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Current Issues Committee

Newsletter February 2008 The content of this newsletter is a summary of some of the current issues that might be of interest to UK General Insurance actuaries and that have come to the attention of the Current Issues Committee. As such it is not a complete list. Anyone who feels that relevant issues have been omitted or that the above summaries are in anyway misleading is invited to contact the Chairman of the Committee, Laurence Townley. The information provided has been derived from a variety of sources. The Committee has not been able to check independently the veracity of all of the facts stated. Any opinions expressed are those of the Committee members, and do not necessarily reflect the position of the Institute or Faculty of Actuaries.

CONTENTS

International 2

Claims and Legal Issues 7

Market News 12

Solvency 2 15

Government and Regulatory Issues 19

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USA

New York Proposes Principles-Based Regulation

New York Superintendent Eric Dinallo has put together a draft proposal to establish principles-based regulation. The superintendent issued 10 principles for insurers and 10 for regulators. Mr Dinallo contends that this will help create a more nimble insurance industry that will be more competitive on the world stage in the face of increased competition.

A department official said principles-based rules can be used in a wide range of areas, including:

• establishment of reserves on a non-formulaic basis;

• claims-handling by insurers; and

• capital requirements based on internal models instead of the department’s risk-based capital formulas.

The full text of the principles is available at the department’s website at www.ins.state.ny.us.

New York Moves To Alter Foreign Reinsurance Collateral Mandate

New York Insurance Superintendent Eric Dinallo has also announced a proposal to unilaterally do away with, or at least lower, collateral requirements for foreign reinsurers with good financial ratings. The proposed regulation would go into effect in July 2008. Under the new rule, the highest-rated US and non-US reinsurance companies not authorized or accredited to do business in New York would be treated the same as New York reinsurers, and would no longer have to post any collateral. Companies not as strong would have to post collateral on a sliding scale from 10% to 100%. This would apply to both US and non-US reinsurers not authorised or accredited in New York.

The proposals aim to reduce transactional costs and increase reinsurance capacity. It aims to also bring New York in line with global insurance markets and worldwide accounting standards governing reinsurance contracts. Most foreign jurisdictions do not require collateral from non-domestic reinsurers for their insurers to get credit, the department noted.

New Mexico Regulators Call for End to Immunity and Uniform Rates

The New Mexico Public Regulation Commission, which regulates insurance in the state, has proposed removing statutory immunity for title insurance companies and ending uniform rates for policies, steps the elected body said will promote competition. The PRC said a 1999 law that immunized the title insurance industry from paying damages due to a negligent search is unusual and unfair to consumers.

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“Unlike every other professional or service provider in New Mexico, if a title agent or insurer makes a mistake due to negligence that results in monetary damages to the customer, the customer has no legal recourse to recover those damages”, the letter stated.

According to the PRC, the New Mexico Title Insurance Law of 1985 requires the superintendent of insurance to set uniform rates for all title insurance in the state, removing the potential for competition by insurance companies based on price or value.

New York Eyes Fee Disclosure For All Brokers

A new mandate requiring every retail broker in New York to disclose to their clients the value of all compensation deals with insurers is being drafted by the state insurance department. The proposed “producer transparency rule” would “ban any New York broker from accepting any compensation from an insurer if not disclosed to the client beforehand,” said Steven Nachman, Deputy Superintendent for frauds and consumer services in the state insurance department.

“If the amount of compensation cannot be determined up front” he noted, such as with contingent deals based on the overall profitability of the total book of business an agency writes with a particular carrier, “the broker would have to provide an estimate and then disclose the actual amount within a reasonable time - say, within 10 business days of knowing the figure.”

The proposed regulation would only apply to brokers dealing directly with the public, meaning it would effectively exempt wholesalers and managing general agents.

Europe

Ireland - Landmark Ruling Finds Travel Firm Liable Over Tourist’s Fall

A landmark court decision making holiday operators liable for injuries suffered by tourists in its resorts abroad has been hailed as a potential ‘revolution for customers’. The Supreme Court found the Falcon group liable for injuries suffered by a holidaymaker who fell on a slippery floor in a Spanish hotel. The judgment means that even if a holiday operator does nothing wrong, it can still be liable for the actions of hotels and other services abroad.

Ireland - New Code of Practice to Regulate Insurance Information

Data protection commissioner Billy Hawkes intends to implement a new code of practice with or without the agreement of the insurance companies and has the legal power to do so. Negotiations are ongoing with the insurance industry to agree a wording for the code and it is hoped that the industry will sign up voluntarily over the next few weeks. The long awaited new guidelines will regulate the use of private investigators hired by insurance companies to settle claims quickly and cheaply.

