The Institute of Economic Affairs
12 November 2003
David Strachan
Director, Insurance Firms Division FSA

1. Good morning. I’m delighted to be here to launch what promises to be an informative and full programme for the IEA’s Annual Conference. The title of my speech suggests that together we can achieve a win/win/win outcome which meets the needs of consumers, firms and even – dare I say - the regulator.

2. However, implicit in the title is the suggestion that it is the regulator’s job to ensure success and deliver safety for consumers, on its own and without any help. As you might expect, we don’t quite view it that way. Indeed, regulated firms and consumers have an essential contribution to make if there is to be a positive outcome for all.

3. Those of you well-versed in the detail of the Financial Services and Markets Act (FSMA), will recall that FSMA underscores the need for senior management to take responsibility for regulatory matters, including complying with the safeguards which we have put in place to help protect consumers. Of equal import, however, is the emphasis that FSMA places on consumers taking some responsibility for looking after their own interests. For anyone keen to note down the relevant parts of the Act, they can be found in sections 2(3)(b) and 5(2)(d) respectively.

4. But even without scurrying off to check the specific wording of FSMA, the spirit of what is meant is clear: both firms and consumers have their respective responsibilities which complement those imposed on the FSA. The senior management of firms must ensure that the business risk they are running is suitably managed and controlled. And with the latter, as individuals consumers must ensure that they understand, financially, what they are getting involved in.

5. On public awareness, you should note that we will soon publish our Financial Capabilities Strategy. This is the first national strategy that aims to deliver a step-change in consumers’ financial awareness and will require a partnership approach from a range of stakeholders, including firms, consumer groups, employers, trade unions and the media. The publication of the strategy is essentially a call to action, and for those of you who are interested to know more, further information can be found on our website.

6. I think it is probably fair to say that the commonality of interest between the regulator and those consumers it is seeking to protect is well recognised. However, any reader of the financial press would be forgiven for thinking that such commonality of interest simply does not exist between the regulator and the regulated. Such a reader might conclude that there is nothing but tension and conflict between the regulatory and the regulated.

7. Such a conclusion would miss a very important point which is, I think, increasingly evident to any financial services firms. Namely that treating customers well is not only good for business, but it also – when it happens – has the fortunate side effect of keeping the regulatory happy.

8. I would therefore like to concentrate this morning on what we view as the increasing alignment between our and your objectives, looking in particular at three specific examples: governance; business models; and customers.

9. First, good governance. Many studies I have seen have struggled to establish a strong causal link between good governance and increased shareholder value. I have encountered some people who therefore argue that the regulatory’s emphasis on governance is misplaced. I think this misses a very obvious point – namely that it is clear that poor governance can wreck a company inflict losses on its customers and decimate shareholder value. Notably, poor governance featured consistently in the London Working Group’s report on the Prudential Supervision of Insurance Undertakings in December 2002, in which the group examined the causes of recent failures or ‘near misses’ in the insurance industry.

10. Strong governance structures are important for both the regulator and for a firm’s Board and senior management - and ultimately shareholders and other capital providers. Good governance is not just an end in itself – rather it is the starting point, from which a firm’s culture and, in a regulatory context, its strategy for treating its customers should spring.

11. Moreover - and here’s the incentive - a firm with a strong governance structure in which we as regulators have confidence, should expect less direct intervention from us. Conversely, where we do not have confidence in the governance and senior management structures, intervention will be more frequent.

12. Moving onto business models, I would like to make a few remarks on the premium cycle, a phenomenon that we have come to know and love. My starting point today is the proposition – which I hope isn’t too controversial - that companies want to write sound, profitable, business. This seems pretty straightforward. But history is full of examples of Boards and senior management apparently trying to do just the opposite. And in the spirit of the age-old adage that those who do not understand the mistakes of the past are condemned to repeat them, I think it is worth taking a few minutes to remind ourselves of the fundamentals of the premium cycle.

13. The general insurance industry goes through pricing cycles lasting around 7 - 8 years. The key driver of the premium cycle is typically the level of underwriting capacity. The ‘hard’ phase of the pricing cycle begins when capital levels are low, i.e. when firms reduce the level of new business, withdraw from certain lines or go out of business altogether. It arises either because the previous ‘soft’ market results in underwriting losses and/or because an event reduces capital directly. Indeed, the ultra-hard market of the past two years is the result of both such factors: with losses resulting from the late 1990s soft market being compounded by heavy losses from WTC, rising loss reserves and weak asset markets.

14. The competitive nature of insurance means hard markets do not last long: with new firms quickly attracted to the market by high prices and with existing players - balance sheets bolstered during the hard market - soon prepared to cut premium growth in an attempt to gain market share and maintain revenue growth. As a result the hard market is quickly replaced by a prolonged period in which firms cut premiums and, arguably, relax underwriting standards.

15. Soft market conditions create competing pressures. Firms who are too quick to cut prices (or allow more generous contract terms) can quickly find themselves losing money. Firms that do not cut prices risk losing market share.

