7th Annual conference of the Institute of Economic Affairs.
Marriott Hotel, Grosvenor Square, London.
23 March 2003
Speech by David Strachan

1. Good morning ladies and gentlemen. I'm delighted to see so many of you here and to round off what I'm sure has been a thought-provoking start to the conference. Unfortunately, I can only steal away an hour with you this morning, but casting an eye over the rich pickings of the programme, it is certainly encouraging to see that in the face of "adversity" – government reviews and inquiries either being launched or published; mortgage endowments once again very much in the spotlight; and concerns over the 1% world to name just a few recent issues – the industry is not cowed by the challenges it faces and has not slunk off to the nearest bunker.

2. Amidst the volley of gunfire and the lobbing of grenades, we too as regulator have our sights firmly set. Collectively, we are, without doubt, in the midst of a period of unprecedented change in the way that insurance firms are regulated. What all of us in this room and beyond are witness to is nothing short of wholesale root and branch reform. Though oft bandied about, the phrase neatly depicts the essence of our modernisation programme. Reform of the root by way of our new prudential requirements that will ensure a firm has enough capital to support its business. And reform of the branch by way of new conduct of business rules that will govern the way a firm treats its customers, both pre and post sale.

3. For those of you with well-thumbed copies of CPs 195, 207 and their precursors, the integrated programme of root and branch reform that aims to tackle the shortcoming of the current regime should be familiar territory. I will not then, you will be relieved to hear, give you a blow by blow account of each and every one of our new proposals. Instead, I will focus my remarks this morning on two very current aspects of the new regime - realistic reporting and something which will be exercising many of you at the moment - the requirement for firms to produce a document called the Principles and Practices of Financial Management.

Realistic reporting

4. The ultimate aim of our proposals for prudential reform is to ensure that firms have sufficient reserves to cover all of their liabilities, guaranteed or otherwise. Although standard practice within the industry, those not acquainted with the world of insurance and all of its idiosyncrasies would be astounded to hear that under the existing regime, firms are not required to back all of their promises with hard financial resources, with the rules effectively allowing them to ignore some significant non-contractual promises, including policyholders’ expectations that they would receive a fair terminal or final bonus. Even for contractual options or guarantees to pay minimum annuities, firms' approaches are not as robust as might be expected. Hardly controversial then, you would have thought, to propose a regime that requires the proper valuation of all liabilities and commensurate levels of capital accordingly.

5. As you know, the new rules require firms to assess the cost of their with-profits liabilities to determine whether they need additional capital on top of their statutory reserves to cover discretionary payments. Our original target for introducing the new realistic accounting system was the end of 2004. However, to help alleviate the pressure that some of the larger firms were under through the resilience test to offload their equities when markets fell sharply in 2002, we granted “realistic waivers” to a number of firms enabling them to operate on a realistic basis with immediate effect. Firms that were granted waivers on this basis will be publicly disclosing their realistic balance sheets for the first time at the end of this month, as an annex to the year-end returns that they submit to us.

6. To help firms prepare for the change, we have been receiving private submissions of realistic data from 37 firms (accounting for around 98% of the with-profits market) since 2002. Enormous progress has been made since then, and we have been greatly encouraged by the industry’s commitment to grapple with the challenge to modernise the way in which liabilities are measured. Since 2002, there has been continuous improvement in the quality of firms’ private submissions. Many have upgraded their valuation methodologies. Although detailed realistic reserving calculations are not universally yet up to actuarial good practice standard, almost all firms have plans to improve their liability modelling further before the end of the year. This is timely, given that realistic reporting will be implemented in full as part of the introduction of the Integrated Prudential Sourcebook for insurers at the end of 2004.

7. There is clear support for the new risk-sensitive approach - from trade associations, analysts, commentators and indeed firms themselves. But whispers of unease have also been audible since the turn of the year. Undoubtedly, for some, the realities of implementation have proved uncomfortable to say the least. Whilst not wanting to dismiss this simply as carping in the wings, it is important to be clear about the reasons for this apparent change of heart. The fact is that the transition from statutory to realistic reporting has revealed that some firms had been too slow to adjust the management of their business to a low inflation world. And in moving from deterministic models to more sophisticated stochastic techniques to calculate the costs of guarantees embedded in their with-profits products, many have been forced to confront a more accurate picture of the costs of guarantees. In some cases, these are now significantly higher than they had originally thought.

