ASSOCIATION OF BRITISH INSURERS ANNUAL CONFERENCE
QEII CONFERENCE CENTRE, WESTMINSTER - 10 APRIL 2003
Howard Davies
Chairman, Financial Services Authority

I should begin by congratulating the ABI on their initiative in launching this Annual Conference. In the normal way, I take the view that there are quite enough financial conferences in London in any given year. Either I, or one of my senior colleagues, are invited to almost all of them. Not, I sometimes think, because people want to hear from us. I assume the calculation is that if we are speaking at a conference we can’t be doing anything else, more damaging to the industry.

But, in this case, I do believe there is something of a gap. There has so far been no opportunity for a roundup of developments in the insurance industry across the board.

I find the opportunity particularly useful at the present time. You do not need me to tell you that there is a huge amount of change under way in the regulation of insurance in the UK. And while we frequently find that most people in the industry support individual elements of our reform programme, they often say that it is hard for them to see the wood for the trees. So this morning I shall attempt, as Tommy Cooper used to say, ‘the impossible’. I will try to present a grand unified theory of regulatory change. And I am pleased to say that the organisers have given me through until lunchtime to do so.

One preliminary point should be made at the outset. The last 3 years have been a particularly turbulent period for the insurance industry, particularly for life insurance. We have had the most severe and prolonged bear market since the 1930s. The Equitable Life affair has cast a long shadow. The pensions mis-selling review has cost the industry over £11 billion in compensation payments. There is more compensation to come, though not on the same scale, in relation to mis-sold endowment mortgages. Pay-outs have had to be reduced on many policies. Dividends have been cut in some cases. Equity markets remain weak, making marketing difficult, though business volumes are not, perhaps, as low as they might be in the circumstances.

On the non-life side, the failure of Independent Insurance was a blow to the market, and while the premium cycle has turned, underwriting remains unprofitable, for the most part, and investment income struggles to bridge the gap.

Against that background, it might be thought surprising that there are so many people still here today. Some commentary has implied that the whole industry is on its uppers, and about to go out of business. So it is important to recognise that most companies have managed themselves prudently through these difficult times. Of course capital cushions are thinner than before. Of course some funds have closed to new business. Over the last 4½ years a number of funds have closed, but representing, in total, about 13 per cent of the market. That is not surprising in such difficult market conditions, and some further industry concentration was to be expected. So it is important for us to keep things in perspective. Even though the insurance industry worldwide has had several difficult years, Britain’s insurance sector, is holding its own in international competition, and indeed gaining market share in some major developing markets in the Far East. And our intention, like yours, is to keep it that way.

If the industry is to remain successful, both at home and overseas, it needs sensitive and effective regulation. That is what we aim to deliver. The FSA aims high - to be a leading edge regulator globally, respected for its expertise and integrity around the world. And I would frankly tell you that the regime we inherited in 1999 was not in that happy condition.

On the prudential side, the FSA took over a small division of the Department of Trade and Industry. Some of them had been engaged in insurance supervision for a good while, and all of them were highly dedicated to the task. But much of the technical expertise was housed elsewhere, in the Government Actuary’s Department. And the resources devoted to prudential regulation were very small by international standards. A recent confidential survey for one of our overseas counterparts has shown that the UK devoted, on a comparable basis adjusted for industry size, around a quarter of the average resource dedicated to supervision by countries with similar industry structures.

On the conduct of business side, we inherited the Personal Investment Authority which, itself, was the result of a merger between LAUTRO and FIMBRA a few years before. The philosophies of the two regulators - prudential and conduct of business - were very different, and there was little communication or collaboration between the two.

Today, the picture is very different. In the first place, we have been able to integrate the actuaries from the Government Actuaries Department who previously supported the DTI. That contributes to much more efficient working, and to a much closer relationship between specialist actuaries and supervisors. For all insurance institutions we have achieved a full integration of prudential and conduct of business regulation now, and are supervising them in consolidated teams.

