13 Dec 2004
Speech by John Tiner
It is a great pleasure for me to be here in New York, a city in which I have spent much of my career and to talk about a subject which, during the last three years, has become close to my heart, that of the insurance industry. While my attention has been focused on fundamentally reforming and modernising the system of regulation of life insurance in the United Kingdom I refer in my remarks today to the non-life or general insurance market, as it is known in the UK, or the Property and Casualty market as you know it here in the United States.
The general insurance market plays a critical role in the global economy by providing the mechanism for risk to be transferred from those individuals, corporations, governments and other bodies, who do not have the knowledge or the appetite to absorb and manage those risks to organisations that do and have the capital to back that up. Experts estimate that the global flow of insurance premium in the property and casualty business amounts to some $1.3 trillion per year, in turn providing cover to the people and institutions of the world of a multiple of this amount.
The UK insurance market is the third largest insurance market in the world. In 2003 premium income of insurance business conducted in the UK market amounted to £67 billion. The so called London Market (which includes Lloyd’s and the companies which operate in London) is a major contributor to this amount with Lloyd’s alone accounting for £14.5billion. The London Market has long been a place respected around the world for its ability to understand, price, accept and manage speciality risks and is perhaps the most international of all insurance markets. I will focus my comments today on this international marketplace – the London Market.
Following the formation of the FSA in 1998, the FSA took on responsibility for regulating the underwriting of insurance from December 2001. I mentioned previously that during the last three years we had completely overhauled the regulation of life insurance but I should also mention that we are currently in the process of rolling out a new risk based capital regime for the general insurance market and have overhauled how we regulate the Lloyd's of London Market. So far, we have not had responsibility for the intermediary sector – the insurance brokers who act between their clients and the underwriters. This is about to change, however, as from 14 January 2005, just a month from tomorrow, we take on responsibility for regulating all insurance intermediaries as a consequence of the implementation of the Insurance Mediation Directive across the European Union.
The FSA's approach to regulation is founded on the fundamental principle of working with the grain of the market. We take the view that market solutions to issues which might pose risks to market confidence and consumer protection are likely to be more effective and less costly than those imposed by regulators. However, there are several market sectors in financial services where market forces have been unable either to identify or to resolve such issues and so then regulation clearly has a role, if it can be justified on the benefits outweighing the costs.
We have set ourselves a strategic aim to promote efficient orderly and fair markets and so we are interested to analyse the market characteristics of the sectors for which we have regulatory responsibilities in order to inform the style and intensity of our regulatory intervention. London also plays host to the leading international markets in Foreign Exchange, Bonds and Equities, together with their derivatives. Generally speaking, we find these markets characterised by buyers and sellers who punch their weight in the market, a high level of market liquidity and price transparency, efficient trade and settlement systems and an understanding of the risks and the financial economics of their business which facilitates the making of informed decisions. Having worked in the banking and capital markets for much of my career, I would say that these characteristics have come about due to huge investments in technology, people and infrastructure, very often prompted by a major scare such as the collapse of Barings. Of course, these markets are not perfect and there is more to do.
In the last two or three weeks, a London based think-tank called the Centre for the Study of Financial Innovation (CSFI) published a report on the regulation of the non-life insurance industry titled "Why is it so damn difficult?". Well apart from finding some sympathy with the title, it is interesting to reflect on the factors put forward by the author in support of her argument that the insurance industry is difficult and different to other financial services sectors and is "riddled with the kind of Spanish practices that banking dumped years ago".
So what does a quick market analysis of the wholesale insurance market reveal? First, there seems to be a long standing and well recognised information asymmetry between the insured on one hand and the underwriter on the other. This is a structural problem in large parts of the retail financial services market but it is, to me, odd that this should continue to exist in the provision of insurance cover and insurance services to some of the world's largest industrial and services sector corporations. One of the earliest important English legal decisions about insurance dealt with this very issue. In 1766, Lord Justice Mansfield said that an insured was liable to make full disclosure in pre-contract negotiations because otherwise “the risqué run by the insurer is really different from the risqué understood and intended to be run at the time of the agreement”. Insureds seem not to have been a significant driver for change in the market infrastructure or the distribution of value in the supply chain and, indeed, seem to have been unwilling to dis-intermediate the middle man.
