Regulation of Friendly Societies
Speech by Ian Tower, Head of department, FSA
The Association of Friendly Societies
13 October 2005
I am grateful to the Association of Friendly Societies (AFS) and to you, President, in particular for the opportunity to join you today on the “English Riviera”. Having spoken in Glasgow last year on the fringe – I took one of the morning breakout sessions before the start of the AGM itself - I am very pleased, and rather honoured, to have been promoted to the top table this year.
I am under instructions to resist the normal inclinations of FSA speakers to give you simply an overview of our recent policy developments and to focus my remarks on a front line view of the issues facing friendly societies in their insurance business. I am pleased to do so – as that is what much of my day-to-day work at the FSA is all about. So I am not going to talk only about the Myners Review and governance, as the programme says. I also want to cover the wider challenges on strategy and financial management. I am of course happy to answer questions on these issues or anything else on your minds.
The opportunity to talk to you now is good timing from my point of view. Much of our recent work on the reform of insurance supervision has been on the larger firms. But we have been turning recently to the smaller firms and to the regulatory approach which we should now be taking. And Myners has of course brought a new focus on the life mutuals in particular.
I should say that we do not equate friendly societies with smaller firms. It is striking to read in your programme that the assets of individual AFS members now range from under £200,000 to over £6 billion. A key distinction for us is whether a society is large enough to be among the 1,500 or so regulated firms – out of 25,000 in total - assigned an FSA supervisor. Of the 56 AFS members, 20 societies are at present supervised in this way. The others, and most of the non-AFS friendly societies, will be familiar with our rather different approach to smaller firms, where we are in more reactive mode and where much of our work is undertaken on what we call a thematic basis – identifying issues that may be a risk to our statutory objectives and working with a selection of firms (with maybe some published output) to address them.
We are also conscious of the diversity of business encompassed by the AFS membership. Our interest as regulators, as you know, is strictly speaking confined to your insurance and any other regulated business. We are aware that for many of you, providing insurance services – or more accurately the facility to enable your customers to save - is not your only (or in one or two cases even your main) reason for coming into the office each morning. You are providing a wider service to your members – who are of course generally also your proprietors. In many cases, you are very much part of the particular community or profession which you have chosen to serve.
We are ready to be reminded from time to time – as some of you do remind us – that you are different from the bulk of what I might call the high street insurance industry.
It is our job at the FSA, however, to see that for all insurance businesses, whatever their size or business model, the minimum standards on governance, financial resources and fair treatment of customers apply. While we have regard to developments such as Myners, the standards that we set are our own, reflecting our statutory objectives. And I freely admit that we have been applying these standards more rigorously to insurance businesses and will continue to do so in the coming years. I plan to use the remainder of my talk to challenge you, as a good regulator should, on whether you are doing enough to respond to this changing environment.
But let me start with some more detailed observations on how we see you. In addition to our day-to-day supervisory work, we have been looking at a sample of friendly societies, large and small, and a few other insurers, to develop a perspective on three key issues:
- whether firms are meeting modern governance standards – with an eye to Myners of course as well as existing FSA regulatory standards and expectations;
- whether there are signs of emerging capital constraints or adverse trends in operating expenses – on the basis that cost control as well as healthy investment returns are key to maintaining a competitive offering to new customers and fair treatment of existing ones; and
- strategy – including emerging opportunities and vulnerabilities due to dependencies on particular products or niche markets.
Let me look briefly at each. On governance, the Myners Review highlighted a key issue that we have seen at some friendly societies – achieving the right balance between management, boards and policyholders. There are a number of ways in which this balance is not always ideal. As per the Myners analysis and while by no means universal, we have seen too many non-executive directors – and chairmen of the board - who lack the real understanding of the business to challenge management.
We have also seen some over dominant CEOs, significant key person risk and generally weak frameworks of accountability. And we have seen policyholder communities which, although nominally the owners of the business, exercise little or no effective discipline on management in practice.
I have to say that we continue to find some of these shortcomings – and amongst the smaller firms in particular. Over half the firms in our sample of smaller firms that I have mentioned had no Non-Executive Director with, as far as we can tell, any life insurance or financial sector experience. A further 25% have only one NED with life experience. Only one firm had a genuinely independent NED.
I say that this is the picture “as far as we can tell” because we have relied in this work on what societies themselves disclose. Recommendation 8 of Myners was that life mutuals should improve their disclosure of their corporate governance, including making clear the expertise and experience of each director. A further recommendation was that firms include a governance statement in their Annual Reports. It is clear to us that a number of societies have much to do in this area.
We also observed that half the smaller firms in the survey had only one executive director – or in some cases no executive at all - on the board. And we found evidence of a concentration of influence in the executive management, particularly the CEO. In about a quarter of the sampled firms, the CEO is performing up to five FSA controlled functions – including chief executive, compliance oversight, risk assessment and internal audit, often not backed up by adequate risk management or internal audit resources.