8. Again, it is important to remind ourselves that the aim of this reform is no more complex than to ensure that firms ultimately have enough capital to be able to honour the promises they make to their customers. Clearly, it is right – even overdue – to have a regime which seeks to ensure just that. Essentially, it is an approach shot through with common sense that is not only in the interests of policyholders, but firms as well, not to mention confidence in the industry more generally.

9. The realistic approach throws a stark light onto all of the promises a firm makes and requires them to hold commensurate resources to back them. Bold reform was needed and bold reform is being delivered. This has revealed all sorts of things that firms had either overlooked or had preferred to keep out of sight, out of mind and ultimately off the balance sheet. And whilst this will undoubtedly make the unprepared squint and even wince, any short term pain is clearly outweighed by the long-term gains.

Management actions and PPFMs

10. To manage the difference between the old and the new calculations of the costs of guarantees and make up any shortfall, some firms are proposing to introduce or increase charges against asset share. Given that firms are required to hold capital against such guarantees, charging can be an acceptable part of the management of a with-profits fund, provided that it does not compromise the obligation of firms to "pay due regard to the interests of their customers and treat them fairly" – also known in the business as Principle 6. And, just to reflect on this for a moment, by "fair", policyholders and firms can be reassured that we mean the plain meaning of the word, as opposed to any technical specialist interpretations that can be derived from accounting, legal or actuarial worlds. Our judgement on whether a firm is complying with this obligation, and the rules supplementing its application to with-profits business, will always therefore be a question of fact, based on the particular circumstances of the firm.

11. Not only is this issue of particular relevance now because a small number of firms will be publicly disclosing their realistic balance sheets in the next week or so, but also because of the imminent implementation of PPFM. From the end of April, all life offices will be required to produce and make public a document called the Principles and Practices of Financial Management. This document will effectively provide a blueprint for the way in which a firm’s with-profits fund is managed, detailing its approach to setting annual and final bonus rates, smoothing, investment strategy and the management of any relevant inherited estate. Designed to dovetail with the new realistic reporting requirements, firms will also be required to set out any charges to policyholders, including any covering the costs of guarantees.

12. Over the last few weeks, we have viewed a range of draft PPFMs. Of the draft documents we have seen – from around 85-90% of the industry – we are on the whole encouraged by the significant effort that firms have put in to ensure their documents are in place on time. There are, however, a few areas which require further attention prior to publication. These include making sure the PPFM indicates the approximations that are being used; improving the use of historic data for investment return assumptions; and ensuring that the language used is not only clear, but also precise.

13. We are particularly pleased that many firms are thinking constructively about how to introduce a range of different independent perspectives into their governance arrangements for assessing compliance with PPFM, including through with-profits committees, by whatever name they may be known.

14. Although we have requested sight of the draft documents prior to publication, we will not be approving individual PPFMs that firms produce. As with other aspects of the governance of with-profits business, this is entirely in keeping with the importance we place on the principle of the responsibility of firms’ senior management. It is for Boards and senior management to get this right. We simply do not have access to the detailed records and other information that is needed to produce a PPFM. We do expect however, that there will be a period of bedding in and that PPFMs will, to a degree, evolve in the first year. For our part, we also need to iron out the issue of policyholder notification when a firm changes its PPFM. In the run up to implementation at the end of April, we will be doing what we can to help firms help themselves.

15. The introduction of PPFMs is a significant new departure for life offices and, along with its consumer-friendly counterpart – which we have proposed should be publicly available from all firms by the turn of the year - will ultimately prove an invaluable vehicle through which greater transparency for consumers and market commentators will be delivered.

16. Speaking of greater transparency, and as an aside, I would like to briefly draw your attention to an imminent change to the guidance on Key Features documents. Under the rules, in a Key Features document firms are required to provide a brief description of the factors which may have "an adverse effect on performance or are otherwise material to the decision to invest". The guidance that accompanies this rule lists a number of factors which firms need take into consideration. It is not exhaustive and does not mention that guarantees or their potential effects on the returns from the product the customer is proposing to buy are among the factors that may have to be described. But, clearly they are. New guidance will be implemented as of May to make it clear that Key Features documents for packaged products may have to include descriptions of any such guarantees provided or other actual or potential liabilities and their effect or potential effect.

The "seven popular myths"

17. Let me return to my main theme. Our programme of reform – of which realistic reporting and PPFMs are two central pillars – is about delivering wholesale responsible reform that will provide a robust platform on which the industry can build a sustainable future that serves its customers well. Only the most staunch of critics could attempt to mount an assault on such a regime that proposes requirements that uphold appropriate financial strength and the fair treatment of consumers.

