ABI RESPONSE TO CP139: INTERIM INSURANCE PRUDENTIAL RULES
(MINOR CHANGES TO VALUATION AND REPORTING)
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EXECUTIVE SUMMARY
1.1
Issues raised in CP139
1.1.1 CP139 consults on proposed changes to the rules in the Interim Prudential
Sourcebook for Insurance Companies on:
1.2

Increases in the admissibility limit for equities backing with-profit
business;

Simplification of the reporting in regulatory returns for self-invested
and “broker” funds;

Clarification and simplification of the rules for calculating equity
earning yields to determine the maximum discount rate for long-term
liabilities, and

A number of minor changes.
Key ABI response to points

The underlying theme of reducing the need for waivers is welcome. It
reduces administrative requirements and costs for insurers and the
FSA enabling both to target resources more productively.

Similarly, the approach of seeking to simplify procedures is positive.

The changes proposed to the asset admissibility rules are welcome
but should be extended to the limits permitted by the Directives.

The overarching principle of appropriate asset diversification is the
key to a more risk based approach enshrined in increased use of
principles rather than prescriptive limits. Companies should be
allowed to move as soon as practicable to the final Integrated
Prudential Sourcebook approach for determining asset admissibility.

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Form 48, which shows expected income from non-linked life assets,
serves two purposes: calculation of the earnings adjusted yield for
valuation purposes and providing the regulator with information on the
strength of reserving in the light of the backing equity assets. The two
roles should be separated and simplified with management
information being used for the purposes of assessing reserving
strength in the light of backing equity assets.
DETAILED RESPONSE
ADMISSIBILITY LIMIT FOR EQUITIES
Q1
Is the proposed change to the limit on equity holdings desirable? Would
you prefer an alternative formula? Should the formula be adjusted for free
floating capitalisation? If so, how? Is the factor 0.60 appropriate and why?
Should the formula reflect the actual amounts invested in equities?
2.1
Desirability of change
2.1.1 We fully support the concept of the UK moving to the maximum flexibility
permitted by the Directives. The approach of placing greater onus on the
overarching rule of diversification and spreading (but supported by
requirements on firms to demonstrate their own risk management systems
and controls) is the correct one and is a Directive requirement. In the
medium term it can be envisaged that Solvency II is likely to move to such
an approach replacing the current EU numerical limits.
2.1.2 Companies so wishing should be permitted to move to the PSB approach
for diversification and spreading as soon as the details of this are agreed.
In particular this will require finalisation of the proposals for stress and
scenario testing. As many of the companies likely to wish to accelerate
developments will have regular supervisory contact with the FSA on an
ongoing basis, it will not be necessary in those cases for the consultations
on regulatory reporting to be finalised as the key information on
diversification can be made available to the regulator using data already
used for management information reporting.
2.1.3 The proposed changes are clearly a move in the right direction and
welcome as such but should be extended to the full EU limits – ie 5%
holding in any one company, with the limit applied only to assets backing
mathematical reserves. They should also be extended to all life insurance
business and not limited to assets backing with-profits business. If it is
decided to retain the proposals in the CP for with-profits business,
consideration should be given to extending the approach to non with-profits
business.
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2.2
Details of the formula and possible alternatives
2.2.1 The case for greater flexibility than proposed in CP139 is supported by a
analysis of the Third Life Directive:

The limits in Article 22 are restricted to assets covering technical
provisions. The effect of the current and proposed UK approach of
calculating the limit by reference to the long-term insurance business
amounts is to reduce flexibility in respect of assets held to back the
required solvency margin and other free assets and is more
restrictive.

The principles of diversification and adequate spread in investments
are requirements of Article 22(2)(i) of the Directive. Where these can
be demonstrated to be satisfied, there appears no case for more
restrictive prescribed limits in the UK than the Directive.

