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Diversification could reduce capital requirements by 50%, says ABI

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Risk diversification should typically reduce capital requirements for British life insurers by between 25% and 50% under the Financial Services Authority's new individual capital assessment regime, according to a report commissioned by the Association of British Insurers (ABI).

The conclusion of the report, entitled Key correlation assumptions in ICA for life offices, will come as welcome news to UK insurers, who are still getting used to their regulator's new risk-based capital adequacy framework which came into play at the beginning of the year. European insurers in general have been pushing regulators and rating agencies to take account of diversification across business lines when assessing capital adequacy.

"If the effect of risk diversification is not fully taken into account then capital levels will be set too high, with adverse effects on the price of life insurance products and the returns customers receive on their investments and pensions," warns Peter Vipond, the ABI's London-based director of financial regulation and taxation.

The report examines correlations in four key areas, such as the relationship between market risk and lapse/surrender risks. Here the report gives an indicative correlation of between 0% and 75%, "with many companies using values in the range of 25% to 50%". On the relationship between market risk and mortality the researchers conclude there is little explicit evidence of direct linkage between variables, with indicative correlation set at between -10% and 10%, but typically taken as 0%. The indicative range for the correlation between annuitant mortality and assured lives mortality, the third key area covered, is between -75% and -20%. Finally, the researchers considered intra-market correlation factors, offering a range of indicative correlation numbers (see table).

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