Response to Financial Services Authority

RESPONSE TO FINANCIAL SERVICES AUTHORITY

CONSULTATION PAPER 97

THE INTEGRATED PRUDENTIAL SOURCEBOOK

1

CONTENTS

Page Number

OVERVIEW

Executive Summary

Overview and General Comments

2. RESPONSE TO QUESTIONS FURTHER DETAILED COMMENTS AND RESPONSES TO QUESTIONS:

1

Detailed Comments on Chapters of the IPSB :

Introduction

– Questions and Responses

2 Overview

– Questions and Responses

3 Compatibility

– Questions and Responses

4 Application and General Requirements (PRAG) -

Detailed Comments including:

·  Applications, purpose and contents (PRAG1)

·  Application to Groups (PRAG2)

·  Adequacy of Financial Resources (PRAG4)

·  Valuation (PRAG 5)

·  Prudential Systems and Controls (PRAG 6)

Application and General Requirements (PRAG) -

Questions and Responses

Capital (PRCA)

5 Capital (PRCA) -

Detailed Comments including:

·  Calculation of Capital Resources Requirements (PRCA 1)

·  Capital Resources (PRCA 2)

Capital (PRCA) -

Questions and Responses

6

Credit Risk (PRCR)

Credit Risk (PRCR) -

Detailed Comments including:

·  Credit Risk Systems and Controls (PRCR 1)

·  Credit Risk in Insurance Funds (PRCR 10)

Credit Risk (PRCR) -

Questions and Responses

Market Risk (PRMR)

7 Market Risk (PRMR) -

Detailed Comments:

·  Market Risk in Insurance Funds (PRMR 11)

·  Derivatives in Insurance Funds (PRMR 12) including:

Market Risk Systems and Controls (PRMR 1)

·  Market Risk in Insurance Funds (PRMR 11)

Derivatives in Insurance Funds (PRMR 12)

Market Risk (PRMR) -

Questions and Responses

Operational Risk (PROR)

8 Operational Risk (PROR) -

Detailed Comments including:

·  Operational Risk systems and Controls (PROR 1)

·  Outsourcing (PROR 2)

Professional Indemnity Insurance (PROR 3)

Operational Risk (PROR) -

Questions and Responses

Insurance Risk (PRIR)

9 Insurance Risk (PRIR) –

Detailed Comments including:

·  Insurance Risk Systems and Controls (PRIR 1)

·  Financial Resources for Insurance Business (PRIR 2)

·  Mathematical Reserves (PRIR 3)

·  Equalisation Provisions (PRIR 4)

·  Internal Contagion Risk (PRIR 5)

Insurance Risk (PRIR) –

Questions and Responses

10

Group Risk (PRGR)

Group Risk (PRGR) –

Detailed Comments: including;

·  Introduction (PRGR 1)

·  Systems and Controls (PRGR 2)

·  Capital Requirements: Insurance and Reinsurance

Groups (PRGR 4)

·  Capital Requirements: Cross – sector Groups (PRGR 5)

Group Risk (PRGR) –

Questions and Responses

11

Definitions3. APPENDIX 1 – DRAFTING COMMENTS

4.12 APPENDIX 2 - DEFINITITIONS

EXECUTIVE SUMMARY

INTRODUCTION

This response sets out the comments of the Association of British Insurers on CP97 – The Integrated Prudential Sourcebook. The Association represents over 400 insurance companies and accounts for 96% of the worldwide business of UK insurance companies.

The Integrated Prudential Sourcebook (the “PSB”) covers requirements for firms to have adequate financial resources and appropriate systems and controls. In contrast to previous practice it sets requirements by reference to risk categories, eg market, operational or insurance risks, rather than to sectors eg insurance or investment activities, to produce a single set of rules and guidance applicable to all sectors.

The PSB is based on an underlying requirement for firms in all sectors to take their own view of their financial resource requirements. For insurance companies this means an increased emphasis on risk identification and management. This response seeks to concentrate on the aspects applicable to insurance companies.

This consultation is part of a wider series of consultations including both the ‘Tiner Project’ and the Penrose Enquiry. In addition, the content of the PSB will be determined in part by a series of important international developments including the EU Solvency II Review, the draft EU Directive on the Supervision of Financial Conglomerates, the introduction of new International Accounting Standards and the revised Basel Accord.