18. Whilst the broad thrust of what we are trying to secure - greater transparency and greater protection for consumers - is largely understood, a number of unhelpful misconceptions about our reforms linger. Rather than let these grow - and potentially take root - before I close I would like to put some of these to rest. I apologise in advance if I am stating the obvious to you.

19. One, realistic reporting has mutated from saviour to destroyer. I think I have probably covered this in enough detail earlier. But to sum up: realistic reporting embodies common-sense responsible reform. It is right that firms hold enough capital to back their promises to consumers. Yes, we are in a period of readjustment, but ultimately the benefits of a more risk-sensitive and transparent regime greatly outweigh any short term pain.

20. Two, there is an FSA conspiracy against the mutual sector. Let me absolutely unequivocal: our position is one of neutrality towards mutuality - we have no view one way or the other about the merits of a mutual structure compared to a proprietary one. Regardless of ownership, life offices need to have appropriate resources to back their promises to policyholders. Undoubtedly some aspects of our reform may mean that firms need to increase their financial resources. While this may prove easier for proprietary firms seeking to raise additional funds from shareholders, mutuals are not restricted from access to the capital markets. Within appropriate limits, all life insurers can raise subordinated debt or other forms of innovative capital.

21. Three, the FSA’s proposals aim to strong-arm firms into dumping equities regardless of the price in favour of bonds. This view is also quite wrong. Realistic waivers were originally granted precisely to allow firms to avoid the bulk selling of equities in a falling market. While we accept that there may well be some movement from equities to bonds when realistic reporting is implemented in full - since firms that have given substantial guarantees may find it easier to honour these commitments by investing in bonds – equities will continue to form an important component of firms' asset allocation.

22. Four, the long term savings industry does not have a future. Clearly, in the face of an ageing population and the shift from public to private pension provision, opportunities are aplenty. The regulatory infrastructure we are in the process of putting in place seeks to provide a foundation on which to build on these opportunities. But it is now up to you, the industry, to capitalise on these in a way that will serve both yourselves and consumers in the long term.

23. Five, consumer confidence has fallen through the floor. I'm not going to stand before you and tell you that contrary to popular belief, consumer confidence is actually riding high. Of course it is at low ebb. But, the outlook is not quite as bleak as it may first appear. In fact, given recent headlines, it may surprise you to hear that independent research shows that nearly half of UK adults say they have confidence in long term savings. Although I prefer to view this as a glass that is half full, a committed and sustained effort is required to replenish it. Further, consumers accept that they need to take more responsibility for their own financial decisions; the same research shows that 91% of UK adults believe that when it comes to mortgages and pensions, consumers should take more responsibility for what they are buying.

24. Six, the FSA’s proposals herald the death of with-profits. Let's be clear: the FSA does not want to bleed the with-profits product dry, forcing more funds to close to new business. Neither do we wish to denude the product of the features that have enabled it to serve very many investors well in the past. Yes, with-profits may well have to evolve (and indeed this appears to be happening in some parts of the market). Ultimately though, the answer to the question of whether the spectre of with-profits demise becomes a reality is only one that you, the industry, can provide.

25. Seven, the FSA’s reforms are a knee-jerk reaction to Equitable Life. You will note that I have deliberately not touched on Equitable Life or the Penrose Inquiry in my remarks this morning. I want to say just two things on this. First, finding its genesis in the FSA's own internal investigation into the regulation of Equitable Life, all aspects of the modernisation of insurance regulation predate the publication of the Penrose Report. Clearly, we are looking very carefully at the issues identified by Lord Penrose in his report. We will make changes as necessary. But at this stage I do not envisage a major, round of new consultations. As the report recognises, our programme of reform "…has sought to anticipate many of the lessons drawn by the inquiry" and that the work so far "…has reflected a major comprehensive reassessment of the requirements of an efficient regulatory system for the insurance sector." And second, as regulator our job is to protect consumers and build and maintain confidence in the insurance market. All of our proposals have these principles running through them to the core. A programme of reform that is conditioned by knee-jerk reaction - to Equitable Life or indeed any other issue - is one which is destined to founder.

Conclusion

26. I opened this morning by remarking on the particular resonance of the phrase "root and branch reform" in relation to the modernisation of insurance regulation. It is clear that a sustainable future for the industry rests on the successful implementation of both types of reform. Reform of the root without reform of the way in which firms treat their customers would make for an industry which was financially robust but that would ultimately wither in an age of increasing consumer power. Reform of the branch without reforming requirements on capital adequacy would make for a precarious industry unable to withstand the forces of the external environment.

27. I would be delighted to take some questions.

More Speeches: