Solvency II News February 2013 (2)

7/28/2019 Solvency II News February 2013 (2)

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Solvency ii Association1200 G Street NW Suite 800 Washington, DC 20005-6705 USA

Tel: 202-449-9750 www.solvency-ii-association.com

Dear member,

Good news. In UK, firms can use theirSolvency II work to meet, as far as possible,the current regulatory requirements.

Yes, it means more Solvency I I jobs, more opportunities.

Solvency I I early use of Solvency I I work to meetICAS requirements

Dear Firm

At the PRA launch event for insurers on 22 October 2012, I acknowledgedthe delay to the implementation of Solvency II and set out a new planninghorizon of 31 December 2015.

I also set out the intention to ***allow firms to use their Solvency I Iwork to meet, as far as possible, the current regulatory requirements***under the Individual Capital Adequacy Standards (ICAS).

The extended planning horizon has led us to re-plan ICAS reviews overthe next 24 months, including for many firms in the internal modelapproval process (IM AP).

In developing the approach, we have benefited from industry technical

input in expert groups we have convened; we are grateful to those firmswho participated in the groups.

Solvency ii Associationwww.solvency-ii-association.com
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In the speech, I set out a two-phase approach to allow the early use ofSolvency I I models.

In the first phase, we envisaged that firms intending to use their SolvencyI I model for ICAS purposes would additionally need to provide areconciliation between the calculations performed to take account of thedifferences in the two regimes.

In the second phase we said we would allow firms to use their SolvencyI I balance sheet and model for ICAS purposes without further on-goingreconciliations.

We believe that we have now developed an approach (referred to asICAS+as shorthand) that provides a practical solution available to

both life and non-life firms consistent with our current regulatoryapproach and whichallows firms to continue to make progress towardsSolvency I I .

We consider ICAS+ to be most appropriate for those IMAP firms subjectto an I CAS review to the end of 2014, and firms should discuss with theirsupervisor the timing and content of their reviews.

Firms are reminded that they are not obliged to enter the two-phaseapproach, and it is not a condition for IM AP review or approval.

On 20 December 2012, EIOPA published its opinion on interimmeasures regarding Solvency I I .

We are working with E IOPA on the details of the interim measures, anda consultation is planned for spring 2013 on guidance for nationalsupervisory authorities to ensure a harmonised approach toimplementation.

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The key elements of the two-phase ICAS+ approach

Current ICAS rules will continue to apply, including the requirement tocarry out an ICA and the setting of individual capital guidance (ICG).ICAS+ does not require Solvency I I tests and standards to be met.

We have set out the information needed from firms for an ICAS+ reviewin the appendix. This includes the reconciliations we would need tounderstand the relationship between the firmsSolvency I I model and itsprevious Individual Capital Assessment (ICA) model.

We will seek to use existing IMAP material provided by the firm whereverappropriate in our review of the ICA but firms will need to confirm thescope of material that should form part of the ICAS+ review.

The scope of the ICAS review will seek to leverage IMAP work alreadyconducted. To the extent that we receive an ICAS+ submission ofsufficiently high quality (see appendix), we will seek to provide as muchdetailed feedback on IMAP progress as possible.

The detail will depend on timing, quality of materials, policy certainty,the scope of the review and our resource availability.Our starting assumption is that our current I CAS approach will continuefor groups (see below).

In the interests of efficiency, we intend to combine ICAS+ and IMAPprocesses and governance. There are three main outcomes of an ICAS+review:

i)a review of the firms ICA and setting ICG;

ii)feedback to the firm on the development of the Solvency I I internalmodel; and

iii) an updated work plan for the Solvency I I model review.



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We will review the in-development ORSA to facilitate the PRA approach,for instance as a way of bringing together business model analysis,forward-looking capital planning, assessment of stress and scenariotesting, evidence of use and capital risk management.

Firms should discuss with their supervisor how their in-developmentORSA may be used to meet the current I NSPRU requirements.

Solvency II reporting. I said in my October speech that we will requireenhanced information to deliver the PRAs objectives and we will look tosee if we need to supplement the existing data we get from firms in areassuch as stress testing or some market-wide data as we refine our work inareas such as assessing the sustainability and vulnerability of insurersbusiness models.

As I said in October, it is not our intention to bring in Solvency IIreporting any sooner than required by EIOPA.

We are working with EIOPA on the detail of its interim measures insetting policy for insurers.

The current supervisory approach will continue for groups. We will focuson UK solo firms and take into account group risks in ICAS+.

A number of firms have requested a group ICA and we will consider suchrequests as part of our rescheduling of reviews, taking into account theappropriate considerations including our own resource availability.

Next steps

Our discussions with firms indicate that industry interest is currentlymainly for phase 1, in part reflecting the significant policy uncertainty.

As noted above, we are updating our implementation plans to reflect thenew planning horizon of 31 December 2015, and we are scheduling ICASreviews over the next 24 months.



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Supervisors are discussing with firms whether they want to integrate theirICAS and IMAP reviews (revising slots as needed) and leverage theinvestment in Solvency I I work for ICAS purposes.