There is to be extensive consultation by the FSA which will cover aspects such as specific capital requirements of firms and the revision of financial reporting requirements. The ABI is keen to continue to have a full involvement in these discussions to represent the interests of the insurance industry and to develop an interactive debate with the FSA on these issues.

APPROACH TO CONSULTATION ISSUES

The PSB is intended to promote the FSA’s statutory objectives of consumer protection and market confidence and also their statutory obligation to have regard to the international competitiveness of the UK. The ABI regards these as complementary. International competitiveness is crucial for the UK economy. In an era of increasingly international capital markets facilitating mobility of capital, mobile capital market it is also essential if the UK is to attract and, more importantly, retain adequate capital resources to enable the domestic insurance industry to supply the levels of protection and savings products required in the UK.

A system based upon identification and management of risks offers the potential to focus on achieving these objectives. Nevertheless this approach needs to be complemented by:

q  Measures being proportionate;

q  Consistency in the application of rules between sectors and individual companies within a sector having due regard both to the cost which results from a measure and also the practicality in the timing of its introduction, and

q  Flexibility to respond to developments, and indeed to encourage innovation, and particularly to adapt to changing EU requirements and other wider international developments.

KEY ABI RESPONSES TO CONSULTATION ISSUES

Set out below are the key points in the ABI response to CP97. These are cross-referenced to the main text and have been grouped under headings.

Page ReferenceParagraph Reference

Competitiveness

q  Separate consultation is under way on with profits business and the relevant regulatory reporting implications. The comments in this response are on a preliminary basis ahead of the ABI response to this other consultation and the discussion which the ABI will be seeking with the FSA. The key issue at this stage is that the reserving rules should not be so onerous as unnecessarily to restrict investment freedom lowering returns to policyholders. / 9.14 to 9.20 and Response to Q.62, paras. 9.38 to 9.40 [to be inserted]
q  Super-equivalence, ie the imposition of higher standards than those required by relevant European Directives, should not be allowed to reduce the international competitiveness of the UK insurance industry. / General Comments
Paras. 3.2 & 3.3
and Response to Q.5
q  The rules for the use of derivatives by insurance companies should be applied as flexibly as possible within the constraints of the Directives to level the playing field with other financial institutions as well as assisting insurers in the
management of financial risk faced by their businesses.. / 7.8 to 7.11

Proportionality and Consistency

q  We welcome the PSB’s approach to rules for the valuation of assets whereby the basis for regulatory reporting and accounting purposes will be the same. However, it is essential that any changes to financial reporting requirements are fully coordinated with the changes which will flow from the international developments referred to in the Introduction. In particular successive systems changes should be avoided. / General Comments
Para. 5.7 and paras. 4.8 to 4.13
q  The FSA should provide guidance on resilience testing issues and this should not be left to the ABI or professional bodies. We propose a joint working group of the FSA and the actuarial professional bodies as the best way of producing such guidance. / General Comments para. 2.2 and Response to Q.48 paras. 7.35 to 7.38
q  Provision should be made for different permissible structures for the risk assessment function in firms to reflect their differing management and operational structures. / 4.16 to 4.18
q  The requirements for measurement of exposure to third parties on a daily basis should not usually apply to insurers. It is primarily a matter of control in the banking industry.
/ 6.3
q  Are changes to the rules relating to the implementation of the Insurance Groups Directive intentional?
/ 10.3 to 10.6
and Response to Q.5, Para 2.3

Principal Issues for Clarification or Further Consultation

q  Further guidance/consultation is required on the requirements for self-assessment of capital needs of insurance companies.
/ 4.5
q  Further consultation is required to achieve a satisfactory level of specific guidance on the stress and scenario testing requirements for both life and general insurers. Clarification is also required on the FSA’s proposals to monitor compliance and on whether there will be an audit requirement. Please refer to our proposal under proportionality and consistency above. / 4.4 to 4.6
q  Clarification is required on the operation of the prohibition of insurance firms from entering into new contracts of general insurance on inadequate terms. / 9.5
q  Consultation is required to achieve simplification of the practical difficulties in applying the proposals on margins for adverse deviation. / 9.7 and 9.25
q  Consultation is required to simplify the difficulties which result from the change in the rules to be applied in the calculation of equity yields. / 7.6
q  Clarification is required on the application of the rules regarding material outsourcing by insurance companies. / 8.1 to 8.4
q  Clarification is required concerning tThe interaction between the requirements for concerning capital adequacy at regulated firm level and those at group level need clarification. / 4.6
q  Clarification is needed of the position when assets exceed the counterparty limits. is needed. / 6.5 and Response to Q.41, para 6.7
q  Consultation is required to develop workable rules and guidance on the introduction of a requirement to include a provision for the anticipated cost of terminal (final) bonuses. / 9.11 and Response to Q.59
q  Clarification and consultation is needed on various aspects of the rules and guidance on internal contagion risk. / 9.14 to 9.20
q  Guidance is required on the undertaking of non-insurance activities by insurance companies. / 9.21

