12 July 2004
Speech by David Strachan

  1. Good afternoon. I am delighted to be here today to take part in the CEOs' panel session as part of the Society's 40th annual meeting. It is always a pleasure to share a platform with colleagues from the international insurance community. Moreover, given the increasingly global nature of this industry – be it through business models or increasing convergence of regulatory requirements – conferences such as this are very welcome. They facilitate a constructive dialogue on issues of mutual interest.

  2. The sharp-eyed among you will have noticed that my position at the Financial Services Authority is not that of CEO. Not wanting our hosts to be accused of misleading advertising though, my role at the FSA - that of Sector Leader for Insurance – does give me a perspective that covers the whole of the insurance landscape, encompassing both domestic and international issues. It is from this vantage point then, that I hope to make an interesting contribution to today's debate.

  3. The question I am asked to address is: who is running this industry anyway? It is unlikely that I will be accused of courting controversy by stating at the outset that we are quite spoiled for choice as to who might be thought to run the industry. Although opinion on which particular group is 'running' the industry at any one given time will as one might expect vary according to an individual's own point of reference, the frontrunners in my mind include firms' senior management; shareholders; consumers and rating agencies. I could lengthen the list to include accountants, lawyers and governments, given that in some countries insurers and reinsurers remain in state ownership. But I won't for the purposes of today's discussion. Others, of course, might even include regulators on their lists, but I would not venture to be so bold.

Senior management

  1. Taking each of these in turn then, I will start with the senior management and Boards of insurance companies.

  2. Those of you here today from the domestic market in the UK will recognise 'senior management responsibility' as a constant refrain of ours. A central maxim of the regulatory doctrine for the UK, the onus of responsibility that we place on the senior management of all financial services firms is a cornerstone of our regulatory approach.

  3. What this means in practice is that we expect a firm's senior management to take responsibility for ensuring that it complies with the regulatory requirements – both in terms of our high level principles for business and the detail of specific rules on capital adequacy and the way in which they treat their customers.

  4. I would like to give one recent example of the prominence we place on senior management responsibility. At the beginning of this month, we published our rules on how much capital insurers are required to hold. The key objective of this reform was to introduce a more risk-sensitive requirement that better reflects the business model, risk appetite and control systems of individual firms. Moving from the current 'one-size fits all' to a more bespoke approach, from 31 December every insurance company in the UK will be required to carry out its own assessment of how much capital it needs as part of our new Individual Capital Adequacy framework.

  5. Suffice it to say, the introduction of this sophisticated approach to the calculation of capital required marks a significant departure from the existing regime. Enormous progress has been made so far in terms of preparing for the new regime and the UK insurance industry is to be applauded for its commitment to come to terms with this radical new approach.

  6. Under the umbrella of senior management responsibility we also expect senior management to ensure that their systems and controls are appropriate to the scale, nature and complexity of its business and that there is an appropriate apportionment of responsibilities amongst a firm's directors and senior managers.

  7. This latter point has been thrust into the media glare of late, given that the governance of insurance firms was one point that Lord Penrose examined in his inquiry into Equitable Life. His focus was specifically Equitable Life and the governance of mutuals, but a number of the issues are, to my mind, just as relevant to the sector as a whole. In the Equitable case the specific example was that of a Chief Executive who was also the appointed actuary – in this particular case a clear conflict of interest. Prior to the publication of the Penrose Report, we had taken action to remove that conflict through the new rules for the actuarial function. But the general point is an important one and a key risk on our radar is to make sure that individuals do not wield too much power, or at least not without adequate challenge.

  8. One important safeguard is, in our view, provided by non-executive directors (NEDs). Clearly, NEDs need to have adequate skills and experience to provide the right kinds of checks and balances to counter the powers of the executive. As Lord Penrose observed, in firms owned by larger shareholders, those shareholders are likely to ensure that the NEDs are chosen wisely. But even there a certain degree of care is needed. I am not for one moment suggesting that we are going to produce a prescriptive list of the skills and experience that we expect to see on the board of a regulated firm. Nor are we going to expect NEDs to become expert in things that they have no reason to be expert in. Nor do we expect a board to be qualified in every discipline known to man. But what we do expect is evidence that the NEDs are actively challenging the executive management to satisfy themselves about the appropriateness of the executive decisions. Of course, in order to do this they must have some degree of relevant knowledge and/or experience as well as access to the right people, information and, training. We consider all of these in our risk assessment work.

