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The Actuary The magazine of the Institute & Faculty of Actuaries

Learning from banks

As the prudential regulatory regimes for banks and
insurance companies converge, it is important
to understand how banks manage regulatory
capital, with a view to life companies learning from them. Last summer the Life Research Committee set up a working party to do just that. The working party gave a presentation to the Life Convention in November and submitted an interim paper to the Life Research Committee for scrutiny.

The Financial Groups Directive
The Financial Groups Directive (FGD), which came into force in January 2005, requires additional prudential supervision of financial groups that straddle the insurance, banking, and investment sectors significantly. The new regulatory framework is expected to cause firms to revisit their capital structures. Prior to the FGD, EU Directives have required financial groups to be prudentially supervised within each major business sector. For banking and investment groups, this supervision has included the requirement to pass a capital adequacy test for the group as a whole. For insurance groups, the result has had to be reported, and supervisory action was liable to follow if the test was not passed.
Insurance groups that are structured as holding companies have been able to increase the reported solvency/capital position of their operating companies through the use of leverage. Leverage is debt which has been issued by the holding company and passed down as equity into the operating company. This has enabled holding company insurance groups to make use of the lower cost and tax-efficient benefits of debt to obtain regulatory capital credit within the operating companies.
The ability of insurance groups to maximise leverage within their regulatory solvency submissions has diminished. This is because the Financial Services Authority now looks at the capital position of the group as a whole and not just the reported solvency position of the operating companies. This insurance group analysis is captured through the Insurance Group’s Directive calculation.

Loss absorbance
The loss absorbance qualities are important when considering an insurance company’s capital. Consequently, capital is divided into tiers I and II (and further subdivided within these tiers) according to their ability to absorb loss. At the top is core tier I, ordinary shares. This is the most subordinate form of capital in as much as it is non-redeemable and its rights are ranked below all other creditors including other types of capital. From a regulatory point of view, it is the best form of capital. At the other extreme are fixed-term capital instruments, which rank as lower tier II, because, being redeemable, they offer limited support. Consequently, there are limits placed upon the amount of capital other than core tier I as set out in table 1, which describes the limits on the various types of capital which can be used to meet the overall minimum capital resources requirements for insurance companies.

Life companies need to manage and, in some cases, increase their regulatory capital in order to finance new business and other group developments over the next few years. In addition, some of the existing regulatory capital may have a limited lifespan.
Life companies should have more active treasury functions with business models that can project over the next five years, helping them to plan for business capital requirements. The following need to be included in such models:
– Planned business volumes
– Impact of tax on different forms of capital
– Transaction costs
– Regulatory capital requirements
– Dividend policy
– Anticipated corporate actions
– Capital maturity dates
– Regulatory capital resources
– Rating agency ratios
The model used should be able to track the relevant ratios on a monthly basis and give forecasts on a quarterly basis allowing management to be constantly aware of its capacity to raise tier II capital. A tier II plan put in place at the start of the year can give flexibility to take any market opportunities that may arise over the year. An even profile of existing capital maturity dates provides flexibility in the future and ensures that the insurer will not have to finance large capital needs at inopportune times.
Issuance of capital securities is, however, just one way of increasing regulatory capital. Others include optimising the asset mix, buying derivative protection, implementing other derivative strategies, and financial reinsurance.
The working party comprised Clare Beale, Rolf van den Heever, Tim James, Mark Versey, and Icki Iqbal (chairman). Paula Kelly of the FSA scrutinised our work and we also received tremendous support from David Joyce of Lloyds TSB.
This article summarises the main findings. For further details, please refer to the interim paper.
Terms of reference are currently being prepared for a follow-up working party on effective treasury management. Please contact Icki Iqbal if you would like to be part of the party.