UK: Deloitte Insurance Market Update (Part 1 of 3) - Introduction, Capital Alternatives, FSA Initiatives

Last Updated: 21 February 2005
Article by Icki Iqbal

Most Read Contributor in UK, August 2017

To insurance industry executives

Welcome to the latest edition of our Insurance Market Update in which we focus upon issues facing the life insurance industry.

 Insurance companies will have submitted their ICAs in time and started the new year with fingers crossed for the Financial Services Authority’s (FSA’s) verdict. Change continues to be the order of the day.

On financial management and reporting, the rules and text of the Prudential Sourcebook have only just been finalised, Sarbanes- Oxley is with us but some firms are threatening to de-list from the US stock exchange (in its many forms), operational risk measurement and control requires more work, IFRS looms in as yet unclear form and Solvency II is not that far away.

On the sales and marketing front, depolarisation and the menu system is now with us, and the Insurance Mediation Directive came into force on 14th January, in terms of how the FSA sees it. Pension reform seems miles away as they only come into effect in 2006. In reality, its implications are immediate. First companies need to assess how the market will change and then assess what opportunities it presents them with before judging the practical implications and setting in train the necessary systems and products.

In terms of operational management, systems have to be put in place to comply with whatever has been enunciated in the PPFM and assumed in the ICA calculations. There is an issue here that companies need to face up to. A recent Deloitte survey showed that very few companies have reliable and mechanised systems that connect actuarial models to the general ledger. In the new era of greater transparency and accountability with the need to Treat individual Customers Fairly, companies will have to be able to demonstrate that the charges and costs allocated to individual asset shares, for example, are "correct and fair".

The theme of this publication is maximising shareholder value. Running a business to maximise shareholder value requires giving attention to the wide variety of issues outlined earlier as well as other pressing day to day issues. Inevitably resources are finite and attention needs to be prioritised. Usually such prioritisation focuses upon the availability of capital and technology resources. Both are currently limited and the regulatory demands often have a first call on much of these.

However there is an even more important resource, management time. Some of the problems companies face today, have arisen because wrong decisions have been made in the past. The main problem was the failure to think through the longer term consequences of seminal changes such as the increasing power of consumers and their champions, the implications of the death of inflation and improving longevity. In general ephemeral pressures of today have got in the way of more strategic thinking.

In order to enable management to reassert control over their business, we contribute a series of articles in this issue.

We begin by looking at how to add value through capital management. Life companies have much to learn from banks on effective treasury management. In the first article we consider what can be done. One or two life companies are already making rapid strides but there is much that others can learn.

We next look at what Treating Customers Fairly (TCF) means for life companies. The challenge of course is to make it value enhancing. If it cannot be then, granted that TCF is a Good Thing, to borrow an expression from "1066 and all that" the inevitable implication is that the current valuations of life companies are too high.

The serene flow of pensions simplification can only be achieved with much furious paddling below the surface. We therefore look at the implications for front and back office systems. Whilst the devil is in the detail, the overall focus must not be lost sight of.

We then consider how the overlapping regulatory changes (PSB/IFRS/Sarbanes-Oxley et al) can be managed in a resource effective way so that the objective is to use the changes to the company’s benefit rather than because they were a mandatory requirement. 

Finally we shed light on effective tax risk management an important but under regarded way of increasing shareholder value.

Such has been the focus on ICAs that many will not have realised the swathe of changes to taxation presaged in the pre-budget announcement. Somehow companies need to be driving their tax position rather than reacting to it. So we consider ways of managing the tax risk in a thematic article.

The article is timely for two reasons. Firstly because of the possibility that some outsourced contracts might be subject to VAT if a case currently with the European Court of Justice is upheld. A technical update in this issue alerts readers to the threat.

Secondly, as part of the pre-budget statement, the Inland Revenue (Revenue) proposes an unprecedented scale of change to the tax regime for with-profits funds. It attempted to take advantage of the sterling work done by the life industry to produce Realistic Balance Sheets (RBS) by taxing the apparently free assets reported in Form 19 of the RBS. This approach demonstrated a fundamental misunderstanding of the RBS framework and could have a negative impact on policyholders by weakening the capital base of with profits companies as a result of increased tax liabilities. It is disappointing that given the good works done by the FSA and the industry in re-building with-profit business that the Revenue should propose regulation that could significantly damage the industry.