  9. So, to repeat myself, and for the avoidance of doubt. We see Boards and senior management as running the industry and have imposed on them very clear regulatory requirements as to what they need first to deliver. But that is not to say that the other stakeholders I mentioned do not exert very significant influences.

Shareholders

  1. The first sphere of potential influence that I want to touch on is that of shareholders. I say potential here because in spite of a smattering of instances of shareholder activism, intervention winning the day at AGMs is the exception rather than the rule. And although ultimately, shareholders can vote with their feet, this particular front of shareholder influence remains largely untapped. While it is clearly not the responsibility of shareholders of public companies to manage firms on a day to day basis, broad issues such as the performance of senior management and the appropriateness of their strategy for the company are quite rightly the concern of shareholders. In this sense, and from a wider perspective shareholders provide an essential source of market discipline.

  2. As a regulator, we want to harness market forces and market discipline as effectively as we can, especially if by so doing we can reduce the need for rule-making and other forms of regulatory intervention. Consistent with this we are looking to enhanced disclosure requirements as a means of helping the market to exert discipline more effectively. In the field of insurance there is already a great deal of disclosure. We are adding to that (especially for life insurance), and we are also amending our general and life insurance annual regulatory returns to make the information more meaningful and accessible. This will benefit shareholders, analysts and other market commentators and, of course, policyholders. Better disclosure may also facilitate more active engagement by shareholders, but it may not be sufficient. The Shareholder Voting Working Group, under the stewardship of Paul Myners, recommended electronic voting as one means of increasing engagement.

  3. As one of the heavyweights in institutional investment, insurance companies clearly have their own responsibilities in terms of exercising their franchise. However, it would be no small achievement if the insurance industry were to grasp the nettle and be at the frontier of any drive to step up shareholder activity through the widespread introduction of more efficient voting systems.

Customers

  1. Moving to a second, and very important, group of potential influencers: customers. My general proposition to you today is that customers have not, [in proprietary companies,] been able to exert a significant influence on how companies are run. Here I am not referring to the day-to-day running of the companies – which is rightly the domain of firms' senior management – but in terms of how well they are treated, and how products are developed and marketed to meet real customer needs.

  2. I think it is important to set my remarks in context and what I am going to say is not just relevant to insurance companies, of course. Many UK firms have real commitment and zeal to driving up standards, and examples of good practice are not difficult to uncover. But we have to recognise that suppliers of financial services typically know and understand much more than their customers reasonably can about their products and services. There is therefore a significant imbalance (an information asymmetry, to use the jargon) which some firms choose to exploit – inadvertently or otherwise - to the detriment of their customers. This may well be because they perceive the short-term benefits to outweigh any longer-term ones.

  3. In markets where customer service is a competitive differentiator, consumer influence can be immense, with supplier behaviour having to dance to the tune of purchaser decisions. The fact is though, today's insurance market in the UK – and indeed the financial services market as a whole - is an imperfect one. (Although I would say that some of the personal lines general insurance business is more competitive than many.) It is for this reason that regulatory intervention is required and we remain resolute in our commitment and determination to take swift action where necessary. Of course, ideally there would be fewer instances of this type of action, which are essentially corrective in nature.

  4. So as well as taking a robust stance towards those who succumb to these temptations to exploit their advantage, we are also setting greater store by what we term our Treating Customers Fairly agenda. Greater prescription is not the solution. Even if we were to draft reams of rules on the subject of fairness, the prize would no doubt continue to elude us in many cases. The days of the compliance officer – and to be fair, in some cases the regulator – sitting back content in the knowledge that all necessary boxes have been duly ticked are a thing of the past. Instead, we believe the solution lies in a principle-based approach. And more specifically, through firms' senior management embracing our current high level principles for business.

  5. Treating customers fairly does not – as some consumers may mistakenly believe - equate to policyholder returns that outstrip market performance in perpetuity. Neither does it mean that all firms are required to offer the same level of service, nor a rolling back of individual responsibility on the part of the consumer. Reports of the demise of caveat emptor have been much exaggerated! On a more serious note though, the fact that these misconceptions have been gaining currency sharply illustrates the fact that we still have some way to go in terms of communicating to firms what we mean by the fair treatment of customers. Allied to this must be a greater push on consumer education, focusing on redressing the balance of knowledge between industry and customer. Knowledge is power; power is influence; and in this case, influence will lead to a less imperfect market. The corollary of that is clearly less frequent regulatory intervention.

