5-6 February 2003

Thank you for inviting me to speak at your 20th Anniversary Conference on Life Insurance. The fact that it has become an important event in the calendar of the Life Insurance industry is a testament to the quality of the conferences you have staged over the years and perhaps, also, the increasing level of interest in what used to be an inpenetrable sector of the financial markets. I hope those days are gone and that Life Insurance companies are fully engaged in working with the FSA, and the Government to take the lid off the black box for the benefit of consumers and followers of the Life Insurance sector. From where I sit, I do detect an increasing commitment to this. I hope your conference also benefits from the quite dramatic improvement in statistics about mortality and that you can now look forward to at least another 65 annual conferences. When I accepted this invitation back in Autumn, we agreed on a title – current consultations and the regulatory agenda – which left scope to adapt the subject to the most topical issues. We could not have known at that time just how topical the regulatory agenda for life insurers would be – I was in a hotel room in Denver, Colorado on Monday and CNBC had an "expert" on analysing the market movements who said he was "not sure what FSA" stands for but the letter they had written to firms on Friday was surely one of the key movers of the market. Well, not all of the regulatory agenda is as market sensitive as we have seen over the last few days (and yesterday’s market shows there are clearly other important factors) but we believe it is crucial that senior management understands and engages in this major programme of change for insurance regulation we have embarked upon. I will come onto a number of these initiatives later in my remarks but first I thought it would be helpful to explain some of the background to the letter I sent on Friday to the Chief executives of all life insurance companies operating in the UK.

My letter referred to the significant impact that falling equity prices were having on the financial position of life insurance companies and to the difficult decisions that Boards and senior management of those companies were having to make about what actions to take to protect policyholders. It reminded them that we stand ready to discuss these decisions with individual firms and, most importantly, set out particular considerations that we would take into account in those discussions.

The letter drew attention to the potential for mis-interpretation as to the meaning of our current regulatory requirement for an insurance company to maintain a minimum margin over solvency – referred to as the required minimum margin or RMM. Although sometimes referred to as statutory or regulatory solvency, the RMM does not represent solvency in the traditional use of the term. It is a regulatory trigger point, that is a cue for more intense regulatory attention, and not the point at which breach necessarily suggests an inability to meet contractual obligations as they fall due. Nor is the RMM even, as one might suppose from its name, a description of the level of capital that an insurance company needs to maintain in excess of its liabilities. You may have seen some press reports saying the RMM is set at 4% in excess of liabilities. The RMM is indeed 4% but it is not in excess of any realistic calculation of liabilities. It is 4% in excess of a complex actuarial calculation that is called the mathematical reserves. Mathematical reserves are a deliberate overestimation of contractual liabilities, which in addition include some implicit provision for future discretionary benefits. The degree of over-estimation – or as we regulators prefer to call it, prudence – depends on a complex inter-action of the detail of our regulatory rules and an insurance company’s bespoke insurance products and other circumstances and in some cases may be very large.

This overestimation, or prudence, is not in itself a bad thing except that due to the way that our rules require it to be calculated it has two unhelpful features.

  • First for some firms, even in normal equity market conditions, it can be so large as to be excessive. The prudence required is not robustly related to risk.
  • Second, for many firms writing traditional with-profits insurance, the prudence required increases as equity values fall. Following a sustained and large fall in equity values it can become excessive. The reason for this is simple. Following a sustained fall in equities, after perhaps some delay, the benefits that an insurance company pays out to its with-profits policyholders typically fall. The contractually guaranteed benefits remain unchanged but future discretionary bonuses may be cut. However, the mathematical reserves held to meet those benefits does not fall or, if they do fall, only by a little.

When I launched the Tiner review of the future of insurance regulation one of the early actions I identified was the need better to understand the extent to which mathematical reserves overestimated liabilities and how that overestimation or prudence affected the difficult decisions that insurance companies needed to make. From this work it became clear, due to the way the rules require mathematical reserves to be calculated, that some insurance companies feel under pressure as equity prices fall to sell equities to continue meet our RMM, even though they reasonably consider holding equities to be prudent and good value for policyholders.

In my letter, I sought to make clear that, where the existing rules were requiring excess prudence, we would be prepared to relax those rules. However, insurance companies would need to demonstrate that in their particular case the existing rules were excessively prudent. They would do this by calculating their realistic liabilities, including a safety margin on top of those realistic liabilities to take account of risks not picked up in the realistic calculations themselves. Where this proved to be a significantly lower number than that required by our existing rules, we would consider relaxing those rules.