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Romania - New Foreign Insurers on Romanian Market in 2007

Over 150 insurers from the European Union have entered the Romanian market after they notified the Insurance Supervision Commission (CSA) and took advantage of the European passporting regime.

The majority of the insurers that intend to sell policies on the Romanian market are from the UK (over 40 companies), Ireland (15), Austria (12) and France (11). Seven Hungarian insurers can sell policies directly on the Romanian market, but only two Bulgarian ones. Two companies decided to set up branches on the local market - Australian QBE, via their London-based subsidiary, and the French insurance group Coface.

Ukraine - State Agricultural Insurance Agency

In the draft national agricultural insurance program, the Ukrainian Ministry of Agricultural Policy has put forward an initiative to create the State Agricultural Insurance Agency in 2008-2009. In addition, the Ministry proposes to establish an all-Ukrainian Agricultural Insurance Pool in 2008 that will consist of large Ukrainian insurance companies. The creation of this pool will allow an effective system of crop insurance to be introduced that will take into account the needs of insurers and agricultural producers.

According to the bill, the State Agricultural Insurance Agency will be commissioned with forming an informational and consulting database, creating methodical literature and settling controversy in the agricultural insurance area. The Ministry expects the newly established Agency to send its consultants to various regions of Ukraine, as well as to start forming the structure of non-commerce insurance by means of creating agricultural mutual insurance companies and agricultural insurance cooperatives performing the same duties as insurers.

Australia

Refinements to the General Insurance Prudential Framework

The Australian Prudential Regulation Authority (APRA) issued its second consultation package on proposed refinements to the general insurance prudential framework to recognise the differing risk profiles of insurers. The package comprises a response paper and draft prudential standards and prudential practice guides. The proposed refinements are expected to apply from 1 July 2008.

The response paper outlines APRA’s response to submissions received on the discussion paper released by APRA on 31 July 2007. It contains proposals for the categorisation of insurers that are largely aimed at clarifying and simplifying APRA’s requirements of branches and subsidiaries of foreign insurers. The proposals will also scale back some of the requirements of smaller insurers and captives while maintaining the integrity of APRA’s prudential framework.

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The paper also contains a number of proposals applying to all insurers. They include the recognition of ‘kangaroo bonds’, the measurement of capital and, importantly, certain reinsurance and investment-related measures.

On reinsurance, the paper contains a proposal aimed at encouraging foreign reinsurers not authorised by APRA to lodge security in Australia, after a grace period, in respect of amounts recoverable by APRA-authorised insurers from these reinsurers. In cases where these reinsurers do not lodge security, APRA-authorised insurers will be required, after the grace period, to hold capital to match the unsecured recoverables.

Feedback on General Insurance Financial Conditions Report

Robert Thompson outlined APRA’s initial thoughts on the first round of GI Financial Condition Reports (FCRs) at the Biennial Convention held in September 2007 in Christchurch. He commented that APRA had been pleased on the whole with the standard of the FCRs that had been received. He also noted that in most cases actuaries had covered all of the prescribed areas with a reasonable amount of detail (including the asset/liability management and risk management).

Areas where APRA suggested that there could be improvement in future FCRs included:

• greater analysis of emerging loss ratios by accident year, with linkage to ongoing loss ratio assumptions for Premium Liability calculations;

• more discussion of the insurer’s pricing processes and the actuary’s degree of involvement;

• more commentary on contagion risk (where appropriate for those insurers forming part of a larger group);

• more detail on diversification assumptions, and justification where a valuation methodology is changed from that used the previous year;

• discussion of case estimation techniques/adequacy where appropriate;

• description of asset valuation techniques for those insurers with unusual asset profiles;

• commentary on whether the actuary is involved in setting and monitoring the insurer’s target surplus position;

• discussion of the reasonableness of assumptions underlying the insurer’s capital adequacy projections; and

• details of the method used to set and assess the insurer’s Maximum Event Retention (MER).

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Robert summarised by saying that APRA thought the best FCRs had been those where the actuary was prepared to tackle the difficult issues and include in the FCR recommendations and suggestions for improvement, grouped in terms of impact on the insurer’s financial condition. Robert also noted that the majority of feedback on the new FCRs that APRA had received from directors of insurers had been positive.