16. As you might expect, we take a keen interest in all of this, and there is a growing body of evidence to suggest that the premium cycle may already be starting to turn. First, there are increasing signs of new capacity entering the industry and, in some cases, undercutting prices significantly. And second, our own research indicates pricing trends consistent with those seen in previous softening markets: with motor premiums softening first, followed by household and property and then casualty.

17. Worryingly though, there are two reasons to believe that a return to soft market conditions at this time could result in greater financial stress than normal:

  • the combination of the sheer scale of losses resulting from WTC, adverse reserve developments and investment impairment mean that few firms have rebuilt their balance sheets to the levels typically seen ahead of the soft market; and
  • investment income may not compensate for underwriting losses as much as in the past, with fixed income yields remaining close to historic lows.

18. Further, arguments put forward by commentators that “this time will be different” are not wholly convincing - especially since analysts have argued that each previous cycle would be different! These include arguments that insurance markets are seeing a flight to quality as financial strength grows in importance; greater industry consolidation will limit the scope for discounting; and the lack of reinsurance capacity could temper the soft market.

19. Whilst some of these factors may well alter the nature of the soft market, none seems likely to prevent the onset of it completely. As a result it will become increasingly important to monitor the financial implications of softer premium increases on individual firms’ finances - especially as many firms have not fully repaired the recent damage to their balance sheets and can no longer rely on solid investment earnings to offset increased underwriting losses.

20. However, I do not believe that firms need to resign themselves to the inevitability in the cycle. This would suggest a degree of powerlessness and passivity that need not exist. There are actions that underwriters could take to protect themselves from some of the worst effects of the softening market. What is important to say, though, is that there is no easy solution.

21. The first lesson that firms can learn is from their peers. Some insurers manage to maintain underwriting discipline throughout the cycle, avoiding the worst excesses of price cutting, whilst also ensuring they control other aspects of leakage which arise from terms and conditions and so on. Their results across the cycle speak for themselves.

22. The second is a matter of education and culture. I don’t think it would be wrong to say that many insurance company staff seem to behave as if they do not properly understand the implications of pricing on the bottom line. Unfortunately, profit and sustainability tend to play second fiddle to sales and market share. All firms could [and should] do more to impress upon their staff the need for financial discipline, making sure that the noises coming from the boardroom are consistent with the flourishes of the underwriter’s pen. As part of this, I wonder how much consideration is given by Boards to remuneration structures, especially bonuses, and whether they create the right incentives for sustainable profitability.

23. Third, and perhaps most importantly, insurers need to take a long hard look at the structure of their cost base. Inflexibility in cost structures (be they attributed to staff, premises, systems etc.) provides a perverse incentive to write business at a loss. Other parts of the financial services sector have already had to face up to this challenge, but for insurers it is perhaps only starting to become a serious reality.

24. Finally, I’d like to turn to the issue of customers. Treating Customers Fairly will become an even higher priority in our work programme for the FSA in the coming period. In relation to the general insurance industry it will make itself most keenly felt through the introduction of the Insurance Mediation Directive in 2005 and the application of conduct of business standards to general insurance companies.

25. We are in the business of protecting consumers, as dictated by our statutory objectives. So far, on the general insurance side, we have achieved this almost exclusively through prudential regulation and we are currently consulting on what will be a more risk-sensitive, and generally better approach to regulatory capital.

26. However, from January 2005 - when the IMD comes into force - we will looking more closely than before at how general insurers treat their customers at the point of sale and thereafter.

27. Although N(GI) - the snappy acronym for the IMD implementation date - is another thirteen and a half months away, early preparation is crucial. The countdown has begun and most key aspects of the regulatory regime are in place. It is now time for firms - from product providers down to the smallest intermediaries - to decide what the new regime will mean for them.

28. So what do we hope to achieve for consumers through the implementation of the IMD?

  • point of sale - transparency and understanding about who the consumer is dealing with (status disclosure), and better transparency about what they are buying, what it will – and importantly, what it will not, cover and the cost of that protection;
  • after sale – that claims are dealt with fairly and promptly. Consumers will have a better understanding why in some cases claims cannot be settled in full, or at all;
  • policyholders – both retail and commercial policyholders will received renewal notices in good time to make alternative arrangements if renewal terms are unacceptable or unavailable; and
  • throughout – protection of any client money held by intermediaries.

29. Undeniably, there is lot you need to be thinking about. We accept that the coming period will be a challenging one, and we will be doing what we can to help the transition to the new regime be a smooth one. There is plenty of information available on our website, including a factsheet for those who need to vary their permission in advance of N(GI). You should have also recently received the first of a series of newsletters keeping you up to date with developments and making clear what you need to be doing now.

30. I’ve covered a number of areas in my remarks this morning. If I’m to leave you with one message it is this: (to use the words of our new Chairman Callum McCarthy) there appears to be “a greater confluence of purpose” between the regulated and the regulator than before. And as I mentioned at the start, I am greatly encouraged to see that firms are beginning to have an appreciation of this interdependence. The areas I have touched on this morning - strong governance; good business practice; and customers who receive good service and good products - sound like a simple formula. But experience has taught us that the theory is much easier than its practical application. Therein lies the challenge for all of us if we are to produce a win/win/win result.

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