22 April 2004
Speech by David Strachan

Introduction

1. Good morning. I am delighted to be here today following on from what I hear was an excellent opening day yesterday. Glancing down the programme, and indeed hearing from those who attended, yesterday's session focused largely on the health of the industry with reference no doubt having been made to the new prudential and other requirements that we are now in the process of finalising for the life industry.

2. I have argued in the past that our efforts to secure a more robust basis for the way in which firms measure their financial strength run to the very heart of consumer protection. I still very much advocate that view. But, it is important not to lose sight of the fact that the true lifeblood of the industry is, of course, the consumer. Without whom, the industry is little more than a cadaver: in effect - if you will pardon the pun - lifeless.

3. Much has been written in recent months of the downward spiral of consumer confidence in the life industry. It can be all too easy to depersonalise the notion of "consumer confidence" and think of this as a faceless collective – indeed, to such an extent that it becomes that bit easier to disengage from what really matters to the individual policyholders that are so critical to the future of the sector. So this morning, I want to spend some of my time with you taking a closer look at these individuals, their confidence in you, the industry, and explore the ways in which such confidence might be increased.

4. To be clear from the outset: this is not about performing a post mortem; we are of course, nowhere near body on the slab territory. There is no doubt in my mind that the new breed of senior management in the life sector appreciates the increasing power that consumers wield, and as such the primacy of the word "service" in the financial services industry. But, the current position of the industry is undoubtedly an uncomfortable one. It is said that confidence is contagious. Unfortunately, it would seem that the same could be said for a lack of confidence.

5. Clearly, a sizeable group of policyholders has been treated badly, and it is here that as regulator, we have had to intervene and seek policyholder redress. A second grouping, though perhaps not requiring redress, have not always been treated as well as they could have been, particularly in terms of being told how their money is being invested and what they might expect to get back. Others will feel that they have been subject to unfair treatment, though in reality this is symptomatic of the impact of adverse market conditions on their policy returns rather than any specific misdemeanour on the part of a firm. There is also a fourth group of consumers: those who have not suffered any detriment, including of course, that other sub-set who have actually done rather well. These individuals don't feel they've been treated particularly unfairly and appreciate that markets (and with them policy returns) go down as well as up. Quite obviously, this is a very crude segmentation and I would be the first to acknowledge that the picture is more complex. Moreover, I would not like to hazard a guess at the number of constituents in each grouping. It is not, however, rocket science to work out which of these groups are the most vocal.

6. So vocal sometimes, that perception can become skewed. Some of you may be surprised to hear that just a short time after the publication of the Penrose Report into Equitable Life, independent research showed that only 8% of consumers cited Equitable Life as having had a significant impact on their confidence levels. Further, contrary to the picture that is painted time and again, over 70% of UK adults say they have confidence in the financial services industry. We could no doubt now have a quite fascinating debate about these figures and ask all sorts of probing questions about them. But, ultimately, all of this is largely academic.

7. If the average man or woman in the street, perceives – regardless of their own personal experience – that policyholders are treated unfairly, then both trust and confidence are destabilised. At best, this simply further instils existing lack of engagement; at worst, contempt can set in.

8. We have, I think, reached a point whereby there is widespread public acceptance of the perception that consumers are not being treated fairly, and that QED, there is a loss of confidence in the industry. Whether that acceptance actually runs contrary to an individual's own personal experience, and how you explain that conundrum, is largely irrelevant. A quick sidelong glance at new business figures for with-profits contracts bears witness to the fact that endless repetition of this view has made it a self-fulfilling prophesy. Against that, I would note the evidence that overall new business seems to have picked up at the end of the year – and that there are signs of that trend continuing.

9. I do not have enough time to give this topic the attention is deserves today to try and explain and understand the forces at work here. They are undoubtedly complex and the industry will need to come to terms with them in the process – which is already underway – of rebuilding confidence.

Realistic Balance Sheets and Management Actions

10. As regulator, we can but help facilitate a restoration of consumer confidence in the sector. And while not explicitly focused on achieving consumer confidence in the sector, our package of responsible reforms clearly aims to achieve greater transparency and protection for consumers. As such, it provides the foundation on which the industry itself can seek to rebuild confidence.

