Beruflich Dokumente
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Subject SA5
CMP Upgrade 2013/2014
This CMP Upgrade lists all significant changes to the Core Reading and the ActEd
material since last year so that you can manually amend your 2013 study material to
make it suitable for study for the 2014 exams. It includes replacement pages and
additional pages where appropriate. Alternatively, you can buy a full replacement set
of up-to-date Course Notes at a significantly reduced price if you have previously
bought the full price Course Notes in this subject. Please see our 2013/14 Student
Brochure for more details.
Syllabus item (a) has been reworded and now refers to developed and emerging
markets:
(a) Demonstrate a knowledge and understanding of the financial markets with particular
reference to the needs of a United Kingdom user.
(i) Outline the main features of the capital markets in the United Kingdom and
other developed and emerging markets.
(ii) Outline the main features of the derivatives markets in the United Kingdom and
other developed and emerging markets.
(iii) Outline the main features of the structures of the economies of the United
Kingdom and other developed and emerging markets.
Chapter 0
The reading list has not been changed, but three of the references have slightly changed.
The amended references are copied below - all other entries remain the same.
Chapter 1
There have been many small changes to this chapter and replacement pages are attached
to the end of this upgrade note.
The sentence describing quantitative easing has been updated and now reads:
In March 2009 the MPC and the Chancellor of the Exchequer started a
programme of quantitative easing which injected 375 billion into the UK
economy by April 2013.
2013 / 14
In addition, the additional rate tax rate has been updated and now reads:
The tax rates applicable to dividends are 10% ordinary rate, the 32.5% dividend
upper rate and the dividend additional rate of 37.5%.
Chapter 4, section 3
The rate of corporation tax has been updated and now reads:
The main rate of CT is 23%. This is charged on the whole of profits where they
exceed 1.5m (and in all cases for closed investment-holding companies).
Chapter 4, section 4
The capital gains tax allowance has been updated and now reads:
For 2013/14, the first 10,900 of an individuals net gains realised during the tax
year are free of CGT. The excess is taxed as if it was the top slice of income,
at the rates that apply to savings income and for 2013/14 it is taxed at 28%.
The section on tax on capital gains has been updated and now reads:
Unless there is eligibility for Entrepreneurs Relief (which, for shares, requires at
least 5% of the ordinary share capital to be held), individuals, who have not used
up all the basic income tax and with income, will pay 18% tax on capital gains
above the annual exempt amount (10,900 for 2013/14) until the basic rate band
is exhausted. Thereafter, and for higher rate taxpayers, capital gains tax is paid
at 28%.
The section on general insurance taxation has been rewritten and now reads:
Tax at Lloyds is levied on the individual and corporate members of Lloyds. Each
member is taxed in the UK on its worldwide Lloyds profits. The taxable profits
consist of the aggregate of:
its share of profits or losses from syndicate activity
its profits or losses from activity outside the syndicate (member-level
items).
Chapter 6
There have been numerous small changes to the EU regulation sections and a complete
re-write of the UK regulatory sections in this chapter. As a result a replacement chapter
is attached to this upgrade note.
Chapter 12
There has been a new section added on Basel III. Replacement pages are attached to the
end of this upgrade note.
Chapter 1
The examples for the additional rate taxpayer has been updated and now reads:
An additional (45%) taxpayer who receives 1,000 net dividends plus a tax credit
(ie 1,111 gross income) needs to pay additional tax of 27.5% of the gross dividend, ie
an additional 306 in tax.
Chapter 1
Question 3.7
What is the difference between the duties of the MPC and the Financial Policy
Committee?
Solution 3.7
MPC
Two members of the MPC have full-time executive responsibilities for the
Banks monetary policy functions.
The MPC meets monthly and its decisions are announced immediately after the
meeting.
Minutes of each meeting are published within 2 weeks
Q&A Bank 1
Economic variables such as PE and dividend yields have been updated, but the questions
remain the same.
Q&A Bank 3
Question 3.2
Under Solvency II, in order to calculate the SCR, an insurer must model the risks in its
asset and its liability portfolio.
(i) List the risks that require to be modelled in the asset portfolio of a typical
insurer. [3]
(ii) Describe the attributes of such a model that would be tested by the supervisor
before it was passed for use. [7]
(iii) Describe briefly how operational risk might be measured under the standard
formula approach. [3]
[Total 13]
Solution 3.2
Equity
Property
Interest rate
Credit spread
Currency
Concentration
Illiquidity
Credit / default
[ for each, maximum 3]
The model must be able to estimate the VaR of both assets and liabilities over a period
of, for example, one year. []
It must be tailored to the specific risk profile and unique risks faced by the institution.
[]
The model must be widely used (the use test) throughout the organisation, for
example to price products, and to manage risks. [1]
It must be used to allocate capital between the different divisions of the company. []
The quality of the data used and the assumptions in the model must be good. []
One important part will be the method that the model uses to aggregate risks between
different categories such as equity risk and property risk, or between different equity
shares in similar sectors. [1]
Likewise how the model aggregates asset risks such as interest rate and illiquidity risk,
with insurance risks such as mortality and lapse. []
The model must meet certain standard of calibration relative to historical observations.
[]
The model must be able to attribute profits and losses to particular sources such as
improvements in mortality, falls in the equity market, etc []
The model must be validated on a regular basis by testing its predictions with actual
outcomes. []
The model must be fully documented both in terms of its design and functioning, and
also how to run it. [1]
[Total 7]
These percentages are likely to be either taken from statistical studies, or perhaps the
cost of insurance for these risks. But they are likely to be very broad brush. [1]
The model will add the operational risk on to the Basic SCR without allowance for
correlation with any other risks ie it will be added on to the total without reduction. [1]
[Total 3]
The following question, which is now Question 3.14 has been extended to cover
Basel III.
Question 3.14
(i) Describe the objectives of the first Basel Accord and the capital requirements that
it imposed on banks. [8]
(ii) Discuss why Basel II was developed, briefly outline its approach and describe
the changes that banks have had to make to their business and to their
management procedures as a consequence of the introduction of Basel II. [20]
(iii) Explain the new features that Basel III will bring to the calculations. [7]
[Total 35]
Solution 3.14
(i) Objectives
Capital requirements
Asset are risk-weighted based on certain criteria that represent the credit risk exposure.