Having said that, we have also been encouraged that many societies are reviewing whether their governance arrangements are still appropriate in the current environment. Many societies have been weighing up the delegate board system against the one member, one vote approach in recent years. Some have set up member groups to co-ordinate member views and engage with executive management. And thanks in part to the AFS’s own work, societies are increasingly providing training to board members.
Let me move on to capital strain. We are all aware of the pressures which the life industry has been under in recent years from falling equity markets, reduced consumer confidence, increasing longevity and rising costs. The impact has been felt amongst friendly societies as well as insurers. We have not found smaller firms to be under any worse pressures than larger players. Smaller firms have experienced capital depletion. But so too have the larger players and, according to some of the evidence, at a higher rate.
The picture is similar on expenses – focusing on maintenance expenses, that is the costs of servicing existing business as opposed to acquiring new business. These have generally been rising at firms large and small. The difference is in the costs of acquiring new business – where we see much more pressure on smaller firms, the implications of which I will return to in a moment.
Finally, on strategy, we again see signs of some vulnerability amongst smaller players in particular. There is a significant degree of dependence on a smallish range of products. Of our sample of smaller firms, many were selling only three products – a tax-exempt bond, income protection and cash plans. But there are clearly also new opportunities, including Child Trust Funds (CTFs), which now looks like a growing market.
We have also observed that many smaller firms rely on a close association with particular affinity or worksite groups. Most do not have direct sales forces (they are not alone there of course), relying on direct marketing, workplace presentations and acquisitions to maintain growth. Interestingly, only around 10% of our sample of smaller firms were closed to new business.
You will be wondering where all this is leading in terms of firm conclusions and indications of our future regulatory priorities. Let me outline what is worrying us.
First, it seems to us that some firms are going to come under increasing financial pressure in the next few years. In a number of the firms which we have been looking at, new business is now so limited and the costs of acquiring it so great that firms may actually be paying more in costs than the value of the new premiums. This must increase the prospect of delivering poor value for policyholders in the future. It also raises some thorny questions about whether firms in this position should not really be regarding themselves as closed to new business - with all the implications of managing run-off that this entails.
The good news, from our point of view and for policyholders, is that we have not so far seen significant increases in charges to policyholders’ funds relative to those levied by firms with more rapidly growing businesses, usually the larger players. But rising costs accompanied by stable charges can only be bad news for profits and capital longer term.
The FSA may appear to you to be adding to these financial pressures through our changes in the regulatory capital regime. This concern is often associated with realistic balance sheet reporting for with-profits business. But only two AFS members are required to adopt realistic reporting at present. (One other volunteers.) As I said here last year, we do not expect to extend the scope of this new regime in the foreseeable future.
However, we do now require all directive friendly societies to prepare an Individual Capital Assessment or ICA. And ICAs may well, we expect, highlight gaps in your risk management and maybe capital shortfalls. This is a challenge that all insurance firms are facing – and the best are using it as an opportunity really to improve their risk identification and risk management approaches.
Which brings me to the second of our concerns - which is that some friendly societies may not be equipped to deal with the challenges from the changes in the economic, business and regulatory environment. I have already mentioned changes in the regulatory capital regime and increasing expectations of risk management. One recent example, more market than FSA driven, that has caught my attention is the initiative of the Continuous Mortality Investigation Board on stochastic modelling of mortality risk. Today’s new initiatives, however complex, tend rapidly to become tomorrow’s standard practice of course. And all this underlines how technically complex as well as capital intensive is much life insurance business these days.
At the FSA we are also placing increasing emphasis on what some people have called our sixth commandment – the Principle that firms treat their customers fairly. We were delighted to see the main points of our TCF message eloquently set out on the back page of the latest edition of “Friendly Face”. I would add to this the specific TCF requirements we have introduced for with-profit business, including the setting of target ranges for payouts on maturity and surrender and for smoothing.
We are also increasing the requirements on with-profits firms to publish useful information. Directive societies will soon be required to make available a “consumer friendly” version of your Principles and Practices of Financial Management (PPFM). We are also looking for improvements in PPFM themselves – less woolly language along the lines of "bonus rates will be declared at the discretion of the Board taking into account financial conditions at the time".
And annual returns next year will contain details of actual payouts on with-profits polices. All this is going to bring into the open the financial performance of life insurers, whether they like it or not. No more avoiding disclosure simply by declining to participate in the annual Money Management survey!
More generally, friendly societies face the challenges and opportunities of a depolarised market for financial advice. There is A Day for pensions providers to look forward next April. These are all major challenges, even for the best run and most highly resourced players. They require preparation and evaluation of the risks as well as the opportunities. I have to say that we are not yet persuaded that all societies have the management or financial resources to meet these challenges – and the broader trend towards higher standards - while continuing to provide fair treatment of the policyholders.
Our third concern is that not all societies, to be frank, will be prepared to face up to their situation or to grasp the nettle of change when required. We have seen cases where societies faced with major compliance issues have been reluctant to consider either closing to new business or the possibility of transferring obligations to other societies, even where there is reason to consider this in the best interests of policyholders. And they have not always been entirely candid with policyholders about their position.