The present UK and Directive rules contain prescriptive and principle
driven elements. The thrust of regulatory reform in both the UK and
the EU is towards a greater principle driven element. This approach
is necessary for a culture of management responsibility and risk
assessment as opposed to a culture of compliance with detailed
prescriptive regulations. At present application of the diversification
principle across all asset classes means that some life assurers are
not affected by the current prescriptive limits, for instance, because
their weightings of equities are below the limits. In other cases
implementation of business decisions based on risk and
diversification principles has to be modified to comply with the current
prescriptive limits. This confirms our view that the UK should move as
fast as possible to the maximum flexibility permitted under the
Directives.
2.2.2 The 0.60 factor in the formula may give an appropriate answer in some
cases. Like the formulae at both UK and EU level, the operation is
arbitrary. Where an office is very strong, it can act as an unnecessary
impediment to holding a market-weighted diversified portfolio and may also
vitiate a tracking approach. In other cases the current numerical limits are
higher than would be considered prudent under the appropriate
diversification principle. Once again, our preference would be for the EU
maximum applied in the context of the requirement for diversification and
on this basis the 0.60 factor has no role to play.
2.2.3 On the reasoning in the last paragraph, we do not support a formula linked
to the actual relative holdings of equities as an element of the prescriptive
maximum. Such a calculation is likely to feature in risk assessment
calculations in this area but this is a matter of application of the
diversification principle. It is not a reason to seek to incorporate it into the
prescriptive rules.
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Q2
Should we extend the application of the overarching rule for appropriate
spreading to cover all firms prudentially regulated in the UK and not just
those with a UK head office? Is a transitional provision needed?
2.2.4 Equality and consistency of treatment between supervised firms support
the concept of extending the application of the overarching rule to all firms
prudentially regulated in the UK.
2.2.5 The recognition in paragraph 3.20 of the risk of possible relocation of
reinsurers from the UK if the UK regulatory environment is not competitive
is welcome.
Q3
Should we align the limit for friendly societies with those for insurers by
including hybrid securities within the equity limit? Is a transitional provision
needed?
2.2.6 We have no comments on this.
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LINKED BUSINESS CARRIED ON BY OVERSEAS FIRMS
Q4
Are the proposed changes in the scope of the rules about covering
liabilities under linked contract necessary?
Should the scope be
increased? Is a transitional provision needed?
3.1
These are primarily tidying up measures and no points appear to arise.
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SELF INVESTED AND “BROKER” FUNDS
Q5
Do you agree with the proposed relaxation of the requirement to show
information about self-invested and “broker” (or advisor) funds in the
annual returns? Are the conditions appropriate? If not, how should they be
changed?
4.1
We welcome the policy approach of reducing the need to apply for routine
waivers and directions and its application through the present proposals.
4.2
The shift from a primary requirement for detailed reporting to aggregated
reporting plus exception reporting is welcome and reflects the principles in
DP12. The requirement for separate reporting where there is either
mismatching of units or negative liquidity in the fund is appropriate.
4.3
Similarly the principle of the avoidance of duplication of data provision in
cases where the policyholder is given the information directly is welcome.
We would suggest that the application should be slightly different from that
suggested in the CP to permit an equivalent, rather than an identical, level
of information, eg size of fund and percentage distribution rather than the
actual cash distribution as would have appeared in the returns. The aim
should be to allow for flexibility in approach and to avoid undue
prescriptiveness.
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YIELDS ON EQUITIES
5.1
As the CP acknowledges in paragraphs 5.7 and 5.8, forecasts of earnings,
and also dividends are not certain. This suggests that the aim should be to
simplify procedures and to have regard to the purpose of the calculations
and the information presented on Form 48. The first purpose of Form 48 is
to provide an overall check on the valuation rates of interest particularly in
Forms 51,52 and 57. The second purpose is to enable a view to be formed
on the prudence or otherwise of the firm’s valuation bases.
5.2
In some cases companies use the “earnings adjusted” basis to calculate
the valuation rate of interest which they use. In these cases there is clearly
a need to calculate it. In other cases, the calculation is only for the purpose
of the regulator forming a view on the prudence or otherwise of the
valuation basis. This raises the question of whether this second objective
could be achieved more simply. Because of the effects of averaging and
the overall limit of twice the dividend yield, it is questionable whether the
calculation serves this second purposes at all well. For instance,

Nil yielding equities may or may not have significant earnings but these
are omitted from the calculation because of the dividend yield limitation;

A disclosed dividend yield of 3% and cover of 2 would show an
earnings yield of 4.5% but so would a portfolio with half the equities nil
yielding and half on a dividend yield of 6% with a cover of 2 (or a p/e of
8.33) although the risk and sustainable income profiles are probably
significantly different, and

It takes no account of diversification in a portfolio between market
sectors and the spread at sector level.
5.3
There appears a strong case to separate the two objectives and in each
case to seek the maximum simplicity in approach. On this basis Form 48
would be required to show the dividend yield but calculation of the earnings
yield would be restricted to cases where it is being used for valuation rate
purposes. In addition, life assurers would provide their regulator with a
summary of their equity portfolio to enable a view to be formed of the
strength of the assets matching the liabilities.
5.4
The approach would be to use management information supplied on a
confidential basis and there would not be a prescriptive form or
presentation but only a number of principles as to the information to be
provided. For instance the following might be considered:

Details of the largest holdings, perhaps all those representing more
than 1% of the equity portfolio;