We have considerably strengthened the resources devoted, although it is fair to say that by international standards we still remain lightly resourced. Within our Major Financial Groups Division we have put people with insurance, banking and securities expertise together to work on the biggest insurers. And we have recruited 35 insurance specialists from the market. That amounts to a radical and focused increase in the level of experience and expertise we are able to dedicate to regulating the insurance sector. And we have appointed a number of insurance grey panthers - former industry executives who act in an advisory capacity to other regulatory staff. The grey panthers have been an integral part of banking supervision since the post-Barings review. They have proved their worth there, and are now adding value on the insurance front. So the staff devoted to insurance regulation now is stronger, larger and more integrated than it was when we took over. These changes take time to have their full effect, but firms are beginning to see the consequences already.

Also, we now have a fully functioning risk-based supervision system in the FSA, with a highly developed risk model which tells us which firms are most in need of regulatory attention. That, again, builds on work done in the Bank of England in the overhaul of banking regulation in the mid ‘90s.

I believe that we do now have a regulatory system which is at the leading edge internationally. My opinion on that might be thought self-interested. So let me quote instead from the IMF assessment of our regulatory system, published in February after an 18-month review involving a team of more than 20 international experts. The IMF conclusion was "the UK’s large and sophisticated financial sector features fundamentally sound and highly developed financial institutions, markets and infrastructure. It is supported by a financial stability policy framework that has been significantly strengthened in a number of ways in recent years, and that in many respects is at the forefront internationally".

Specifically on insurance regulation, the IMF recognised the scale of the change programme under way, and commented "The FSA is already making important progress on insurance supervision reform. It is in the process of rolling-out a strengthened approach under its risk-based framework, in line with its own comprehensive review of the prudential regime for insurance". This, the report says, is "significantly strengthening supervision in this area".

But having a stronger team, and better internal technology, does not guarantee success. The rules and regulations we operate must make sense, and be well adapted to the state of the industry and the market. It is also important that the senior management of insurance companies accepts its own responsibilities, since our regulation is built on the principles that it is for firms themselves to understand and comply with the rules in force.

In both the prudential and conduct of business areas, there was a lot of work to be done when we took over. There is more still to do, but we can now point to some significant moves forward.

Prudential regulation

I do not propose today - you will be pleased to hear - to go into all the gory details of every change we have already made to the prudential regime, and the changes still in prospect. But the main lines of our reform programme can be quite simply described. In future, we wish to adopt, for the insurance sector, a three pillar approach on the lines being developed for banking in Basel. In other words, there will be a basic minimum capital requirement - Pillar 1. The second pillar is supervisory review, whereby supervisors adjust the capital requirement in Pillar 1 in the light of their perceptions of the risk characteristics of an individual firm and, crucially, of that firm’s demonstrated ability to manage its risks effectively. Pillar 3 is an enhanced disclosure regime, allowing customers and counterparties to make better informed decisions for themselves, strengthening market discipline and reducing the need for intrusive regulation.

But this overall approach will need to be buttressed by changes to individual elements of the way in which insurance capital is calculated. The Baird review of our regulation of Equitable Life revealed some weaknesses in the way the regime captured risk in the past - notably the failure to value options on a stochastic basis. And our experience of falling equity markets over the last 3 years has shown that features of the old regime could have perverse effects in difficult markets, sometimes requiring firms to sell equities when it was against their judgement to do so and providing market counterparties with a target at which to aim, as they became aware that firms might be forced sellers at particular market prices.

As you know, our initial response, in the extreme market disruption following September 11th, was to suspend parts of the regime. But that was not a long-term response to the problem, and could be wrongly interpreted as an overall weakening of the soundness of insurance companies, which would not be in your interests, or ours.

We have subsequently explained, after considerable analysis of the true solvency position of life companies, that we propose to move to a realistic basis of assessing solvency, including a safety margin, rather than the somewhat artificial approach used in the past. It would not be sensible to wait and introduce the change in a "big-bang" at the beginning of next year. So to enable firms to move to the proposed new approach, we have been prepared to grant appropriate waivers to those companies who can demonstrate that their financial position is sound, including prudential margins for adverse market effects. We will consult later this year on the details of the new regime.

I should emphasise that this remains a wholly prudent approach to insurance regulation. It is not a soft option. The first waiver was published earlier this week. More will follow. The detail will be available on the FSA web site for analysts and counterparties to see. I believe that data shows, to paraphrase Stevie Smith, that the insurance industry is not drowning, but waiving.