A very challenging timetable for consultation was in put in place and the industry unanimously rejected the proposals having presented some very well thought through and credible arguments. This is not the end of the story as the Revenue still wishes to introduce the proposed changes in the 2005 Finance Bill that would be effective from 1st January 2005. However, this does provide an opportunity for proper debate and consultation to ensure the Revenue’s concerns are properly addressed without adversely affecting life companies. Deloitte is participating in this process and in this issue our technical update section provides further details of the proposed tax changes.

Capital Alternatives

Different sources and types of funding carry different limits under PRU and may also have different strategic implications. The new regulatory framework highlights the need for life companies to review the structure of their funding and develop more proactive and forward-looking treasury functions.

With Special thanks to the Institute of Actuaries Working Party on capital management for life insurance companies.


In this article we consider how life companies can manage their balance sheet to enhance returns and to manage liquidity and solvency.

Definition of capital

All companies require capital, to finance cash flow imbalances on work in progress (working capital), to finance new developments and to act as a buffer to provide protection against risks inherent in or external to but which might impinge upon the business. Capital in the context of this article is available financial resources to meet ie fund the requirements outlined above.

Reasons for different types of capital

The sources of funding vary greatly. The ability of funding to absorb losses and its permanence vary. The cost of funding and the payment streams vary. Providers of funding can utilise the securitisation of funding sources to select a portfolio commensurate with their risk appetite. As a consequence more sources of funding improve market efficiency.

The Modigliani & Miller propositions suggest that the future profit stream of a company is independent of its capital structure and therefore there is no point to this article! Their proposition is however based on certain assumptions, closer inspection of these assumptions reveal the follow reasons for different sources of funding:

  • The impact of the funding on an investor’s tax charge.
  • The impact of the funding on the issuer’s tax bill.
  • The transaction costs associated with raising the different form of funding.
  • The impact of the different forms of funding on the potential financial distress of the firm, in particular the potential breach of regulatory limits.
  • The interpretation made by investors based on the source of funding chosen or the dividend paid.

The new regulatory framework highlights the need to revisit the funding structure of a firm. Such evaluation and consequential change can only add value to the extent that it impacts on the costs identified above. In addition the evaluation will highlight the strategic consequences of different sources of funding. For example, the issuance of debt can be interpreted as management’s confidence in the ability of the firm to cover the cost of financing while the issuance of equity can be interpreted either as management’s desperation to salvage a firm in dire straits, or their confidence in their track record, depending upon the terms at which further equity is sought.

Calculation of capital resources and requirements

The overall requirement is that Capital Resources (CR) must exceed Capital Resources Requirements (CRR). The three Pillar approach applies to Insurers. On a Pillar 1 basis, non-profit and linked companies and small with profit companies are required to meet the Minimum Capital Requirement (MCR). Larger with profits companies are required to meet the higher of MCR and Enhanced Capital Requirement (ECR) or realistic peak. The two peaks taken together are referred to as "twin peaks".

PRU makes it clear that a market consistent method must be used to assess the value of options in contracts. More modern, marketconsistent methods will be required in PSB. For example in the valuation of options that are currently only slightly in the money, or even out of the money, may yet become more valuable in future, if circumstances change.

Under Pillar 2 (supervisory review pillar), the FSA can "clawback" additional capital, where Pillar 1 is not deemed to be robust. Companies submit an Individual Capital Assessment (ICA) to the FSA covering in addition operational and liquidity risks. The FSA considers this and reports back to the company with Individual Capital Guidance (ICG) – in other words the FSA’s recommendation on the amount of capital the company should hold.

Up until now, EU Directives required financial groups to be prudentially supervised within each major business sector. For banking and investment firm groups, this supervision included the requirement to pass a capital adequacy test for the group. For insurance groups, the result of a group capital calculation must be reported, and supervisory action is liable to follow if the group does not pass this test. The Financial Groups Directive requires the introduction (from financial years beginning in 2005) of additional prudential supervision of those groups comprising significant elements of both insurance and banking/investment business, known as financial conglomerates in the directive.

Insurance groups which are structured as holding companies have in the past been able to increase the reported solvency/capital position of their operating companies through the use of leverage. Leverage is debt, including hybrid, which has been issued by the holding company and down-streamed as equity into the operating company. This has enabled holding company insurance groups to make use of the lower cost and tax-efficient benefits of debt to obtain regulatory capital credit within the operating companies.

