Dear Chief Executive
The FSA made it clear earlier this week that it was monitoring closely the position of the life insurance industry in the light of recent sharp falls in equity prices. Since then markets have stabilised a little but the uncertain outlook suggests that prices may remain volatile throughout the world.
There is no doubt that falling equity prices have had, and will continue to have, a significant impact on the financial position of life insurance companies. And the Boards and senior management of a number of life insurance companies are having to make difficult decisions about which actions to take to protect policyholder interests. As always, we stand ready to discuss these decisions with individual firms, particularly how they might affect their regulatory obligations. We therefore thought that it would be helpful for both life insurance firms and the public to set out particular considerations that we would take into account in these discussions with individual firms.
Our prime focus in current market conditions is on life insurance companies maintaining financial resources sufficient to meet their responsibilities to policyholders, including their ability to absorb any further market falls that may occur.
The current regulatory rules require firms to maintain a minimum margin over solvency (referred to as the regulatory minimum margin or RMM). The terminology used here has been enshrined in insurance legislation for a long time and yet, to all but avid followers of insurance, could lead to a misinterpretation as to its meaning. Breach of the RMM triggers a requirement for the firm to provide the FSA with a plan to restore their financial position above the regulatory minimum and is a cue for further regulatory attention. Although sometimes referred to as "statutory solvency" it does not represent "solvency" in the traditional use of the term, where a deficiency suggests an inability to meet its contractual obligations, and might be better characterised as a "regulatory trigger point".
Although the RMM is an important indicator of the financial health of a life insurance company, it is by no means the only indicator. It is, for example, only one of the factors taken into account by rating agencies. Nor is the RMM necessarily the most accurate indicator. As we have made clear in the past, the calculations which go to make up the RMM are in some respects very conservative, in particular in the way that they value certain liabilities and require firms to maintain certain margins. Largely as a reflection of this we have begun in addition to collect data on firms' solvency using an alternative approach, the so-called "realistic" approach. We have commented previously on this approach in our paper on the Future Regulation of Insurance and in a speech by Howard Davies, both in October 2002.
One effect of the mechanics of the RMM approach is that it can put life insurance companies under pressure to sell equities (either outright or through derivative contracts) as equity prices fall, even though the firm may reasonably consider holding equities to be prudent and good value for policyholders in the longer term. There is a risk that these sales cause further falls which in turn trigger additional selling and a downward spiral in equity market prices.
We have stated previously that we intend to move from the current approach to a new, realistic approach (which would need also to include allowances for risks not picked-up in the realistic calculations themselves). We plan to introduce this realistic approach from the beginning of 2004 and are considering allowing firms to disclose their financial position on a realistic basis in their 2003 year end regulatory returns. We will also consider making rule changes to facilitate an earlier transition to the new approach. In the meantime, it is also open to life insurance firms, whether or not they are pressing against their RMM, to apply to us to waive or modify particular rules which form part of the existing RMM calculation, so long as they continue to meet the EC minima. The effect of granting such a waiver or modification would also be to align this calculation more closely with the realistic calculation. In considering requests for waivers, we would take into account the firm's realistic position. This would help us satisfy ourselves that, if the waiver were to be granted, there would be no undue risk to consumers.
Life insurance firms that are pressing against or have breached their RMM, and who have a relatively weaker financial position measured on a realistic basis, should discuss immediately with the FSA what actions they propose in order to maintain or restore the required minimum margin of solvency (statutory solvency). These actions might include: new capital being injected by shareholders, closing to new business, sale or transfer of the business, asset re-allocation. At present few firms have indicated to us that they are pressing against or have breached their RMM. Some of these will in fact be stronger on a realistic basis.
Yours sincerely
John Tiner
Background
- The FSA regulates the financial services industry and has four objectives under the Financial Services and Markets Act 2000: maintaining market confidence; promoting public understanding of the financial system; the protection of consumers; and fighting financial crime.
- The FSA aims to maintain efficient, orderly and clean financial markets and help retail consumers achieve a fair deal.
