Risk management for reinsurers – tackling issues, finding solutions.
Presentation given at Barlow Lyde and Gilbert Conference ‘Risk Management for reinsurers’.
By Andrew M. Whittaker
General Counsel
Financial Services Authority

Thank you for that kind introduction. I am very pleased to take part in this conference on risk management for reinsurers.

The focus of my presentation is the FSA’s role in resolving issues facing the industry. I hope that in these comments, I will be able to give you a better understanding of how we see our role, what we have done or still need to do, and how this can impact on the issues we all face.

It is clear that there are many issues facing the industry which it is not the role of any regulator to resolve. We cannot be expected to resolve commercial issues, such as capacity or funding. Nor can we usurp the role of the courts, in deciding particular cases, or the legal principles on which those cases are founded, though these clearly impact on risk.

But what we can be expected to do is to ensure that the regulatory system itself is suitably risk based, and that we, and the system we run, encourage good risk management in individual companies, not least by giving guidance on regulatory issues which affect them, like the definition of insurance.

So today, I want to focus on three particular ways in which aim to do this, in developing the framework of rules applying to insurers and reinsurers, in delivering ‘smarter regulation’ ourselves, and in encouraging better identification and mitigation of legal risk.

Let me start with work on developing the framework of rules applying to insurers and reinsurers.

The FSA really started work as a new integrated single regulator 18 months or so ago, on 1 December 2001, when the main provisions of the Financial Services and Markets Act came into force.

From that date, we started to operate as an integrated regulator of insurance, banking, and investment business, together with operating as the UK listing authority for stocks and bonds.

In operating as an integrated regulator, we have been determined to work on a risk-based approach looking at risk across the board to our four statutory objectives of maintaining confidence in the financial system, promoting public understanding of it, protecting consumers of the financial services industry’s services, and contributing to the reduction of financial crime.

Our risk framework, which we call Arrow, attempts to bring together risks to these four regulatory objectives, in place of the narrower range of risks dealt with by our predecessors.

The framework of rules we use to mitigate these risks has changed, and further changes are on the way. There are three main drivers.

The first is Europe, though in a way this can be seen as in part a transmission mechanism, through which new standards are set, rather than a driver in its own right.

Europe will impinge on reinsurers in particular because of two new measures, the insurance winding up directive, recently implemented by Treasury regulations, and the draft Solvency 2 directive.

The insurance winding-up directive amongst other things gives priority in the winding up of an insurance undertaking to claims under direct insurance, over claims under a reinsurance policy. And it operates retrospectively, in the sense that in any future insolvency of an insurance company, it will be the new priority that operates, over that which applied when the deal was done. So no doubt many of you will have been considering how the security of reinsurance claims against firms which write both insurance and reinsurance, can be improved.

The UK’s proposed implementation of Solvency 1 (on which we are consulting) applies to both insurers and reinsurers, with exceptions for pure reinsurers that do not have a permission to effect contracts. For those firms to which it will apply, Solvency 1 involves more stringent requirements in several areas. These include a requirement to gross up earned/ written premiums in respect of certain classes of liability by 50%. They also include limitations on the discounting of liabilities.

Solvency 2 is on the horizon. In addition, the European Commission has now circulated a draft Reinsurance Directive which, by and large, will apply to reinsurers the Solvency 1 regime for insurers.

In parallel with these changes for reinsurers, the Insurance Mediation directive will require all UK insurance brokers to be authorised and regulated by the FSA – a prospect which will significantly increase the number of firms we regulate.

After Europe, the second key driver is the need to take an integrated approach to risk.

So we are developing, by end 2004, an ‘integrated prudential sourcebook’ which will deal with the capital requirements for insurers (including reinsurers), banks and investment houses in an integrated way. This will mean that the same risk will be treated in the same way, or at least within a consistent framework, whatever the financial institution where it arises. This integrated prudential sourcebook will aim to complement the integrated approach to identifying risk provided by the Arrow framework.

Third, and perhaps most important of all, of our key drivers there is real life. We have had quite a heavy dose of real life over the last few years. This period has seen the closure to new business of Equitable Life, the collapse of the Independent and HIH, the September 11 attacks and Iraq war, and major falls in world equity markets.

Events of these kinds challenge us all, industry participants and regulators alike, to look at the way we identify and mitigate risk.

