Individual Capital Assessment

David King

8th September 2004

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Contents

• Regulatory Requirements: Pillar 1 vs Pillar 2

• ICA: Implementation Progress

• ICA: Assumptions

• ICA: Implications

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Regulatory Requirements:

Pillar 1 vs Pillar 2

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Pillar 1 vs Pillar 2 Capital Requirements

Admissible assets

Mathematical reserves

Regulatory Peak

Resilience Capital

Requirement

Long-term Insurance

Capital Requirement

WPICC

Regulatory Surplus

Realistic Value

Liabilities

Realistic Surplus

Market Value Assets

Market (Fair) Value

Liabilities

ICA

Realistic Peak

Pillar 1 Pillar 2

Realistic Value Assets

Risk Capital Margin

• WPICC is set so that regulatory surplus equals realistic surplus if the former is higher; zero otherwise• If realistic assets equal admissible assets, WPICC is the amount of capital to bring the regulatory peak up to the realistic level

Pillar 2 Surplus

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Risks Covered: Peak 1 vs Peak 2 vs ICA

Peak 1

(LTICR + RCR + WPICC)ICA Peak 2 (RCM)

Market Risk

Credit Risk

Insurance Risk

Mortality

Persistency

Expenses

Operational Risk

Liquidity Risk

Group Risk Group Risk

Liquidity Risk

Operational Risk

Insurance Risk

Credit Risk

Market Risk

Group Risk

Liquidity Risk

Operational Risk

Insurance Risk

Mortality

Persistency

Expenses

Credit Risk

Market Risk

Mortality

Persistency

Expenses

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Capital Requirement Rules: Peak 1R

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Risk Category Assets Liabilities

Market Risk

Equity

Property

Fixed Interest

10-25% fall depending on:

- Current to 90-day average FTSE All Share level

- Earnings yield of FTSE All Share after fall equal to 4/3rds long-term gilt yield

10-20% fall depending on:

- Current to 3 -year average real estate index level

20% rise or fall in long-term gilt yield

Divided yield assumed unchanged

Earnings yield assumed to fall by 10%

Running yield assumed to fall by 10%

20% rise or fall in long-term gilt yield

Market Risk - 3% mathematical reserves where firm bears some investment risk, reduced by up to 15% for reinsurance

Insurance Risk

Expense - 1% mathematical reserves where firm bears some investment risk, reduced by up to 15% for reinsurance

25% previous year’s net administration expenses where firm bears no investment risk

Mortality - 0.3% aggregate capital at risk reduced by up to 50% for reinsurance

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Capital Requirement Rules: Peak 2

Risk Category Assets and asset share*

* Taking into account management and p/h actions

Value of contractual guarantees

Market Risk

Equity 10-20% rise or fall depending on:

- Current to 90-day average FTSE All share level

Dividend yield assumed unchanged

Earnings yield assumed unchanged

Property 12.5% rise or fall Running yield assumed unchanged

Fixed Interest 17.5% rise or fall in long-term gilt yield 17.5% rise or fall in long-term gilt yield

Value of In-Force for non-profit contracts

Outside with-profit fund: unchanged

Inside with-profit fund: stress tested

Unchanged

Credit Risk Credit spreads increased by:

(Spread Factor) x sq rt (Current Spread in Basis Points)

where: Rating Spread Factor AAA 3.0 AA 5.25 A 6.75 BBB 9.25

Risk free yields assumed unchanged

Insurance Risk

Persistency Risk

For with-profit contracts, 35% increase or decrease in realistic lapse, surrender and PUP assumptions, excluding at policy guarantee dates

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Calculation of Capital Resource Requirements (CRR)

• PRU 2.1.35 defines a firm’s CRR to be:

Resilience Capital Requirement

+ Long-Term Insurance Capital Requirement

+ With-Profit Insurance Capital Component

• FSA will issue Individual Capital Guidance (FSA’s view of appropriate capital resources for a firm), based on the firm’s ICA

• To compare ICA with CRR, adjustment is needed for any differences in valuing assets and liabilities under Pillar 2. Possible approach:

Adjusted ICA = ICA – Max (0, Realistic Value Reserves – Market Value Liabilities)

– (Market Value Assets – Realistic Value Assets)

• Additional capital required as a result of ICA is

Max (0, Adjusted ICA – CRR)

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ICA: Implementation Progress

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Typical ICA Methodologies: end 2004

Overall approach • Time zero stress tests or projection to run off

Market Risk • Proprietary Economic Scenario Generator (ESG) used to inform stress tests

Credit Risk • Modelled by ESG

• Assets assumed held to maturity to capture liquidity risk premium

Insurance Risk • Stress tests for mortality, longevity, persistency and expenses

• A few companies are investigating stochastic mortality for annuities

Operational Risk • Characterised by lack of data

• Reluctant to build models without data

• Broad metrics used (eg x% assets)

Liquidity Risk • Mitigated by contingency funding arrangements (if necessary) rather than capital

Group Risk • Contagion risk from other group companies depends on group structure

• Closure to new business from contagion likely to reduce capital

Aggregation Approach • Market and credit risk use correlations implied by ESG

• Correlation matrix assumed for the other risks (assumes Normal distribution)

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Methodology enhancements for 2005?