The ability of insurance groups to maximise leverage within their regulatory solvency filings has diminished. This is due to a greater focus now by the FSA to look at the capital position of the Insurance Group and not just the reported solvency position of the operating companies. This insurance group analysis is captured through the Insurance Group’s Directive calculation.

Capital resources regulatory limits

The loss absorbance qualities are important when considering as insurance company’s capital. The following table describes the limits set under PRU 2.2 on the various types of capital which can be used to meet the overall minimum capital resources requirements for insurance companies as set out in PRU 2.1.

Key characteristics of different types of capital (ie. funding) 

Security has no fixed maturity date. In its purest form buyers of such a security gain a dividend or interest payments only in perpetuity. 

Fixed term
Security has a fixed maturity date on which the principal is returned to the buyers of the security. Example: Legal & General £5.875% 11 Dec 2031. 

Callable securities allow the issuer of the security to pay the principal back at least 5 or 10 years after issuance. This gives capital management flexibility to the issuer. Callable dates are usually discrete happening every 5 years from the first callable date with an associated Step Up.

Structures where the issuer has the option to redeem the securities before the maturity dated are commonly referred to by the final maturity date and the first optional redemption date, e.g. "20 non-call 10" means that the securities have a final maturity of 20 years but the issuer can choose to redeem them after 10 years.

Step up
The coupon/dividend gets larger on a pre-determined date or occurrence of an event. Typically used in conjunction with a Callable date so that if the Issuer does not "Call" the security then the investor is compensated with a larger coupon. The modest interest rate step-up at the first optional redemption dated has become a market standard for communicating the issuer’s intention to redeem the securities, resulting in "quasi-dated" pricing by institutional investors.

Example: Aviva £6.125% 16 Nov 2036 Callable 2026/Step Up to 5YrG+285bps. Note that this bond was issued at a spread of [185bps] to Gilts and the step up coupon is set at a spread 100 bps above the issue level for the 5 years following the Step up date. If the Bond were not called in 2026 the next Callable Date would be in 2031 where the coupon would reset to the then prevailing 5 year Gilt rate + 285bps.

Non-cumulative dividends
Dividends or interest payments can be cancelled by the Issuer and do not have to be repaid at a later date. Cumulative interest Cumulative Interest payments, if deferred, still have to be paid in the future.

Coupon stock settlement
Used in Innovative Tier I instruments to ensure that if coupons are cumulative and have been deferred they will be paid in the form of permanent share capital, a core Tier I capital item. This ensures the loss absorbing capability of the Innovative instrument. 

Hybrid Structures convert to a different form of security on certain trigger events. For example this is used in Innovative Tier I structures where the security converts to preference shares or ordinary share capital on breach of the Minimum Capital Requirements. Before any conversion the capital may perform like Upper Tier II capital (plus some extra charge) if the company breaches its capital requirements then the capital becomes Tier I when it is needed the most.

Tax relief
Capital securities can be designed to allow an insurance issuer to offset the interest payments against its investment income in its tax computation. So for its taxable life business, where tax is payable on investment income (I) less expenses (E), the interest payments would count as E or as negative I, where interest is receivable.

Management of capital resources and requirements

For all life Insurers there is a need to manage, and in some cases to increase, the regulatory capital in order to finance new business and other group developments over the next few years. In addition, some of existing regulatory capital may have a limited lifespan. Insurers should consider a more active treasury function with forward looking business models which can project over the next 5 years planning for business capital requirements. These include:

  • Planned existing and new business volumes based on expected accounting and regulatory framework.
  • Tax impact of different forms of capital.
  • Transaction costs associated with different forms of capital.
  • Regulatory capital requirements based on business plans.
  • Dividend policy.
  • Anticipated corporate actions.
  • Existing capital maturity dates.
  • Available regulatory capital resources.
  • Impact of projected results on rating agency ratios.

The model should be able to track ratios on a monthly basis and give forecasts on a frequent basis allowing management to assess its capacity to raise Tier II Capital. A Tier II plan put in place at the start of the year can give flexibility allowing any market opportunities which may arise to be taken. An even profile of existing capital maturity dates ensures that flexibility is maintained in the future and the Insurer will not have to finance large capital needs at inopportune times.

Issuance of capital securities is however just one way of increasing regulatory capital, other ways include optimising the asset mix, purchasing derivative protection and implementing other derivative strategies as well as financial reinsurance and securitization.

