On 28 June 2012, Julian Adams (the UK FSA's Director of Insurance) delivered a Nicholas Barbon Lecture on "The Impact of Changing Regulation on the Insurance Industry" (the speech is available here).

Although most of the speech is dedicated to the development of insurance regulation over the last 100 years, from a market participant's perspective, Julian's his most interesting - and most challenging - remarks are about the regulatory response to recent market developments, and the implementation of Solvency II. (If you want to go straight there, turn to page 9.)

Long story short: the FSA has apparently decided to require internal model firms to: (i) calculate and monitor a series of ratios; (ii) include the ratios in their regulatory returns; and (iii) give immediate notice to the FSA if the results fall outside a predetermined range. If notice is given, an immediate supervisory review of the firm's internal model will follow. The firm may then be required to change its model. It could also be required to revert to the standard formula and/or the FSA may impose a capital add-on, with all of the publicity and other consequences that will eventually follow. The FSA's stated objective is to ensure that internal model's consistently deliver results that are calibrated at a confidence level of 99.5% over a one year period.

From an industry perspective, this is all rather curious:

  • The FSA seems to have decided that it will require all internal model firms to do these things. And it's made its decision before Omnibus II has been settled and the final Level 2 Regulation has been published. This may suggest that the FSA was unable to persuade EIOPA and the Commission to include these additional requirements in the new regime, and the FSA has been 'forced' to to go it alone?
  • Although the FSA might be filling a gap in the Solvency II regime, it seems more likely that it is gold-plating, notwithstanding repeated assurances that it will not do that. (Those who've already read the FSA's letter to firms of 13 June 2012 (available here) are allowed a wry smile at this point, as they fondly remember the FSA's closing remarks).
  • It's not yet clear why the FSA has decided to impose these requirements on all firms, when it could just impose them on the particular firms whose circumstances genuinely require more detailed checks. After all, Solvency II already requires firms to validate their internal models, and to test the outputs against experience, before making appropriate adjustments. It also requires firms to calculate their SCR at a confidence level of 99.5%, and includes a ladder of supervisory intervention that's triggered if there is a mere risk that the SCR will be breached within three months.

But perhaps the most curious thing is that the FSA seems to have persuaded itself that these steps can be justified by reference to problems that clearly arose in the banking sector, and the risks that might (but only might) arise in the insurance sector. If that is right, it can only be grist to the mill of those who believe that regulators don't fully appreciate the difference between insurance and banking, and that the problems this creates will only get worse when prudential insurance regulation moves over to the Bank of England.

The FSA will be required to consult on these proposals before they are implemented in rules and guidance. Firms may wish to consider what their response will be, when the time comes.