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The Actuary The magazine of the Institute & Faculty of Actuaries

SIAS sessional meeting: Twin peaks – the enhanced capital requirement for realistic basis life fir

The regulation of the life insurance industry in the UK is currently undergoing significant change. Since August 2002 the larger insurance firms have been making private half-yearly disclosures of their liabilities on a realistic basis to the Financial Services Authority. For these submissions liabilities, including discretionary benefits, are valued using a market-consistent approach. In August 2003 the FSA published a consultation paper, CP195 (‘Enhanced capital requirements and individual capital assessments for life insurers’). This consultation paper included draft rules and guidance on the ‘twin peaks’ approach to assessing capital requirements for with-profits business, providing the first formal consultation in the development of the new regime.

CP195 was the subject matter and the springboard for Martin Muir and Richard Waller’s paper, ‘Twin peaks: the enhanced capital requirement for realistic basis life firms’. As well as summarising the development of the twin peaks approach, the authors provided a critique of the proposed approach and discussed the issues surrounding market-consistent valuations and assumptions – including the choice of asset model and the calibration of that model. The paper also identified possible implications for the management of with-profits business under the new regime.

The paper was presented at a SIAS sessional meeting at Staple Inn on 5 November 2003. In the debate that followed, there was widespread acknowledgement that the new regime presents a significant step forward as regards promoting sound risk management in with-profits firms. Market-consistent techniques can be helpful in providing greater insight into the risks that a with-profits fund is exposed to, and can assist in developing appropriate risk mitigation measures. The techniques can also assist in pricing with-profits guarantees.

Concerns were raised that a market-consistent calculation of liabilities, albeit subject to a stress test, may not be the most appropriate underpin for the calculation of regulatory capital. In particular, the inability to hedge with-profits insurance liabilities fully in the market reduces the security offered by a capital assessment based on the theoretical price of hedging these liabilities. In addition, market-consistent liabilities are based on the marginal cost of buying and selling. The appropriateness of this basis was questioned in light of the substantial size of the larger firms’ liabilities.

The authors’ view is that, as a solvency measure, a market-consistent calculation of liabilities has the advantages of being a reasonably objective, potentially comparable method. It is broadly consistent with the regulation of the banking sector and with developments in other regulatory regimes, such as the Netherlands and Switzerland. Issues such as the inability of insurance firms to close out all their risk in the market weaken the approach but do not invalidate it; in any case, individual capital assessments should address any concerns with capital requirements determined from the twin peaks calculation.

A concern expressed in the paper regarding the potential lack of comparability of different firms’ valuation results was picked up on during the meeting, and there was general agreement relating to the desirability of more detailed guidance and the development of an industry standard. Such guidance (or standard) would also remove some of the subjectivity possible under the draft regulatory proposals, especially in the calibration of asset models and the modelling of management decisions.

There was also some discussion about the likely effects of the twin peaks approach on capital markets, especially as a result of hedge funds taking positions in anticipation of buy and sell activity by insurance firms. Concern was expressed about the possible unintended consequences of the new regime, such as a reduction in the published financial strength of the insurance industry after an increase in implied volatilities, with the result that firms might become forced sellers of volatility in the future where they have been forced sellers of equities in the past.