Bob Haken looks at how insurance firms are responding to the FSA's demands to improve risk management

After a year of life under the Individual Capital Adequacy (ICA) Standards regime, many firms have been asking the FSA for some feedback. In response, the FSA has published accumulated "good practice" to assist firms in compiling their ICA submissions.

The briefing seeks to explain how well the FSA's process is or isn't working. Anecdotal evidence suggests that the industry's experience has not been consistently satisfactory.

Feedback indicates that a lack of resources at the FSA has resulted in long delays in agreeing an Individual Capital Guidance (ICG). David Strachan, the FSA's insurance sector leader, admitted: "We acknowledge that in some cases, our communication during the ICA review has been less that ideal and that some reviews have taken too long to complete."

The FSA seems to be prioritising high-impact firms, rather than dealing with each submission in the order received. There also appears to be little consistency within the FSA, with different personnel taking very different approaches.

Given this variance, firms believe they are not getting the "right" answer from the FSA. In these circumstances, it may be possible to instigate judicial review proceedings, although few firms are likely to find this attractive.

Alternatively, the firm could simply object to the ICG, and leave it to the FSA to decide whether to insist on its figures by varying the firm's permission on its own initiative. Such a decision would then be liable to challenge in front of the Financial Services and Markets Tribunal.

At the time of publishing their recent insurance sector briefing entitled ICAS - one year on, the FSA had received ICA submissions from about 100 firms. ICG had been given to about a third, mainly in general insurance, and set at a higher level than the firm's ICA.

The FSA pleads a defence by saying it has tried to avoid being overly-prescriptive, as individual firms are best placed to assess the risks they face.

It also claims the process is proportionate. Smaller firms are not required to invest the same resources as larger, more complex firms that pose a greater risk to the FSA's statutory objectives.

The FSA's approach is to consider the how reasonable the firms' calculations are and the answers derived by their application. Although its ability to do so is limited, the intention is to develop benchmarking across the industry as the regime matures.

The FSA is placing a lot of weight on the credibility of the submission. Several factors affect this, including the extent of involvement of senior management in the ICA process.

The major difficulty faced by firms is in quantifying operational risk.

"We recognise that operational risk poses one of the most difficult challenges in capital assessments, and it is not surprising that this is one of the least developed areas within firms' ICAs," said Strachan.

The FSA recognises that most operational risk functions are in their infancy, and that there is a dearth of historic loss experience on which to base calculations. It also comments that as operational risk impact varies hugely across the industry, benchmarking comparisons with other firms is not helpful.

Given the uncertainty over any figure produced by modelling, the FSA expects to see appropriate stress and scenario testing and a prudent margin built in, with an explanation of the underlying uncertainties, mitigants and the basis for setting the margin.

The FSA highlights the need for scenario testing to properly reflect the effect of more than one risk crystallising at the same time. In what comes across more as a policy statement, the FSA has emphasised the integration of risk and capital management.

This embedding of the process within the business is expected to lead to the commercial benefit of better risk management, in turn reducing the requirement to hold capital against those risks.

The FSA views improving risk management as one of the key aims of the ICA process and intends to carry out further thematic work throughout 2006.

Strachan added: "We see the ICA process as a key driver towards improvements in the quality of a firm's risk management. The benefits might extend to improving the quality of a firm's management more generally including, for instance, strategy formulation, capital planning, product development, governance and decision making processes in a firm."

Although it is accepted that management will take steps to mitigate risks as they arise, firms must consider the likely delay in implementing any changes.

So for the FSA, it is clear the ICA is an important supervisory tool, which aims to eliminate any significant risk of the firm being unable to pay its liabilities.

The ICA does not deal with normal prudent management but with more extreme circumstances. This explains its concerns with reinsurance credit risk at more extreme rates of default and catastrophe risk.

At the outset, the FSA believed that it would be too complicated to give its ICG by reference to the figure provided by firms, as that would entail detailed amendments to the models, each of which is normally produced bespoke in-house. This remains true for general insurance, as ICG is generally expressed as a percentage of the Enhanced Capital Requirement.

The FSA's intention is that the ICA evaluation and the Arrow process will work in tandem, with the findings from one illuminating the other, although the FSA does acknowledge that that is way off.

In the meantime, it expects firms to keep it informed if there is a material change in the business, possibly prompting the need for a review. Without such a change, ICAs will generally be reviewed every 18 months to two years.

In any event, the vast majority of firms in the market hold capital way in excess of their minimum capital requirement, so having a higher ICG imposed by the FSA may not result in additional capital being needed. IT

‘ Bob Haken is an associate in the corporate and regulatory insurance team at Norton Rose.

What's ICA all about?
Under the ICA Standards regime, a firm is required to undertake regular assessments of the amount and quality of capital which in their view is adequate for the size and nature of their business - their ICA.

The ICA objectives are to:

  • Give firms incentives to develop their risk measurement and risk management
  • Put the onus on the management of firms to develop their own view of their capital needs
  • Deliver capital that is appropriate to the risk in the individual firm's business.
  • How does it work?
    When the FSA reviews a firm's ICA, it aims to focus on material issues.

    When giving ICG the FSA considers both quantitative measures (it sets a number for the amount of capital it thinks appropriate), and qualitative issues (comment on risk management concerns it may have).

    The ICG reflects the full range of supervisory information and assessment of a firm in terms of the risks posed to our statutory objectives.

    ICG may be significantly different from a firm's ICA although the ICA itself will be an important input into the determination of the ICG. The less firms are able to demonstrate that their risk assessment processes capture and quantify all their risks, then the higher the FSA is likely to assess their ICG.

    So far, ICA submissions have varied in quality and length, with submissions ranging from four pages in total to more than 800 pages.