Fair play – turning the talk into action

The FSA’s Treating Customers Fairly (TCF) initiative has implications for the life insurance industry that reach far beyond good intentions and good PR. The FSA expects to see clear demonstrations of how TCF principles are woven into the fabric of your business, from vision and culture to practices and charges. It will take more than a few focus groups but differentiation and competitive advantage await those that take TCF seriously.

TCF is now firmly established as one of the FSA’s major crossindustry initiatives for the next few years. It comes as no great surprise in a time where:

  • The Sandler review declared the medium and long term savings industry to be inefficient with weak consumer influence.
  • The Treasury Select Committee (TSC) examining the subject of restoring trust in the UK savings market has stated that the industry needs "a thorough re-think of the nature of the products it sells, how it sells them and the after-sales service it provides".
  • Miss-selling continues to occur, most recently with splits and precipice bonds.
  • The Turner review of the pensions has highlighted the inadequacy of savings and described the "bewildering complexity" that exists.
  • The Department of Works and Pensions is focusing on Informed Choice in the pensions market.
  • Consumer organisations and media are becoming ever more vocal on the shortcomings of the industry.

It would seem inevitable that the life insurance market in particular is headed for a future when firms will be expected to show that they have heard and listened to the consumer voice more clearly than has perhaps been the case in the past.

What do consumers say about TCF?

Much work is to be done to develop a definitive view of fair treatment and the reasonable customer although it may be useful to highlight some sample views to help set the context. Recent research conducted by Deloitte solicited views about the financial services industry from consumers.

"I don’t expect to pay the same amount as someone who’s constantly claiming."

"If I had bad kidneys or something, I would definitely expect to pay more on life insurance. Common sense really." "A financial adviser has a problem when he walks through my threshold because he is a second-hand car dealer until he convinces me otherwise."

"I have very little trust for financial institutions I’m afraid. My feeling is that they look after themselves."

What does the FSA say about TCF?

In July 2004, the FSA published its "Progress and Next Steps" paper on TCF. The paper introduces TCF as an obligation that arises from principle-based regulation, as opposed to prescriptive rules and guidance. The FSA believes that the requirement to treat customers fairly underpins the efficient operation of the financial services retail market. The FSA is looking to senior management to embed TCF into their corporate strategy, and part of the pilot involved interviewing senior management to test their understanding and commitment.

It is suggested that firms address fairness by focusing on:

  • Corporate strategy and culture.
  • Product design and governance.
  • Financial Promotions.
  • Sales and advice process.
  • Information provided after point of sale. 
  • Complaint handling procedure.

All of these elements of this lifecycle apply to the life insurance sector, specifically where firms are operating in the retail market.

The FSA admits that a TCF statement of principle does not go far enough and so intends to provide examples of good and bad practice for firms, which it is developing over the next six months or so through discussions with industry and consumer groups. The FSA has invited firms to engage with it on what most effectively constitutes fair treatment, and how such approaches can be cascaded through organisations.

In terms of the FSA’s plans over the coming months, it is intended that supervisory activity will be extended over a range of different size firms and sectors. In order to help develop a better understanding of fairness, further work will be carried out to clarify aspects of the relative responsibilities of product manufacturers and distributors across all sectors.

A business solution for TCF

Responding to the principles laid down by the FSA will be a challenge for many firms. A lack of clear rules and guidelines will not excuse firms who have not reviewed their own business principles, practices and people to ensure that TCF is embedded in their firm’s culture.

In order to satisfy the FSA in future, firms will have to demonstrate that:

  • they have reviewed their strategy to ensure that it reflects TCF principles;
  • that these principles are reflected in processes that could have a bearing on the customer relationship;
  • that the practices that the firm adopts are TCF compliant;
  • that the culture of the business and the people in it are customer facing.

A starting point for assessing TCF compliance is the corporate vision. Does it even mention customers? Some corporate visions have been known to focus on the profitability of distribution relationships or products, so setting the tone for corporate strategy that could dilute any TCF policy. Secondly, does the vision for the business describe how customers should be treated and what the firm will deliver to them? TCF goes to the heart of the future of the business. Without a customer facing vision, firms may find it hard to set the right tone for strategy.