Classification of the holdings according to yield and cover or p/e;
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
Minor holdings, ie those below 1% to be in summarised form only.
5.5
The overarching aim is to simplify the provision of information by life
assurers by relying on management information while providing the
regulator with more useful information for the particular regulatory
purposes. We believe that this reflects the future direction of regulatory
reporting as set out in DP12.
Q6
Are the proposed changes to the rule determining the discount rates
sensible and helpful? Would an alternative definition of the financial year
to be used for determining profits be better? Should account be taken of
draft or forecast profits and why? If recent accounts are unavailable, should
account be taken of the earning yield, and what definition of recent should
be used?
5.6
As argued above, we support the principle of a greatly simplified approach.
In particular a distinction should be drawn between calculations for the
purposes of justifying the use of a higher rate of valuation interest than the
dividend yield, where a higher standard of accuracy is appropriate, and
information to enable the regulator to assess the strength of reserving in
the context of the asset match. Nevertheless even with a calculation to
justify a higher rate of valuation interest it should be borne in mind that
there can be significant differences between UK, US and IAS GAAP, and
attempts at overprecision should be avoided.
5.7
The suggestion that where accounts do not comply with the relevant GAAP
the earnings yield should be deemed to be nil has a superficial attraction
from a regulatory standpoint. Nevertheless, it would appear to require
examination of audit reports in all cases. It is not without its own
uncertainties where there are minor or technical breaches of rules. The
position is also unclear where accounts are subsequently revised. The
proposal is aimed at meeting a point that is already covered by the
requirement in Rule 5.11(7A) for an adjustment “to compensate for the risk
that the aggregate profits….might not be maintained” and should not be
pursued.
5.8
In the case of companies listed on a recognised stock exchange we would
usually expect the latest accounts produced for the stock exchange as at
the date to which the regulatory report is prepared to be the appropriate
ones to use. The requirement to use the accounts for the ”most recent
financial year ending on or before the relevant date” would introduce
problems when an annual return is being prepared as at the calendar year
end as this will coincide with the reporting date for probably most of a
company’s equity investments.
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5.9
In the case of companies not listed on a stock exchange, the prudence
requirement in Rule 5.11(7A) would appear to be the appropriate litmus
test. For the same reason, we do not see the need for more detailed
prescriptive rules as to whether accounts are “recent”.
5.10
The emphasis should be on the overall picture and materiality. In particular
assurers should be free to use information from sources such as the
quotations published daily in the financial press and other market
information. The requirements in Rule 5.11.(7A) provides overarching
regulatory protection here in any event.
5.11
In principle there is no reason why account should not be taken of
forecasts subject to the overarching prudence requirement which already
effectively requires account to be taken of them to assess whether the yield
should be reduced.
Q7
Do the proposed changes to the instructions to Form 48 go far enough to
reduce the burden of compiling the information? How material do you
consider the loss of information to be? Is the revised guidance helpful?
5.12
The approach of reducing the need for modifications and directions is
welcome. We argue above for a more radical approach with a view to
reducing the compliance burden. If the present approach is to be
maintained the following changes should be introduced:

Excess amounts in internal linked funds (ie over and above the linked
liabilities) should be covered by Form 48 only where they are actually
used to back non-linked liabilities with an approach similar to that in
matching rectangle being used to determine whether this is the case;

The de minimis limit should be greatly increased and we suggest
20%.
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OTHER PROPOSED CHANGES
Q8
Should the EBRD be an approved financial institution? Should there be
other changes to the list of approved financial institutions and why?
6.1
Yes. We are not aware of any other changes which our members are
seeking at present.
Q9
Is the change proposed to the directors’ certificate desirable?
6.2
Yes.
Q10
Are the changes to GN9.1 helpful?
6.3
Yes. It is helpful to have alignment between the ABI SORP and the
regulatory returns.
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Q11
Is the revised guidance about regulated markets in GN4.2 helpful?
6.4
It is helpful to publish the official list of regulated markets in the UK in
guidance.
Q12
Are the amendments to Rule 2.1 and Form 13 helpful?
6.5
We have no comments at this stage.
Q13
Is the proposed treatment of deposits with the Accountant General
appropriate?
6.6
It is appropriate to treat deposits made with the Accountant General of the
Supreme Court before 1 December 2001 as being with an approved credit
institution
Q14
Do you have any comments on the other minor changes proposed?
6.7
No.
Q15
Is the cost to firms of the rule changes described in this CP indeed
minimal?
6.8
Generally the proposals should be cost saving and this has been a
principle behind the suggestions we have made.
Ref J/640/025C
30 August 2002
[N011907A.FR&T.BMCH.NOTES.02]
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