We are working through the next level of detail to implement the two-phase approach and will provide more information on what firms willneed to provide in their ICAS+ review in Q2 2013.

Please address any comment or feedback you may have on the I CAS+approach to your usual supervisory contact or email us [email protected].

Yours sincerely

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AppendixInputs to the ICAS+ review

For the purpose ofICAS+, the firm will need to provide:

- details of those aspects of itsSolvency I I internal model that it will beusing to satisfy (if only partly) IN SPRU7;

- any additional materials, including where relevant an in-developmentORSA, that it will be using to satisfy INSPRU7;

- appropriate reconciliations between the Solvency II model (or thosecomponents of the Solvency II model that the firms will be utilising)and the previous ICA model; and

- the firms assessment of its progress in developing its Solvency I Iinternal model and a summary of any additional work required tomeet the Solvency I I tests and standards.

Firms not in the submission phase of IM AP will also be expected toprovide any additional materials we deem necessary to inform our reviewand assessment of the key risk areas of the Solvency I I model against thetests and standards.

This would include, where appropriate, information on Solvency II groupmodels. We expect all materials submitted for an ICAS+ review to havebeen approved by the firms Board.

What does the reconciliation involve?

In order to be able to perform the ICAS+ review, we need to be able tounderstand changes in the firmsbusiness and model since the previousICA review, and the relationship between the Solvency I I model and the

previous ICA model.



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Firms wishing to take part in ICAS+ will have to produce thesereconciliations.

We understand that some firms have developed their existing models forSolvency II purposes whilst others have created new model architecture.

To this end, there are a number of possible methods available to firms toprovide the reconciliation between the previous and new ICA.

Firms wishing to enter ICAS+ should discuss with their usualsupervisory contact the method the firm wishes to use and how thereconciliations will need to be performed as they will be bespoke to theindividual firm.



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BERMUDA MONETARY AUTHORITYSETS OUT REGULATORY PRIORITIESFOR 2013 IN LATEST BUSINESS PLAN

Key Areas of Focus:-Bermuda will not Apply Solvency I I -type Regime to Captives-BMA to Balance International Cooperation with IndependentApproach to Regulation- Faciliating Quality New Business for Bermudawhile retainingeffective oversight

HAMILTON, BERMUDA - The Bermuda Monetary Authoritypublished its2013 Business Plan which sets out its regulatory prioritiesand goals for the year.

Jeremy Cox, the AuthoritysChief Executive Officer, presented the Planto stakeholders from the public and private sector at the AuthoritysAnnual Meeting held at BMA H ouse.

Describing what will be another extremely busy year for the Authority,Mr Cox said, We will work hard to ensure that Bermuda firms willcontinue to benefit from operating within a practical, risk-basedregulatory and supervisory environment that fits the unique nature ofBermudasmarket.

Several key areas of focus in the Plan were highlighted, including:

Bermuda Will Not Apply Solvency I I -type Regime to Captives

We can definitively state that Bermuda will not apply any Solvency I I -

type regime to the captive sector,Mr Cox said, as he described plans toimplement refined reporting requirements for captives this year.

Wewill introduce a risk return as part of consolidated annual filing forcaptives that they will submit electronically, which will createefficiencies in the process for both the market and the Authority.



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That is the extent of our refinements,Mr. Cox said.

What the risk return embodies is something that allows the regulator toget that key risk information and I think it is something the industry willbe quite happy to see in place given that they were volunteering so muchof this information already.

Itsgood for Bermuda and the market that we can make this decisionbased on the proven appropriateness of our regime for captives, he said.

This step, as well as the changes to our framework for the commercialsector, reflects our ability to take independent decisions on regulatorychange at a pace thats right for Bermuda and according to what makessense for our diverse market, while taking into account achieving global

recognition for our supervisory regimes.

Balance International Cooperation with an IndependentApproach to Regulation

Mr Cox also indicated that the Authority remains committed toappropriate international engagement, while implementing fit-for-purpose regulations for Bermuda.

The Authority recognises the importance of contributing to, as well aspreparing for, global changes that can affect the Bermuda market.

Wewill continue our advocacy efforts, and to have a seat at the tablewithin global standard setting bodies.

This means we can contribute to international developments as well asdetermine on going relevance or impacts for Bermuda of such changes,he said.

Maintaining strong working relationships with key decision-makers is avery important aspect of reinforcing the credibility we have earned



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overseas, and supports acceptance of Bermudas regulatory approachglobally.

This also facilitates our work on group supervision of the insurancemarket, and the supervisory colleges programme we have introducedand will continue through this year.

What we need to be doing is having our own independent views of whatneeds to be done for our Bermuda market recognising that there arecompanies here that have a global footprint, he said.

We are strong enough, we are credible enough, we are skilled enoughas a jurisdiction and as a regulator to make our own independent viewson how we should be positioning the regulatory and supervisory

framework here in Bermuda.

Faciliating Quality New Business for BermudaWhileRetaining Effective Oversight

Mr Cox also announced regulatory projects planned for 2013 that willsupport initiatives identified as new business development opportunitiesfor Bermuda.