11. I think it's important to recognise at the outset, the huge effort that the industry, collectively, has shown in its commitment and drive to modernise established practices. At the end of March, a number of firms publicly disclosed their balance sheets as calculated on a realistic basis for the first time. The new realistic approach is a major departure for the sector in terms of the way in which firms measure their liabilities and calculate how much capital is required to cover these. Final details of the approach are currently being finalised and we plan to set out our position in June before realistic reporting is implemented in full by the close of the year. As such, firms that published their realistic balance sheets as part of their year-end return for 2003 did so under guidelines drawn up by the ABI. And while these preliminary disclosures signal steady progress towards full implementation of realistic reporting, this is necessarily a transitional stage, albeit an important one.

12. Other important staging posts have been the private submissions of realistic data that we have received from 37 firms since 2002. This exercise has been critical in helping firms prepare for the new realistic world, and unlike the publicly disclosed balance sheets, this data has been collated according to the more stringent requirements as set out in CP 195.

13. Along with any period of transition, there comes a degree of acclimatisation. The transition from statutory to realistic reporting has for some been more dramatic than for others. And, some firms had undoubtedly been less than nimble in adjusting the management of their business to the realities of a low inflation world. And, when coupled with the move from deterministic to more sophisticated stochastic modelling techniques to calculate the costs of with-profits guarantees, many had to acknowledge that these costs had been somewhat under-estimated.

14. Simply put, the move to realistic reporting has revealed that some with-profits funds are not as financially strong as their management thought they were. A number of funds – both open and closed – are now finding that they need additional financial resources on the new basis of measurement.

15. In such a situation, if a firm is unable to raise additional capital, it may have to consider reducing benefits to policyholders. Reducing policyholder benefits – often known as "management actions" – can take a variety of forms, for example, cutting allocations or payouts, reducing the Equity Backing Ratio or charging policyholders explicitly for the guarantees given. All of these raise fairness issues which is why this issue is particularly pertinent to our subject matter this morning.

16. Essentially, what we are talking about here is the practical reality of how shortfalls in life offices should be treated and how any resulting "burden" should be shared. Shared between owners and policyholders of the business; between different classes of policyholders, such as GAR/non GAR; and between different generations of policyholders. Management action, including, for example, charging for guarantees is not of itself objectionable. Indeed, it is an acceptable part of the management of a with-profits fund so long as firms meet their obligation to treat customers fairly. The obligation to treat customers fairly is, of course, only one of a number of regulatory obligations to which firms and their management are subject. But to my mind, in terms of consumer confidence and trust, it is perhaps the most critical. And it is for this reason that, over the past few months, we have been involved in detailed discussions with firms on any management actions that they proposed to take.

17. Clearly it is for firms to comply with the obligation to treat their customers fairly, but if there are reasons to believe that management actions are, or would be, unfair to policyholders we will intervene. In deciding whether a firm's management actions are fair we take into account, amongst other things, two guiding principles. First, fairness must be assessed in the light of the particular circumstances of the firm in question, at the time when fairness is assessed. Second, other things being equal, fairness does not entitle policyholders to have benefits that the firm is practically incapable of delivering. It follows that significant changes in circumstances might justify a firm treating its policyholders differently than before, even if that entails delivering less than policyholders might have expected, given different circumstances or different choices. It also follows that we are less likely to object to a particular management action if a firm can satisfy us that there are no other management actions realistically available to it that are less problematic in fairness terms.

PPFMs

18. The relevance of management actions is two-fold at the current time: first because of the inherent relationship with the steady progress towards the full implementation of realistic reporting; and second, because of the introduction of PPFMs in just eight days' time. Designed to dovetail with the realistic reporting requirements, this blueprint document will set out a firm's approach to the management of its with-profits fund, including details on annual and final bonus rates, smoothing, investment strategy and the management of any inherited estate. Importantly, the PPFM will also set out any management actions that the firm plans to take.

19. It is clear to us that we will not have completed all our discussions with firms about the acceptability or otherwise of some of the proposed management actions by the end of this month. We will be seeking to complete these discussions as quickly as possible. In the meantime, we will be making it clear to firms that where management actions are still being considered by the FSA, they should indicate this in their PPFMs. Firms that are still developing their modelling techniques for calculating how much capital they require under the new realistic regime may also need to make subsequent changes to their initial PPFM. Again, where this is the case, firms should signal this in the document they produce at the end of the month. All of this is also consistent with the need for firms to communicate clearly to their customers and for senior management to ensure that this happens.