Presentational, Timing and Cost Issues

q  Implementation must be no earlier than 1 January 2004, with the full text agreed 12 months before, to allow the necessary time for systems changes.
/ General Comments paras. 5.1 and 5.2 and Response to Q1. paras. 1.1 and 1.2
q  We consider that the cost benefit analysis considerably understates the cost to the insurance industry. / Response to Q.9
Paras. 3.1 to 3.4
q  The introduction of increased solvency requirements to comply with the EU Solvency Directives must be accompanied by the transitional provisions permitted by the Directives. FSA should not anticipate the outcome of Solvency II by introducing further requirements until there is a definitive conclusion to that Review which has been adopted by the EU. / General Comments
Para. 5.5
q  The structure of the draft PSB is hard to navigate. It should be simplified by bringing together all the systems and controls requirements and introducing links so that users can readily find definitions, cross references etc. There should be more provision of tables to gather together obligations for each category of firm in a single place. / General Comments
Para.4
Response to Q.3 Paras 1.3 to 1.5
and Response to Q.20, Para 4.28
q  Appendix 1 sets out comments on drafting points including incorrect cross references and typographical errors. / Appendix 1
q  Appendix 2 identifies definitions which are incorrect or where additional wording is required to give a clearer meaning. It also identifies areas in the text which would benefit from additional definitions. / Appendix 2

Next Steps

ABI wishes to be involved with FSA in the development of the next version of the draft PSB, and looks forward to participating in an interactive dialogue with FSA.

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Practical difficulties which result from a change in the rules to be applied in the calculation of equity yield

GENERAL COMMENTS

1 BACKGROUND AND CONTEXT

1.1 The PSB was first published for consultation in the summer of 2001, since when, the insurance industry has come under an increasing amount of scrutiny by Government and others. It must therefore be viewed in the context of:

·  the Baird Report on the FSA’s supervision of Equitable Life;,

·  the FSA’s response to the Baird Report, published in November 2001 (The Future Regulation of Insurance) ;;

·  the Penrose enquiry into the Equitable Life affairregulation of the life insurance industry;

·  the FSA’s review of With – Profits Business and in particular Issues Paperre 2; and

·  the implications of the collapse of Independent Insurance. changes in regulation of general insurance business which will undoubtedly result from the collapse of Independent Insurance.

All of these enquiries, which are being coordinated under the aegis of ‘The Tiner Project ‘ will, doubtless, have an impact on the form and content of the PSB as well as other parts of the FSA Handbook of Rules and Guidance, when it is finally adopted by the Board of the FSA. To that extent, the draft Rules as set out in CP97 may be regarded as something of a moving target.

1.2 In addition to the foregoing events which will change the basis upon which the insurance industry is regulated, ABI wishes to point out that, after a considerable gestation period, the FSA Handbook of Rules and Guidance has finally come into force on 1 December 2001. This has brought with it a number of immediate changes in the supervisory requirements affecting the insurance industry. It is worth pointing out that, even under the Interim Prudential Supervision regime insurers are required to submit annual returns at a much earlier date than under the previous regulations, which requires additional work on the part of finance and other areas within companies as well as additional audit time. There may well be systems issues which have to be addressed in order to comply. In addition, the Interim Prudential Sourcebook for Insurers implements the EU Insurance Groups Directive, and the PSB builds on this implementation and additional systems changes will be necessary in that context.

1.3 Since N2 has only recently been reached, it must be said that ABI and its member companies would have preferred a longer period for response. This is partly because many of the key people in the industry who are deeply concerned with the review of CP97 have also been heavily involved in the work needed in their companies to ensure a smooth transition to the post N2 regime but also, and more importantly, because it would been helpful to have experienced a few months of FSA supervision under the 2000 Act. That way, a more fully informed and considered response would have been produced; something which would have been of benefit to the FSA as well as ABI member companies.