The current solvency standard is simple, but inadequate. The FSA's proposals for calculating capital requirements could prove more effective, says Lord Hunt
The right level of capital for a general insurer is a complex question. As George Bernard Shaw said: "To every complex question there is a simple answer - and it is wrong."
European regulators are coming slowly to that conclusion. A new Directive, Solvency 2, will abandon the current simple solvency standard that requires 16%-18% of premium income to be held as a margin above assets matching liabilities. This is unlikely to be adopted before 2007, but the FSA is moving much faster. CP 190 proposes a more effective, but more complex solution - to be implemented during 2004.
CP 190 proposes a risk-based approach for calculating capital requirements. These will be calculated, for each company, by reference to six generic risks: credit risk, market risk, liquidity risk, group risk, insurance risk and operational risk. There will be two stages:
1. A basic enhanced capital requirement (ECR) built up from separate requirements for premium income, assets and technical liabilities. As such it covers insurance risk, market risk and to some extent credit risk and liquidity risk.
2. Companies will need to assess the amount and quality of the capital they should hold, having regard to the size and nature of their business, and by reference to all of the six risk factors mentioned above.
The FSA reserves the right to make its own assessment and to impose it through individual capital guidance (ICG). In most cases an ICG will be higher than the result of the ECR calculation. But where the FSA is satisfied that this can be justified by the company's ability to model and control its risks, the ICG may allow a lower capital requirement (although it can never be lower than whatever level is set by EU rules).
Some broad conclusions can be drawn now of the effect of the FSA's proposed capital requirements.
Deciding on the effective use and allocation of capital will be a key part of long-term strategy for insurance companies.
The right reinsurance strategy will be critical for companies writing long-tail business. Some of the benefit to be gained by transferring insurance risk will be offset by a capital charge in respect of increased credit risk - particularly where this is concentrated through use of only one or two reinsurers.
CP 190 makes clear that, for the purpose of calculating capital requirements, discounting of liabilities will not be allowed. For companies writing long tail business this may lead to increased use of financial reinsurance to achieve the same results. The FSA's attitude to such a development is as yet unclear.
Investment strategies will also need to be reviewed. Individual capital assessments will be expected to take account of the credit ratings of the bond portfolio. Holding equities will carry a capital penalty - although this is partially offset by the higher yields that CP 190 allows by comparison with bonds.
Of course, getting your pricing - and achieving these prices as the market softens - must remain the crucial strategic imperative for general insurance companies. But, a key conclusion from CP 190 is that, as a result of the FSA's actions, modelling and managing all forms of risk, and allocating capital effectively, will be increasingly key to determining profitability and remunerating capital.