I should make a few points as to how, in these cases, we would relax the rules, as this did not come across altogether clearly in the press reports.

  • We do not propose to waive the 4% RMM in excess of mathematical reserves. This will remain. It is the detail of the rules as to how mathematical reserves will be calculated that will change. Mathematical reserves will remain a prudent overestimate of contractual liabilities but the degree of that overestimation may be reduced where it is excessive.
  • We will make it a condition of this waiver of the existing rules, that the insurance company remains adequately capitalised on a realistic basis. That is its assets need to exceed not only realistic liabilities but also the safety margin in excess of realistic liabilities to which I referred to a moment ago.

In addition, I should make clear that we would only waive our existing rules to the extent allowed by EC law. The EC directives on insurance regulation lay down some detailed rules on how mathematical reserves should be calculated. Our UK rules implement these EU rules and add more detail. It is only in the area of this extra detail that we would grant waivers. However we believe that, for the present circumstances, this gives ample scope for insurance companies to obtain the waivers they need.

This leads me to the question of what are the areas of our existing rules that, on occasions, can give rise to excessive prudence and that we can waive because they are not required by the EU directives. I do not intend here to give a definitive list but I would identify two key areas.

  • First, as already mentioned, following a sustained fall in equity values the benefits paid to policyholders typically fall but the mathematical reserves do not fall or only fall a little. This is due to several reasons but one of the main reasons is that the implicit margins included in mathematical reserves for future discretionary bonuses (under an arcane actuarial rule called the "net premium" method) remain largely constant even though bonus levels are falling. We would consider waiving the "net premium" rule relying instead upon the "realistic" assessment of liabilities to ensure that an insurance company remains sufficiently strong financially.
  • Second is the difficult area of the valuation of guarantees. We see two aspects that could be reconsidered. The first is our guidance on annuity guarantees, which many believe set an unreal standard. We would consider waivers here where accompanied by a more realistic approach to the time value of such options. Similarly our rules require a strict approach to persistency of policies to eventually reach and claim against the guarantees at particular dates, particularly on unitised with-profits business. This may also be an area for waivers, though a large degree of prudence is still required for guarantees that bite long into the future.

There is one final point I want to make on our approach to waivers. Our purpose, as I stated at the beginning, was to facilitate the management of insurance companies in taking the difficult decisions that they have to make based on sensible financial analysis. We do not plan to confine this only to those firms that are pressing against their RMM under the existing rules. We intend that insurance companies that are well in excess of their RMM would be welcome to apply for these waivers where this would be helpful to them in the management of their financial affairs, including their investment strategy. This reflects our longer term aim to amend our rules early in time for early 2004 for all major firms to remove the need for individual waivers.

This recent initiative is just a part of the wider, longer term programme of reforming insurance regulation. I should briefly re-cap on the context of this work, which started with my own review of the future of insurance regulation, commissioned by the FSA’s Board following the Baird report into Equitable. We set out in both reports on the Tiner Project the three broad areas which we would review – I am sure you have all read the reports cover to cover but for the benefit of those of you with short memories I will repeat the three workstreams:

  • Getting a fair deal for consumers
  • Smarter regulation, and
  • Soundly managed insurance firms with adequate financial resources – which is essentially about prudential issues, and this is clearly where the realistic solvency work fits.

I do not intend to run through the list of all of the different initiatives and policy developments under these three headings but I thought it would be useful to update you on a few examples. Although the last of these workstreams refers to ‘soundly managed insurance firms’, I would argue that sound management is key to all of our proposals and essential if the industry is to regain some of the reputation it has lost over recent years.

Two of the major initiatives in the prudential workstream were aimed at strengthening the governance of life insurers. These relate to the role of actuaries and the governance of with-profits business. We have recently published detailed proposals on these initiatives.

Our proposals on actuaries stem from a review of the traditional role of the appointed actuary in the governance of life insurers, in the light of the new Financial Services and Markets Act regime. Central to this is the responsibility of the governing body for all key decisions relating to the business and for complying with our high-level requirements, including treating customers fairly. For life business, actuarial advice is an essential component of this decision-making.

We are therefore proposing that:

  • all life insurers must have an actuarial function responsible for providing actuarial advice to the governing body, in particular on the valuation of policyholder liabilities.
  • Firms carrying on with-profits business would also have to have a with-profits actuary, to provide technical advice on areas where discretion is exercised, such as bonus rates.
  • The scope of the audit would be widened to include the valuation of policyholder liabilities and, in reaching their opinion, the auditors would have to take advice from an actuary who is independent both of the insurer and its actuarial function
  • The information currently published in the appointed actuary's report would be provided instead in a "management report" from the directors.