Initially these weightings applied to broad categories such as government bonds and
corporate credit, but these were later amended to be based on credit ratings under
Basel II [1]
For example a AA-rated sovereign credit might be weighted 20% of its face value
whereas a AA-rated corporate credit might be rated 50% of its face value. []
(ii) Basel II
The Basel I had the benefit of simplicity but also led to some distortions. []
In particular, the regulatory capital requirements imposed by the Basel Accord may
have differed greatly from the economic capital that the bank felt necessary to hold to
protect itself against the risks to which it was exposed. [1]
These differences would arise because very broad categories of asset were used for risk-
weighting purposes. In particular, commercial loans were subject to a risk-weighting of
100%, regardless of the credit quality of the counterparty. []
This:
encouraged banks to lend to low-quality credits, which were more profitable and
where the assessed regulatory capital was less than the economic capital, and
discouraged them from lending to high-quality credits where the opposite
applied [1]
encouraged banks to move high quality assets off the balance sheet, as by doing
so they were still able to gain exposure to the risk margin available on good
credits but with reduced regulatory capital requirements. [1]
provides a capital adequacy methodology that more closely reflects the true risks
incurred and in doing so reduces the distortions that arise when economic and
regulatory capital differ and reduces the incentive to move assets off the balance
sheet. [1]
This is achieved by:
the use of narrower risk-weighting categories based on genuine credit
ratings rather than broad categories []
the inclusion of additional sources of risk, eg operational risk and interest
rate risk. []
Pillar 1 deals with the amount of regulatory capital that banks will be required to
hold to cover:
credit risk
the market risk on the banks investment trading activities
the operational risk of losses due to failures of internal people and
systems and external events. [1]
It also covers risk mitigation and harmonises the requirements as regards asset
securitisation. []
Two approaches to credit risk are allowable:
2. the internal ratings based (IRB) approach based on the banks own
internal credit ratings. []
Pillar 2 deals with supervisory issues, economic capital and the interest rate risk
on the banks traditional banking book. [1]
The supervisory element of Pillar 2 is based on the principles of:
banks having a process for assessing their capital requirements in relation
to their individual risk profiles []
Changes to business
Both the mix of loans and the required margins have changed in response to the changes
in risk-weightings and hence regulatory capital. []
Banks no longer have a dis-incentive to loan to good quality credits, whereas in the past
the regulatory capital for good and bad credits was the same. [1]
The use of risk mitigation techniques such as collateral and credit derivatives has
increased because Basel II allows risk-weightings to be reduced to reflect the reduced
credit risk in a secured loan. [1]
Banks developed more enhanced credit rating and risk modelling systems, as they will
be rewarded for doing so by being allowed to hold less regulatory capital (for
example, if they can assess credit risk via the internal-ratings based approach rather than
the standardised approach). [1]
Banks have developed better risk measurement and management systems due to the
enhanced level of supervision of risk systems and procedures by the regulators. [1]
The more stringent disclosure requirements has led to the development of improved
information systems, leading to more available information both internally and
externally to third parties. [1]
Banks have developed procedures to measure and management operational risk more
carefully than before. [1]
[Total 20]
Basel III will increase the hurdle for banks by setting higher capital targets, although
these have not yet been decided (May 2013) [1]
This will in turn reduce the return on capital for the banking sector and possibly reduce
the ease with which banks can raise capital in the future. [1]
This in turn may make it harder and more expensive for customers and corporate to
raise money from banks, and encourage them to raise finance directly in the markets or
through other unlisted entities. [1]
Basel III has introduced a leverage ratio that limits the amount of loans a bank can have
based on the capital it has, irrespective of how risky or otherwise the loans are. [1]
There are complex requirements to model liquidity risk, which involve estimating the
cash inflow and outflows over the coming 30 days. Banks will have to ensure that they
can cover these outflows with cash inflows or with highly secure and marketable
securities that have proven to be easily saleable in difficult markets. [2]
Assets that qualify are referred to as High Quality Liquid Assets (HQLA) []
Basel III also introduces a Net Stable Funding Ratio (NSFR) which ensures that inflows
with terms of more than one year are sufficient to cover commitments over one year. [1]
[Maximum 7]
Throughout the X Assignments, the economic commentary has been updated, and the
references to FSA have been replaced by references to the FCA (or PRA where
applicable)
X1 Assignments
The currency movements, dividend yields and PEs have been updated to make the market
commentary up to date. However, the questions remain the same.
X3 Assignments
The solution to Question 3.3 has been updated. Parts (iii), (v) and (vi) have been
amended and now read:
(iii) Describe how you would go about calculating the VaR stochastically using the
historical simulation method and discuss the drawbacks of the historical
simulation method and the drawbacks of VaR in general as a measure of risk.[13]
(v) Explain how the bank would calculate its credit risk-weighted assets for the
purposes of Basel II, assuming that there are no off balance sheet instruments
and ignoring market risk. [2]
(vi) Calculate the amount of Tier 1 and Tier 2 capital that the bank has, and explain
what comparison would be made to determine if this is sufficient. [3]
The first step would be to describe each asset in terms of a number of chosen market
factors. [1]
The next step would be to collect historical data sets for our chosen market factors over
a selected period in the past. We might, for example, look at the changes in the three
market factors over various 99-day periods over the last 10 years. (This would give us
only about 40 data sets, so we might consider taking overlapping 99-day periods that
start at monthly intervals to get 120 data sets, or even weekly intervals to get 520 data
sets.) [1]
We would then calculate the change in the market value of the banks trading assets
when subjected to the changes experienced in the past ie 40 (or 120) observed
changes. [1]
Due to the small percentage tail chosen, we would then fit a distribution to the results
for example, the normal distribution might be selected. This would allow us to
calculate a mean and a standard deviation for the distribution. [1]
We would then calculate the start of the one-sided 0.5% tail of the distribution in this
case we would calculate the mean return less 2.576 standard deviations. [1]
The difference in value between the trading assets at this point and the current value of
the trading assets would be the desired VaR figure. It would normally represent a loss
under these extreme conditions. [1]
Because the method uses a specific set of market factor movements, it may be that this
set is not representative of the real correlations and volatilities of the market factors.
Other methods such as the analytical variance/covariance methods allow us to specify
the behaviour of the market factors using a suitable economic model, which may be
more accurate. [1]
It is sow to respond to changes in asset mix if the exercise is repeated in 3 months, the
VaR would barely change. []
One potential problem is the choice of holding period 99 days in this case. VaR
assumes that the banks positions can be liquidated within 99 days if it was required.
Although this might be the case for most of the liquid asset categories it would probably
not be in the case for many of the corporate bonds, commercial loans or swaps and
derivatives (if they exist). [2]
Many assets do not exhibit a linear relationship to movements in the market factors
they exhibit a degree of curvature. Thus the calculated result over 99 days cannot be
scaled up or down to longer or shorter periods without an assumption of linearity. To
do this it is normal to assume that the variance of the distribution grows linearly with
time, which is often not the case. [1]
If the bank is exposed to other risks such as equity price movements, the VaR result
becomes very dependent on the correlation data that links movements in the market
factors. This is more important where analytical covariance or Monte Carlo methods
are used to generate results. This correlation data is often the most unreliable,
particularly between asset categories and particularly in times of market stress. [1]
The choice of observation period over which to collect data (irrespective of what
method is used) will have a large impact on the result. If the period is short it has the
advantage of being more relevant, but the disadvantage of containing too little data and
may have no extreme movements. If the period is long then the amount of data is large,
but the relevance may be questionable. [1]
In general, the VaR collects data during normal trading periods and uses them to predict
the losses under more extreme events. In fact, during market turbulence, the variances
and covariances break down and the values collected are no longer valid at all. Thus the
predicted loss under extreme circumstances might be completely different and possibly
much larger. [1]
Normal distribution is usually used, which is unrealistic and underestimates the size of
the tails. []
[Maximum 13]
... which could either be determined by using an established credit rating agency such as
S&P or by using an approved internal model. []
The exposure of each asset would be multiplied by the risk-weighting associated with
that credit rating to derive a risk-weighted exposure. []
Any collateral and many hedging instruments can be used to improve the ratings []
[Maximum 2]
The bank has 40m of share capital and reserves. This is the highest quality of capital
and would count as Tier 1. []
The bank also has 100m of subordinated long-term debt which counts as Tier 2 capital
as it rank subordinate to depositors. []
However Tier 2 capital is limited to the amount of Tier 1 capital, and so the bank can
only count 40m of Tier 2 capital. []
This would be compared to the regulatory limit of 8% of the total risk-weighted assets
calculated earlier ... []
...however, credit risk is only one of the sources of risk-weighted assets, and the amount
for market risk, and operational risk would also need to be brought into the calculation.
[]
[Total 3]
X3 Assignments
The last part of X4.3 has been replaced. The new question reads:
First mortgage also lends in the money and bond markets and loans to some corporate
customers. The banks management has stated that First Mortgage will not lend to
customers or buy securities with a credit rating below AA (or equivalent). To date the
bank has relied on ratings supplied by global credit rating agencies when deciding
which instruments to buy and which customers to lend to. In the wake of a large
publicised default, the credit rating agencies have stopped publishing their ratings
information.
(v) Outline how credit ratings could be obtained or computed so that the bank can
continue to lend in line with the managements objective and expectations. [12]
Comment
This question part is taken from a past exam paper (Subject SA5, September 2008,
Question 1, part (iii)). The solution is not designed around any particular part of core
reading, but uses concepts discussed in various parts of the course in general. The
allocation of marks may not necessarily be how the marks were allocated in the exam.
First Mortgage could try to substitute credit rating information with another source. []
... which will need to rely on published financial reports and analyses in the first
instance. []
Any system must be scalable / mechanistic (ie use quantitative methods to reduce the
workload). []
It is unlikely that First Mortgage can carry out in-depth credit research on every bond or
issuer. []
Markers give another half mark for a reasonable attempt at the formula:
Note that using purely objective, quantitative, formula-driven, models have proved
problematical to date (cant capture all nuances). [1]
First Mortgage could rely on implied default info from credit default swaps, mapped to
(former) ratings. [1]
Any systems used must be credible to the management who have specified the
constraint. [1]
There will be other companies in the same situation, who were using published credit
ratings. First Mortgage could join with other firms in similar situation to carry out
ratings to reduce the workload. [1]
If the policy is quoted in any marketing literature, the bank must adjust marketing
materials to reflect the new policy. [1]
The bank will probably need to reduce number of bonds or loans in portfolio if ratings
are now internally generated in order to manage the workload. []
The existing loans (not just the new loans) will need to be rated as default probabilities
change over time. []
[Maximum 12]
Mock Exam A
Additional Mock Pack
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5.2 Tutorials
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or by fax to 0844 583 4501.
