26 NOVEMBER 2003
John Tiner

Introduction

1. I am very pleased to be here this morning. Even more so because I see the Economist has grasped the nettle and asked the question, that only really a journal of its calibre could, that is: regulator - friend or foe? No doubt if we did a quick straw poll now (anonymous, of course) responses to that question would tend towards the latter. I’m not, you’ll be relieved to hear, going to spend my time this morning trying to persuade you that regulator and regulated are natural bedfellows. I do, however, want to focus my remarks on the fact that although we have achieved some important changes over the last year or two in progressing how insurance firms are regulated, there remains a significant challenge ahead; one that is only surmountable if we tackle it together.

2. I have said on previous occasions that the last five years or so have been characterised by a huge programme of reform. Nowhere is this more true than in the insurance sector where very little in our approach to regulation has escaped scrutiny and/ or review. If success were to be measured by volume of material produced alone, then I think we could all agree that the FSA’s record would be surpassed by none. I am, however, only too keenly aware of the prevailing perception that too much of our time is spent producing consultation after consultation. Indeed, it is a view that I have some sympathy with.

3. Last week I read with interest a newspaper which commented in passing that if you were to lay every page of our 203 CPs end to end, you would be presented with a trail of material that extends for some 4 miles - I can well believe it. But a much more constructive response, is not to view this as a mountain of bureaucracy bearing down on you, but rather as a road stretching out ahead with clearly defined staging posts along the way.

4. Nevertheless, we do not underestimate the tremendous effort that the fruits of our labour have required on your behalf. You have listened, considered and, in many cases, contributed to these consultations. It is right that policy development must slow down and we give the industry and its customers, not to mention our own supervisors, time to become accustomed to the changes and to realise the benefits of them. The natural evolution of the Authority has meant that we are now seeing a shift from policy development and consultation to implementation and delivery. Reflecting this shift, very early on in my new incarnation I made a commitment to reduce dramatically the number of consultation documents that we produce. There are of course some outstanding issues that still require attention, as well as our mandatory consultations which spring forth from Whitehall and the EU - but nevertheless we are on the brink of embarking upon the next stage of financial services regulation. Now is therefore an appropriate juncture to take stock and review where we are, before taking a deep breath and launching into the next challenging phase.

5. This morning then, I want to talk to you about where we have got to, giving a brief tour d’horizon of the key developments and policy areas that we have been working on in the recent past which affects both life and general insurers. These cover developments that are directly related to firms’ financial soundness and those which focus on the way in which firms treat their customers. And, just to be absolutely clear from the outset, I want to emphasise the importance we attach to both prudential and conduct of business requirements. Similarly, firms’ senior management need to view these two regulatory disciplines as interdependent – twin tracks that will provide a means for the industry to progress and drive forward.

Prudential reform

6. That said, to begin with I would like to guide you through the most recent developments to the prudential regime, focusing largely on the proposals set out in CPs 190 and 195.

7. Shortcomings of the current capital requirements for life insurers have led regulators in the UK and elsewhere to adapt the existing approach in different ways to deliver more prudent insurance regulation. Here, we generally expect firms to hold a minimum of one and a half times the EU requirement, and in some cases a higher multiple, depending on the nature of business written. Elsewhere in Europe, regulators expect insurers to make more stringent provisions for claims. While this may help achieve a better prudential outcome, questions of transparency and international consistency inevitably arise. Fortuitously though, much of this will, I hope, be addressed by the arrival of Solvency II. I was encouraged to hear Mr Schaub, Director of DG Markt, say only yesterday that the Commissions aims for Solvency II include (1) that capital will be the key prudential tool for supervisors instead of untransparent but sometimes excessively prudent assessments of liabilities; (2) that the financial position of an insurer will be determined on the basis of modern financial risk evaluation methods; and (3) that there should be convergence in the underlying principles used for published financial reporting and for regulatory purposes.

8. Given the shortcomings in the statutory valuation methods so exposed during the recent bear market we have decided, with the industry's support, to introduce our own domestic proposals for capital requirements for life insurers ahead of Solvency II. And as such, CP 195 was published earlier this year, building on the realistic reporting work which began over a year ago.

9. The proposals develop what we term the “twin peaks” approach. Broadly speaking, this requires life firms to make a realistic assessment of their with-profits liabilities, to determine whether they need additional capital on top of mathematical reserves to cover expected discretionary bonus payments. Although the consultation period on the new capital requirements is now nearing a close – just a few days left to submit responses for those who haven’t yet done so – we have actually been collecting data from firms on a “realistic” basis for well over a year.

