Insurance Institute of London Luncheon
The Mansion House, London
24 March 2004
Speech by Callum McCarthy

I doubt whether, when the date of this annual event was set, anyone had a view as to how topical it would prove for the life insurance industry. March has seen the publication of Lord Penrose's report on Equitable Life which, although a detailed account of one institution, clearly has implications for the industry as a whole; in the same month we have had the Treasury Select Committee Report on endowment mortgages; later this month we will have the returns from life companies based on the new realistic accounting basis. And, of course, we have had acres of newsprint devoted to these issues, much of which has proved critical or pessimistic, or both. So today is certainly a topical occasion.

2. I should like to take this occasion to step back a little from the specific details of the various issues, and instead consider where we are; what is to be expected of those who provide insurance, of those who purchase insurance and of those who regulate this market – that is the firms, their customers, and the FSA; and where we go from the present set of issues. I will concentrate on life insurance. I apologise to those here today representing general insurance in not covering your issues – but you may take some comfort in the fact that to be neglected by your regulator (only in public speeches, I can assure you) is something which you should regard as at least a backhanded compliment. And there is certainly enough to talk about in discussing life issues.

Demographics

3. Let me start by establishing the importance of what we are discussing. I would claim that the most important long-term economic issue in Britain, as in every other advanced economy, is how to come to grips with the realities of an ageing population. We now live longer, and we have fewer children: by 2031, the life expectancy for men is now estimated to be 81.0 years, and for women 84.9 years – roughly 5 years more than they were in 2002, and an increase in the estimate of expected life of 1½ years since the figures was last estimated – in itself an indication of how quickly demographics are changing. By 2031, there will be four million more people of pensionable age in Britain than there will be children; around 30 per cent of the population will be over 60 – up from today's figure of about 20 per cent. At the same time, there has been and I expect to continue a movement which places greater responsibilities in the hands of individuals: a series of decisions which used to be taken for us, by government or by employers, are now decisions for which we are responsible as individuals. Provision for our retirement is arguably the most important of those decisions.

4. These movements – demographics on the one hand, an increased reliance on individuals rather than institutions for investment decisions on the other – represent an enormous opportunity for the life insurance industry. And, for exactly that reason, they place equally important responsibilities on all concerned: to make sure that the products are in fact suitable for those to whom they are sold; that the companies or societies have assets which match their liabilities; that customers are given information that enables them to make responsible decisions; that they face up to those responsibilities.

5. What we – the industry, its customers, and the FSA as the regulatory organisation – all seek is an efficient and properly functioning market for life products. I'll talk in a moment about how we at the FSA intend to discharge our responsibilities. Let me first deal with the responsibilities of customers and of producers.

The Customers

6. First, customers: we want to improve the capability of customers to take responsible decisions. This requires an understanding that risk and returns are inextricably – and properly – linked; and that decisions about something as important as provision for old age require careful thought. It is profoundly unhelpful that we start from a low level of competence in financial affairs – something which we are seeking to address through our work on financial capability, but which is a task which lies fair and square within the education system; and a task of a scale which will require a generation to make the full progress needed. I would simply say that it is as much in the interests of the industry as it is of the customer that this improvement in competence is achieved. You have an overriding interest in an efficient market – which requires informed, responsible and capable customers.

The Industry

7. What do we expect of the industry? First, we expect firms to face up to their responsibility to sell products which meet the needs of their customers – not in any way an unreasonable requirement, or a requirement special to the life insurance market. But it is necessary to observe that too often this has not occurred: the examples of pension mis-selling, or of precipice bond mis-selling, illustrate this all too clearly. The examples are too frequent and too important to let them pass without mention, or to regard them as isolated events. Behind them lies not only or mainly acts of irresponsibility by individual salesmen and women but – more worrying – incentive systems and even cultures introduced and tolerated by the management of firms which have encouraged irresponsible behaviour. This is something we should all be able to agree should cease; it is damaging to the consumer, damaging to the firm, and damaging to the reputation of the industry. I look forward to a time when there is no longer a need for compensation to be paid for mis-selling; and when it is no longer necessary for the FSA to impose financial penalties on companies who have mis-sold. In the meantime, you must expect us to act against mis-selling with determination. There really is no excuse.

8. The second quality we seek from firms is greater clarity in their description of what they are offering. This has many aspects: there is what I would call demystification of many products, where the vocabulary and terminology of life insurance products are obviously capable of being simplified and clarified; and – much more fundamental – there is a need for firms to be more transparent in their dealings with policyholders about the practices they employ and the qualities of the products they are offering.

9. The third change we are seeking from the industry is a more realistic assessment of the financial backing they require to meet the very long-term liabilities which they have entered into – which in turn requires a more realistic assessment of those liabilities.

10. The aim we have is firms whose capital structure and assets are well matched against their realistic liabilities; firms which set out clearly, and with as little jargon as possible, what they offer policyholders; and firms which neither mis-sell their products nor allow others to mis-sell their products. The business environment in which firms are now operating – which includes the FSA – means that increasingly all of these are in the long- term interests of the firms themselves – as they are in the interests of the customers of those firms. Any alternative approach by firms – to use their superiority of information and expertise relative to their customers – would lead to a world of more intensive and intrusive regulation which is emphatically not in their interest.

