MARKET COMMENT
FSA Treads Dangerous Path On Solvency

By James Carlisle
September 24, 2001

The FSA is treading a dangerous path with today's further relaxation of solvency requirements for insurance companies.

The precise details are contained in the FSA's press realease, but basically it amends the "resilience test". According to this, insurance companies had to consider the effect of a simultaneous 25% fall in equity markets coupled with a 3% rise in long-term interest rates. Apparently because of the lower inflation environment that now exists, William Hewitson, head of actuarial services at the FSA, wrote to insurance companies on 10th September (the day before the terrorist attacks on America) telling them that, instead, they should now consider a fall in equities of the greater of:

(a) 25%, limited to a fall to a level where the market PE is 75% of the inverse of the long dated gilt yield (for the current long gilt yield of around 5%, that would imply a market PE of 15 compared to the current market PE of about 17); or

(b) 10%.

Today's letter to insurance company actuaries further relaxes this test by saying that the "suggested figure of 10%...should not be regarded as an absolute figure that need be applied in all circumstances." Actuaries instead should "apply their professional judgement in this area."

The FSA is understandably keen to stop insurance companies from having to sell shares for technical reasons in a falling market. One of the FSA's goals is to maintain market confidence. To do this, it needs to help the market value assets efficiently and investors selling things for technical reasons doesn't help one bit. The last thing we need, of course, is for technical selling to become self-fulfilling and lead to a spiral downwards (which some sources suggest was part of the problem last week).

The trouble is that by relaxing the requirements now, by telling insurance companies not to worry so much about potential falls in shares, the FSA can't escape the fact that it is effectively saying that the market is better value now than it was before. Everyone will have their own view about this, but the fact that it's already fallen a long way is not a good reason in itself. Circumstances, and the market's perception of the future, are always changing and it's perfectly possible to think that the market is more expensive now that it was. Exactly the same percentage falls are also available to it now as were available before.

Perhaps the decision is necessary to protect confidence in the market now. We should also remember that actuaries should still be exercising their full professional judgment over maintaining solvency. But if the market continues to fall and insurance companies start going bust because they didn't sell shares sooner, then the effect on confidence in the market would only be eclipsed by the effect on confidence in the FSA. I don't envy Mr Hewitson having to make this sort of decision in the slightest.

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