10. The third set of data from firms as at 30 June 2003 covered 98% of the total UK with-profits business and showed that the quality of reporting had improved markedly from the previous rounds. Our analysis also shows that the financial health of the sector has stabilised with the aggregate financial strength of with-profits funds remaining unchanged since December 2002.

11. It is worth noting that between 31 December 2002 and 30 June 2003 there were modest movements in underlying market conditions, with the FTSE 100 up just 2.3% to 4031 and 15 year gilt yields remaining unchanged at 4.45%. Of course, during this six month period the stockmarket fell sharply in the first quarter leading to a low in March of around 3,300. It was during this first quarter that around 75% of the £12 billion of equity sales in the first half of the year took place. This has led to a pure equity weighting in asset portfolios which back with-profit liabilities, of 36% at 30 June compared to 39% at the end of 2002. These rise to 49% and 51% respectively, when investment in property is included. We think it likely that the combination of steadier markets and the ability of firms to obtain waivers against statutory reserving requirements, based on the relative strength of their realistic position, has led to a levelling of the equity backing ratio in the second quarter.


12. In terms of the methods used by firms to construct their realistic balance sheets, especially in the area of valuing options and guarantees embedded in insurance contracts, we have seen some good progress. Undeniably, the deterministic approach of valuation that had been used by most firms was largely inadequate. The recent shift towards adopting market consistent stochastic modelling by the majority of firms is greatly encouraging and should result in more accurate and appropriate reporting of firms’ liabilities. The progress that is being made will also help ensure a smooth the transition when the Integrated Prudential Sourcebook is switched on for insurers in 2004.

13. The drawbacks of the existing approach for life insurers find their mirror image in the current requirements for general insurers. Our new approach, as you might expect, is again more risk sensitive. CP190 proposes that firms hold capital at least equivalent to the higher of the Minimum Capital Requirement (MCR), which is dictated by Solvency 1, and the Enhanced Capital Requirement (ECR). For some, these new requirements will have only a modest effect because the firm may already hold capital in excess of the proposed requirements. For others it could require them to respond by either raising new capital or by reducing the risks they face or underwrite.

14. The new approach to capital adequacy for both life and general insurance firms produces a minimum level of capital that we expect insurers to hold. However, the amount of capital required to match an individual firm’s particular circumstances could be higher, or less frequently, lower than this generic minimum requirement. So in order to capture this spectrum of idiosyncrasies, we have also proposed a framework of individual capital adequacy standards for both life and general insurers. Central to this bespoke approach is the role of senior management in ensuring that their firm holds financial resources that appropriately match its particular business mix and plans. It is critical that firms’ senior management take unequivocal responsibility for their own risk profile and make an assessment of the amount of capital they need accordingly.

15. These proposals are one of the major staging posts in the modernisation of insurance regulation, providing a more appropriate and sensitive calculation of regulatory capital requirements. They will lead to greater transparency, earlier regulatory intervention where it is required and, perhaps most importantly, a closer alignment of capital to the risks of the business.

Conduct of business

16. Hopefully the ground I’ve just covered is somewhat familiar to you. As I mentioned earlier, running on a parallel track to prudential regulation, conduct of business developments should now be firmly embedded in the consciousness of senior management. And, as I have been at pains to emphasis since my appointment in September, the concept of Treating Customers Fairly will become a more pronounced characteristic of our work programme going forward.

17. First, on the life side, something which will soon be a recognised feature of the regulatory landscape for with-profits funds: PPFMs – or for the uninitiated, firms’ Principles and Practices of Financial Management.

18. Under our new rules, each year firms’ directors will have to certify whether their with-profits business has been run in accordance with the PPFM and report to policyholders on whether, and how, the firm has complied with its PPFM obligations. The PPFM will cover issues such as the firm’s approach to setting annual and final bonus rates and “smoothing”; its investment strategy for with-profits business; the management of any inherited estate; and how it plans to balance the interests of with-profits policyholders and any shareholders of the firm.

19. The introduction of PPFMs will make the discretion that exists in with-profits funds and the way in which this is exercised by the Board and senior management more transparent helping ensure that consumers are treated fairly. These new arrangements are a central plank of our reforms – another staging post, if you will - and firms will be required to make these publicly available from March 2004. It is critical that firms get this right - and, to do so, PPFM preparations, if not already underway, should begin now.

