The pressure is on insurers to start implementing the FSA's prudential sourcebook, which sets out guidance for insurers on how to manage the allocation of capital for their business risks. Michael Faulkner reports
This year new FSA rules will come into effect requiring insurers to make radical changes to the way they manages risk and allocate capital. Under the new regime, known as the integrated prudential sourcebook (PSB), firms will have to make significant changes to their internal processes and may have to increase their capital reserves. The cost could run into millions of pounds per firm. Yet, despite the costs, there are commercial benefits to be gained for firms that embrace the rules and use them as a catalyst for wider change. The FSA says, ultimately, the PSB could increase firms' profitability and the confidence of shareholders and customers. But time is running out. The deadline for implementation is fast approaching; insurers should be making preparations now to ensure that the FSA's timetable is met. The PSB represents a fundamental change in prudential regulation. It creates a single regime for the whole financial services sector, setting standards that are based on type of risk rather than industry sector.The PSB is derived from the near-final rules (PS115) published in October 2003 following two consultation papers, CP97 and CP115. No major changes are expected when the final rules are published. Deloitte director Rick Lester says: "The rationale for this integrated approach is to enable the FSA to have a better and more focused oversight of the industry. "It is also designed to meet the FSA's objectives of maintaining market confidence, protecting consumers and ensuring the international competitiveness of the UK as a financial sector."The full regime of the PSB will come into force for the insurance industry in the final quarter of this year. The date will be in the final rules due to be published shortly.The PSB concentrates on two key principles: risk management and financial soundness. It divides risk into six classes. These are market risk, credit risk, operational risk, liquidity risk, insurance risk and group risk. "Firms will need to decide which risk classes apply to them, and this will vary from one industry sector to the next," says Lester. "In the case of banks, for instance, market risk, liquidity risk, credit risk and operational risk will apply; group risk will also be relevant if the firm is part of a group. Insurance companies, on the other hand, will also need to consider insurance risk."For each risk class the PSB sets standards for the systems and controls necessary to manage the risk. This is made up of rules and guidance. The rules are relatively high-level in nature and there is no flexibility in their application, but some discretion is given in the implementation of the guidance. Lester says: "The guidance must be interpreted according to the nature and scale of the firm's business activities. If a firm wishes to depart from the guidelines it will need to satisfy the FSA that it has considered them and that is has a sound basis for departing from them. Firms will also need to show that their systems and controls form an integral part of the operation of the business; they cannot simply sit alongside the business and be visited once a year."In addition to the systems and controls standards, the PSB also sets financial resource requirements. The FSA has moved away from a deterministic approach, in which capital requirements are based on the application of a formula, to a risk-based approach. The amount of capital that a firm must hold will depend on the particular firm and the class of risk; the greater the risk, the greater the amount of capital that must be held. "The FSA's intention is not to change the total amount of capital in the market, but to change the distribution of capital, determined by the risk profile of each firm," says Lester. "There will be winners and losers; some firms will need to hold more capital, others less." Lester argues that firms should see the PSB as an opportunity to effect positive business change. "If firms do more than the bare minimum to comply and treat the rules as a catalyst then commercial benefits can be gained. It will enable firms to make more economic use of capital, and they will have better systems and controls which will reduce losses and earnings volatility. "Ultimately, the PSB will also increase the confidence of shareholders and customers in the financial services industry, which will improve investment and sales. It is therefore vital that senior management recognises the importance of the PSB." N
Making PSB workImplementing the prudential sourcebook (PSB) is not without cost and difficulty. At the very least, the costs will run into millions of pounds for smaller firms and upwards of £10m for larger firms. The PSB is also problematic because of a lack of clarity, says Deloitte director Rick Lester. "The term 'risk appetite' is used throughout the PSB, which is not a standard market term and which does not have standard practices for its measurement. The FSA has also introduced a requirement for firms to conduct stress and scenario testing, but has not provided guidance on these areas."Companies will need to devise their own solutions to address these issues. "The FSA will determine what is best practice through the course of its discovery visits," says Lester. "It is therefore vital that firms keep abreast of what their peers are doing and how market practices are evolving. If not, firms could fall short of the FSA's expectations." The pressure on the insurance industry is particularly great, argues Lester. "Not only does the industry have to implement the full PSB regime this year, it also has more work to do to achieve compliance than other sectors. Some of the industry's risk management practices are not as sophisticated as those of other financial services companies. The banking industry, for example, is more advanced in terms of managing operational and credit risk."At this stage of the year firms should have already performed a business aspect analysis to determine what is required of them by the PSB, advises Lester. Equally, a GAAP analysis should have been conducted to assess how firms' current approach falls short of regulatory requirements. "Firms should now be taking corrective action to redress any shortfalls in their processes, designing and building new frameworks to effect the necessary changes. After this it is matter of implementing the changes and undertaking continuous assessment to ensure long-term compliance."Lester also says that it is vital for firms to consider the PSB in the context of other developing regulatory changes. "The International Financial Reporting Standards (IFRS) and, for US-registered firms, the Sarbanes-Oxley legislation, impact on firms' management of risk and capital allocation. As such, the rules cannot be viewed in isolation, and firms must take an integrated approach."
Impact on businessThe move to risk-based capital could have a significant impact on insurers, says Deloitte director Rick Lester. "The risk-based approach will make firms much more aware of the use, consumption and efficiency of capital. It may see firms reassess their business strategies, their customers, and their products. As a result, insurers may move away from long tail risks such as employers' liability, to shorter tail risk where capital demands will be lower. "He also argues that the move may drive consolidation in the market. "Firms may see advantages in terms of risk profile. They may gain diversification benefits; a risk in one part of the business may lead to a benefit in another part of the business, such as a demand for a product."