Chapter 1
Syllabus objectives
(i) Outline the main features of the capital markets in the United Kingdom,
and other developed and emerging markets.
(iii) Outline the main features of the structures of the economies of the United
Kingdom, and other developed and emerging markets.
0 Introduction
At this stage in your studies you should keep abreast of changes in global economies
and be able to discuss economic matters. In the run up to the SA5 exam you should
keep an eye on the FT to keep tabs on market forecasts and corporate activity in the
major markets described in this chapter. Of particular interest will be:
growth and inflation estimates
budget and current account deficits and surpluses
corporate profitability
corporate activity in the sense of mergers, acquisitions, privatisations, etc.
tax changes and trends
international events such as EU agreements, WTO free trade agreements, etc.
In the past, the finer details contained in this chapter have not been examined.
However, a thorough knowledge of economic events, government action on the
economy, and banking sector intervention has been required.
Students are expected to use the Reports to appreciate the key characteristics of
the capital markets and economies in these regions.
1 Major markets UK
Economic strategy
The economy
The UK economy is the worlds sixth largest (after the USA, China, Japan,
Germany and France) measured by nominal Gross Domestic Product (GDP) and
eighth largest (after USA, China, Japan, India, Germany, Russia and Brazil)
measured by Purchasing Power Parity (PPP).
Inflation
The retail price index at 31 December 2008 was at an annual rate of 0.9% it
became negative for the first time since 1960 when it fell to 0.4% in March 2009
but rose to 2.4% by 31 December 2009 and rose further to 4.8% at 31 December
2010 and it was still at 4.8% in December 2011. It fell back to 3.0% at 31
December 2012.
In 2003 the base rate was reduced twice, then increased once and increased four
times in 2004 to give a base rate of 4.75% at the end of 2004. During 2005 base
rates were cut to 4.5% and then raised twice during 2006 to end at 5.0%. During
2007, rates were raised three times before being cut once to end the year at 5.5%.
During 2008, rates were cut five times to end the year at 2.0%. There were three
further cuts in 2009 bringing the rate down to 0.5%. The rate remains at this level
(as at May 2013).
The UK had a current account deficit of 14.0 billion in the fourth quarter of 2012.
The UK is highly dependent on foreign trade. It must import almost all its
copper, ferrous metals, lead, zinc, rubber, and raw cotton and about one-third of
its food. The UK exports manufactured items such as telecommunications
equipment, cars, automatic data processing equipment, medicinal and
pharmaceutical products and aircraft. Its main trading partners are the European
Union, the USA, China and Japan.
Employment
In December 2012, the employment rate in the UK for those aged 16 to 64 was
71.5%. There were 29.73 million people in employment aged 16 and over. The
unemployment rate was 7.8% of the economically active population. There were
2.50 million unemployed people. The inactivity rate for those aged from 16 to 64
was 22.3% and there were 8.98 million economically inactive people aged from
16 to 64.
The Bank of England is the UKs central bank and is responsible for promoting
and maintaining a stable and efficient monetary and financial framework. In
pursuing this goal, it has three main purposes:
1. maintaining the integrity and value of the currency
2. maintaining the stability of the financial system
3. seeking to ensure the effectiveness of the financial services sector.
The Banks Monetary Policy Committee has responsibility for meeting this target
and for setting interest rates.
Currently the Banks target is to maintain the rate of increase of the Consumer Price
Index within plus or minus 1% of 2% pa.
Much more on the Bank of Englands objectives, as well as those of the Monetary
Policy Committee, and how those objectives are attained, is covered in Chapter 3.
Banks are supervised by the PRA (Prudential Regulatory Authority). Again, you
will learn much more detail on this in later chapters, particularly Chapters 5 and 6.
The insurance sector is supervised by the PRA. Its prime focus is on insurers
maintaining financial resources sufficient to meet their responsibilities to
policyholders, including their ability to absorb any market falls that may occur.
London market
1.4 Investment
The economy
The size of the economy and the domestic market means that economies of
scale can be more easily achieved than in other countries but the scope for
growth is lower than in newly industrialised nations due to its maturity.
There is a wide choice of industries and companies in which to invest. The stock
market is very large and marketability is high. The country is politically stable,
accounting standards and information flows are good and there are no language
problems.
Markets
The American stock and bond markets are the largest in the world.
Fixed interest stocks are issued by both government and corporations. The US
government started to issue index-linked bonds in 1997.
The American market is very strictly regulated by the Securities and Exchange
Commission (SEC). The US system is based almost entirely on statute, with a
minimum of self regulation.
2.2 Japan
The country has few indigenous energy sources and raw materials. However, it
is advanced in manufacturing and over the years has become strongly export-
based with an emphasis on manufactured goods such as cars and consumer
electronics. However, the strength of the yen, reflecting large trade surpluses,
has put a squeeze on exporting industries, so that Japanese companies often
find it cheaper to manufacture overseas.
For example, there are the Nissan and Toyota car factories in the UK. The strong yen
has meant that Japan can buy overseas assets cheaply, and produce goods more cheaply
in other countries than it can domestically. Local production also saves on the costs of
transporting the finished product.
Savings levels are high, and traditionally provided the capital for high levels of
real investment. However, in recent times much of the surplus funds have been
attracted into overseas (largely US) safe-haven investment.
Economic growth
Japan had a record of consistent industrial growth in the 1950s, 60s, 70s and 80s which
was unmatched by other economies. However, growth in the 1990s was disappointing.
The government tried repeatedly to stimulate the economy by:
However, all of these measures met with limited success. Since 2005 the economy has
struggled with the credit crisis and then the tsunami of 2011. The central bank has tried
to keep the Yen from strengthening to help exporters.
Inflation
Inflation levels in Japan have been very low during the last 20 or more years, and in the
late 1990s and 2000s the Japanese economy has regularly experienced periods of
deflation.
Interest rates
Like Japanese inflation, Japanese interest rates have been low and often set to zero in
recent decades.
Real interest rates in Japan have also been low in an attempt to stimulate demand.
As mentioned earlier, Japans growth has been based on very high exports, which have
led to trade surpluses year after year.
Stock market
The Japanese stock and bond markets are the second largest in the world.
There are five stock exchanges, the largest being the Tokyo Stock Exchange,
which accounts for over 80% of total turnover. There is a mixture of government
and corporate bonds. The average term of Japanese debt securities has been
increasing over the last decade. However, long bonds are still uncommon.
Question 1.1
2.3 Germany
For many years, Germany has been Europes largest and most powerful economy. It is
the major player within the European Union.
Germany is the largest national economy in Europe and the fourth largest in the
world. It is a mature industrialised country and is the world's second largest
exporter, with exports accounting for more than one-third of national output.
Germany also has a large banking and insurance sector.
The country is relatively poor in raw materials, importing about two-thirds of its
energy. It is planning to phase out all nuclear power plants by 2021.
The bond market has been increasing in size recently, from a relatively low base.
Inflation
The European Central Bank (ECB) is now responsible for setting interest rates in
Europe.
Germany has always been a strong exporter, and its exports to emerging economies
such as China have helped it survive the financial crisis.
Fiscal deficit
Like most countries around the globe, fiscal deficits rose dramatically in 2009, and were
above the Maastricht limit of 3% of GDP. However, Germany has tackled its budget
deficit and now has a balanced budget in 2012 (unlike many other countries).
2.4 France
France is the world's fifth largest economy. It is the second largest economy in
Europe (behind Germany).
France has a broadly based economy and the Government works closely with
industry on major projects. Manufacturing is important and services also
represent a significant proportion of GNP.
Compared with the US, Japan and Germany, political issues have a major bearing on
the French economy. For example, a significant proportion of French industry has been
under State control, although a privatisation programme is in progress. Agriculture
still exerts great political influence. A larger proportion of the economy is
agriculturally based than is the case in the other economies we study. Like Germany,
France is a major player within the European Union.
Economic growth
GDP per head growth has been similar to that of Germany in recent years. A
privatisation programme is in progress but the French government continues to
play a significant role in the economy.