Treating Policyholders Fairly

20. We are also about to consult on a paper reiterating to firms what it means to treat their with-profits customers fairly. Treating Policyholders Fairly is the last major piece of the jigsaw of our with-profits review and will be published early next week. And given the current climate, its publication is most timely. Essentially, our proposals build on what is already implicit in the existing regime – a codification of the principles that have traditionally underpinned good practice in the with-profits sector. The CP will include rules and guidance on treating with-profits policyholders fairly; proposed improvements in the process for reattribution of inherited estates; and our views on with-profits issues arising from the Sandler Review. Surrender values and market value reductions, in terms of striking the correct balance between the interests of surrendering with-profits policyholders and remaining policyholders, and what charges to with-profits funds are fair also come under scrutiny.

21. Treating Policyholders Fairly also builds on our thinking on PPFMs and specifically will provide detailed proposals for the consumer-friendly delivery of PPFM. Firms will be required to extract key parts of their PPFM and make it available to consumers on request, free of charge. Because of the importance of getting this right for consumers, during the consultation period we will be consumer-testing these documents to see if the information extracted from the PPFM does, in practice, deliver better understanding of with-profits products. This is something that we will be looking to a sample of firms to help us with.

22. As I mentioned earlier, firms will be required to produce their PPFM by the end of March next year. We appreciate, however, that some of the proposed new rules will mean the firms may have to make changes to their PPFM. To accommodate this, we are therefore suggesting our proposals should not come into effect until around a year later in 2005.

23. You will, no doubt, be pleased to hear, that our proposals are not all about adding further tonnage to our Handbook. It is our view that the introduction of PPFM and the consumer-friendly counterpart, will render with-profits guides redundant. We are therefore proposing to abolish this requirement and along with it, a whole section of our seemingly ever-burgeoning Handbook.

24. The consultation paper will in particular consider the introduction of target ranges - which would be specified in PPFM - for pay-outs that firms should make to policyholders when their policies mature or are surrendered. Indeed, this is a good illustration of where conduct of business and prudential requirements converge – firms will be required to manage their with-profits business with the aim of achieving their target ranges for pay-outs to their customers but these will need to be set within the wider context of our new prudential requirements, as set out in CP 195. Without wanting to state the obvious, firms will need to take account of the impact that future market conditions could have on their ability to pay-out within the specified range. For their part, consumers will also need to start making the correlation between market conditions and their own financial situation – and in this scenario, appreciate that if market conditions are less favourable that the pay-out they receive will in all likelihood tend towards the bottom end of the firm’s stated range.

IMD

25. Switching to general insurance, conduct of business developments will make themselves most keenly felt through the introduction of the Insurance Mediation Directive (IMD) in 2005 and the application of conduct of business standards to general insurance companies.

26. We are in the business of protecting consumers, as set out in our statutory objectives. So far, on the general insurance side, we have achieved this almost exclusively through prudential regulation. However, from January 2005 - when the IMD comes into force - we will be 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 down the line, as always early preparation is key to successful implementation and delivery. 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. For consumers, the IMD will mean a number of things. First, at point of sale, it will mean greater transparency and understanding about who they are dealing with and better transparency about what they are buying. Second, after sale, claims will be dealt with fairly and promptly. Consumers will also have a greater understanding of why some claims cannot be settled in full, or at all. Third, both retail and commercial policyholders will receive renewal notices in good time for them to make alternative arrangements if necessary. Finally, there will be greater protection of any client money held by intermediaries.

29. Along with the new capital requirements, there is, undeniably, an awful lot that general insurers need to be thinking about and engaging with now. The coming period will be a challenging one, but we are doing what we can to help ensure the transition to the new regime is smooth.

Forthcoming challenges

30. As you might expect, as we progress down the road of implementation and delivery, a number of challenges will present themselves. I’m not going to spend too much time detailing these – most, if not all, of us in this room already have an intimate knowledge and understanding of the key issues that the industry faces. I would, however, like to close this morning, by touching on a few which are uppermost in my mind.

Underwriting Cycle

31. First, an insurance specific issue - the underwriting cycle, a phenomenon that we have come to know and love. A crude snapshot would depict a cycle that lasts around 7 - 8 years, comprising of both hard and soft phases. The ‘hard’ phase occurs when capital levels are low (usually resulting from underwriting losses of the previous soft conditions) with the ‘soft’ phase taking hold when firms cut premiums and arguably underwriting standards too.