These include a new licensing and supervisory regime for CorporateService Providers (CSP).

The Corporate Service Provider Business Act came into effect on 1stJanuary 2013.

Under the CSP regime the Authority will license and superviseprofessional service providers in Bermuda that act as agents for formingcorporate entities, as well as providing other corporate services.

This addresses an opportunity that industry identified some time ago forbuilding new business in this area, while establishing appropriateoversight.



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The Authority will also be focused on the hedge fund area, participatingin the on going jurisdictional effort to position Bermuda as a domicile ofchoice for asset managers.

Based on my own interactions with stakeholders in key marketsoverseas regarding hedge funds, Bermuda has the opportunity to raiseits profile further and compete more aggressively in this area, he said.

The Authority is also engaged as a priority with local industryparticipants and the Bermuda Government on developing Bermudasposition regarding EuropesAlternative Investment Fund ManagersDirective.

Its appropriate for the Authority to be part of such jurisdictional efforts to

facilitate quality new businessfor Bermuda while ensuring we achieveregulatory objectives appropriately, in a manner that is workable for allparties.



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Interview with Carlos Montalvo, ExecutiveDirector of E IOPA, conducted by GarryBooth, Reactions magazine (the UK)

Can you explain what the interim Solvency I Imeasures, sometimes known as Solvency 1.5,encompass?

Perhaps I should start with a disclaimer: I thinkthe name Solvency 1.5 is unfortunate.

We are not building from Solvency I , we arepreparing forRisk Based Supervision.

EIOPA will issue Guidelines addressed to nationalsupervisors on how to proceed in the interim phaseleading up to Solvency I I .

These Guidelines will cover the system ofgovernance, including risk management systemand a forward looking assessment of theundertaking's own risks (based on the ORSAprinciples),pre+application of internal models,and reporting to supervisors.

For more information you may wish to consult theEIOPA Opinion on interim measures regarding Solvency I I :

https:/ /eiopa.europa.eu/ fileadmin/ tx_dam/files/publications/ opinions/EIOPA_Opinion+Interim+Measures+Solvency+II.pdf



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Does the proposal have acceptance among EU country supervisors? Willeveryone move forward together?

The above mentioned Opinion of EIOPA wasfirst welcomed, and thenapproved by the EIOPA Board of Supervisors, which consists of thenational supervisory authorities of the EU Member States.

EIOPA expects that all our Board of Supervisors members arecommitted to set the grounds to develop a consistent and convergentsupervisory approach with respect to the preparation of Solvency II .

EIOPA's Guidelines will ensure that important aspects of the newregime will be phased in, taking into account due proportionality.

However, by nature these Interim Guidelines are soft regulation (i.e.used on a so called "Comply or Explain basis"), so there will be nosanctions if some National Supervisory Authorities (NSAs) do not fullycomply with the Guidelines at this stage.

Why have you decided to issue guidelines (Spring 2013)? What's in theguidelines?

In the absence of a final agreement on Solvency I I in the scheduledtimeline, EIOPA has expressed an opinion in order to ensure andenhance sound risk based supervision and prepare the industry for thefinal Solvency II Directive.

Instead of reaching consistent and convergent supervision in the EU,different national solutions may emerge to the detriment of a goodfunctioning internal market.

In order to avoid this scenario EIOPA decided to develop guidelines andto take a lead in the preparatory process aimed at a consistent and

convergent approach with respect to the preparation of Solvency II .

EIOPA Guidelines will allow supervisors and undertakings to be betterprepared for the application of the new regulatory framework.



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To cut a long story short, the guidelines are an excellent way for allparties to use the extra time of the delay as a way to be better preparedfor implementation.

The CRO of global reinsurer recently told me, 'We are experiencing everincreasing requirements for internal model approval, with each countrycarrying out its own assessment, with limited relation to proportionality...

This process consumes a lot of resources without creating value it haseven started to destroy value. And the situation might get even worseuntil the full formal implementation of all Solvency II 's three pillars in2015/16 (or even 17).

It is my sincere hope that EIOPA will have the power to convince local

supervisors to stick to the original intention: a principle based approachfollowing the principle of proportionality.'

What's your response?

The requirements for the use of internal models are set out in theSolvency I I Directive, and will indeed be further developed in theupcoming implementing measures, and EIOPA standards andguidelines.

Such requirements will have to be fulfilled by all undertakings(irrespective of their size) if they want to use an internal model for SCRcalculations under Solvency II .

EIOPA has been supporting the role of Internal Models in a risk basedframework, even after the experience of the Banking sector, wheremodels which were too principle based had a significant role in thecrisis.

This support should be acknowledged, and the need to learn from whathappened as well.



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EIOPA recognises that the uses of the internal model will vary fromundertaking to undertaking and will point out to NSAs that they have toassess compliance with requirements based on proportionality,according to the nature, scale and complexity of the risks and business ofthe undertaking.