We think these changes would improve consumer protection, in particular by having the entire balance sheet subject to inspection by the auditors including a review of the valuation of liabilities on the basis of advice from an independent actuary. We recognise that the actuarial profession would prefer us to require the publication of an independent actuarial review of the valuation of policyholder liabilities. However, we do not think that this would be as effective in influencing the behaviour of firms' governing bodies as our proposed package of measures.

The changes we are proposing in the governance of with-profits funds are designed to improve transparency in firms' use of discretion and how they have managed any conflicts of interest and ensured customers are treated fairly. We are proposing that firms document, and make publicly available, the "Principles and Practices of Financial Management" (or PPFM) they use in exercising their discretion in managing with-profits funds. Governance arrangements for with-profits business should ensure that the PPFM are complied with, and an annual report to with-profits policyholders would be introduced. One way to comply with these new high-level requirements would be to set up an advisory committee of the governing body – a With-profits Committee – including some external non-directors.

Again, some people are uncomfortable with some aspects of these proposals. The value of requiring insurers to define and publish their PPFM seems to be generally accepted but there are concerns about the cost of producing these and doubts about their value to consumers. Our current view is that opening up the ‘black box’ of with profits products in this way is key to improving consumers’ understanding and we would expect firms to rise to the challenge of communicating clearly and fairly with their customers. Improving the transparency of with-profits is recognised as desirable but our proposals for With-profits Committee have been criticised for introducing either too much, or not enough, external involvement in governance arrangements: so maybe we have it about right.

We have sought comments on these two initiatives before the end of April and, subject to the results of the consultation, plan to bring any changes into effect by early next year. This would impose a tight timetable on the industry, and the actuarial and accounting professions, but we consider these initiatives to be a key plank of our reforms and I would encourage you all to engage in this consultation as soon as possible.

On the second workstream of getting a fair deal for consumers, one of the major pieces of work on our agenda over the last year has been a review of the product disclosure regime – known in some quarters as ‘Son of Key Features'. We are planning to publish this paper in a few days time. It has been a long time coming - and some might ask why we've waited until now, particularly since Raising Standards has made a significant contribution in terms of improving the quality of firms' literature - including Key Features documents - and we hope that this work will continue so making more firms aware of the importance of plain language and thoughtfully constructed and presented information. Not to mention the other important customer-focused standards that Raising Standards has worked to deliver.

So why have we chosen this moment to launch the new regime - Key Facts - on an industry that we know is feeling rather embattled, and seems to be trying hard in all sorts of positive ways? We're not ignoring all that Raising Standards has achieved. But I'm sure you'll recognise that the scheme has been constrained in what it could achieve because it has had to work within the current regime, which we know brings with it all sorts of problems. Consumers don't want to read Key Features, and when they do, they often find them difficult to fathom - not least because the information we currently prescribe is complex and some of the messages can get lost. In contrast to Raising Standards, we have been able to take a blank sheet of paper to try out our ideas, and we've been able to consider new approaches, some of which have worked, and some of which we've rejected.

We know that that change to the current approach will bring costs. But we believe that the new measures we're going to propose will bring clear improvements, in terms of consumer use of the document, and their understanding of the key messages it presents.

So what exactly are our new proposals? Key Features will be replaced by a document called 'Key Facts'. This will be a brand, with its own logo, that we're going to make extensive use of, to help consumers spot important information. We hope that its wider use will mean that over time, people will start to look out for the Key Facts logo when faced with a pile of paperwork, to tell them where to start.

In terms of a product information brochure, we will specify quite precisely how the Key Facts document is going to look, and we will market that document to consumers as a source of information about important features of a product, and about its cost. The content won't be that different to a key features document - and for Raising Standards firms, we think the transition will be easier because they have already taken on our key requirements about plain language and organising the information.

One new feature will be the Quick Guide. This is a brief (one or two page) summary of key factors that a consumer should take account of when thinking about whether or not the product is a good fit for them. In industry jargon, it focuses on 'suitability' factors.

The big changes on content - which we know will be expensive to implement - will be the move away from the current personal illustration to a much more streamlined and simplified example showing how charges can affect the growth of a product. This should, we hope, encourage consumers to do more shopping around, possibly using our Comparative Tables as a source of useful information.