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UK Floods – 07C

Extensive flooding caused severe damage in north-eastern England in June 2007 and central and south-western England in July 2007. In total, more than 130,000 insurance claims were submitted, with insured losses now estimated at over £3 billion.

The summer of 2007 was the wettest season on record, and parts of the UK experienced their worst flooding in 60 years. Flood in the UK is a persistent risk that can potentially cause great levels of damage and disruption.

The damage cost was mostly absorbed by the UK insurance industry, with only a relatively small proportion of the losses ceded to reinsurers. The impact of the 2007 UK flood losses on reinsurance pricing is not expected to be significant, and additional sideways cover is expected to be purchased to absorb the increased frequency arising from higher retentions. In addition, in order to mitigate the possibility of more severe events in the future, interest in catastrophe bonds and other capital market solutions such as index-linked products is expected to increase.

Increasing Rate of Accidents for Young Motorists

Young motorists' accident rates are getting worse while older drivers' are improving, according to Norwich Union. Insurance claims by drivers under 23 have increased more than 300% in the past five years. Claims by the over 23’s fell by 10% in the same period.

Credit Crunch Continued

Higher interest rates and falling property prices have contributed to rising mortgage defaults among sub-prime borrowers in the US. This, coupled with increased relaxation of underwriting standards, has led to the bankruptcy of several US mortgage lenders and to increased regulatory scrutiny.

To date, worldwide corporate losses relating to US sub-prime exposure are estimated to be in excess of $170 billion. Commercial banks and investment banks have been the hardest hit, with write-downs by Citigroup and UBS alone accounting for more than $28 billion.

According to a report by Guy Carpenter, sub-prime related D&O insured losses are expected to reach $2 billion for claims filed in 2007; with analyst estimates for ultimate losses ranging from $3 billion - $6 billion. Add to this the possible litigation in other insurance lines, such as Professional Indemnity and Errors & Omissions, and things could get considerably worse as the full impact of sub-prime exposure becomes known over 2008 and 2009.

A major concern for the insurance industry is the possible ripple effect spreading throughout the economy, which might give rise to more than professional liability litigation. Investors might also file against companies not directly involved in sub-prime lending, but running into financial

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difficulty on the back of the sub-prime crisis, such as Northern Rock. The industry could also see an increase in claims directed at surveyors and solicitors, involved in the valuation and conveyancing process, if the expected economic downturn results in a housing market collapse.

Stanford Law School has listed 32 sub-prime related class action lawsuits to date, with companies involved ranging from rating agencies to mortgage banks, pension funds and even builders.

In an unusual claim, the city of Cleveland is suing 21 of the largest US financial institutions for damages of hundreds of millions, accusing them of knowingly making loans available to people never able to repay. According to city mayor, Frank G. Jackson, these institutions would be “held accountable” for plunging the city into a financial crisis, as entire city blocks have been abandoned and the city’s budget strained by maintaining thousands of boarded up homes.

Changing Environment for D&O and E&O Insurance?

Current economic conditions, combined with UK legislative changes potentially making it easier for shareholders to bring claims, might lead to directors for some UK companies being sued.

Firstly, the recent crises in financial markets may give rise to claims against directors. The way in which these claims arise will have varying impact on D&O claims for insurers. Directors may be exposed to claims in the following ways:

• Directors may be exposed to claims either from their own company where the company's new management believe the problems are the fault of former directors, or from derivative actions whereby shareholders are able to bring a claim. Protection against both of these types of claim is core to effective D&O cover.

• Directors may be exposed to claims by disappointed investors, who believe that they purchased shares that were substantially overvalued in light of information the company knew but had not revealed. The effect of such claims on the D&O market, however, will depend on how widely cover against such liabilities has been provided.

• Directors may be exposed to claims arising from regulatory action, particularly as the credit crisis has impacted on the heavily regulated financial services industry. While policies do not insure against regulator's fines and penalties, an important component of D&O insurance for regulated companies is costs provision for the defence of individuals facing regulatory investigation, which may be expensive.

This is exacerbated by the Companies Act 2006 which came into force in October 2007. The Act combines codification of directors' duties with changes to the law governing derivative

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actions. Many argue that this has brought about an expansion of directors' responsibilities and there is a fear that there will be an increase in the number of derivative actions brought.

Previously, the law would permit a shareholders derivative action only in limited circumstances (primarily where a company's assets were being misappropriated by 'wrongdoers' in charge of the company). A derivative action can now be brought in respect of directors' negligence, default, breach of duty and breach of trust. Directors were already exposed to such claims by companies if instigated by management, however, and so the real increase in risk may be limited to those circumstances where a single or group of shareholders is inclined to sue, but the company's management is not.