Interest rates
Monetary policy for Euro countries is carried out by the European Central Bank. So
interest rates in EMU countries are aligned.
Fiscal deficit
France suffered a large increase in its budget deficit during the recession. It was around
5% of GDP in 2012.
Stock Market
Euronext, the leading European exchange, covers trading in the French, Belgian,
Dutch and Portuguese markets.
The main sectors in the market are building materials, banks and, reflecting the
agricultural bias, food and drink.
Bond Market
The French bond market is rather smaller than that of Germany, and similar in
size to that of the UK.
There is a freer single market in goods and services with more transparency of
prices and costs. A single currency removes the exchange rate risks of
investing in other EMU participants and there has been a rebalancing of
institutional portfolios to reflect the increased attractiveness of investments in
other EMU countries.
The recent financial crises within the Eurozone and the effect of the financial
measures imposed mean that it is now unlikely that the UK will join the EMU in
the foreseeable future. Indeed, some commentators question whether the euro
itself will survive.
Chapter 1 summary
The UK market
The UK Governments (Labour govt to 2010) economic strategy has six main elements:
1. maintaining macroeconomic stability
2. meeting the productivity challenge
3. increasing employment opportunity for all
4. building a fairer society
5. delivering high-quality public services
6. protecting the environment
Up until the credit crunch, the UK economy had performed relatively well over the
previous 10 years in terms of economic growth, low inflation and low unemployment.
However, since 2008 there has been a lot of uncertainty about excessive borrowing,
rising unemployment and economic recession. Inflation is proving to be a problem
(May 2013), and the governments quantitative easing strategy along with the policy of
low interest rates may stoke inflationary pressures in the future.
The government is forecast to borrow around 120 billion in 2013 to fund its deficit.
Outstanding government debt is going to rise sharply over the next 5 years as a result.
The insurance market has been affected by weak equity markets worldwide.
In the UK market, equity yields are around 3.2%, bond yields are around 3.1% and base
rates are 0.5% (May 2013).
Overseas markets
For each, we need to know about the condition of the economy, the budget deficit
situation, the performance of the equity markets and the level of interest rates.
This page has been left blank so that you can keep the chapter
summaries together for revision purposes.
Chapter 1 Solutions
Solution 1.1
Chapter 6
Applications of the legislative and regulatory
framework (2)
Syllabus objectives
0 Introduction
In this (now very long!) chapter we continue our look at the UK regulatory
environment, focusing closely on the UK-specific regulators that affect the UK market.
The ideas covered in this chapter change on a regular basis and students should keep a
close look out for articles in the newspapers and in the actuarial journals concerning
regulation in the UK.
This material can be tested either in the form of bookwork knowledge, or can be tested
in an application-style question. Examples in the past have presented students with
unusual or borderline activities and asked them to discuss whether it should be
allowed by the compliance officer of the firm, and if not, what actions the compliance
officer or national regulator may consider taking.
Question 6.1
Prior to 2013, the Financial Services Authority (FSA) was the primary regulator
for financial services in the UK. The FSA exercised its statutory powers under
the Finance Services & Markets Act 2000 (FSMA 2000) in the regulation of banks,
insurance companies and financial advisers.
In April 2013 three new regulatory bodies were established by the Financial
Services Act 2012:
the Financial Policy Committee (FPC)
the Prudential Regulation Authority (PRA)
the Financial Conduct Authority (FCA).
The PRA and the FCA have effectively taken over the functions of the FSA.
The FPC is a committee of the Court of Directors of the Bank of England (BoE)
which is responsible for macro-prudential regulation (in contrast to the PRAs
responsibility for micro-prudential regulation).
The FPC monitors the financial system as a whole. Consequently, unlike the
PRA and the FCA, it does not have direct regulatory responsibility for any
particular types of firm.
The FPC is chaired by the Governor of the BoE. Other members of the FPC
include the PRA chief executive and the FCA chief executive.
The PRA has a general objective to promote the safety and soundness of
regulated firms. The PRA seeks to meet this objective by working to minimise
any adverse effects of firm failure on the UK financial system and by ensuring
that firms carry on their business in a way that avoids adverse effects on the
system.
The PRA has operational independence from the BoE and the FPC for day-to-day
regulation and supervision of dual-regulated firms. Its focus is on setting
institution-specific capital requirements.
The PRAs board include the Governor of the BoE as chairman and the BoE
Deputy Governor for prudential regulation as chief executive. The FCA chairman
also sits on the PRA board.
The PRA is accountable to the BoE, to Parliament (in particular, the Treasury
Select Committee) and to the National Audit Office.
The FCA has inherited the majority of the FSAs roles and functions. In
particular:
3. it has inherited the FSAs market conduct regulatory functions, with the
exception of responsibility for systemically important infrastructure which
has been transferred to the BoE.
Strategic objective
The strategic objective is to ensure that the relevant markets function well.
Operational objective
The FCA is also obliged to discharge its general functions in a way that
promotes competition.
The FCA is independent of government and the BoE, and takes the form of a
company limited by guarantee. It has adopted the legal corporate identity of the
FSA.
Powers
The FCA has been given a number of powers additional to those held by the
FSA, including powers to:
The following firms are dual-regulated, ie regulated by the PRA for prudential
purposes and the FCA for conduct purposes:
banks
building societies
credit unions
insurers (including friendly societies)
Lloyds of London and Lloyds managing agents
certain systemically important investment firms that have been
designated by the PRA.
The FCA is the prudential and conduct regulator for all other firms that were
previously regulated by the FSA.
A brief summary of the three bodies and their responsibilities is as follows (not Core
Reading):
HM Treasury
Treasury Select Committee
A number of additional powers were introduced in 2013 when the FCA was
established, including the power to block an imminent product launch or to stop
an existing product.
4. the powers of the FCA and PRA to authorise, regulate, investigate and
discipline authorised persons and to intervene in their activities
There are eleven principles set out by the FCA and PRA for the conduct of
investment business.
These principles are set out in the FCA and PRA Handbooks and are:
1. Integrity
A firm must conduct its business with due skill, care and diligence.
A firm must take reasonable care to organise and control its affairs
responsibly and effectively, with adequate risk management systems.
Question 6.2
What type of risk are the requirements regarding management and control intended to
limit?
4. Financial Prudence
5. Market Conduct
For example, there may be a requirement that those carrying out financial
practice have certain qualifications.
6. Customers Interests
A firm must pay due regard to the interests of its customers and treat
them fairly.
A firm must pay due regard to the information needs of its clients, and
communicate information to them in a way which is clear, fair and not
misleading.
8. Conflicts of Interest
A firm must manage conflicts of interest fairly, both between itself and its
customers and between a customer and another client.
A firm must take reasonable care to ensure the suitability of its advice and
discretionary decisions for any customer who is entitled to rely upon its
judgement.
Question 6.3
List the information a firm should seek when advising an individual wishing to save for
his childs school fees.
A firm must deal with its regulators in an open and cooperative way, and
must disclose to the PRA and/or FCA appropriately anything relating to
the firm of which the appropriate regulator would reasonably expect
notice.
Question 6.4
Give examples of the information that the firm might reasonably be expected to disclose
to the regulator.
Principles-based regulation
The FCA and PRA handbooks of rules and guidance are based on principles
based regulation, under which there are fewer prescriptive rules and the FCA
and PRA instead rely on these higher level principles.
Question 6.5
4 Regulated Activities
4.1 Types of activity
The types of activity that may require authorisation under FSMA 2000 are:
1. accepting deposits
8. investment advice (the area with which actuaries are most likely to be
concerned)
DPB licensed
FCA Sourcebook
If you are providing advice under PRA or FCA authorisation, the requirements
under the FCAs Training & Competence Sourcebook will apply.
5.1 Introduction
Within the FSAP, 42 different measures are described, which set out the barriers
that need to be removed and gaps that should be filled if an integrated EU
financial services market is to succeed.
In the United Kingdom, the FSA is responsible for implementing the action plan.
Question 6.6
The MAD was implemented in the UK in 2005. As part of this implementation, the
FSA have sought to maintain their existing rules wherever possible resulting in
broadening of the MADs scope.
The MiFID was introduced in November 2007, it replaces the existing Investment
Services Directive (ISD) while expanding the scope and coverage of the ISD
regime. It provides a harmonised regulatory regime for investment services
across the 30 member states of the European Economic Area. The main
objectives of the Directive are to increase competition and consumer protection
in investment services.
