) • Three new statutory actuarial roles instead: • Actuarial Function Holder • With-profits Actuary • Reviewing Actuary • Realistic reporting required where with-profits funds >£500m • Treating Customers Fairly (TCF) • Replaces PRE • Principles & Practice of Financial Management (PPFM) • Individual Capital Assessments (ICA) • Individual Capital Guidance (ICG)

3. Background Company Information • Closed to new business(one of 66 companies closed to new business in the UK, representing total AUM of £191bn) • 2 with-profits funds – both 100%:0% • Annuity liabilities of £1.5bn • Guaranteed Annuity Options

4. External Environment • FSA root & branch review of regulatory reporting regime • Dichotomy between messages to customers and reserving approach • Lots of contractual guarantees introduced when economic climate and outlook for life expectancy were very different but ….… falling interest rates, stock-market falls and improvements in life expectancy have seen chickens coming home to roost

5. Actuarial role in liability calculation • Appointed Actuary’s assessment of solvency liabilities historically outside the scope of the external audit • Since 31/12/04: • Appointed Actuary role no longer exists • Actuarial Function Holder (AFH) responsible for calculating liabilities based on methodology and assumptions set by Board • Reviewing Actuary appointed by auditor to review AFH’s work • Process has worked well so far • Communication is key – longevity assumption good example

6. Realistic Basis for With-profits • PPFM required- transparency on operation of with-profits fund- Principles v Practices- Customer Friendly version on the way • Realistic Liabilities- should make adequate provision for benefits promised- should reflect principles of PPFM- consider range of eventualities- can be quite complex in practice

7. Expert View? “The best realistic peak hedge of a long-dated policy will often be a short-term option - (it) provides gamma and vega coverage for long-term delta hedging implicit within dynamic asset allocation”

8. Realistic Liabilities • Cost of guarantees- where simulations show projected assets < guaranteed benefits • Cost of smoothing- where simulations show future annual falls in assets > maximum benefit reductions allowed by PPFM • Judgement required when modelling - what is “normal”?- what us “extraordinary”

9. With-profits Actuary • Required for with-profits companies • Main role is to advise the Board & mgt on exercising discretion • Particular challenges for closed funds • distribution of “inherited estate” • calculation of surrender values • Also advises Board on • consistency of liability assumptions with PPFM • investment policy • allocation of expenses • Required to report annually to policyholders on extent to which their interests are taken into account in the exercising of discretion by the Board

10. Pillar 1 and Pillar 2 • Pillar 1- twin peaks, WPICC etc. • Pillar 2- ICA prepared by firm and submitted to FSA- ICG then determined by FSACapital required = Max (Pillar1, Pillar 2)

11. Pillar 2 • All material risks should be considered • Market & Credit Risk • Insurance Risk • Operational Risk • Group Risk • Liquidity Risk • Minimum acceptable capital = amount required based on 99.5% probability that assets will exceed liabilities after one year on a realistic basis(or lower probability over a longer period if appropriate) • 99.5% one year probability test equates to BBB credit rating

12. Modelling Risks • Stochastic or deterministic? • Independence of risks - e.g. risk of stock-market crash v risk of living longer- some risks have offsetting characteristics- Anecdotally diversification benefits of up to 40%

13. Cost Benefit Analysis of ICA • Costs include: • project management • consulting support • heavy senior management time • processing costs • etc. • Benefits include valuable insights into risks inherent in the business and formal consideration of how to mitigate and manage those risks • On balance, very difficult to justify for smaller companies

14. Lessons from the new regulatory frameworkfor life assurance presented by Colm Fagan at the Life Strategies conference, Dublin, 2 March 2005