Secondly, the mantra of the underwriting cycle. I won't today rehearse the arguments of the many academic and market studies carried out into the reasons for the almost predictable cyclical nature of the insurance industry. But it is not clear that the cycle flows with the balance of supply and demand and so observes usual market economics. It seems to have more to do with experience of, and especially reaction to, previous bad news events as well as the ability of capital to move quickly and at relatively low cost in and out of the insurance industry, exaggerating the effects of the cycle at both its peak and its trough. But if experience of reaction to previous events is a significant factor, then experience needs quality data such as on claims, underwriting experience and also requires certainty in policy wordings, a subject I shall return to in a moment.
Thirdly, it does not seem that the industry has invested sufficiently in its human capital. Few graduates look for their first employment in the insurance industry and while training and competence have improved considerably in the UK market, thanks to the excellent work of organisations like the Chartered Institute of Insurance, I remain concerned that investment in people is directed at the so called "front office" areas such as underwriting and claims management and not in the essential back office functions which can oil the wheels of efficiency in the market. I also think the industry needs to invest in critical oversight areas such as risk management and internal audit.
Fourthly, market infrastructure. While it is estimated that some $40 billion of capital has flooded into the insurance industry during the last three years, the market infrastructure has not kept pace with market developments. The industry has underinvested in technology and in process improvement and it has become a field day for lawyers who pick up the pieces when an insured makes a claim on cover which they believe has been underwritten but for which policy wording has not been agreed. The Silverstein case in this city is the most pre-eminent example of the problems that this lack of market and operational discipline can provide for insureds, underwriters and intermediaries.
Fifth, contract certainty – or lack of it – but what do we mean by contract certainty? Greater certainty at inception of the contract, with full policy documentation promptly thereafter. We want to see the end of a practice which is “deal now, detail later”. The lack of contract certainty creates risks for the policyholder as well as the insurer and the brokers. For underwriters there is substantial operational risk related to pricing and documentation errors and delays which create uncertainty. Also the insurer has an incomplete knowledge of the risk it has underwritten and the share of any risks taken by each insurer (the signed line exposure). For the brokers there are large and unquantifiable legal risks. Delays create treacle in the back office and ever longer more arduous reconciliations and create unnecessary costs as it is usually the broker who is left to sort out the policy wording once the cover has been written. As the business model of the brokers has come under such close scrutiny they can ill afford a fat cost base due to basic inefficiencies. And last but not least, the insureds do not know exactly what protection they have bought.
I am told that the major brokers have thousands of outstanding policy wordings from 2002 and prior. All told there maybe several hundred thousand outstanding policy wordings across the insurance market. I understand that there continues to be a high error rate on policies – about 35% - much the same as it was several years ago. Automation is a key factor, but process simplification, integration and discipline are needed badly if this significant problem is to be resolved. Perhaps most of all it needs a change in mindset by all market players so that accuracy and getting it right first time become the norm. I should note that this issue is common to many major insurance markets and is not specific to the UK.
