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Realistic reporting for insurers
Simon Spencer, from the Life Insurance Consultancy team in the London office, reports on FSA proposals for the realistic reporting of insurance companies' liabilities.
A fundamental change to the way in which UK insurance companies report their financial position will arise when the Integrated Prudential Sourcebook (PSB) comes into force in 2004. The Financial Services Authority (FSA) has published various consultation documents setting out its vision of how this will change to a "risk-based" regime, and final text of the new regulations is expected later this year. One of the key areas flagged is a move towards "realistic" reporting of financial results.
Current regulations require insurers to effectively undervalue their assets and overvalue their liabilities in order to present a prudent solvency position. Thus, demonstrating regulatory solvency gives confidence to the FSA that an insurer's actual solvency position is sound. A breach (or heading towards a breach) of the regulatory solvency position would provide an early warning of problems and enable pre-emptive action to be taken before a firm actually became insolvent.
However, the FSA recognises that published regulatory solvency returns can paint an unrealistic picture of firms' actual solvency positions, and to that end it would like to move to a situation where realistic assessments of the liabilities are calculated, with a requirement that assets in excess of these liabilities must at least cover an amount that is dependent on the risk profile of the firm.
This will not change the actual financial situation of insurers - they will still have the same assets and contractual obligations to policyholders - but it will change how this information is presented. This can be simplistically represented as follows:
It should be noted that each company will need to carry out its own capital assessment, and so the existing margins in the valuation of the liabilities may not necessarily translate exactly to its capital requirement in the new regime. However, this demonstrates broadly how the system will work. The immediate consequence should be a strengthening of an insurer's balance sheet, as margins are replaced with capital requirements. Free assets, traditionally an indicator of financial strength, should increase.
A combination of the current market conditions and regulatory requirements are making life very difficult for many insurers, particularly those conducting with-profits business. In fact, the regulations could have the potentially undesirable side-effect of making an insurer act specifically to protect its regulatory solvency position (despite actual solvency not being threatened) to the possible detriment of its policyholders. For example, investment policy might switched from (riskier) equities to (safer) bonds at precisely the time when equity values have fallen, thus crystallising any losses and reducing the benefits of an upturn in the market.
In an attempt to counteract this, the FSA sent a letter to all insurers on 11 March 2003 setting out its willingness to consider requests from firms that want to start using the realistic reporting approach ahead of formal implementation of the PSB. This is not, though, carte blanche for insurers to wave a magic wand and suddenly present a rosy-looking balance sheet. Firms must still be able to demonstrate "that they are holding sufficient financial resources to meet expected liabilities, even under adverse conditions". Furthermore, any request for a change to the current rules must be backed up with evidence that:
- either the current rules are unduly burdensome or would not achieve the purpose for which they were made, and
- granting the change will not result in undue risk to policyholders.
This is a welcome move by the FSA that should go some way towards improving our understanding of insurers' true financial positions and removing some of the unintended problems inherent in the existing regulatory framework.
Simon Spencer, March 2003