The court rules introduced to give effect to the new derivative action may also increase insurers' exposure. These rules include early examination of whether a claim ought to be brought at all and there may be a contested hearing of that issue which may prove expensive.

Ruling on Pleural Plaques

In October 2007, the House of Lords unanimously dismissed the appeal brought by former employees who had developed pleural plaques and in one case psychiatric injury, and upheld the majority decision of the Court of Appeal.

The main issue in this case was whether the Appellants, who had been negligently exposed to asbestos dust/fibre and developed pleural plaques could sue their employers in negligence. It was argued on behalf of the Appellants that the development of pleural plaques amounted to an actionable injury and/or that pleural plaques together with the risk of developing more serious asbestos related disease and the anxiety that was thereby created was sufficient to give rise to a cause of action.

Lord Hoffman, who gave the leading speech, stated that proof of damage is an essential element in a claim in negligence and that in his opinion (which was shared by the remainder of the House) symptom-less plaques are not compensatable damage nor does the risk of future illness or anxiety about the possibility of that risk materialising amount to damage for the purpose of creating a cause of action.

In addition, it was held that even if the anxiety causes a recognised psychiatric illness such as clinical depression no cause of action arises - the risk of the future disease is not actionable and neither is a psychiatric illness caused by contemplation of that risk.

Johnston v NEI International Combustion Ltd; Rothwell v Chemical & Insulating Co Ltd; Topping v Benchtown Ltd; Grieves v F T Everard & Sons (The pleural plaque test case) 17th October 2007

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Repudiated Claims

Policyholders in the UK have collectively had insurance claims worth £750 million rejected during the past year after failing to read their policies' small print. Around one million people have tried to claim on a car, home or travel insurance policy during the past 12 months only to find they have not been covered.

Fraudulent Motor Claims

The latest figures released by the Association of British Insurers suggest that insurance companies are becoming increasingly effective at detecting and dealing with fraud, successfully preventing £480 million of fraudulent general insurance claims in 2006 - a three-fold increase on 2003.

The industry appears to be able to better monitor the fraudsters' response in relation to evolving fraud trends. Taking the motor sector, for example, using in excess of 3,000 claims based on incident frequency from July to September, it is possible to identify the top 10 motor fraud trends during this period and see how that compares to previous periods.

The most common is fraudulent motor vehicle theft where the finance is in arrears, and the occurrence has continued to increase significantly. There has also been an increase in theft while the keys were left in the car involving deception - as the public are aware that their insurers will not pay these cases, various intricate layers of deception are being used in an attempt to hide this fact.

Top 10 Types of Fraud

Position for Q3 2007 *

Position for Q2 2007 **

Type of claim

1 1 Motor vehicle theft where finance is in arrears 2 10 Increase in theft while 'keys in car' involving deception 3 2 Arson 4 3 Increased theft of older vehicles 5 9 Misrepresentation 6 4 Theft by deception 7 5 Recovered theft cases involving drink driving 8 6 Theft of vehicles following burglaries 9 7 Policies being taken out with stolen credit cards

10 8 Policies being taken out under false ID Source: Absolute CM. * based on 3,000 claims between July and September 2007 ** April to June 2007

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No Specific Measurement of Minimum Duration of Exposure to Asbestos Required

In November 2007, the Court of Appeal rejected the proposition that in cases of exposure to asbestos fibres resulting in mesothelioma, a specific measurement of the duration of the material exposure is required for a claim to succeed. What is required is a finding that the duration of the exposure had constituted a material increase in the risk of contracting mesothelioma. Exposure which was de minimus would be insufficient.

Rolls Royce Industrial Power (India) Ltd v Cox [2007] EWCA Civ 1189

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Insurance Growth Pains

After highly competitive market conditions during 2006, which saw the UK commercial general insurance market contracting and personal lines GWP rising by a mere 1.4%, growth in the UK commercial market is expected to exceed that of personal lines between 2007 and 2012. According to new reports from Datamonitor, the personal lines market is expected to grow on average by 4.8% per annum, while the commercial market is expected to achieve a stronger average growth rate of 5.3% per annum during this period.

After 12 years of underwriting losses and a 0.9% fall in GWP during 2006, the private motor sector is now at a similar size to that of 2002. Fortunes in this sector are expected to improve along with a strong expected growth in the household and pecuniary loss markets. This should see the personal lines market reach a value of £33.1 billion by 2012.