There have also of course been cases of societies embracing change and cases of real innovation. I have mentioned CTFs and we have obviously seen many cases of transfers of obligations and a recent, well-publicised demutualisation with injection of new capital. But given the pressures on the industry, including the need to invest in new systems, it is surprising that the extent of consolidation has not been greater.
Let me finish with some indications of FSA priorities for friendly society regulation against this background.
I’ll begin with Myners. There are two key sets of issues for us. First, we were encouraged by Myners to take account of the issues raised in the Review in our supervision of life mutuals. We are ready to do so - and to a large extent already do so. We very much agree on the importance of our looking at the board of a mutual in the round, as Myners recommended – i.e. the total composition rather than just the skills and suitability of each individual. And we do have discussions with Non-Executive Directors (NEDs) of the 20 societies who have an FSA supervisor, as part of our risk assessment work. We particularly value a relationship with the chairman of the board and the chairman of the audit committee.
I might mention that the Myners emphasis on FSA seeing NEDs without executive management present was particularly welcome to us - as the need for and value of this is not always understood by the executives themselves! We also want, where appropriate and for similar reasons, to have a direct relationship with internal audit, the external auditors and the head of actuarial function and/or the with-profits actuary.
The second set of issues for us is about the relationship between FSA regulation and the annotated combined code for mutuals. We have been taking a close interest in the joint AMI and AFS rollout of the main code and now in the work on the supporting guidance. As we said to Paul Myners and he reported in the Review, there are limits to our role in this area set by our statutory objectives. We set our own requirements on governance that reflect these objectives. And we do not set requirements for the dealings of life mutuals with their policyholders in their capacity as members and owners.
So we will not enforce the code. But we do support the objective that by following the annotated code, life mutuals should be able to demonstrate that they have had regard to our requirements on governance. This will parallel our approach to the Combined Code itself where we make clear that in considering whether a firm's obligations to maintain appropriate systems and controls are met, we will give it due credit for following corresponding provisions in the Code and related guidance. We are also conscious of the need for a proportionate approach to smaller firms. This is how we apply our own corporate governance standards currently.
I hope all this is encouragement to you to be considering now the issues raised for you by the annotated code and to take action where necessary to come into line with the code's provisions. We are already looking forward to 2008 when we undertake the review to which we have committed ourselves of the reasons given by mutuals for non-compliance with the annotated code.
What about other priorities for us? I have spoken about a number of related issues about financial strength, strategy, governance and TCF and possible ways forward, including for some firms closure to new business and transfers of obligations. Some of the work we are planning on these issues is for next year and beyond. Our review of ICAs – individual capital assessments – is, for almost all affected friendly societies, for next year and into 2007. If our experience of reviewing major firms’ ICAs to date is any guide, we may well find areas of weakness which we will want to reflect in what we call Individual Capital Guidance. We do encourage you as senior management to take a close interest in this work and not leave it to the actuaries.
We will also want to revert, for pension providers, to A day preparations in the run-up to April. You need clearly to be making system changes ahead of the day, taking account of the need for flexibility while final Revenue requirements are awaited and planning ahead for possible increased transfers if you think this may be a result and for SIPPs and other opportunities. Similarly, we may be taking an interest in readiness for the distribution of Child Trust Fund cash to Revenue-allocated accounts next year.
But we expect the emphasis of discussions with you to be as much on how your approach to these developments fits in with and supports your wider strategy and meets your obligations to treat customers fairly. As supervisors, we increasingly observe that if the governance (including internal controls) and strategy are right and there is a commitment to treat customers fairly, then compliance with the detailed requirements follows.
We also plan between now and Christmas to translate the sample work on governance, financial and TCF issues that I referred to earlier into a detailed plan for tackling the issues directly with relevant firms – in our risk assessment work or thematically. There are difficult issues here and we do not want to leap in without careful consideration: so we are planning, if there is interest and enthusiasm, to hold maybe a half day session in the next few months with senior staff of life insurers to discuss the analysis for smaller firms, including the scope for FSA to take action to help deliver the outcomes that we all desire for policyholders.
To be clear, it is not for us to broker mergers or alliances. And our objectives require us to seek from firms not the best possible outcome for their policyholders but one that is fair in all the circumstances. But we will challenge firms – and, if really necessary, require them - to consider all the options that may be open to them, particularly where we identify weaknesses such as those I have mentioned today. And we are ready, as ever, to facilitate the practical measures needed to effect a Part VII transfer or whatever, while ensuring that customers are treated fairly as a key part of the deal.
To conclude, we see tremendous strengths in many AFS members and we will continue to give credit for them in our regulation of these firms. We are prepared – to pick up on your President’s rather striking remarks on FSA in the programme - to be a regulator who understands friendly societies and considers their needs in a sympathetic way. But we must and will challenge where we see potential for policyholders not being treated fairly. And we hope for the support of the broad AFS movement in this. As Myners noted, there are great benefits to customers in the mutual model for doing life insurance business. But they will be realised only if there is sound management. Fundamentally, we simply want to help make this happen.