As the FSA prepares to take on regulatory responsibility for insurance mediation, we challenge the London Market – the underwriters, the brokers, the infrastructure providers and the clients - to develop and execute as rapidly as is possible a market based solution to this issue of contract certainty. Consistent with our philosophy of working with the grain of the market, the FSA wants to see the insurance industry grasping this nettle and moving to a business and operating model which is transparent and efficient. As I have said, we want to see the end of a practice which is "deal now, detail later". We believe that in today's world of high-end technology the insurance industry must be able to square the circle of a richly diverse market which is able to price and absorb complex risks with one which is efficient, orderly and fair. We are aware that there have been various attempts to address this issue through such initiatives as standardised wordings on slips, but to date there has not been general market support for a serious market wide solution. I have today invited the Chairman or CEOs of the major brokers and underwriters operating in the UK market, together with Lloyd's, the relevant trade associations and representatives of the insureds to attend a meeting with me to agree how the industry is going to take forward this challenge. They are the market experts, not me, and I look to them to take an industry leadership role to deliver solutions within a period of two years from now. I do not want to use the FSA rule book to tell the industry exactly what they have to do as I believe that would be more likely to produce a costly and over burdensome solution which may adversely affect competition and innovation. But we do have a requirement in our new insurance mediation rules for firms to issue policy documentation promptly and we will be looking to enforce this. If the market is not able to come up with its own solution or set of solutions which addresses adequately this issue we have a number of tools at our disposal which can create tough incentives for them to get it right. At our meeting, I will be asking the market to organise itself to take this forward and to come up with a work plan which will see delivery of solutions within two years. We will, of course, want to be kept closely informed of how the industry proposes to tackle the issue and the detail of the solutions it proposes to bring forward. But we regard our role as oversight and facilitation and for the leadership and the resourcing to be provided by the industry.
So the issue of contract certainty will be among our early priorities when we have full responsibility for regulating the entire insurance supply chain, as of 14 January 2005. Let me cover, briefly, some of other early priorities.
First, we must be attentive to what we call "perimeter" issues - where firms are doing general insurance intermediation business without being authorised to do so. We are already doing this in the mortgage market - which has been our patch since 31 October of this year - and we expect to crack down on any firms carrying on unauthorised general insurance intermediation business in the same way.
In the wholesale insurance markets, conflicts of interest will be an early priority. We intend to look at business practices of firms and the systems and controls they have in place to identify, disclose and manage potential conflicts of interest. We have been alert to this issue in considering firms’ applications for authorization and we will be following up to see that our rules are observed, particularly those concerning inducements, which go to the heart of the conflict of interest issue. We note that the major brokers have signaled already that they will stop Contingent Fee Agreements from the new year – but we will be interested to see how they address this loss of revenue and how the middle and smaller broker market responds.
We have introduced new requirements for client money segregation across the board. This a fundamental part of our approach and we will review how well this has been implemented. We will review issues such as accounting for client money, management information and appropriately documented agreements between all parties (eg insurers, brokers and policyholders).
We want to look at the quality of systems and controls around binding authorities - that is accepting risks which are outside the terms of the binder or after a facility has been closed. We intend to look at all parties to these agreements including insurers and Lloyd’s Managing Agents as well as brokers.
As far as retail issues are concerned, a keystone of our new consumer protection regime is clear disclosure at the right time. The devil is often in the detail in insurance contracts so we will be checking in particular that insurers are drawing their customers' attention to any significant or unusual exclusions. Further down the line we expect to follow this to its logical conclusion by looking at the quality of claims handling. Our new regime expects insurers and their agents to handle claims promptly and fairly. We already expect and, if necessary, enforce high standards in complaints handling under our current regime. We are looking forward to bringing similar pressure to bear for claims handling, given its importance to general insurance policyholders.
We emphasise the importance of senior management responsibility. "Networks" are a feature of distribution in the U.K. retail investment market - these are arrangements where a principal firm takes responsibility for a number of smaller companies or individuals which act as its "appointed representatives". This model has been copied across to the new general insurance regime and we intend to make sure that the principal firms concerned exercise proper control over their representatives.
I am grateful to LeBoeuf Lamb Greene MacRae for giving me this opportunity to set out some of our thinking as we prepare to take on major new regulatory responsibilities for insurance mediation. I have not had the time to cover the substantial developments in the underwriting sector, such as the introduction of Individual Capital Adequacy Standards in 2005 or to touch on some of the transatlantic issues such as the continued requirement on non-US reinsurers to post 100% collateral when reinsuring US carriers. We continue to believe this is not warranted as a mandated requirement as far as the UK is concerned, where regulatory standards are high by international comparison and the market effects are to distort competition in the international reinsurance market.
Thank You