But regulators and industry look at risk from different standpoints.

The regulator looks at risk not only to a particular institution but across an industry, across a financial sector, or across an economy. Its aim is not to eliminate risk, but to identify forms of risk which cannot be traded or mitigated in the usual ways.

Industry participants, particularly in an industry like your own, not only mitigate risk, but trade it. This is often not an option for the risks identified by the regulator, due to lack of buyers!

So our only choice is to try to mitigate, by smarter regulation.

Smarter Regulation of insurers

Smarter regulation means taking practical, risk aware decisions, whether for life assurers, general insurers, reinsurers or insurance brokers.

We are developing better sector analysis and regulatory reporting for insurance firms, to allow more timely analysis of data, and have set up a cross-FSA Insurance Risks Group to identify emerging risks across the industry so that they can be dealt with in a timely, proportionate and decisive way, together with an insurance strategy group, to ensure that progress towards smarter regulation continues.

In the context of the falls in the equity markets, we took action to free life office investment managers to rebalance their portfolios over time, rather than under pressure. We complemented this by a move to encourage the use of ‘realistic solvency’ to give a clearer picture of the financial position of life companies.

And as part of this, we are looking to tighten up on the use of financial reinsurance by insurers we regulate, to ensure that its use is properly monitored and understood.

On the general insurance side, we have focussed particularly on the arrangements for supervision of Lloyd’s, in parallel with its own strategy to restructure its market. The new approach will mean us looking in more detail ourselves not only at the position of the market as a whole, but also that of its members.

And we are also consulting on bringing Lloyd’s policies into the scope of the Financial Services Compensation Scheme, so that private policyholders can do business with confidence in the same ultimate safety net, wherever they place their business.

We have also started smartening up our own act, by recruiting 35 new insurance supervisors, mostly from the industry, to strengthen our supervision and policy areas.

They will be a more proactive approach to supervision, implementing risk based supervision by assessing business and control risks relevant to our statutory objectives, identifying consumer, product, market and industry wide issues, and aiming to maintain a close and continuing relationship with the highest impact firms.

We have dealt in a practical way with difficulties in the availability of the professional indemnity cover we require for financial intermediaries.

In particular, we have modified the terms which such cover must meet. We have also authorised a new mutual insurer, Magian, set up to add capacity to the market.

The changes we have made have received some positive international encouragement.

In its February 2003 review of the UK financial system, the IMF said "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-framework, in line with its own comprehensive review of the prudential regime for insurance. This has significantly strengthened supervision in this area".

Will all this regulatory change help to resolve the industry’s problems?

My answer is ‘yes and no’. Regulatory change can change legal relationships, allow risks to be monitored, and necessary intervention action to be taken.

But on its own, regulatory change is just that: it does not necessarily change the underlying reality on the ground.

That requires action by each of us to respond, to take advantage of new choices, or stay within new boundaries. And to do what we can to manage risk. In particular, I would like to encourage everyone here today to think more about legal risk.

Managing Legal Risk

The expression ‘legal risk’ is used with a variety of different meanings. Essentially, it means the risk that the law gives a result in a particular situation which is both unexpected and unwelcome –at least to one of the parties!

Legal risk is important to regulators, because it is important to the industries they regulate. Legal risk is particularly likely to be high in four circumstances.

The first is where the legal risk challenges the firm’s business model or fundamental business practices. The second is where it leads to large or uncertain liabilities. The third is where it impacts across the industry as a whole rather than being confined to a single institution. The fourth is where it crystallises rapidly, rather than progressively over a period.

Legal risk can be expected to be of particular significance to regulators where its importance is underestimated or its impact undermanaged by the industries they regulate.

And it must be recognised that this would be understandable at the moment.

Because, although we can all see that big risks often contain substantial elements of legal risk – analyst conflicts of interest, whether the World Trade Centre was one event or two, or the duties of disclosure in insurance based banking transactions – there is little learning on the management of legal risk.

So, I would like to close my presentation today by offering five key ‘to dos’ for managing legal risk:

Ensure you understand the law that applies to your business

Look at legal risk as a whole, not just deal by deal, and recognising the impact of other variables like changing economic circumstances

Regularly review the key legal judgements on which your operations depend

Recognise the importance of using the right legal skills to help you.

Finally work out what you can do to mitigate legal risk, alone or along with others, and do it.

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