During 2006, the commercial sector saw income decline by 1.1%, driven by competitive pricing and falling GWP in the liability, pecuniary loss and commercial motor sectors. Market statistics showed a significant deterioration of operating conditions in the employer’s liability sector having a large impact in the decline of the general liability insurance sector. UK EL premium rates fell significantly in 2006 by 6.3%, whilst claims conditions deteriorated in light of factors such as NHS claw-back and structured settlements. Market conditions remained difficult during 2007 with further rate reductions across the EL market.

The commercial property and group accident lines however, defied poor market conditions in 2006 to return to positive growth of 0.5% and 3% respectively. The rest of the commercial market is expected to follow suit, and see the market reach a value of £22.1 billion by 2012.

Finite Trouble

Finite risk reinsurance is yet again at the forefront of litigation, as former executives of GenRe and AIG are facing criminal fraud charges over a $500 million transaction that allegedly artificially boosted AIG's reserves in 2000. Among five defendants is former CEO of GenRe, Ronald Ferguson, who co-developed the widely used Bornhuetter-Ferguson method for estimating loss reserves.

Lloyd's Go To Chile

Under a new ruling, following the Free Trade Agreement between Chile and the EU, Lloyd's has become the first foreign entity permitted to solicit or broke direct insurance business to a Chilean entity. Under regulation No. 197, Lloyd's has been granted permission to write direct insurance business in the Marine, Aviation and Transportation (MAT) lines.

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M&A Activity on Increase … Again

The insurance market can expect to see an increase in merger and acquisition activity, following a period of continued tough market competition and global economic uncertainty.

A recent bid by Royal & SunAlliance to acquire a 20% stake holding in struggling broker Heath Lambert was rejected. Heath Lambert also denied having takeover talks with AXA, whilst a potential sale to rival JLT failed in 2006. Other players reported to have shown interest in a possible acquisition are AJ Gallagher, Willis, Aon and Towergate.

It is also believed that Willis, the world’s third largest insurance broker, has approached Marsh & McLennan about a possible takeover deal. The transaction, which would also include subsidiaries Mercer pension consultants and Kroll security consulting unit, could value the insurer in excess of $15 billion.

Independently Jailed

Closure has finally come to the Independent Insurance Company criminal trial, where three former executives were found guilty of conspiracy to defraud at Southwark Crown Court.

Michael John Bright, who was CEO between 1987 and 2001, was sentenced to seven years imprisonment on two counts of fraud, as well as being disqualified from serving as a director of a company for 12 years. Dennis Lomas, the company's former finance director, was given four years in prison on each of the two conspiracy to defraud charges and Philip Condon, the former deputy managing director of the insurer, was sentenced to three years on the single count of conspiracy to defraud, although the judge said the three would serve half their sentences.

The Serious Fraud Office accusation came in light of the Independent commercial disaster which shocked the insurance industry in 2001. Independent had 500,000 private and 40,000 corporate policyholders at the time of its collapse. Some 1,000 staff lost their jobs and the resultant claims on the industry-funded compensation scheme had reached £366m by September 2007.

Mr Bright and his colleagues dishonestly withheld claims information and failed to disclose details of important reinsurance contracts to consulting actuaries Watson Wyatt, hiding the dire financial state of the company. As a result of their dishonesty, the company continued to trade unprofitably, which made it impossible to rescue the situation once the truth emerged. Expert actuaries estimated a required potential increase in reserves in the range of £110 million to £250 million as a result of the revelation of the withheld data.

The SFO said “This has been one of the most technical and complex cases we've had to deal with. It took a diligent and painstaking investigation involving a mountain of documents. Around 30,000 pages constituted the prosecution case, nearly 240 witness statements were taken

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and over 1,500 documents shown to the jury. This is the nature of serious fraud investigations and prosecutions.”

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CEIOPS Publishes QIS3 Report

The Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) has published a report on its third quantitative impact study (QIS3), which tested the design framework for Solvency II insurance regulation. The report represents feedback from 1,027 insurance companies from 28 of the 30 states within the European Economic Area, almost double the 514 respondents to QIS2.

QIS3 tested group supervision for the first time, and multiple approaches for some elements, contributing towards an informed adoption of the best option by the 2012 deadline – although further calibration will come with QIS4.

CEIOPS said feedback was less consistent for some more controversial topics, such as the treatment of concentration and counterparty risk, and the equity risk approach based on the duration of liabilities; and while QIS3 was the first study to consider the implication on groups, only a few groups participated in the study so the key findings are mainly qualitative rather than quantitative.