Having said that, it is fair to say that EIOPA recognises that differencesbetween supervisory cultures,Member States' legal regimes and anumber of resources available, have led, in the short term, to someinconsistencies in the supervisory approaches with respect to internalmodel reviews in pre application.

Precisely because of that, when you look at our Work Program andobjectives for 2013 onwards, you will see that E IOPA is building a Center

of Expertise for Internal Models that will work on enhancing consistencyand supporting those supervisors that may need help achieving it.

Theresbeen a lot of uncertainty around the implementation date ofSolvency II . Realistically, when will the project be completed?

Letsstart with what matters most: Solvency I I will be implemented, andthere should be no doubts about it.

On the application date, we are confident that the framework will be

applicable in 2016 though I cannot give you 100% reassurance becausethe decision is not made at the E IOPA level.

The decision has to be made by agreement between the EuropeanCouncil, European Parliament and the European Commission.

I can confirm that EIOPA will do the necessary work to make theimplementation of Solvency II happen on January 2016.

But lets be clear, once we settle the pending issue of Long TermGuarantees, parties must avoid the temptation of reopening more issues.



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Solvency I I is a good framework, it will not be perfect on day 1, but thisshould not be an obstacle to start.

Dr Elke Koenig, president of the German supervisor Bafin recently saidofSolvency II , You have created a massively complex system which isprobably only fully understandable for those that have created it.Whatsyour response?

The basis of the system is quite simple: it strives forrisk basedsupervision that incorporates transparency, calls for a clearunderstanding of risk and good governance.

So the idea is simple but the way it has to be translated into a regulatory

framework is complex.

So Dr Koenig is right in that sense.

Why is it so complex?

I would say that it is everybodys responsibility (the regulators, theEuropean Commission).

But in many cases the complexity is also being driven by the industry.

What can we do to make things less complex?

We need to enhance the principle ofproportionality while bearing inmind that the same objectivescan be met in different ways in particularfor the companies that are not doing complicated business, for SMEsetc.

EIOPA is also aiming at reducing part of this complexity, with initiativessuch as an IT toolkit for undertakings that could include a way tocalculate the SCR, etc.

We dont just acknowledge the problem, we try to come with solutions.



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Another CRO told me that regulators appear to no longer follow theoriginal Solvency II framework route of principle based regulation.

For example, the Level Three proposal to add a compliance function andan actuarial function, with the added requirement that no person can besimultaneously responsible for more than one function.

Should Solvency II , as a principle based regime, force companies tomake such departmental changes?

I was surprised at this question.

The actions the CRO refers to, are explicitly captured in the level 1Directive (articles 46 and 48).

There is a full article on the actuarial function (Article 48) that containsnumber of requirements.

The level 1 text is principle based and there is a second level which getsinto more nitty gritty details to do with best practice around thecompliance and actuarial functions.

But the principle of proportionality should always be kept in mind.

Furthermore, the intention of Solvency II is not to force companies to dotheir business in one way or another.

It should ensure that risks are addressed and that the means to do so,subject to proportionality, are implemented.

On that basis we are not going to force companies to recruit a person tobe a compliance officer or anything like that.

What we expect is that they comply with the principles stated in levels 1and 2 comply in a sound way but not in the same way for all thecompanies.



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Some individuals interpret the principles as prescriptive but it is not ourintention to tell companies how to structure their business.

We use the word actuarial function but function does not mean person.

So in a tiny company you could have an actuarial function that does nothave to be performed by a pureactuary but instead by someone whohas strong mathematical knowledge.Are country supervisors straying from the original Solvency II script?

Our duty is to make sure that all 27 NSAs understand the principle ofrisk based supervision in a convergent way and apply it consistently.

Some of our members have told us that they need to enhance risk

management, internal controls, or disclosure.

So they had some internal projects on hold because these projectswere to be channelled via Solvency II , which is the same for everybody.

Now Solvency I I is not coming in January 2014 as they expected andthey want to move in those areas.

So exactly the necessity to avoid the development of national solutionswas stated in E IOPA Opinion on Interim Measures Regarding Solvency

I I , where we are talking about number of areas for which there will beinterim guidelines targeted to enhance preparedness towards Solvency 2.

These Guidelines indicate that supervisors are supporting the originalidea of convergence and harmonization, they believe in the concept ofrisk based supervision, and EIOPA is taking the lead to ensure thatimplementation will take place in a consistent way.

EIOPA wants to pave the way for further mutual understanding andfuture convergence between the EU and the U.S. on insuranceregulation and supervision.



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But many people in the US argue strongly against convergence. Why isconvergence important in your opinion?

The convergence is important for our overriding aim, which is to developstrong global regulatory and supervisory standards.

The purpose of the EU+US Insurance Dialogue is to enhance mutualunderstanding and cooperation as well as to promote businessopportunity, consumer protection and effective supervision.

We remain respectfully aware of the commonalities and differences ofboth regimes, continue to strive to address important issues in technicaldetail, and may, over time, move toward improved compatibility that willbenefit insurance consumers, industry participants, and the economy.

There is a growing view that Solvency II will lead to restructuring in there/insurance industry with M&A and consolidation to follow. Do youagree this could be an unintended consequence?