The MiFID:
widens the range of core investment services and activities that are
regulated by the EU to include:
personal investment advice
commodity derivatives
credit derivatives
contracts for difference
operating a multilateral trading facility.
Firms that comply with MiFID will, in general, have to comply with the new
Capital Requirements Directive (CRD). For firms not previously covered by the
ISD, this could mean being required to hold minimum capital amounts for the
first time.
It also applies to many futures and options firms and some commodities firms.
For retail banks and building societies the MiFID covers only parts of their
business, for example, selling investment products that contain securities to
their customers.
In October 2011, the European Commission published its legislative proposal for
MiFID II which aims to update the original MiFID. At the time of writing (April
2012), it is expected that the new legislation will be introduced later in the year.
Question 6.7
The PD came into force on 31 December 2003 and was implemented in the UK on
1 July 2005. The PD regulates the laws which govern the drawing up and
publication of prospectuses whenever securities are offered to the public or
admitted to a regulated exchange.
It therefore aims to ensure that report & accounts give investors sufficient insight into
the financial condition of the company. This is consistent with the aims of International
Accounting Standards (IAS).
The TD came into force on 20 January 2005 and was implemented in the UK
through the Companies Act 2006.
The FSA implemented the directive for UK based reinsurers at the end of 2006.
While it has had a minimal impact on the operations of non-life reinsurance
business the regulatory solvency capital on many classes of life protection
reinsurance business has fallen considerably.
Question 6.8
List three forms of market abuse as defined by the Market Abuse Directive.
Question 6.9
Question 6.10
Think of an easy way to memorise the first letter of the five directives in the Financial
Services Action Plan.
6 EU legislation solvency
All information included in this chapter is current as at the time of writing (April
2013). However, since Solvency II remains under development during 2013 and
potentially also 2014, some of the details may have been amended or replaced by
the time of the examination.
The new Solvency II framework has been created in accordance with the
Lamfalussy four-level process:
At the time of writing (April 2013), progress has been made on the first three
Levels but these have not yet been fully finalised and ratified. The current
timetable expects formal agreement of the Omnibus II text in 2013 (this updates
the Level 1 measures originally set out in the 2009 Solvency II Directive) and
approval of the Level 2 implementing measures. This will be followed by the
introduction of Level 3 guidance.
The Solvency II Directive will apply to all insurance and reinsurance companies
with gross premium income exceeding 5 million or gross technical provisions
in excess of 25 million.
Transitional arrangements may be available for some aspects although any such
transitional arrangements adopted must be at least equivalent in effect to the
Solvency II proposals and should be in place for up to a defined maximum period
only. The intention is to avoid unnecessary disruption of markets and
availability of insurance products. Full compliance with the new regime should
be encouraged and achieved as quickly as possible.
6.2 Structure
Pillar 1 in brief
Pillar 1 sets out the minimum capital requirements that firms will be required to
meet. It specifies valuation methodologies for assets and liabilities (technical
provisions), based on market consistent principles. Under Pillar 1 there are two
distinct capital requirements:
the Solvency Capital Requirement (SCR)
the Minimum Capital Requirement (MCR).
The SCR and MCR both represent capital requirements that must be held in
addition to the technical provisions.
Pillar 2 in brief
Pillar 2 is the supervisory review process, under which supervisors may decide
that a firm should hold additional capital against risks that are either not covered
or are inadequately modelled under Pillar 1. Each insurance company will be
required to carry out an Own Risk and Solvency Assessment (ORSA). The ORSA
requires each insurer to identify the risks to which it is exposed, to identify the
risk management processes and controls in place, and to quantify its ongoing
ability to continue to meet the MCR and SCR.
Pillar 3 in brief
Pillar 3 is the disclosure and supervisory reporting regime, under which defined
reports to regulators and the public are required to be made.
The following diagram (which is Core Reading) shows an insurance companys capital
and how it might be broken down into the various regulatory components.
Ineligible capital
Tier 3 Free
Tier 2
Capital
Eligible
capital SCR
Tier 1
MCR
Risk margin
Technical
Best
estimate provisions
liability
Other
liabilities
This shows that a companys capital (which will consist of instruments that rank below
policyholder in the event of a wind up) can be broken down into Tier 1, Tier 2, Tier 3,
and some ineligible capital. Tier 1 will be equity capital and other forms that that the
regulator has deemed to be excellent for absorbing losses, and deemed to be very long
term. Tier 3 may consist of some subordinated debt capital which the regulator is
willing to consider but does not think is as high quality as equity capital for absorbing
losses. Some of the companys capital will not qualify at all as regulatory capital and is
deemed ineligible capital. This will be excluded from any capital ratio.
So in effect the left hand column is the real balance sheet capital and liabilities, and the
right hand column represents the capital and liabilities as the regulator sees them
(excluding ineligible capital). The total value of the left hand column would be
expected to equal the value of the assets valued in accordance with the rules of
Solvency II (see below).
The capital available in the company must be sufficient to cover certain unexpected
events. The minimum is the MCR, and a higher hurdle is the SCR. The MCR will
normally be about 40% of the SCR. Note that the MCR and SCR are two separate
calculations, and are not added together. Most companies would expect eligible capital
to be above the level of the SCR, and the surplus is called free capital.
The companys balance sheet will also contain policyholders reserves or technical
provisions and other liabilities, which will normally be much bigger than shown in the
diagram. These are the best estimate of the liability to policyholder using risk free rates,
plus other liabilities plus a risk margin.
6.3 Pillar 1
Valuation of assets
If such prices are not available then mark-to-model techniques can be used
provided these are consistent with the overall market consistent (or fair value
or economic value) approach, ie the amount at which the assets could be
exchanged between knowledgeable willing parties in an arms length
transaction.
This is a significant change for much of Europe, where book values are often still
used under Solvency I.
The best estimate liability is the present value of expected future cashflows,
discounted using a risk-free yield curve (ie term dependent rates).
At the time of writing, the precise specification of the risk-free discount rate has
not yet been finalised. This includes whether swap rates or government bond
yield curves should be used as the starting point, and then the extent to which
this should be adjusted (eg a deduction from swap rates to allow for credit risk).
It is also noted that the method used to determine the discount rate needs to be
consistent between different currencies, including those without an active
government bond or swap market or where the market is not active for as long a
duration as the liabilities.
The risk margin is intended to increase the technical provision to the amount
that would have to be paid to another insurance company in order for them to
take on the best estimate liability. It therefore represents the theoretical
compensation for the risk of future experience being worse than the best
estimate assumptions, and for the cost of holding regulatory capital against this.
The risk margin is determined using the cost of capital method, ie based on
the cost of holding capital to support those risks that cannot be hedged. These
include all insurance risk, reinsurance credit risk, operational risk and residual
market risk.
The risk margin calculation involves first projecting forward the future capital
that the company is required to hold at the end of each projection period
(eg year) during the run-off of the existing business. For Solvency II, the
projected capital requirement is a subset of the SCR (see 6.4 below), consisting
of those risks that cannot be hedged in financial markets.
These projected capital amounts are then multiplied by a cost of capital rate.
This rate can be considered to represent the cost of raising incremental capital
in excess of the risk-free rate, or alternatively it represents the frictional cost to
the company of locking in this capital to earn a risk-free rate rather than being
able to invest it freely for higher reward. For Solvency II it is currently proposed
that it is a fixed rate of 6% per annum.
The product of the cost of capital rate and the capital requirement at each future
projection point is then discounted, using risk-free discount rates, to give the
overall risk margin.
Although the risk margin must be disclosed separately for each line of business,
it is proposed that it can be reduced to take into account diversification between
lines up to legal entity level. The allocation of diversification benefit can be
approximated by apportioning the total diversified risk margin across lines of
business in proportion to the SCR calculated on a standalone basis for each line,
or by other approximate methods if appropriate given the materiality of the
results.
There is a prescribed list of risk groups that the SCR has to cover:
non-life underwriting risk
life underwriting risk
health underwriting risk
market risk
counterparty default risk
operational risk
intangible asset risk.
The SCR can be calculated using standard prescribed stress tests or factors,
which are then aggregated using prescribed correlation matrices. This approach
is known as the standard formula.
The two approaches (standard formula and internal model) are described in more
detail below.
Additional constraints apply to the calculation of the SCR if there are ring-fenced
funds with limitations on capital fungibility.
