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The Actuary The magazine of the Institute & Faculty of Actuaries

Financial condition reporting where now?

A financial condition report presented to the
Board might have opened up the subject of
risk and such a report would also be invaluable in an external peer review. We therefore recommend that the provision of an annual financial condition report be made mandatory even if its format remains a matter for best practice.
(Report of the Corley Committee of Inquiry, para 35)
Add to this post-N2 requirements on directors and other approved persons, the need for stochastic modelling under the proposed International Financial Reporting Standard (IFRS), and the FSA’s interest in FCRs: the scene is set for more sophisticated and extensive financial risk assessment and modelling than ever before.

What is a financial condition report?
An FCR is a report, currently best practice under GN2, on the solvency position of an insurance company now and in various possible future scenarios. To model this properly normally requires a ‘dynamic solvency testing’ approach where the future behaviour of the management is simulated in a way that is responsive to the changing economic and other risks considered in the scenario in question. This article considers some of the issues to be addressed in developing the framework for a mandatory FCR. The extent to which these will be codified in revised guidance remains to be seen.

Whom is it for?
First, it seems sensible to consider whom the report is for, and what they will do with it. The key audience is the board of directors. They should find it important in understanding the financial dynamics of the company in particular, the kind of scenarios that threaten commercial flexibility and, ultimately, solvency. This should allow them to develop risk reduction strategies and contingency plans. The FCR should therefore recommend solutions to potential problems, rather than just showing what the problems might be.
The FSA is working with the actuarial profession to make sure that the guidance for Appointed Actuaries on FCRs is consistent with the FSA’s overall risk management requirements for life insurers.
This is from ‘The future of insurance regulation’ 4.3.11 and expresses the FSA’s interest in FCRs. It is to be hoped that the new mandatory FCR will cover the IPSB’s requirements for stress testing and scenario analysis and avoid the need for a separate but similar reporting process. The FCR will also be of crucial interest to the appointed actuary’s peer, or compliance reviewer. The FCR is therefore a fundamental part of the firm’s risk monitoring systems.

How should test scenarios be selected?
One important question to be answered is whether, or how much, to use stochastic rather than deterministic projections.
In general, the use of deterministic projections should provide a method for devising scenarios that are clearly understood, and which are suspected to be difficult for the particular company to cope with. An example of this approach is the New York 7, as required by the NY state regulator. The seven scenarios attempt to capture credible future outcomes with respect to market movement and interest rate changes. However, any process of defining these projections may be compromised by limits on what the scenario setter thinks is possible.
Stochastic projections may only identify unfavourable scenarios ‘by accident’, but they will, if you have faith in the underlying investment model, give some quantification of how likely it is that an unfavourable outcome will occur.
It seems then that a combination of deterministic projections (for detailed investigation of possible strategies to cope with unfavourable scenarios), and stochastic modelling to understand how likely these unfavourable scenarios are, will be required.

I have talked above about future investment return scenarios. For some companies, future difficulties may be more likely to arise because of unplanned new business growth, deteriorating mortality or persistency experience, or some other risk factors. It is essential that the mandatory FCR gives the actuary enough flexibility and the obligation to focus on scenarios stressful to the company in question.

Impact studies
As well as investigating the effect of unfavourable experience on the solvency of a company, the FCR should quantify the likely impact of emerging future regulatory and accounting developments, and other ‘operational risk’ events, for example:
– Market pricing for options (which the FSA wants to see implemented ahead of the Fair Value IFRS).
– Resource demand to cope with new ‘mis-selling’ review with associated estimated impacts on costs, persistency, and future new business volumes.
– Impact of closure of a sales channel on costs and new business volumes.
– Impact of the type of events envisaged by disaster recovery plans.
Financial quantification of the possible effect of these types of event would give management a clearer picture of the importance of a strategy and a set of contingency plans to deal with potential outcomes.

Rising to the challenge
Implementation of this regime presents a challenge to the profession to be transparent and accountable in our reporting, and to bring our risk management expertise to bear in a wider range of areas. We should rise to this challenge.