20. Along with the introduction of realistic reporting, PPFMs are a significant new feature on the with-profits regulatory landscape. Their introduction will help facilitate greater transparency and fairness for consumers. But, as is the case with such things, the proof of the pudding will be in the eating. If PPFMs are simply left to gather dust, or indeed are drafted in a way that is so broad and bland that they are rendered meaningless, then they will become little more than empty vessels, all but divorced from reality. Although we have spent the last couple of months working closely with the larger firms on their draft PPFMs, it is ultimately the responsibility of firms' senior management to ensure that these documents are clear and meaningful. Inevitably, there will be a degree of evolution to the standard of PPFMs and as such the documents that firms produce at the end of the month will mark a significant, but transitional, step towards greater transparency in the with-profits market.

21. As you know, the concept of a PPFM was designed with the knowledgeable observer in mind. Advisers clearly should fall into this category. The engagement of the IFA community with these documents is critical and we would strongly encourage firms to act on this to ensure IFAs have access to relevant PPFMs and understand them.

22. PPFMs provide IFAs with a greater insight into the management of a with-profits fund and hence with an opportunity to improve further the advice they give their customers. But we also appreciate that some policyholders will want to access this information first hand. Consumers can, of course, request a copy of their fund's PPFM. But it is important to keep in mind that these documents are complex and quite technical. Indeed, it is more than likely that the direct benefits of greater transparency and consumer understanding will only be more readily apparent after the introduction of consumer-friendly PPFMs later this year.

CP207

23. Consumer-friendly PPFMs are, of course, just one of our proposals contained in CP207, Treating with-profits policyholders fairly, which closed for consultation at the end of March. We have received around 70 responses to the consultation from across the entire stakeholder spectrum. Unsurprisingly, respondents have raised issues according to their stakeholder group. For example, one industry concern is that the law of unintended consequences may come into play, particularly with regards inflated capital requirements or lower returns to policyholders, greater prevalence of funds closing to new business and heightened consumer confusion.

24. The industry is also concerned that our considerations have underestimated the costs incurred by systems changes that firms will be required to put in place to comply with our proposals on target ranges, surrenders and consumer-friendly PPFMs. Disquiet has also been voiced by the mutual sector, particularly in relation to our proposals on investing in other businesses and the distribution of "excess" surplus. At the other end of the spectrum, consumer groups are concerned that the proposals may not be sufficiently robust to address consumer detriment in this area.

25. Obviously, these are not easy issues, but I for one, am greatly encouraged by the willingness of stakeholders to engage constructively with this debate. Clearly it is important that we get this right and we are currently considering what changes may need to be made to our proposals, as well as any other fairness issues in light of the Penrose report. We aim to publish our thinking on these and other issue in the Policy Statement in July.

Conclusion

26. Notwithstanding the urgency of transforming industry statements of intent into meaningful action, a clear understanding of why we have got to where we are and why confidence in the sector appears to be languishing so, is pretty fundamental. Time and again, we have seen that those who fail to understand the mistakes of the past are condemned to repeat them. That is why, in my view, a frank and honest appraisal of the current situation, followed by concrete action is clearly what is needed.

27. Let me emphasise here that I do not underestimate the size of this challenge – it is no easy task. It will involve firms asking themselves some very searching questions and taking tough decisions. For instance: what is the fair balance between a healthy balance sheet and policyholders being charged additional costs for guarantees to make it so?

28. Those who are serious about restoring consumer confidence in the industry will recognise immediately that if they are introducing additional policyholder charges it is simply not enough to point to the introduction of the PPFM. Nor is it enough to wait for the introduction of consumer-friendly PPFMs – which despite good progress, are still subject to the outcome of our consultation and consumer testing, and at the very earliest will not be available until the turn of the year. Those who are serious about consumer confidence – that is justifiable consumer confidence - will take it upon themselves to inform their customers, spelling out any charges being made and explaining why these are being applied, not because they have to but because they want to. Because they recognise that it is important information for policyholders to have.

29. Easily rocked, both confidence and trust are hard to stabilise and restore. But, the desire to reverse this unenviable position – again, be it based on perception or reality – is tangible. Now is the time to translate desire and intent into action. I know from discussions with many of you, that this is what you are doing. The restoration of justifiable consumer confidence will be no easy achievement, but the prize is great indeed.

30. I would be delighted to take questions.

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