The testing also revealed the amount of change needed to comply with the Minimum Capital Requirement (MCR) and Solvency Capital Requirement (SCR), concluding that, despite the changes needed to adapt to a risk-orientated system, 98% of firms will meet the MCR without allocating additional capital.

CEIOPS concluded that in 30% of undertakings available surplus would increase by more than 50%, whereas in 34% of undertaking the available surplus would decrease by more than 50%. It is estimated that 16% of undertakings would have to raise capital to meet their new SCR.

On operational risk, CEIOPS reported most firms recognised that the area deserved special attention, although participants said full correlation with the other forms of risk was not possible, and demanded the recognition of diversification effects. Worryingly, 21% of firms still did not consider an operational risk strategy necessary, and, of those that did, 30% considered it unnecessary to define their risk appetites within the strategy.

More encouragingly, 65% of respondents said a committee structure was necessary for operational risk strategy, with most of these involving the board of directors directly in the committee’s work.

FSA Issues UK Country Report on QIS3

Alongside the report published by CEIOPS, the FSA has published a report which summarises the UK results of QIS3. The report also highlights the main issues of the study identified by the UK insurance industry.

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The overall objectives of QIS3 were to test the financial impact on firms and the suitability of the proposed requirements of Solvency II, such as technical provisions, own funds, the MCR and the SCR, as well as solo requirements. QIS3 tested key aspects of the proposed draft Directive (Level 1), published in July 2007, along with CEIOPS' current thinking on Level 2 implementing measures. CEIOPS is due to present its final advice to the Commission on Level 2 in October 2009.

Key Findings

The UK participation in QIS3 was considerably higher than for QIS2, with 39 life firms and 46 non-life firms participating (representing 65% and 75% of the market by premium income respectively). QIS3 showed an overall reduction in firms’ solvency ratios compared to Solvency I. Nevertheless, across the industry as a whole, there would have to be a substantial buffer of capital in excess of the SCR, the effect of which would vary between firms. Over 80% of UK firms had a surplus of available capital over the standard SCR as proposed in QIS3.

MCR Issues

QIS3 results for UK firms revealed a substantial variation in the ratio of the MCR to the SCR, indicating that the modular MCR tested by CEIOPS was insufficiently risk-sensitive. Both life and non-life firms expressed concerns that the MCR was not calibrated in line with the draft Directive and that under the modular approach, the SCR and MCR would not move consistently from year to year, creating problems for capital planning. As a result, CEIOPS will be considering several alternatives for the design of the MCR.

SCR Issues

The key issues with the standard SCR detected by UK firms were the 75% lapse catastrophe component for non-life underwriting risk (premium and reserve) calibration. A comparison of QIS3 results and internal models/ICAS results indicated that the standard SCR overstated the risks of these firms and materially adversely affected their reported solvency ratios.

Comparison with modelled results also detected some areas where the standard approach SCR may understate risk. These included credit risk scope (a number of classes of asset were omitted) and operational risk (firms were concerned that the standard approach does not recognise investment by firms in risk management).

Other important issues raised by firms about the suitability of methodology included the diversification effects between business written in different countries (diversification in all respects was a major issue for groups) and the potential exclusion of free assets for calculating the market risk component.

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Technical provisions

There were relatively few problems reported in calculating best estimate provisions but several comments were made on the calculation of the risk margins under the Cost of Capital approach which related to (i) knock-on effects of over-calibrated aspects of the SCR; (ii) the inclusion of a component for market and premium risk in year 1; and (iii) the absence of any allowance for potential diversification between lines of business.

Own funds

Some firms found the proposed criteria for classifying own funds unclear and expressed uncertainty about the classification of some financial instruments.

Groups

Most UK groups reported a reduction in their overall solvency ration compared to the current requirements under the Insurance Groups Directive.

A copy of the report is available at http://www.fsa.gov.uk/pubs/international/qis3_uk.pdf.

CEIOPS Submits Draft QIS4 Technical Specifications to the EU Commission

On 21 December 2007, the European Commission published the consultation on the draft “QIS4 Technical Specifications” for the Solvency II project. This consultation is open until 15 February 2008. QIS4 is then due to take place between April and July 2008, with CEIOPS then publishing a report on the QIS4 exercise results by the end of November 2008.