I have been hearing this for the last 15 years and also often asked thisquestion at conferences by representatives of smaller companies.

And I used to give such an example:

I like to buy books and I buy my books in a tiny bookshop in Madrid.

The owner reads a lot and he knows what the customer likes and alwaysgives me great recommendations.

I could buy my books at Barnes & Noble or at Amazon.But as long as Iget such a level of service [from my little bookshop] I will never do that.

If smaller insurance companies understand the needs, bring added valueto their customers and also understand the specifics of the business theyunderwrite, they will succeed.



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They will even benefit from Solvency II because it gives them the rightincentives to have better risk management.

As for companies that are subjected to restructuring or mergers, they willface such issues because their problems are related to globalisation andnot to Solvency I I .



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Speech by Andrew Bailey, ManagingDirector, Prudential Business Unit atthe Chartered Institutes NicholasBarbon Lectures, London

Thank you for inviting me to give thisNicholas Barbon Lecture.

And, thank you for giving me the opportunity toremind myself of the career of Nicholas Barbon Isayremind myself because a long time ago I wasan economic historian.

Barbon is certainly one of the founders if not the

founder of the insurance industry in London in thelate seventeenth century.

He was first a builder, indeed, he wrote a tract called an apology for thebuilderin which he defended new construction in London on thegrounds that cities created employment and wealth.

Barbon was probably the leading builder of the time and he offered anintegrated service because he pioneered house insurance.

Indeed there are observations that Barbonsbusiness was to build,insure, and re-build your house when it fell down.

These days you would be in FSA enforcement if you tried that one.

But Barbon was also one of the early economic theoristsin a period atthe end of the seventeenth century when economic theory flourished,before it went into abeyance until Adam Smith and David Hume cameonto the scene.



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Barbon developed the argument that wealth creates demand and heextolled conspicuous consumption: he wrote that a poor man wants aPound; a rich man a Hundred.

Clearly, Barbon never quite imagined that one day investment bankerswould take his idea to a whole new level.

And, finally on Barbon, he was around at the time of the founding of theBank of England.

Indeed, the records suggest that he very much wanted the Bank ofEngland not to be founded, and instead that his own idea of a nationalLand Bank should have received the favour of the Crown andParliament.

That did not happen, and so I guess that Barbon would not be happy onfinding out that the Bank of England will, over three hundred years later,take on regulating his industry of insurance.

But then his writings suggest that Barbon was no fan of regulation.

From my perspective this is a very exciting time because after nearlythree years of work on a wide range of subjectscovering the legislation,the new model of prudential supervision, our staff, property, IT and

other things, we can see the new Prudential Regulation Authoritystarting to take shape for real.

We are in the process of moving into our new home at 20 Moorgate.

There wereseveral reasons why we chose a City location.

One consequence is that it will bring uscloser to the insurance industry,which for the most part resisted the appeal of Canary Wharf and stayedclose to the roots that date back to Barbon.

He would have approved, providing he could have built, insured, andrebuilt your building.



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Time will tell whether you will welcome having your prudential regulatornear to your doorsteps, and as far as we know located in the City for thefirst time.

I want to tackle a number of large issues today, which are closelyconnected.

First, why do we think it makes sense to place prudential supervision ofinsurance in the PRA alongside banks and major investment firms?

Second, what style of supervision will the PRA adopt and how will itaffect insurers?

And third, how do we think about the issue of systemic risk, and

systemically important status for insurers?

There are over 700 insurers in this country which will be subject toprudential supervision by the PRA and conduct supervision by the FCA(in addition, insurance brokers will be entirely supervised by the FCA).

Why place prudential supervision of insurers in the PRA alongsidebanks?

I am tempted to make one point here and conclude, namely that we

asked to have one industry that caused us less trouble than banks.

Of course, that would be on the basis ofpleasekeep it thatway.

Its tempting to stop there, but in all honesty it would not be the fullstory.

Banks and insurers have one crucial thing in common whichdistinguishes them from other financial services providers, namely thatthey bring the funds customers deposit or invest directly onto theirbalance sheets and therefore expose customers directly to the riskinherent in those balance sheets.



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We did not, however, place insurers under the PRA because they are likebanks, even though there are important similarities in the prudentialapproach we apply to both sectors.

Why then?

For me, the logic has to do with what we have learned about our roleduring the crisis.

The traditional model of supervision has been quite industry specific. The

FSA regime introduced in 1997 created a single authority, but withinthe FSA the framework of rules applied to insurance supervision isunique to the industry.

It is true that in the run-up to the start of the crisis, and for some timethereafter, the FSA mingled insurance and bank supervision in terms ofits operating units, but I think that did not work effectively and we havemoved to a clear distinction with an insurance supervision directorateheaded by Julian Adams.

Insurance supervision is a skill of its own, and while our supervisors domove roles between insurance and banking in both directions, we wantto ensure that we have groups of truly expert insurance and banking

supervisors.

The reason for locating insurance and banking in the PRA is in my viewthat we have learned during the crisis that our job as prudentialsupervisors is to ensure that the public and users of financial services,including the corporate sector, can be assured of continuous access tothe critical services on which they depend.