These are a couple of examples of major policy initiatives. Changes are also underway in the relationship between insurance companies and their supervisors. Supervisors are now becoming more pro-active – all but the smallest firms will have been visited on site. In carrying out these assessments, supervisors will be applying their own judgement assisted by market data and knowledge. We believe that leveraging our unique insight of an entire industry sector give us a powerful tool to challenge the behaviour and assertions of firms. As part of this process, supervisors are paying ever-increasing attention to the quality of insurers’ risk management and internal control systems and I thought you might be interested in what we have found so far.

In our analysis of the results of the 240 assessments we have carried out to date risk management has been raised in a majority of assessments where we will be looking for continuous improvements towards the best practices which have emerged in some other sectors of the financial market. The issues identified range from high level corporate governance type issues to technical issues and included

  • Analysis and articulation risk appetite by Boards of Directors.
  • The scope of functions assessing risk in respect of non-insurance risk (for example such as credit and operational risk).
  • Management information related to risk.
  • Controls in respect of other group companies which may make it difficult to aggregate exposures to losses across the group.
  • The stress testing the balance sheet to various market conditions, an issue beigtened by recent market volatility; and,
  • Adequacy of internal audit functions.

These early findings demonstrate the benefits of our approach to risk assessments as we improve our ability to identify potential issues earlier on and pro-actively nip problems in the bud – either at the individual firm level or on a more thematic basis across the industry. Firms will see an increased intensity of supervision which reflects the increased risk profile presented by the sector. This will include more on site visits and wider use of the full range of tools provided by the Financial Services and Markets Act to mitigate the risks – a good example here would be the targeted use of skilled persons to review an aspect of a firm’s business. Industry-wide we have a number of projects, some of which were outlined in our recent Plan & Budget publication, such as continuing the role out of the Tiner recommendations on raising awareness of regulatory issues, transparency, corporate governance, and developing our rule book. Added to this, not surprisingly given what I have just said, will be a project looking at risk management across the industry. It seems to us that it would be useful if the output of this project could be made public in some form or other, in order to inform firms about best practices in the sector.

Before closing, I would commend to you a report from a working group of EU insurance supervisors, under the chairmanship of the FSA’s Paul Sharma. The purpose of this group was to use the practical experiences of supervisors to better understand the risks that can threaten the solvency of insurance firms. The basis of this exercise was the review of 21 recent cases of insurers (both life and non-life) from across Europe that had either breached their solvency requirement or had come close to doing so. They used these examples to develop a number of ‘risk maps’, which charted the typical chain of events that can lead to the failure or near failure of an insurer.

One of the key findings of the working group was that vulnerability to external factors, such as declining investment returns, could be traced to the poor quality of management in the firms. For example, poor or inexperienced managers might make inappropriate strategic decisions that expose their firms to excessive levels of risk. They might design inadequate internal control and risk management systems. Or they might inadvertently encourage their employees to take excessive risks by failing to create a prudent and considered culture towards risk in their organisation. The three key lessons identified in the report, for regulators were:

  • We need to ensure that insurers are able to cope with the financial effects of the risks that they are exposed to.
  • An effective prudential regime is not just about setting captial requirements and maintaining financial resilience, it is also about anticipating and preventing potential problems and ensuring firms do so.
  • Policymakers and supervisors need to pay more attention to internal factors such as the quality of management, the adequacy of corporate governance structures and the effectiveness of a firm’s risk management systems.

This may sound obvious – motherhood and apple pie from the regulators. But our experience from the risk assessments we have carried out so far shows that firms have not always learned the importance of this. In our regulation of insurance firms, as with other types of financial firms, we place the emphasis on senior management to put in place appropriate controls in place to manage the risks in the business. In forming any judgements about the firm, from individual waiver requests to the overall risk assessment of the firm, we take into account the quality of management and the internal systems and controls. For example, in relation to the possible waivers I mentioned at the beginning of the speech, we would not only expect to have regard to the realistic solvency position of the firm but also to the way in which the Board and executives run the business and pro-actively manage the financial condition of the firm.

I hope these examples have highlighted the importance of the regulator agenda to you and how you manage your business. We look forward to continuing and developing our dialogue with senior management in the industry, both on a bilateral basis with individual firms as part of the normal supervisory process, and on a multi-lateral basis through the trade bodies and industry associations on broader policy matters. I would encourage you all to continue to explain to your colleagues the regulatory agenda and the crucial role you, as senior management, have to play in it.

Many thanks.

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