As we move forward we shall also need to take account of developments in Europe as Solvency 2 is negotiated. And we shall also wish to reflect on the lessons that may emerge from the Penrose review here, and perhaps from the Royal Commission in Australia on the failure of HIH. So we shall need to retain some flexibility, and continued willingness to learn from an analysis of past problems.

It will be important in this process to maintain a collaborative approach between the regulators and the regulated. I am pleased to say that at present, I believe we have that kind of relationship with the ABI, both directly with the Politburo under Mike Ross, and with the staff under Mary Francis.

Conduct of Business

The Conduct of Business regime we inherited was also in serious need of reform.

There were a number of respects in which the arrangements we inherited were deficient, partly of course because the market itself had moved on. I will highlight four areas in which we have had to make significant changes.

The first was a change inherent in the reform of regulation introduced by the Chancellor in 1997. It involved bringing prudential and conduct of business regulation together in one organisation. I have already said something about that. Another conclusion of the Baird report was that communication between the two different types of regulator needed to be improved. I would be surprised if others looking at the Equitable Life affair did not reach a similar conclusion. That is a problem we hope we have now solved.

Very shortly after the announcement of the creation of the FSA, the Office of Fair Trading decided to carry out a second review of the polarisation rule and its impact on competition. That review concluded, not surprisingly in my view, that the rule did have a damaging effect on competition, certainly in some product areas. That gave us our second case for treatment. The OFT made it clear that if change was not made, they would recommend to Ministers that elements of our rule book should be overturned. Very sensibly, however, the OFT left us the time and space to work through a reform programme ourselves, in consultation with the industry and with consumers.

That consultation process, which has not been without its quota of controversy, has now demonstrated that the polarisation rule has, to put it no higher, outlived its usefulness. I note that no other country with a similar industry structure has implemented such a draconian constraint on competition. And I am entirely persuaded that the losses in terms of competition and flexibility and innovation in distribution, are not outweighed by the beguiling simplicity of the distinction between independent and tied advice. The outcome of polarisation was to condemn many customers, particularly the less well-off, to restricted choice, and surveys show that they were not typically aware just how restricted that choice was.

But we are now very close to the end of that particular road, so I do not intend to dance on the grave of the polarisation rule here today. There is active dialogue about the detailed requirements surrounding independence and tied relationships. And, on the important niceties of disclosing commission and other selling costs more effectively to consumers, we now have good engagement with ABI and BBA members as well as with the independent sector. The principles of the IFA menu must be replicated in the tied sector.

The third area of difficulty is broader and more complicated. It is agreed that some of the existing regulatory requirements impose significant costs. Some of the requirements on suitability and fact finds may well be entirely appropriate when an adviser is preparing a financial plan for someone with a significant sum to invest, but there is a case for saying that they may sometimes stand in the way of an individual of modest means, keen to find a simple and straightforward product. My own view is that regulatory requirements are not the major drivers of distribution costs. Many firms live comfortably with them, and make decent money from wholly compliant sales. It’s not that hard to do.

Nonetheless, we accept that there is a need to assess whether these requirements meet a rigorous cost-benefit test, and to consider alternative approaches.

Unfortunately, dismantling the whole regime, which some advocate, does not look an attractive option. This is bound to be one of the less popular parts of my speech for you today, but I have to tell you that sections of the industry continue to pay too little regard to the basic principles of treating customers fairly. We have been regularly surprised over the last few years at the number of cases of mis-selling and unsuitable advice we have encountered. I would have thought, in my simple-minded way, that paying out over £11 billion in compensation would have focused the minds of firms more than it evidently has on the need to be sure that their selling practices are compliant and ethical. The ordinary law, and the ability of the FOS to make awards on the basis of what is ‘fair’, means that this is not just a matter of standards set by regulators.