Many financial services may be regarded as critical by their users, butsome are distinctive because it is hard for consumers to replace theirprovider with a substitute without accepting unacceptable cost and loss.



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Insurers provide critical services to the public in terms ofrisk transferand very long-lived savings contracts.

This last point draws out that insurance is not a single homogenousindustrygeneral and life insurance are very different activities - and werecognise that in our supervision.

It would be unacceptable to the public to have access to risk transferthrough, say home or car insurance, or professional indemnity insurance,to name but a few, withdrawn in a disruptive and unannounced way.

In the same way, savings contracts that are long-lived and provided bylife insurers, and are often an individualsprimary pension provision, arecritical financial services that are difficult to replace without

unacceptable cost.

For me, there is therefore a common feature of banking and insurance interms of continuity of access to critical financial services.

This is not, however, the end of the story on the issue of why the PRAwill regulate banks and insurers.

What I have started to describe is the first objective that the newlegislation gives to the PRA, namely the safety and soundness of the

firms we will supervise.

But there is another important leg to the definition of the objective,namely that the underlying objective of our pursuit of safety andsoundness is the stability of the financial system.

For banks, this had led us to emphasise that we will be a proportionatesupervisor, putting more emphasis on the large firms that have morescope to damage the stability of the system.

We think we can do this for banks becausethe depositor is protected bythe deposit insurance arrangements on the first 85,000 of depositsprovided by the FSCS for all banks except branches from other EU



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countries(where the insurance comes from the home country), andbecause as a consequence of the crisis the resolution regime is now setdown in statute, though we clearly have work to do to make the largerbanks resolvable using those resolution powers, supplemented we expectby future EU legislation.

For insurers, the legislation gives the PRA a second objective, namelythe protection of policyholders.

We do not have a comparable objective for depositors.

Policyholder protection means in effect that our approach ofproportionality in supervision cannot be the same for insurers.

Why?

This is a good question because the FSCS is set up to cover insurance.

For me, the reason is that we have more work to do to develop the besttools to ensure continuity of access to critical insurance services.

Why do I think we are short of tools?

To explain my view on this requires some background on the resolution

of banks.

Statutory special resolution regimes for bankslike the one adopted in theUK in 2009 have at their heart the power to alter property rights, thepower to separate the business of a company from its owners, albeit withsafeguards against unfair expropriation.

It is a very powerful tool, and one that should be used carefully for thatreason.

For banks a typical use of the resolution regime is because depositors canlose confidence in their ability to have access to their funds, and thus arun can start which brings down the bank.



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A resolution regime can bring order to that process.

For insurers, policyholders are less likely run in the sense that they canwithdraw their contract and take it somewhere else, though it is possiblefor some life contracts to be surrendered without penalty.

Unlike money, insurance contracts are not fungible because the cover isspecific to the contract.

In the limit, a bank depositor can exchange their claim on the bank(commercial bank money) for a risk-free claim on the central bank (byrequesting bank notes).

An insurance policyholder cannot do this.

Work is under way to determine whether insurance would benefit from aspecial resolution regime that overrides normal insolvency rules in orderto enhance the ability to ensure continuity of critical contacts through,say, the transfer to business to another firm.

I will return to this subject later in this lecture because it is one that weshould consider carefully.

My general view is that the policyholder protection objective for

insurance points to the need for a resolution regime for insurers, but theimportant issue is to be clear on what sort of regime.

There is one further area of insurance that for me clinches the case forthe policyholder protection objective in the PRA.

I almost mentionWith Profitswith trepidation, but I am afraid I mustdo so at this stage.

With about 350bn of policy values outstanding, and policy maturitiesthat can run into decades hence, With Profits is clearly a legacy that willbe very much with us for a good while yet.



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Consequently, I do think that the industry and the authorities need to bealert to its inherent risks and complexities.

In thinking about the implications of With Profits, let me step back for amoment. In broad terms, I can see two distinct types of financial contractinvolving deposits and savings.

A deposit contract with a bank has at its core the promise that the bankwill return the full value of the deposit at any time when it iscontractually obliged to do so.

Loss of confidence in a bank sets in when depositors fear that this maynot happen.

An asset management contract is quite different because the promise isat its simplest to return the proceeds of the investment strategy, whichmay be more or less than the amount invested.

It is cruel to remember the Woody Allen jibe at this point that astockbroker is someone who invests your money until it is all gone.

Economists might call the deposit and asset management contractcorner solutions in that they have a robust definition and lie atopposite ends of a range.

If so, With Profits falls in between, and it is in this ground that issuescan arise.

The proposition was essentially to offer investors a blended exposure tocash, bond, property and equity return with some degree of smoothing ofoverall returns, essentially at managementsdiscretion, to reduce markettiming risk.

The marketingtended to make much of these productspotential to earnabove cash returns without the volatility of pure equity exposure; and thisin turn conditioned policy holdersexpectations, a fact first acknowledgedexplicitly in the UKs prudential solvency regime for



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insurers in 1967 (bear in mind that this was not the original prudentialregime, which was introduced in 1870).