(Mutuality)

  1. I've touched on both consumers and shareholders in terms of the influence they can bring to bear on the running of the industry. It would of course be remiss of me not to say a few words on mutuality.

  2. One of the attractions of mutual organisations is that they should work in the interests of their customers without the distraction of having to please shareholders.

  3. The other main attraction for the consumer of buying or borrowing from a mutual is that it gives them a say in the way the business is run, potentially to a much greater extent than if they buy from a proprietary firm.

  4. In some ways that is a great strength of mutuality, but it is also a great weakness. Echoing the issues in shareholder engagement, time after time we see mutual firms struggling to engage the majority of the members, despite good efforts on both sides. It is no great surprise that the vast majority of members, especially of the larger firms do not attend annual general meetings. When members are spread across the whole of the UK, it is probably not practicable for them to turn up in person. That said, there is often a fairly active core of members who do want to have their say. I have no doubt that those who do participate have the best interests of the membership at heart. But in some cases, participation is often associated with dissent.

  5. Following his work on wider shareholder engagement in voting, the Treasury have invited Paul Myners to look at the question of member participation in mutuals, and life insurance mutuals in particular. Mr Myners published his first consultation paper on Friday. This is a very important document, which I would recommend to those of you with an interest in these issues. One key issue is how to get people to engage in business that they co-own.

  6. This is no easy task. Commentators often suggest that because the customers and owners of a mutual are one in the same, issues of fairness do not arise. But that is just not true. In building societies, quite obviously, borrowers and depositors have opposing views about whether interest rates should go up or down. The balance there is relatively easier to strike. But in life insurance firms with with-profits funds, the balance of interests between different interest groups is a fine one. There are of course the competing interests of the with-profits policyholders and the non with-profits policyholders. The life policies, the annuities and the pensions vehicles. Between young policies and older policies, those close to maturity and those with years to run. Policies with guarantees and those without. The list is almost endless.

  7. This is why, when it comes to matters such as governance and fairness issues, we do not differentiate in the application of our requirements between proprietary firms and mutuals.

Rating agencies

  1. The third group with influence on senior management that I want to mention today (albeit briefly) is the rating agencies. Clearly, for reasons which I'm sure I need not delve into today, the rating agencies currently enjoy considerable influence in terms of market discipline. Their capital "requirements" – or perhaps more appropriately "expectations" – have typically been more sophisticated than those imposed by regulators. In some respects, they have therefore been regarded as being more influential that the regulators, particularly in the reinsurance industry. But, as with so many aspects of the UK industry today, this appears to be changing as we move towards a better and more risk sensitive capital regime.

  2. I would not want you to think we are in any sense "in competition" with the rating agencies. We are not. Our interests clearly coincide on certain issues. But in others they do not. All that said, we can learn from each other. We maintain a good dialogue with the agencies, digest their reports and monitor ratings changes for the firms we regulate.

Conclusion

  1. Those of you with a keen eye – or indeed ear - for detail will notice that although I have pointed to areas of regulatory involvement, I have not carved out any time to talk about any role that the regulator might have in actually "running" the insurance industry. Yes, we are in the business of protecting consumers and safeguarding market confidence, but I can categorically state that the FSA has no interest in running the industry.

  2. Admittedly, to date, our presence has been an obvious one in the insurance industry, and this is largely because since its inception, the FSA has been focused on addressing the imperfections of the regime we inherited and delivering a regime that meets the realities of today's market. Once our reforms have bedded in and a "steady state" emerges, our presence will recede to some degree.

  3. However, before jubilation breaks out, I should say that we will always want to understand an insurance firm's business and strategy. This is at the heart of our risk assessment process. It is there for a very good reason - a good number of the main crystallised risks that we have had to deal with in flawed, very often overambitious, business strategies.

  4. I've covered a lot a ground in my allotted time with you. It is clear, I think, that each of the groups I have mentioned has a clear stake in how the industry is run. Each has its role to play and interlocking dependencies and influences are aplenty. In terms of who ought to be running the industry, it will perhaps not surprise you to hear that my view is that the industry should be run by senior management of firms themselves. Each of the other groups - including the FSA - in a well functioning market has an important supporting role to play in terms of providing a strong incentive to the senior management of the insurance industry to run their business well, in the interests of their stakeholders.

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