Yet in case after case we find examples of products with risk characteristics not properly spelt out, of financial promotions which seem calculated to mislead, and of highly risky products sold extensively to consumers for which they are evidently unsuited. I do not need to go into the details of split capital investment trusts (not your problem, of course) or precipice bonds today to make that point. So reform is fraught with difficulty. We have shown our willingness to consider new approaches. We devised a decision tree for stakeholder pensions, for example, which tested well with potential purchasers, giving the right answer just as frequently as a control group of financial advisers. We have shown that if genuinely simple and low risk products can be devised, we are ready to adapt our regime accordingly. But the response of the Consumer Panel this week to our more recent proposals on the possible regulation of stakeholder products shows that many knowledgeable observers of the market remain to be convinced that simple products can be removed from regulation entirely. If firms to do not pay sufficient regard to suitability, consumers are bound to be suspicious. This, in my view, is probably the key issue in financial regulation which we collectively need to resolve over the coming months.

But a fourth and last problem - at least for this morning - requires more urgent action. It has become clear that there is a significant market problem in the area of professional indemnity insurance. That problem may indeed go further than PII, and there is some evidence that there are difficulties across a wide range of employer liability, directors and officers insurance etc. Indeed the cost of such insurance for accountants and lawyers, and other professionals, has risen by just as much, if not more than it has for Independent Financial Advisers. So I do not think that this is an issue which the FSA can easily resolve on its own. But I am nonetheless willing to acknowledge that there is a regulatory dimension to the problem. The shadow of the pensions review remains over the market, and insurers are concerned about the possibility of further retrospective reviews, which may produce costly compensation bills for them.

We believe some of these concerns arise from misunderstandings about the nature of the reviews that have taken place hitherto. They have necessarily applied the standards in place at the time, not some later reinterpretation of them.

Furthermore, both our new, more proactive approach to regulation, and the FSMA itself make such reviews less likely in the future. We aim to spot emerging problems earlier. And it is also the case that we cannot order an industry-wide review, as the PIA could in the past. Only with an Order in Parliament, laid by the Treasury, could that happen.

Nonetheless, these points seem not to be fully understood. As a result, we have been asked to clarify our intentions in relation to mis-selling reviews, and indeed to seek to produce a definition of mis-selling.

This is not straightforward, for reasons you will understand. No regulator can possibly tie its hands forever in a fast-moving marketplace. But we nonetheless think that we could do more to clarify the position. Indeed I undertook to do so at the annual dinner of AIFA at the end of last year.

We have been preparing some material which we hope will take the debate forward. John Tiner will be writing shortly to you, and to AIFA, setting out our views, and proposing a discussion shortly after Easter, which will need to involve consumer groups as well. I am sure you will wish to take part.

International Issues

Before I close, just one further word about the international scene, to which I have perhaps devoted too little attention this morning.

Whenever two or three international regulators get together, two topics always feature in the conversation : credit risk transfer, and reinsurance.

There remains considerable concern about the extent of credit risk transfer from banks to insurers. Do we know enough about these flows? Is the risk properly understood by those who have taken it on?

More international work on this subject was agreed the Financial Stability Forum last month at its Berlin meeting. But while we can look at the aggregate position, it is for individual firms to ensure that they fully understand their own exposures, particularly where they involve complex derivatives like Collateralised Debt Obligations.

In the case of reinsurance, it is a matter of concern that there is no comprehensive global regulatory regime in place. The point links with the CRT issue, of course. Are reinsurers taking on a growing share of corporate credit risk? What implications might that have for the safety and soundness of the insurance markets as a whole?

For those reasons, we strongly support the work of the IAIS in developing a global standard for reinsurance. We would favour a European reinsurance directive also, in due course.

Conclusion

Over my 6 years at the FSA I have spoken at five annual BBA conferences on banking regulation. I would like to think that, on each occasion, there has been some progress to report. This will be my first and last appearance at the Annual Summit of the ABI. In the first draft of the speech I wrote that "sadly" this would be my first and last appearance. But I have always taken the view that a regulator must be scrupulously honest at all times, so ‘sadly’ had to go. One thing I can say, with all seriousness, is that there will be no shortage of future changes for my successor to announce.

I believe that we are in a significantly better position than we were six years ago, although progress has been slower than I would have liked. And, perhaps more importantly, there is a road map for the future, which - if we follow it - should produce a better functioning market for consumers, and a lively and competitive industry.

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