When reviewing whether the strategy for the business can be said to be TCF-oriented, firms should ask themselves:

  • Is our overall corporate strategy aligned with TCF?
  • Which businesses are we in?
  • - Can we be truly customer facing with the mix of business we have? 
    - Do we need to shed some business lines or acquire others?
  • Target Markets
  • - Do we really understand who buys our products? 
    - Do we understand their real needs? 
  • Products

  • - Have we stress tested them for our customers? Are they all adding real value to customers?
    - Can we deliver even better value? 
    - Do we make it clear what the risks of buying are?
  • Distribution
  • - Are we investing in channels that add value to customers? 
    - Are we rewarding distribution for the value they deliver? 
    - Do our channels have TCF strategies
    - should we withdraw from those that do not?
  • Operations
  • - Does outsourcing help or hinder TCF?
    - Do we really deliver customer service?

This review should show either a confirmation that the vision and strategy are clearly TCF oriented or that a re-articulation or revision of both is required. Furthermore, a set of principles should emerge that can guide the development of processes and practices across the business.

TCF in practice

Some financial services firms have already progressed the development of a set of principles that guide the firm and impact on the business strategy. Examples of TCF style principles from other businesses include:

"The Partnership aims to deal honestly with its customers and secure their loyalty and trust by providing outstanding choice, value and service."

The Principles of the John Lewis Partnership serve everyone.

We aim to cater for the needs of the young, the old, those with disabilities, busy families; in fact to serve the whole community. provide a high quality service.

We seek to offer a friendly, courteous and efficient service to all our customers. provide quality and value for money.

We offer good quality products at fair prices and all our grocery products are backed by our unique guarantee. provide accurate information and to respect our customers’ rights. "We will always aim to adhere scrupulously to all laws designed to protect the customer, and to describe our goods and services accurately, giving as much information about them as we can. We will campaign to secure further legal safeguards wherever we believe the consumer is vulnerable in order to raise standards of protection for all."

Excerpt from The Co-operative Group Statement of Principles

However, TCF goes well beyond strategy and setting principles. It must pervade the whole business. Business practices must be seen to reflect the TCF principles. The industry has recently faced a number of challenges from the FSA and TSC. Although not all obviously linked to TCF, all of the following market issues could be argued to have TCF implications:

  • Depolarisation – many firms are going through the process of aligning themselves with different providers and/or intermediaries. This process and the decision making criteria that are applied could be subjected to a TCF review. One of the impacts would be that a customer perspective should be taken and the benefits to the customer of each decision should be demonstrated.
  • Commission levels and structures – the TSC has already raised the question of whether trail commission is always acceptable. Furthermore, the advent of the FSA’s Menu of commission levels will raise consumer and media awareness of intermediary remuneration. In conjunction with a review of charges, firms may need to consider whether the level of commission and the structure of payments are fair to customers, who after all ultimately pay for it but may not realise the impact on the performance of their funds. Does remuneration reflect the effort, skill and time that are applied to the sale?
  • Charges – 2004 has seen some firms increasing charges on retail product. In a world of low inflation and relatively low investment returns, firms are likely to come under increasing pressure to justify the value of charges to customers. The launch of the new stakeholder suite of products in 2005 may again bring charges into the spotlight.
  • Product risk profiles – the TSC has presented the industry with the challenge of developing a set of risk profiles that can be communicated clearly to customers. Firms will need to work together to develop consistent messages that facilitate better customer understanding of risk and reward trade-offs.

Developing an approach to TCF

2005 is likely to see many life Insurers focusing their attention on TCF. In doing so it is important to remember what TCF is not. TCF is not:

  • just an issue for compliance – it needs to be embraced across the organisation and in particular by senior management;
  • something that the marketing department does – customer fairness should be considered in all parts of the business;
  • just about running some focus groups – understanding customers will be important and customer research and interaction will form a part of the TCF jigsaw but on its own will not convince the FSA of a firms intent;
  • simply a box ticking exercise – whilst firms should introduce a structured approach to reviewing their firms TCF strengths and weaknesses, a true TCF policy will be felt in the culture of the business;
  • something to be done half-heartedly – ultimately the FSA and more importantly customers will come to recognise such an approach.

TCF needs to be at the heart of the business and to be truly successful needs to move beyond the FSA’s immediate requirements. TCF presents the industry with an opportunity to regain the trust of consumers, regulator and government, to achieve real growth for the industry and, as markets become more efficient, to create shareholder value.

One of the real benefits of embedding TCF within your business could be to build sustainable competitive advantage in the marketplace. Most, if not all firms will go some way to adopting TCF practices and processes. The firms that excel at TCF and integrate the vision, principles and practices most effectively will be the ones that are best placed for prosperity in the future market.  

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To read part 2 of this article please click on the next page link below

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This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.