Overall approach • Projected Realistic Balance Sheets modelled

• Run off projections with intermediate solvency testing

Market Risk • Development of in-house ESG expertise; own calibration

Credit Risk • More sophisticated approach to credit risk modelling

Insurance Risk • Stochastic mortality models developed for annuities

• Dynamic linking of persistency and market risk

Operational Risk • Since this is a material component of ICAs, companies develop stochastic models of risks and controls

Liquidity Risk • None

Group Risk • Deeper consideration of contagion risk

Aggregation Approach • Since this has a material impact on capital requirements, development of more sophisticated approaches

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Current Implementation Issues

Overall approach • Projected one-year RBS vs run-off projections

• Determination of additional Pillar 1 capital requirement from ICA

• Assumptions for recalculating ICA after a market fall

Market Risk • Calibration of ESG to produce “real world” scenarios that reflect historic data

Credit Risk • Identifying the liquidity risk premium component of corporate bond credit spreads

• Allowing for credit risk in inter-group reinsurance arrangements

• Managing credit risk concentration risk with reinsurance arrangements

Insurance Risk • Allowance for longevity improvements

Operational Risk • Treatment of final salary pension schemes

• Data to support risk capital calculations

Liquidity Risk

Group Risk • Allowance for capital support from other group companies

• Treatment of ICA for overseas subsidiaries

Aggregation Approach

• Understanding sensitivity of correlation assumptions

• Justification of partial correlations, especially in extreme scenarios

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ICA: Assumptions

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Typical ICA Stress Tests vs RCM

RCM Typical ICA Stress Tests

Market Risk

Equity

Property

Fixed Interest

Yields

-

-

+/- 0.9%

Value

+/- 10%

+/- 12.5%

+/- 6.5% *

Yields

-

-

-1.0%

Value

-40%

-25%

-7.5%

Credit Risk Change in credit spread

Change in market value*

Companies are mainly considering changes in market value for the portfolio; typically this is a fall of around 10%

AAA 21 -10.6%

AA 44 -3.3%

A 68 -5.1%

BBB 113 -8.3%

Insurance Risk

Mortality +20%

Persistency +/-35% +/-50%

Expenses +10% and increase in expense inflation

* Based on 10-year gilts

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Typical Correlation Assumptions

Correlations

Market Credit Insurance Operational Liquidity Group

EquityFixed

interest Property Mortality Persistency Expenses

Equity 1.00 0.00 0.30 0.65 0.00 0.50 0.65 0.50 0.25 0.25

Fixed interest 1.00 0.30 0.65 0.00 0.50 0.50 0.50 0.25 0.25

Property 1.00 0.65 0.00 0.50 0.65 0.50 0.25 0.25

Credit 1.00 0.00 0.40 0.65 0.20 0.10 0.25

Mortality 1.00 0.00 0.00 0.30 0.10 0.10

Persistency 1.00 0.40 0.40 0.25 0.40

Expenses 1.00 0.50 0.25 0.10

Operational 1.0 0.10 0.25

Liquidity 1.00 0.10

Group 1.00

Typically, companies are reporting diversification benefits of around 25-30%

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ICA: Implications

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Shareholder Value Implications of ICA

Product Development

• Price new business using ICA (large impact on annuities and products with guarantees)

• Redefine commission structures

Reduce Risk-Based Capital

• Better matching to reduce market risk

• De-risking with-profit funds (lower EBR, charging for guarantee costs, hedging)

Reinsurance Arrangements

• Manage credit risk exposure

• Review efficiency of existing reinsurance arrangements

Group Structure • Revise group structure to optimise capital position

• Consider combining operating companies

Portfolio Mix • Buy and sell portfolios of business to maximise diversification benefits

Performance Management

• Align performance measures to Risk-Based Capital

• Reward management according to these measures

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Top Ten Management Actions From ICA

1. Ensure the firm’s ICA calculation is consistent with its risk policies

2. Collect and analyse company/market data to justify volatilities and correlations

3. Build management information systems to understand risk exposures

4. Understand key drivers of ICA and develop mitigations to reduce capital requirements

5. Develop analysis of change in ICA over the period

6. Take ownership of calibration of the ESG

7. External review of ICA to negotiate Pillar 1 waivers

8. Develop management information to ensure ICA known at all times

9. Price new business to reflect ICA capital costs

10. Manage business on the basis of risk based capital