The essence of the With Profits contact as I understand it is that theprovider offers a guaranteed minimum return, variously structured, plusthe prospect ofadditional returns derived from the return earned on apooled fund that combines many contracts including over differentgenerations of policyholders.

There is of course a logic to pooling returns, but for the policyholder thereturn can be complicated, and sometimes made opaque, by the practiceof pooling different generations of policyholders who may have differentexpectations on their returns (conditioned, for instance, on changes in theexternal environment); and by the practices of smoothing returns and of

charging differentially for the economic value of the guarantees.

Additionally, problems have arisen because the funds are made up ofmany different groups of policyholders with different guarantees, someof which, essentially on the annuity side, became increasingly valuableas nominal interest rates fell from the mid 1990s.

The existence of these guarantees was often, at best, unclearor, at worstnot disclosed to new joiners to the fund.

Bear in mind also that these contracts are long-lived with maturitiestypically of25 years of more; and that the With Profits insurersthemselves have often built up over many years through the take-over ormergers of many smaller providers, each with their own distinctproducts, associated policyholder expectations, and administrativelegacysystems.

Suffice to say that in the last two years in which I have been involvedwith insurance supervision, some of the most difficult issues that I havefaced have been in the area of With Profits.

For that reason, I think it is appropriate that the PRA should have apolicyholder protection objective because I think we have to recognise



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explicitly the contractual complexity that we inherit and the solvencyrisks this can generate.

I should also add finally that it is not a coincidence that we have foundthis area to be the most challenging in terms of creating the twinpeaksmodel in which the FCA will have responsibility for reaching

judgements, through a formal determination process on fairness topolicyholders and the PRA will be responsible for ensuring that those

judgements are compatible with the prudential soundness of firms.

We have reached a satisfactory conclusion, with specific language in thelegislation, and a special With Profits MoU between the FCA and PRA;but it has required very careful consideration to ensure that eachregulators role and responsibilities has been appropriately defined to

avoid any under-lapsand that the correct balance has been struckbetween them.

Let me now move on to the second subjectwhat style of supervisionwill the PRA adopt and how will it affect insurers?

Let me start by drawing the distinction between regulation andsupervision in our world.

Regulation is about the framework of rules and policies against which

we operate.

Supervision is about how we apply that framework every day.

They are not the same thing.

Rules are for the most part in our world the product of internationalagreement, eventually.

There are good reasons for this in terms of seeking to ensure comparablestandards of protection where services can be provided across borders,and where encouraging free trade in services is consistent with openeconomies.



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When it comes to supervision the PRA will be applying judgementaround the framework of rules.

This is important for a number of reasons, but above all against abackground of inexorable increases in rule making we must have thedetermination to be focussed on the key risks that matter to ourobjectives.

One of my commitments is that we must be focussed on the (I hope)small number of big risks that threaten our objectives of safety andsoundness and policyholder protection.

I donthave any difficulty with intensive and intrusive supervision whereit is focussed and justified by the risks.

We are not, however, substitute compliance officersthat is the job offirms, and one that we will expect to see in place and functioning alongwith risk and audit functions.

Another key aspect ofjudgemental supervision is that it must beforward-looking to the risks that may arise.

This is crucial, and was not properly incorporated into the pre-crisisregime of supervision.

Let me give a few current examplesof this for insurers.

We are focussed on the impact of very low interest rates staying with usfor a protracted time, and when I say this I am offering no viewwhatsoever on the likely course of monetary policy.

Likewise, we want to know that the prudential position of firms alsocaptures the possible impact of an unexpected upward shift in the slopeof the yield curve, and again I am offering no view on monetary policy.



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My third example is different: we are watching the range of possibleoutcomes on flood insurance in this country for their prudentialimplications.

Judgment in supervision is not, however, without its challenges when itcomes to the practice of supervision.

There are two large challengesI see.First, we have to balance the use of sensible judgement against the riskof creating undue uncertainty in our behaviour which damages yourability to do business.

This is not easy I accept.

It requires us almost constantly to check and test our judgementsagainst a framework of reasonable predictability.

Also, it requires a greater degree of transparency from us to you, and Ithink from both of us to the public and investors.

This is important to ensure that we can both be held to account forapplying judgement in a way that is consistent with the pursuit of ourobjectives.

I am conscious that achieving accountability in insurance supervision inthe current environment is challenging because all the focus is on thebanks.

No visits to the Treasury Select Committee may seem like a blessing, butwe have to ensure that the accountability still holds water.

On that point, frankly, I think there should have already been moreaccountability for how the processes of the European Union could havecreated such a vast cost for an industry for the implementation of adirective which has not even yet been finally agreed, and for which Icannot give you a date.



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Largely unseen in the banking crisis has been the shocking cost ofSolvency I I .

The second challenge with the use of judgement in supervision is thatelsewhere we have seen a preference to have many rules, but often oneswhich can then be gamed.

Paul Volcker put it nicely in his evidence to the Parliamentary BankingCommission.