In summary, the changes between QIS3 and QIS4 are:

Counterparty credit risk. The process is similar to the three step process in QIS3 but: loss given default recognises the firm’s reinsurance; it is linked in with catastrophe risk; the SCR is calculated net and gross; and the aggregation formula is simpler.

Premium and reserve risk calibration. The calibration is less or the same for every class (except third party liability and credit) and firms are invited to give own estimates for standard deviation for Premium risk and Reserve risk.

Premium and reserve risk geographical diversification. This is now allowed for.

Catastrophe risk. This has a three layer structure:

• Layer 1: Percentage of premium income if no scenarios for territory from local regulator.

• Layer 2: National scenarios where they exist.

• Layer 3: Firms allowed to personalise catastrophe scenarios instead of Layer 1 and 2.

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For the UK no national scenarios will be given and it is anticipated that firms will use Layer 3 (or, where not material, Layer 1).

MCR. Linear and Compact Approaches are to be tested:

• Linear approach is higher of percentage of premiums and technical provisions.

• Calibration of linear MCR and premium & reserve risk are consistent (different percentiles of same lognormal distributions).

CEIOPS Consultation on Draft Interim Report on Proxies

CEIOPS has also published a consultation on a "Draft interim report on proxies”. The report gives a comparative description of proxy methods (i.e. practical simplified solutions) for the evaluation of technical provisions in Solvency II. The deadline for responses to the consultation is 15 February 2008.

The economic valuation approach envisaged under Solvency II requires (especially for long tail business in non-life insurance) sufficient statistical data and actuarial knowledge in order to apply appropriate actuarial methods. Proxy methods are concerned with those cases where one or both of these conditions are not met, the proposal being that such proxy methods will be a pragmatic solution where there is a lack of data or actuarial expertise in the valuation process.

The use of the proposed proxy methods is likely to be subject to clear admissibility criteria in order to encourage the (re)insurance undertakings to use – whenever this is possible - appropriate actuarial methods for the valuation of liabilities. However, at current, it is accepted that the admissibility conditions apply to a significant number of insurers, especially in non-life insurance where in some markets the use of actuarial techniques has traditionally been less widespread than in life insurance.

CEIOPS Publishes Paper on MCR Architecture

CEIOPS has also published a paper "Architecture of the MCR: Pros and cons of different approaches". The paper gives an overview of the different approaches envisaged for the calculation of the Minimum Capital Requirement (MCR) under Solvency II and intends to make an inventory of the pros and cons of each method. Following the QIS3 exercise, CEIOPS identified the MCR as one of the critical issues on which a decision will need to be made on a political as well as a technical level.

The paper gathers quantitative results and qualitative feedback from QIS3 on the CEIOPS modular approach and the compact approach. It further analyses the approach based on margin over liabilities and proposes two additional approaches.

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Gender Directive

HM Treasury published guidance and its response to the consultation process in November 2007 on how UK insurers should meet their obligations to comply with the EU Gender Directive. The EU directive related to the use of gender as a factor in the assessment of premium rates. The main condition of the directive was that insurance companies could charge different premium amounts or offer different benefits between men and women only if the supporting data relevant to the use of gender as a rating factor could be published and regularly updated.

HM Treasury recognised both that the disclosure of detailed gender data by insurers would not necessarily be in the public interest and that it would be very hard for non-experts to understand. Furthermore, it appeared that no other member EU state was adopting a policy of full disclosure. The Treasury, therefore, proposed to adopt a policy of the publication of aggregated data.

In order for consumers to see accurate and up-to-date data that provides evidence on different premium levels for men and women, the Treasury proposed mandating the publication of high level summary data. This data will include ratios of male to females rather than absolute amounts. The data will be limited to claims cost (frequency / severity) and would exclude other components of a premium calculation such as expenses, capital, tax and acquisition costs. Insurance companies would be allowed, in the submitted data, to allow for known trends on current claims settled in the future but not allow for the impact of future trends on future claims.

The guidance on the publication of data is intended to protect companies from being forced to publish commercially sensitive information. The negative implication of which could be to reduce competition.

HM Treasury, after reviewing the responses of its consultation process, also considered the treatment of group policies and long-term contracts.

The mechanism for implementing these proposals will be to amend the Sex Discrimination Act 1975 and these changes were due to come into force on 21 December 2007. However, the final details are being discussed early in 2008.

FSA Regulation of Travel Insurance

HM Treasury indicated in June 2007 that the FSA would have responsibility for the regulation of the selling of travel insurance when sold alongside a holiday. Subsequently, the FSA published a consultation paper in December 2007 on this regulation of connected travel insurance ("CTI").

