PLANEAMIENTO DE LA PERFORACIÓN DIAMANTINA 1 Programación de los Sondeos

Traditionally, industries are candidates for regulation, when there is one of the following three situations: first, consumer asymmetric information (leading to the possibility of market breakdown); secondly, externalities present mean that the actions of one supplier may spill over onto other producers; or thirdly, if there is the possibility of the abuse of market power. As Davies (2004) notes, the supply of annuities is heavily regulated, because all three of these situations apply. Annuity providers are regulated in three ways: firstly in terms of the way information is provided to consumers (FSA); secondly through the design of products which are acceptable to the Her Majesty’s Revenue and Customs (HMRC) (since pension contributions benefit from tax deductions) and the Department of Work and Pensions (DWP) (through ‘protected rights’ obligations) and thirdly by solvency regulation of the annuity provider in terms of reserves and capital adequacy (FSA). In fact the first and third of these regulations, are statutory objectives of the UK’s FSA. The first falls within the FSA’s remit of promoting public understanding of the financial system, and the third relates to the FSA’s obligation to secure an appropriate degree of protection for consumers.

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As we have already discussed, annuities are complex financial products, the characteristics of which are not easily understood by consumers, so that like ‘treatment goods’, it is only long after the event of purchase (approximately if the annuitant lives for longer than their life expectancy) that annuitants appreciate the benefit of an annuity product. As the Equitable Life case illustrates, assumptions made by one annuity supplier can impact on the rest of the industry. Finally, as Table 6.1 shows the industry is highly concentrated, and although we have documented no abuse of monopoly power in the relatively small purchased life annuity market, the evidence on the pricing in the compulsory annuity market is less well- documented. Indeed, the government introduced the open market option in 2002, which requires that personal pension providers must inform the upcoming pensioners, that they have the right to annuities with an alternative annuity provider. As we have discussed in Chapter 3, Stark (2003) notes that a third of annuitants exercise this option.

Annuity holders are protected from insurance company insolvency by reserving and capital adequacy requirements. Daykin (2001, 2004) outlines a number of issues in reserving for annuities. He notes that reserving may be carried out for a number of different reasons: a) to support the sound and prudential management of the insurer; b) to ensure that the insurer’s accounts give true and fair picture of its assets and liabilities; and c) to provide information for tax authorities. As we note below, these reasons may not be in conflict: the FSA (2005) recognises that if an insurer’s accounts give an accurate picture of its asset-liability mix, then this will ensure that the market will provide the discipline that the insurer practices the appropriate level of prudential management.

Capital requirements for insurance companies, and specifically for annuities (Article 2), are covered by the European Union Directive 2002/83/EC concerning life assurance, Article 28, which states that the required solvency margin should be equal to the sum of a ‘four per cent fraction of the mathematical provisions relating to direct business [net of reinsurance]...[plus]...for policies on which the capital at risk is not a negative figure, a 0.3 per cent fraction of such capital underwritten’

(paragraph 2a, 2b). In addition, Article 29 states that ‘One third of the required solvency margin as specified in Article 28 shall constitute the guarantee fund. This fund shall consist of the items listed in article 27 (2), (3)...The guarantee fund may not be less than a minimum of Euros 3million’ (Article 29 paragraphs 1 and 2). The UK’s FSA makes clear in FSA (2005) that ‘It is widely recognised that the existing capital requirements for insurance companies as set out by the European Directives are inadequate and not sufficiently risk-sensitive’ (paragraph 3.5, page 19).

The EU’s Solvency 2 programme is intended to apply to the insurance industry, the regulatory approach adopted in the Basel 2 reforms for the banking industry. Basel 2, consists of three regulatory pillars. The first pillar consists of risk responsive capital requirements; the second pillar consists of additional capital requirements imposed by the regulator following individual company risk assessments; and pillar 3 relates

to disclosures to ensure market disciplines can operate. However, the timetable for Solvency 2 has fallen behind and is not expected to be implemented until 2009. In the meantime the FSA has recognised the shortcomings of the existing EU insurance directives, and has proceeded with its own risk-based solvency requirements, in part anticipating the likely Solvency 2 rules. Muir and Waller (2003, p.2) note that the reason for the FSA’s need to implement reforms in advance of a European-wide approach, relates to a number of events in the UK’s insurance industry, including the closure of Equitable Life, the Sandler Review of Medium and Long-term savings in the UK, a number of high profile compliance failings, and the fall in equity values after 2000.

The new capital requirement reforms outlined in FSA (2005) came into effect from January 2005, and apply the principles enshrined in the proposed Solvency 2. These are based on a ‘twin-peaks approach’ risk-sensitive regime for with-profit insurance companies: a regulatory peak and a realistic peak. Both of these peaks constitute Pillar 1 of the regulatory regime. Under the FSA’s Integrated Prudential Sourcebook (PRU 2.1) an insurance company must maintain capital resources no less than its Minimum Capital Requirement (MCR), which follows on directly from the EU Directive (four per cent reserves), and is equal to its base capital resources requirement, of Euros 3million (which, starting from the review date of 20 September 2005, increases annually by the European Index of consumer prices from 20 March 2002) (PRU 2.1.27). In addition, life firms that have with-profits liabilities in excess of £500million, must make realistic assessments of their risk- based capital to satisfy the realistic peak, referred to as the resilience capital requirement which arises from market risk for equities, real estate and fixed income securities (PRU 4.2.11). The realistic peak requirements only apply to firms that write significant with-profits business, so that annuities that are written in separate non- profit funds would not be required to comply with the realistic peak, but annuity business written in funds that included significant with-profit business would have to comply.

Furthermore, under Pillar 2 of the new regime, firms must carry out individual risk assessments, relating to other types of risk (group, operational, insurance (including longevity), credit, and liquidity risks) based on stress and scenario testing, to determine whether they need to hold additional capital. The need to hold additional reserves to satisfy the Pillar 2 requirements depends on the views of the senior management of the company and private discussions with the regulator, and since 2002 firms and the FSA have been preparing for the new system. The FSA also intends that a company’s realistic balance sheets will be published, to allow the market to discipline companies, in line with Pillar 3.

It seems appropriate that the risk of annuities be assessed on an individual firm basis, since the risks for insurance companies selling annuities, will be offset by the sales of life insurance by the same company that will act as a natural hedge against longevity risk.

Prudent management of reserves is important, and imprudent management can have catastrophic consequences as illustrated by the Penrose (2004) report into the Equitable Life case. Equitable Life is the UK’s oldest life assurer and during the 1970s and 1980s had offered deferred guaranteed annuities (strictly speaking the option to buy an annuity at a guaranteed rate) to individuals who saved through an Equitable Life personal pension. However, the company appeared to have made no charge for these guarantees nor made any attempt to set aside reserves to cover the cost of the guarantees. These options were out-of-the-money at the time they were made, because nominal interest rates were high during these periods, but as interest rates fell during the 1990s, the guaranteed annuities moved into the money. Other companies who had also offered these guaranteed annuities undertook prudential management in a number of ways: reserving, capping and reinsurance. However, Equitable Life sought to manage these liabilities by paying out smaller terminal bonuses on the with-profits personal pensions to those policyholders with guarantees than those without (to the detriment of the policy holders with guarantees). In the event the Law Lords ruled that this discrimination was illegal, and as a mutual insurer, all policyholders were liable for the guaranteed annuities. In the event, the non-guaranteed policyholders received reduced terminal bonuses to honour the guarantees. This made non-guaranteed policies uncompetitive, and the fund was closed to new members in 2001. This case illustrates the importance of sound and prudential financial management and the role of reserving.