He said that people ask for clear and simple rules so that they can tellwhen they are in abeyance, but they typically fail to add that they want toknow how to get round the rule too, but that is part of the in deal.

At the PRA we will apply judgement rigorously; sometimes you willagree with us, and sometimes you wont. We will be clear andtransparent in our judgements, and we will be accountable.

Finally on the issue of the PRAs approach to supervision, I want toassure you that we will take supervision of insurers just as seriously aswe do the other lot.

It is not in our nature to do otherwise.

And, we are putting more emphasis on senior level contact in the newapproach.

We want to deliver key messages very clearly to senior management andboards, and we want to know how your governance works in practice.

I will give one example of this approach in recent months, returning toSolvency I I .

It was clear to me by the end of last summer that we were facing a longdelay in the directive on top of a bill that, as I have said, was indefensibleand ever rising.



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We have had extensive contact with chief executives and the Associationof British Insurers in recent months, with the overarching objective thatthis cannot go on.

I think we have reached a sensible conclusion which at least makes thebest of where we find ourselves.

Where possible and sensiblewe will use the work done on Solvency II todate to bolster our existing ICAS regime, though I should stress that weare quite comfortable with the core of ICAS and believe that we can use itas the framework to build the PRA approach until such time as SolvencyI I appears.

I hope that this change of approach both alleviates the costs and helps to

create a less pressured environment in which we can seek to obtain abetter framework for prudential supervision of insurers in the future thanwould otherwise be the case.

There is too much at stake for the industry and the economy tocompromise on this objective.

Let me turn to the third and final issue, namely how do we think aboutthe issue of systemic risk, and systemically important status, forinsurers?

This is obviously topical in the context of the I AIS proposed policymeasures for globally systemically important insurers.

First of all, in my view the case for systemic importance for insurers hasto be proved.

It does not follow that because major banks are systemically important,the same must be true for insurers.

And, second, if a case can be made, it does not automatically determinewhat the response should be; in other words, it does not follow that the



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same capital treatment of systemic firms and/ or a statutory resolutionregime are needed as for banks.

The calibration of these responses will have to be proven, and theresponse will need to be consistent with mitigating the cause of thesystemic risk.

So, letsput banks to one side, but only after making one importantpoint, that whereas systemic risk in banking is dangerous in good partbecause that it is in the nature of banking that the confidence issuecombined with a very high level of inter-connectivity of risk within thesystem creates systemic risk, this is not true to the same extent ininsurance.

Over the years, re-insurance has come under the spotlight as a possiblecause of intra-system connectivity and risk, but I have not yet seen aconvincing demonstration of a major systemic issue for pure reinsuranceof idiosyncratic, diversifiable, non-financial risks such as fire, weather,earthquake or liability.

It is of course likely that within the insurance industry there are firmswhich because of some combination of complexity of risk and size posemore risks to the financial system, and as such our supervision should beproportional.

Let me develop this theme drawing on, I should say, valuable input frommy colleaguesPaul Sharma and Julian Adams.

The resolution challenge for non-life insurance involves ensuring short-term continuity of risk cover.

But life insurers make long-term promises to their policyholders whichcan only be matched imperfectly with available financial instruments(securities and derivatives).

This creates a vulnerability to shocks from financial markets such as theimpact of the large fall in equity markets in 2002 to 2003.



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Life insurers do not close down by going into so-called solvent run-off inthe same way as non-life insurers, and bear in mind that the term solventrun-off is the expression of a probability of an outcome.

A non-life insurer when it enters run-off typically ceases to collect newpremiums.

The risk in run-off here and there is a risk that needs examination isthat near-term claims are paid out to the detriment of unidentified far-term claims, thereby creating an inequality through a form of timesubordination.

In contrast, a life insurer that enters run-off continues to collect regularpremiums on its existing in-force life insurance policies.

Moreover, it needs to continue to pay its obligations (e.g. annuities-in-payment) on the exact day contracted whereas a non-life insurer in run-off has some greater flexibility to pay claims to match its cash flow.

Finally, a life insurer in run-off needs to honour contractual policysurrender rights.

These features of life insurers draw out the difference in economicinterest between near-term and far-term policyholders, and one who hasa right of surrender and one who does not.

Moreover as life insurers are making long-term promises to policyholders,they often seek to match those commitments dynamically, using short-term derivatives, and therefore rely on continued access to thosederivatives and the willingness of counterparties to take such exposures toa firm in run-off.

These derivative positions will not be more idiosyncratic like traditionalinsurance, but will be determined by the overall direction of financialmarket prices, giving scope for more system-wide problems.

I described earlier the issues I see with more traditional With-Profitcontracts.



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The issues I highlighted were not so much to do with definite features ofthe contract between the insurer and the policyholder but with theuncertainty around the contract itself arising from the substantialdiscretion afforded to the insurersmanagement to determine final policycharges and returns.

There is an argument that such uncertainty is helpful to the insurerbecause the promise to the policyholder is cautious in terms of accruedincome and gai

Documents

Solvency II News February 2013 (2)