The FSA proposed that the sale of CTI be regulated under the New ICOB Sourcebook and subject to the non protection products principles based regime. In order to sell CTI, travel firms will be able to apply either for their own authorisation to sell CTI or be an appointed

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representative of an authorised firm. Where the travel agent would be a representative, they would either be an Appointed Representative where a regulated firm would be responsible for the unauthorised travel agent, or the travel agent would be an Introducer Appointed Representative where the travel agent would direct the consumer to a regulated firm.

The FSA has asked for responses to their consultation paper to be received by 18 March 2008. The regulation of CTI comes into effect from 1 January 2009, with travel agents being able to apply for authorisation from 30 June 2008.

The announcement from HM Treasury stating the FSA’s regulation of CTI came in December 2007. HM Treasury described the change as a benefit to consumers with 21 million purchasers of travel insurance each year in a market size of £670 million in 2006. In 2004 there were estimated to be 64 million foreign visits of which approximately one third were package holidays.

ABI Research on Insurance Contract Law Review

In 2006, the Law Commission proposed changes to insurance contract law on three issues:

• mis-representation and non-disclosure by an insured before an insurance contract is made;

• warranties and similar terms; and

• cases where an intermediary is wholly or partly responsible for pre-contract misrepresentations or non-disclosures.

The ABI commissioned PwC to carry out a cost-benefit analysis on the implications for consumers and the insurance industry. The cost-benefit analysis considered current market practices and the potential effects on these practices following the implementation of these changes. The analysis also considers the impacts on claims costs, business expenses and the state of the market. Generally, the impact was concluded to be limited, however, there were some areas where it was thought that the impact could be wide-ranging. For example, commercial lines could be affected by relatively large one-off and on-going legal costs and one-off system costs.

The paper estimated the following costs:

• Personal lines: Impact of £20 million to £80 million costs to the industry for on-going costs. The benefits are expected to be minimal.

• Commercial lines: Impact of £400 million to £810 million for on-going costs and £300 million to £500 million for one-off costs. The on-going costs estimate was

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believed to be up to 4% of gross written premium relating largely to the need for an insurer to be more diligent at the point of sale. The benefits are estimated to be £160 million to £310 million.

The research also pointed out that the implications would not be consistent across the industry. For example, small insurers may not find it economic to implement these proposals. Also, changes to UK law could put pressure on the UK’s International Marine market.

FSA Insurance Sector Briefing

In October 2007 the FSA published an insurance sector briefing entitled “ICAS – Lessons learned and looking ahead to Solvency 2”. The aim of the briefing was to give feedback to the market following the completion of all first round ICAS reviews for UK insurance companies, aswell as looking forward to Solvency 2. The briefing provided aggregated feedback to the life and general insurance industry.

For general insurance the ICG was on average 113% of the ICA. While the average ICG for the whole market was 114% of ICA, the actual figure varied considerably from firm to firm, reflecting the varying quality of submissions received. Most firms received ICG within a range of 100% to 110% of ICA, with some firms' ICG/ICA falling well outside of this range, and increasing the average to 114%.

Over 50% of total assessments resulted in ICG being set at the same level as the firm's ICA. Many of these assessments were of small firms, whose approach tended to be more prudent than some of the larger firms. From a risk management perspective, the insights from the ICA are more meaningful if the assessment is based on realistic (rather than prudent) base liabilities with stress tests/scenarios calibrated to the required confidence level, something which will be required under Solvency 2 should those firms wish to opt for an Internal Model approach to their SCR.

The total ICA for general insurance was approximately £14 billion, with 70% of this amount relating to insurance risk.

FSA Regulatory Fees and Levies

In November 2007, the FSA published proposed changes to regulatory fees incurred by insurers for changes in business practice or restructuring. Of particular interest was the application fee for Part VII transfers, which has been introduced for general insurers at £10,000, because of the rising number of transfers and their associated costs. The FSA are also proposing the introduction of a special project fee of £500,000 for Solvency 2 internal model approval, although this fee would only impact the larger insurers.

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FSA Conduct of Business “Insurance Selling and Administration”

In December 2007 the FSA published its response and the final rules on insurance selling following its consultation in June 2007 on the conduct of business. The rules are seen by the FSA as a significant step in the direction of the principles based regime. The standards set out in the document are intended to underpin the meaning of treating customers fairly for insurance companies.

The topics covered by this FSA publication include protection products, payment protection insurance and claims handling procedures.