For some parts of the standard formula, insurance companies can apply to use
undertaking specific parameters instead of the prescribed parameters.
The above diagram illustrates the possible structure of the SCR calculation
under the standard formula, although it should be noted that not all aspects have
yet been finalised.
The SCR is first calculated for each module, as listed above. For the market and
insurance risk modules, each individual stress is performed separately
according to detailed rules. The calibration and application of each stress is
specified within the standard formula, eg 25% stress to property values,
immediate and permanent 15% increase in mortality rates.
The SCR for each individual risk is then determined as the difference between
the net asset value (for practical purposes this can be taken as assets less best
estimate liabilities) in the unstressed balance sheet and the net asset value in the
stressed balance sheet. These individual risk capital amounts are then
combined across the risks within the module, using a specified correlation
matrix and matrix multiplication.
So this risk matrix would allow the stresses of property risk, interest rate risk, and
concentration risk, etc to be combined to form a risk for market risk overall. Likewise it
will allow the stresses for longevity, morbidity, lapse, expenses, etc to be combined to
form a risk for life insurance overall.
For the counterparty risk module the calculation approach is similar, with a
proposal that the insurance company must first differentiate between:
type 1 (may not be diversified and the counterparty is likely to be rated)
and
type 2 (usually diversified and the counterparty is unlikely to be rated)
exposures.
Different detailed approaches are specified for the determination of the SCR for
each type of exposure, which are then combined using a given formula.
Having obtained the SCR for each module, a further specified correlation matrix
is used to combine them to give the Basic SCR (BSCR). Aggregation is therefore
performed at different levels.
This correlation matrix allow the combination of the market risk, the life insurance risk,
counterparty default risk, etc to be combined to generate an overall risk which is the
BSCR.
To obtain the overall SCR, two adjustments are made to the BSCR:
1. an allowance for operational risk
2. an allowance for the loss absorbing capacity of technical provisions and
deferred taxes. This is referred to in the diagram above as Adj, and is one of
the three components of SCR. Loss-absorbing capacity might mean, for
example, the fact that some liabilities may have the capacity to reduce bonuses
in the event of an unexpected event. If the liabilities can be reduced, then the
SCR may be reduced slightly.
The loss absorbing capacity of technical provisions could include the ability to
reduce discretionary benefits under the stressed conditions. The loss absorbing
capacity of deferred taxes could, for example, include a reduction in any base
balance sheet deferred tax liability, as this would no longer be fully payable in a
stressed scenario.
Question 6.11
Can you list four categories of risk that would be included in the calculation of the
SCR?
Question 6.12
What might be the advantages for a company to use the standard model for calculating
its SCR requirement?
Provided that it has been approved by the insurance companys regulatory body,
an internal model can be used as a full or partial alternative to the detailed
standard formula approach.
For example, this might be appropriate if the risk profile of the business differs
materially from that covered by the standard formula, and/or if the company
already uses such a model for risk management or other decision-making
purposes (eg pricing, investment strategy). Indeed, the supervisor can compel
an insurance company to develop an internal model, if it feels that the standard
formula is not appropriate to the risk profile of the company.
The overall capital requirements resulting from the use of an internal model will
generally differ from the outcome of the standard formula calculation, and may
be either higher or lower depending on how the firms tailored risk profile
compares against the assumptions underlying the standard formula.
However, the internal model must still generate an SCR based on the stated
requirements, including coverage of the risk types as noted above and providing
at least the equivalent protection to a 99.5% confidence level over one year.
The tests that the model must pass before it can gain approval are:
1. The use test companies have to demonstrate that their internal model
is widely used throughout all relevant areas of the business and that it
plays a significant role in the internal governance, risk management and
decision-making processes, as well as the economic and solvency capital
assessments and capital allocation processes.
5. Validation standards the internal model must have been fully validated
by the insurance company and must be subject to regular control cycle
review, including testing results against emerging experience.
The use test is seen as one of the most challenging aspects of gaining internal
model approval. As well as embedding the model throughout the company and
developing an effective risk culture, companies will need to be able to evidence
that this is the case.
The quality of data and assumptions can also be an issue. A key challenge is
that historic data available to calibrate extreme events is limited. In practice, it is
likely that some industry consensus will emerge over some of the core
stresses, eg 99.5th percentile equity fall based on a commonly used index and
method. It will be important for companies to allow for their own specific
features however, eg the extent to which their actual equity holdings are more or
less volatile. Similarly, setting dependency structures and correlation factors
that apply under extreme conditions is challenging.
Furthermore, an internal model can be structured in any way that the company
chooses, provided the above tests are met. It does not have to follow the
structure of the standard formula, and can for example be based on stochastic
simulations rather than stress tests plus correlation matrices perhaps using
copulas to model dependency structures. Calibration of such models will also
require care and expertise.
A tight deadline has been imposed of just six months from the supervisory
authority receiving an application for internal model approval to communication
of the decision. Many regulators (eg in the UK) have therefore chosen to set up a
more informal approach (called pre-application), encouraging companies to
engage with them early on in their model development and refinement
processes.
In the UK, the approval process is known as the Internal Model Application
Process (IMAP). The regulator has been issuing sets of guidelines for insurance
companies in relation to this process based on the latest versions of Level 1 and
Level 2 proposals, noting that formal final approval cannot be given until the new
Solvency II regulations come into force.
Having already developed models for the similar ICA calculation described
earlier in this chapter, it is anticipated that insurance companies within the UK,
particularly larger ones with economies of scale, will be more likely to use the
internal model option than insurers in some areas of continental Europe.
Question 6.13
What are the advantages to using an internal model approach rather than a standard
model?
The MCR has a floor of 25% and a cap of 45% of the SCR.
The two capital requirement calculations outlined above define the two ends of a
ladder of supervisory intervention, under which increasingly severe
supervisory authority actions will be taken as a companys eligible capital falls
below the SCR (the first point of intervention) and approaches the MCR. The
MCR is the ultimate point of supervisory intervention, below which the company
would lose its authorisation.
The phrase own funds refers to assets in excess of technical provisions and
subordinated liabilities. These are split into basic and ancillary own funds,
which are then tiered based on specific criteria (namely Tier 1, 2 and 3 and
ineligible).
Basic own funds is broadly capital that already exists within the insurer.
Ancillary own funds is capital that may be called upon in certain adverse
circumstances, but which does not currently exist within the insurer (eg unpaid
share capital).
Restrictions are placed on the quality of capital that can be used to cover the
MCR and SCR. For example, the current proposal is that:
the SCR must be backed by at least 50% Tier 1 capital and less than 15%
Tier 3
the MCR must be backed by at least 80% Tier 1 capital and no Tier 3
capital.
Data Quality
EIOPA (when CEIOPS) issued advice on Standards for Data Quality under the
Level 2 implementing measures. This highlights the importance of having good
quality data for the valuation of technical provisions.
The more complete and correct the data is, the more consistent and
accurate final estimates will be.
It is also noted that the issue of data quality is relevant to other areas of the
solvency assessment, such as the SCR using either the standard formula or
internal models. A consistent approach to data quality issues needs to be taken
across Pillar 1, without disregarding the different objectives.
6.5 Pillar 2
Governance requirements
Pillar 2 sets out requirements for the roles and responsibilities of key functions
within the business, with the Board having overall responsibility for ongoing
compliance with Solvency II.
ORSA
In addition to calculating the MCR and SCR under Pillar 1, each insurance
company will be required to carry out an Own Risk and Solvency Assessment
(ORSA).
It requires each insurance company to identify all the risks to which it is subject
and the related risk management processes and controls. This will include some
of the more qualitative risks that have not necessarily been assessed under
Pillar 1, such as reputational risk.
The company must also quantify its ability to continue to meet the MCR and SCR
over the business planning horizon (usually three to five years), allowing for new
business. This does not have to be at a prescribed confidence level, but at a
level that the company feels is appropriate, for example relating to its own stated
risk appetite and/or to achieving a target credit rating.
Question 6.14
Can you list four types of market risk that require to be modelled when calculating the
SCR?
Question 6.15
Can you list four types of life insurance risk that require to be modelled when
calculating the SCR?
The results of the solvency calculation and details of the ORSA and risk
management processes will need to be disclosed privately to the supervisor in the
Regular Supervisory Report (RSR) which will include both qualitative information
and Quantitative Reporting Templates (QRT). The RSR, including QRT, will need
to be submitted annually. A subset of the QRT (to support the MCR calculation)
will be required quarterly.