32. Right now, there seems to be a growing body of evidence to suggest that the underwriting cycle may already be starting to turn - there are increasing signs of new capacity entering the industry and, in some cases, undercutting prices significantly. Further, 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. While we have no wish to impede competition – quite the contrary in fact – rapidly falling prices are not the good thing they may first appear.

33. Our particular concern this time round is that a return to soft market conditions could result in greater financial stress than normal. First, the combination of the sheer scale of losses resulting from 9/11, adverse reserve developments and investment impairment mean that fewer firms have rebuilt their balance sheets to the levels typically seen ahead of the soft market. And second, investment income may not compensate for underwriting losses as much as in the past, with fixed income yields remaining close to historic lows.

34. Claims that “this time will be different” are frankly unconvincing - especially since analysts have argued that each previous cycle would be different! Arguments that insurance markets are seeing a flight to quality as financial strength grows in importance; that greater industry consolidation will limit the scope for discounting; and that the lack of reinsurance capacity could temper the soft market may well alter the nature and severity of the soft market, but none seem likely to prevent the onset entirely.

35. Whilst there are no easy solutions, there are actions that underwriters can take to protect themselves from the worst excesses. First, firms should learn 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.

36. Second, firms need to examine the culture that prevails within. The behaviour of some insurance company staff suggests a lack of understanding of the implications of pricing on the bottom line, with sales and market share seeming to dominate over profit and sustainability. Firms should do more to impress upon their staff the need for financial discipline. Further, firms’ senior management should be asking themselves tough questions about their remuneration structures – particularly bonuses – and whether these create the right incentives for sustainable profitability.

37. Finally, insurers need to be sensitive to the structure of their cost base. Inflexibility in cost structures can provide a perverse incentive to write business at a loss. Some 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.

Consumer education

38. Another entrenched challenge that insurers face, and one that is more broadly applicable to financial services as a whole, is the extent to which consumers understand the financial services environment, the products they are being sold and even their own financial circumstances.

39. As I have said on previous occasions, we think there needs to be a major step change in activity to educate and inform consumers, and that a national strategy for financial capability will help facilitate this. Just over a month ago, I announced the members of a new Steering Group that, under FSA leadership, will develop and implement such a strategy. Since the FSA has a specific statutory objective to promote understanding of the financial system, we believe we have a natural role in leading this strategy, but that its implementation must be in partnership with firms, employers, trade unions, government, not for profit organisations, the media and so on.

40. The Steering group, chaired by myself, comprises a range of individuals with diverse backgrounds, including government, industry, trade association, not-for-profit organisations and the media, as well as consumers themselves. By the close of March next year, we will have a clear view on what roles the industry, Government and others could most usefully play. But make no mistake – our end goal on this is a long term one, and one which should ultimately help stabilise the health of the industry as whole.

European issues

41. You would not expect me to close my remarks on forthcoming challenges without some reference to developments in the EU. Specifically, in relation to my comments this morning on our new approach to prudential requirements, it is our intention that for individual firms these will eventually feed through to the group level. We have explained in CP204 how this will work and set out proposed rules to implement the Financial Groups Directive and its changes to the Insurance Groups Directive. I would like to highlight two significant aspects of these, both of which are due to take effect from 2005.

42. First, the Financial Groups Directive requires a more prudent treatment of insurers’ investments in related banks, investment firms and other financial institutions. This is designed to eliminate double counting of capital and bring the rules for insurance groups more into line with banking and investment groups.

43. And second, we are proposing to require insurance groups to meet a capital adequacy test at the EEA level as a regulatory obligation, thereby prohibiting negative results under the group capital adequacy calculations. We fully recognise that such a change is likely to have significant cost implications for some groups and so we are proposing a phased introduction. But we believe this ‘hardening’ of the group test is justified by the nature of the risks run by insurance companies and by their exposure to risks arising elsewhere in the groups to which they belong. Fundamentally, it should provide more protection for policyholders and enhance market confidence in the UK insurance sector.

Conclusion

44. So, having looked at what’s in place and glanced down the road ahead, I return to the Economist’s question: friend or foe? We will not always agree. We will not always see eye to eye. Sometimes, we’re going to say things which are difficult for you to acknowledge, and similarly sometimes the reverse of that will be true also. Change has been necessary and change is being delivered. That, to me, does not sound like the action of a foe. And whilst I don’t look for people to say “Tiner espouses tough love”, I genuinely believe that the short-term pain of change and modernisation can result in long-term gains. I’ve talked this morning about the twin tracks of regulation; prudential and conduct of business – in my mind true delivery will only be achieved when these converge and become one. That is the challenge ahead for us both.

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