The Regulator

11. Last, what can you expect of the regulatory organisation? It is clear that the industry and its customers have not been well served by many aspects of the regulatory regime which existed in the 1980s and 1990s. The split between conduct of business regulation conducted by the PIA and prudential regulation conducted by the DTI was unhelpful. There were conceptual problems on each side – conceptual problems which had severe practical implications. The concept of policyholders' reasonable expectations has been anything but clear in its practical implications, with consequent ambiguity over many aspects of with-profit products, where management discretion was often exercised in an opaque manner. In terms of prudential regulation, the previous regime failed properly to identify and quantify the liabilities which firms had entered into – either by way of contractual obligations or guarantees or by way of non-contractual promises or practices.

12. We have set out a programme to change – substantially – both sides of the regulatory regime. Our concern in respect of conduct of business regulation is to establish the flow of information between provider of financial services and customer needs in an efficient market. Much of that is no more than codification of what is already done by the many good firms in the industry. It covers the sales process, where we look for the product being offered to be described in a way which is free from jargon; and with clarity as to what its characteristics – including risks – are. More significantly, it requires a lifting of the veils which have traditionally obscured what was actually on offer in a with-profits policy: in future, we expect information to be made available – comprehensibly – on how a firm manages its with-profits funds, its approach to payouts (on maturity and on surrender), its smoothing policy, its investment strategy and any changes to asset share. This is the information needed if a customer is to make an informed choice between competing companies – and, for that matter, between competing investment opportunities.

13. On the prudential side, we are introducing realistic reporting – a realistic assessment of with-profit liabilities to determine whether companies require additional capital, over and above statutory reserves, to cover those liabilities. The basic principle – that liabilities should be identified and quantified – is one it is hard to argue against, in any commercial activity. In life insurance, where liabilities are so long term, and where it is therefore necessary to think through how they can change over time, implementing this basic principle is even more important than in other commercial fields – which makes past practices all the more difficult to defend.

14. Lastly, as you would expect of an integrated regulator, we are bringing together the implications of conduct of business and of prudential regulation. The assessment of liabilities made by any company must include an assessment of those liabilities it has created via its general promises as well as by its specific guarantees. We need to have clarity in the product offering not only so customers can understand what they are buying, but also so that firms can identify and provide for the liabilities they are entering into.

15. I am conscious that the FSA's proposals for realistic assessments are now subject to criticism, as firms face up to the reality that some have failed in the past to identify liabilities properly, and therefore to establish appropriate levels of capital to match those liabilities. The accusations are various: a compulsion from the FSA to make firms sell equities; a deliberate aim on the part of the FSA to force mutuals to demutualise; the wish to wind up the with-profits sector. You will not be surprised if I say that all these remarks are quite unfounded. It is not for the FSA to tell any firm how much of its assets to hold in a particular asset class – but it is a proper concern for us to encourage firms to have an asset mix and capital resources which enables them to meet the promises they have made to policyholders; and it is inherently unlikely that a product can be offered which offers policyholders guaranteed returns, and a high exposure to volatile assets at the same time. So I am not surprised to find life companies facing up to a realistic assessment of their liabilities by adjusting their assets in ways which includes a reduction in the reliance on equities. Nor am I surprised to find that some life institutions, as part of their recognition of a need to build or rebuild assets, should reconsider the balance of advantage and disadvantage involved in mutual status, with the limitations that this brings in terms of access to capital markets. But again, this is a matter for them. Mutuals have access to capital markets, through subordinated debt, which enables them to build capital. Whether they wish to access under capital markets through changing their legal status is a matter for them. Our concern is with adequate capital, not legal form.

16. Least of all is it true that what is proposed means the end of the with-profit industry. If we succeed in establishing companies – or mutuals – whose assets properly match their long-term liabilities, with clarity as to their policies, and good information available in a form that is capable of being understood by policyholders, this will establish a basis for a healthy life insurance business which has not always been there in the past. It is clear that there will be changes in the form of with-profit products and we are already seeing innovation taking place in the market. Far from being a threat to the industry, the proposals which we are now implementing represent a foundation for the future. I think this was recognised when the proposals for realistic reporting were first discussed. Those in the industry described them at the time as "long overdue"; "a big move in the right direction"; "a boost to transparency and visibility in the life sector"; and "a better way to look at the strengths of the life companies". I hope that we will be able to return to a more sober and sensible assessment of those changes and avoid some of the more wild accusations which have subsequently been made.

17. I have set out what is needed from customers, from the industry and from the FSA for a sensible and efficient life insurance sector to flourish. I stress that the responsibility for achieving this lies with all three – something which, I am glad to say, the public recognise. Independent research shows consumers believe responsibility to be about 40 per cent with the company selling the product, 35 per cent with the individual buying it, and 25 per cent with the regulator. I would claim that the FSA's programme of regulatory reform demonstrates that we are facing up to our responsibilities. I hope it is clear how much it is in the interests both of the industry and of those they serve that both producers and customers face the changes that will occur. That there will be changes is clear. Some are already occurring with the development of new products, and new business models – which we should expect to go much further.

18. We have an opportunity: a growing need to provide for increasing life expectancy; a move from the state to private provision; the recovery of confidence which accompanies rising equity markets; and clear responsibilities for all of us. It is in all our interests that we make use of this opportunity.

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