Each insurance group must cover its overall group SCR (which will allow for
diversification benefits across the group, and is subject to a minimum of the sum
of the MCRs of each subsidiary) and each insurance subsidiary needs to cover
its own SCR.
Group supervision would normally be carried out at the top level company within
the European Economic Area (EEA). Additional rules apply to subsidiaries and
parents located in a third country, ie non-EEA. These broadly impose
Solvency II requirements or, in the case of a non-EEA parent, the establishment
of an EU holding company.
The regime may also have an impact on the optimal product mix for the
company, and on product design.
It is also likely to impact the optimal asset mix for the company, since some
asset classes will become relatively more attractive as a result of their lower
capital requirements.
Management information is also likely to change to align the new metrics with
the business and strategic decision-making process.
External disclosures will change, and in general are likely to increase, so the
impact on the market also needs to be considered.
You should keep an eye on EU events it is not beyond the scope of this exam to
expect you to know about the directives mentioned in sections 3 and 4 above.
Solvency I was a one size fits all approach, whereas Solvency II allow
different insurers to adopt different methods of modelling risk, making the
resulting capital more entity-specific.
Solvency II covers more risks than Solvency I. Solvency II now covers most
risks, both asset and liability based, and has tighter asset recognition rules.
Market, credit, liquidity and operational risks are all covered in addition to
insurance risks.
Solvency II requires more open disclosure to the market (rather than just to the
FSA). Companies have to draw up a Own Risk and Solvency Assessment or
OSRA, which discloses a great deal about their risk assessment and capital
framework, and which is presented to the regulator. In addition they will have to
make public solvency reports and public financial condition reports.
ICAS
Both Solvency II and ICAS give credit for risk-management procedures that are
in place to cope with risks as they occur, which was not the case under
Solvency I.
ICAS were only published to the FSA. Solvency II disclosure will be wider.
Both ICAS and Solvency II allow the use of internal models to determine the
risk, but Solvency II also allows the use of a standard model.
Under both ICAS and Solvency II, companies will present their results and
justify the amount of capital they hold to the regulator, who then approves it.
Under Solvency I there was a minimum capital hurdle that everyone had to
achieve.
Pillar 1 involves the calculation of SCR and MCR as described in the core
reading. If the companys capital is nearer to the MCR, then the regulator will
step in and force action, preventing the company from selling any more business
if necessary. If the company is closer to the SCR or above this level, no action
will be taken.
In general, the MCR will be around 40% of the SCR. The SCR may be
calculated using an internal model, or using a standard model. If the regulator
believes the insurer is exposed to certain unusual risks that are not adequately
captured by the SCR model, then additional capital add-ons can be imposed.
The details of Solvency 2 are relatively important for the SA5 exam. This material was
added to the course for the exam session to April 2012, and a couple of questions since
then have touched on the topic. It has not been examined in great detail, however, a
good understanding would have helped generate ideas in the questions where it has been
relevant.
They may also be responsible for other matters such as taking reasonable steps to:
safeguard the assets of the company
prevent and detect fraud and other irregularities.
There is no necessity for directors to have any executive position, full or part
time, in the company. Shareholder pressure groups have been active in
ensuring directors use their power for the benefit of shareholders. In recent years
many directors have suffered uncomfortable times at the annual shareholder meeting!
Specific problems have arisen in connection with the principle of agency under
which directors act on behalf of shareholders.
Agency problems may arise when the interests of directors and shareholders do not
coincide.
There have been many examples of directors abusing their position of trust as
managers or agents of the companys assets. A response has been to propose a
legal framework of governance for executive and non-executive directors with
the aim of trying to protect the shareholders and stakeholders from director
abuse.
Here we specifically have in mind the proposals included in the Higgs Review of the
role of non-executive directors in the UK (Higgs D. (January 2003), Review of the role
and effectiveness of non-executive directors). Copies of the Higgs review can be
obtained from the Department for Business, Innovation & Skills website
www.BIS.gov.uk
Question 6.16
8.1 Introduction
This section expands on the previous section and describes how Corporate governance
requirements have developed in the UK in recent years.
Copies of each of the above reports can easily be located and downloaded using the
internet.
The recommendations and findings of these reviews have now been combined
into a Code of Corporate Governance, published in July 2003.
It applied to reporting years beginning on or after 1 November 2003 and set out a
number of key principles underpinning good corporate governance. For example, as
regards the role of the board and the directors, the Code suggested that:
All directors must take decisions objectively in the interests of the company.
Whilst with specific regard to the role of non-executive directors, the Code states that:
Question 6.17
What principles do you think the Code might set out as regards executive remuneration?
Disclosure requirements
The Financial Services Authority Listing Rules require each listed company to:
report on how it applies the principles in the Code
confirm that it complies with the Codes provisions or where it does not
to provide an explanation.
However, one argument that has been raised against the Code is that companies will feel
obliged to implement all of its recommendations even when it may be inappropriate or
unduly costly to do so.
the names of the chairman, the deputy chairman (where there is one), the
chief executive, the senior independent director and the chairmen and
members of the nomination, audit and remuneration committees
the number of meetings of the board and those committees and individual
attendance by directors
how performance evaluation of the board, its committees and its directors
has been conducted
the steps the board has taken to ensure that members of the board, and in
particular the non-executive directors, develop an understanding of the
views of major shareholders about their company.
Question 6.18
What do you think are the main responsibilities of the nomination, audit and
remuneration committees?
a statement from the directors that the business is a going concern, with
supporting assumptions or qualifications as necessary
a report that the board has conducted a review of the effectiveness of the
groups system of internal controls
where there is no internal audit function, the reasons for the absence of
such a function
where the board does not accept the audit committees recommendation
on the appointment, reappointment or removal of an external auditor, a
statement from the audit committee explaining the recommendation and
the reasons why the board has taken a different position
The full Code consists of four sections relating to the principles to be observed
by boards and companies, these cover issues relating to:
1. the role of directors
2. remuneration
3. accountability and audit
4. relations with shareholders
It provides that at least half the board should comprise independent, non-
executive directors and that they should normally serve for only 2 three-year
terms, to maintain independence. Non-executive directors who serve for more
than 3 three-year terms should then be subject to annual re-election.
Question 6.19
The Code requires that the board should include a balance of executive and non-
executive directors, and in particular independent non-executive directors. What do you
think is mean by an independent non-executive director?
The first of these provisions is aimed at ensuring that no single individual can dominate
the board and hence the running of a company. The second aims to ensure that the
Chairman is sufficiently independent of the executive.
The Financial Reporting Council has issued also issued a Code of Practice on
corporate governance.
The Code also includes sample documents and checklists that can be used by the board
as part of their good practice.
www.frc.org.uk/corporate/ukcgcode.cfm
Question 6.20
The Code places three key requirements on the board as regards accountability and
audit. What do you think these three key requirements might be?
Chapter 6 Summary
The three principal regulatory bodies in the UK
1. accepting deposits
2. effecting or carrying out contracts of insurance
3. establishing, operating or winding up a collective investment scheme
4. dealing or arranging deals in investments (eg a stockbroker or an exchange)
5. safeguarding and administering securities or contractually based investments
6. using computer based systems for giving investment instructions
7. discretionary investment management
8. investment advice
9. managing the underwriting capacity of, or advising on the merits of membership
of, a Lloyds syndicate.
The EU have launched the Financial Services Action Plan with the aim of encouraging
a single market in financial services throughout the European Union. There are 5 main
directives within this plan:
1. the Market Abuse Directive (MAD) to discourage insider trading and market
manipulation
2. the Markets in Financial Instruments Directive (MiFID) which modernised the
existing Investment Services Directive
3. the Prospectus Directive (PD) which regulates the laws governing the drawing
up and publication of prospectuses whenever securities are offered to the public
or admitted to a regulated exchange
4. the Transparency Directive (TD), which aims to increase transparency on EU
capital markets by increasing disclosure
5. the Reinsurance Directive (RD), which aims to harmonise the supervision of
reinsurance business in the EU.
EU legislation Solvency II
This legislation completely modernises the way that insurance companies are regulated
in the EU. Capital will be calculated within three pillars:
Pillar 1 regulates the amount of capital to be held for a wide variety of risks.
Capital will be assessed relative to the MCR and the SCR.
Pillar 2 looks at qualitative measures to prevent of control risk.
Pillar 3 concerns disclosure of information to the public and to the regulator.
Standard models are available, but some companies may choose to design their own
internal models. The advantages and disadvantages of using the standard model rather
than an internal model are:
+ they are less complex to design
+ they are less complex to justify to the regulator
they are designed for the average company
they may increase the systemic risk in the system if everyone uses it
they may not capture certain risks that are important for any one company.
In the UK, the Code of Corporate Governance published in July 2003 (updated in
2010!) incorporates the recommendations and findings of several previous reports
including:
the Cadbury report (1992) on those aspects of corporate governance relating to
financial reporting and accountability
the Greenbury report (1995), which considered levels of directors remuneration
the Hampel report (1998), which reviewed the implementation of the previous
two reports
the Turnbull committee on internal control
the Higgs Report on the role and effectiveness of non-executive directors
the Smith Report on audit committees
the Tyson Report on the recruitment and development of non-executive
directors.
The full Code consists of four sections relating to the principles to be observed by
boards and companies, these cover issues relating to:
1. the role of directors
2. remuneration
3. accountability and audit
4. relations with shareholders
The sections on companies place considerable emphasis on the role, and independence,
of non-executive directors in scrutinising company operations.
Related guidance and good practice suggestions incorporated in the Code cover:
guidance on internal control (the Turnbull guidance)
guidance on audit committees (the Smith guidance)
suggestions for good practice from the Higgs report including:
guidance for the chairman
guidance for non-executive directors
summary of the principal duties of the remuneration committee which
determines the remuneration of senior executives
summary of the principal duties of the nomination committee which is
responsible for the appointment of new directors.
Chapter 6 Solutions
Solution 6.1
Solution 6.2
These requirements are intended to limit operational risk the risk of losses due to
failure of people or processes within the intermediary itself. In practice, operational risk
is often also defined to include losses due to external events, eg earthquake or bomb.
Solution 6.3
Solution 6.4
Solution 6.5
1. the direct costs that arise in administering the regulation and in compliance for
the regulated firms. In practice, most of these direct costs are borne ultimately
by the investor in the form of either higher taxation to fund the regulator and/or
higher charges and fees for the financial services that are purchased.
Solution 6.6
Solution 6.7
A contract for difference is a form of contract that allows people to profit from share
price movements without actually dealing in the shares. They are similar to forward
contracts and investors can go short or long, allowing them to make money from falling
markets as well as rising markets.
Solution 6.8
Solution 6.9
Solution 6.10
Solution 6.11
Solution 6.12
The main advantage would be one of cost. Building models for each of these risks is
extremely expensive and time-consuming. The SCR standard model allows companies
to quickly produce something that is sufficient and satisfies the regulator.
Also, the standard model is the product of years of research and consultation by the
regulator. It will be an excellent model for most typical insurance companies.
The standard model can be used in combination with internal models if necessary in
order to better cope with a particular form of risk or a peculiarity of the particular
company.
Because many companies will be using the standard model, there will be plenty of
inspection and data collection. Over the years this should improve the model and the
data that is used to calculate the SCR.
Solution 6.13
Internal models will represent the peculiarities of the individual company better than the
one size fits all approach of the standard model.
It will also encourage the company to invest in risk modelling and risk management.
This generates a culture within the organisation that risk is important and should be
monitored and controlled in all parts of the business. This is what the regulator is
aiming to achieve in an organisation.
The building and parameterising of a model will be a useful education for the company
about the risks it faces and the impact of those risks.
One of the biggest criticisms of the standard model is that too many companies will be
using it, which could generate a systemic risk within the insurance industry. For
example, if the model handles a particular branch of insurance in a favourable manner,
then the capital required for that line of business will be small. Since returns on risk
adjusted capital will seem high (because the risk adjusted capital required is too small),
many companies will try to write this business. This could lead to overexposure of the
entire industry to a specific risk, which, if it materialises, could create a systemic risk to
the system.
Solution 6.14
Solution 6.15
Solution 6.16
The main role of non-executive directors is to provide an impartial view on the board of
directors and in particular to represent the interests of the shareholders.
Solution 6.17
Solution 6.18
The nomination committees main responsibility is for the appointment of new board
members.
The audit committees main responsibility is to ensure that the company has appropriate
levels of financial reporting and appropriate financial and risk controls.
Solution 6.19
The Higgs Report, which has been incorporated into the UK Corporate Governance
Code, defines an independent non-executive director as follows:
A non-executive director is considered independent when the board determines that the
director is independent in character and judgement and there are no relationships or
circumstances which could affect, or appear to affect, the directors judgement.
Solution 6.20
The three key requirements placed on the board as regards accountability and audit are:
1. the board should present a balanced and understandable assessment of the
companys position and prospects
2. the board should maintain a sound system of internal control to safeguard
shareholders investment and the companys assets
3. the board should establish formal and transparent arrangements for considering
how they should apply the financial reporting and internal control principles and
for maintaining an appropriate relationship with the companys auditors.
One of the most effective ways of regulating a complex system is to force the providers
to disclose all their flaws and inadequacies clearly to the buyer of the product, and then
to let the market do its work. This works to an extent. However, banks are complex
organisations and it is very easy for a bank to present a set of accounts that look fine
when the bank is actually in dire straits. Hence we cannot rely solely on this route.
The Basel Committee envisages that, as a result of the Accord, the total amount
of regulatory capital supporting banks world-wide will remain unaltered, but that
its distribution will shift from less risky activities to more risky activities. One
outstanding problem, however, is how a banks exposure to operational risk can
be measured.
This is due to the lack of historical and publicly-available data that can be used to assess
this risk compared to say credit risk and market risk.
Question 12.9
How would you estimate the amount of operational risk faced by a bank if you had
access to both external and internal management information?
On January 6, 2013 the global banking sector won a significant easing of Basel III
Rules, when the implementation schedule was extended until 2019 (but see EU
legislation later) and the definition of liquid assets was broadened.
1. Regulatory Capital
Regulatory capital
Risk - weighted assets
Question 12.10
How might a bank raise its ratio over the coming years, if it is lower than the regulatory
minimum, and what would be the effect on the economy?
The changes in how the RWA is calculated have on average increased it by 23%.
Changes include an increase in RWA amounts from trading activities resulting in
many banks reducing the amount of trading they undertake which in turn has
lead to fewer banks quoting prices and consequently
reduced liquidity and
increased costs and
risks for corporates managing their financial exposure.
Leverage ratios
Basel III also introduces a Leverage Ratio such that the amounts of assets and
commitments should not represent more than 33 times the Regulatory Capital.
This is regardless of the level of their risk-weighting and of whether credit
commitments are drawn down.
The Liquidity Coverage Ratio (LCR) requires that the high-quality highly-liquid
assets held must exceed the net cash outflows for the following 30 days. The
Committee developed the LCR to promote the short-term resilience of the
liquidity risk profile of banks by ensuring that they have sufficient High Quality
Liquid Assets (HQLA) to survive a significant stress scenario lasting 30 calendar
days.
Expected cash inflows are, however, not allowed to cover more than 75% of the
expected outflow. This is to ensure that the bank has to maintain a minimum buffer
of HQLA worth 25% of the expected cash outflow at all times.
Question 12.11
Total net cash outflows is defined as the total expected cash outflows minus
total expected cash inflows in the specified stress scenario for the subsequent
30 calendar days. Total expected cash outflows are calculated by multiplying the
outstanding balances of various categories or types of liabilities and off-balance
sheet commitments by the rates at which they are expected to run off or be
drawn down.
In other words, the total expected cash inflows are limited to 75% of the expected
outflows.
The Net Stable Funding Ratio (NSFR) requires that long-term financial resources
exceed long-term commitments, where long term means more than one year.
The main change for banks is in the liquidity ratios (LCR and NSFR). The
definitions are very severe for the corporate sector.
Basel III aims to sharply deleverage the economy which threatens economic
growth at the same time as the debt crisis puts a pressure on governments to
spend less. The need to deleverage the economy is important, but the design of
Basel III has meant that the corporate sector must rely, to a large extent, solely
on funding and hedging from outside of the banking sector.
The basic role of redistributing financial risk and fund trade has been taken from
the banks.
Basel III is relatively new and is still at the discussion stage. However, the concepts are
important as they will shape the regulation sector in many countries for years to come.
There are plenty of websites that discuss the various ideas explained above and they are
worth visiting.