Challenges for the insurance industry
Speech by David Strachan, Insurance Sector Leader, FSA
European Insurance Roadshow 2005
14 October 2005
Introduction
Good morning and many thanks to Fitch for giving me the opportunity to speak to you about challenges for the insurance industry. Over the last few years I have typically used platforms such as this either to announce a particular aspect of the new regulatory regime or to explain the drivers behind the wider modernisation programme. With almost all of the new requirements for insurers now knitted into the fabric of day-to-day supervision, today I plan to do something a bit different.
As I have said on previous occasions, 2005 is the year of delivery and implementation. But for the FSA, implementation is not about sitting back and just letting firms get on with it. Yes, it is very much the responsibility of firms' senior management to embed the new requirements. But it is not the case that, having issued the final details of the new regime we retire to our ivory towers only to emerge to deliver a sharp tap on the shoulder of any firm that subsequently happens to fall short of our requirements. The end–game for us is an industry that is soundly managed and well capitalised and that treats its customers fairly. Good progress is undoubtedly being made in some quarters. But to help ensure we reach this happy outcome, it is crucial that the conversation with the industry that began back in 2001, continues well into 2006 and beyond.
Once upon a time, this conversation focused almost entirely on the design of the new regime, and the theory of change – in essence the "what". Now we are in the land of the practical applications of change – the "how". Today, I want to tell you how this journey will continue. First, by giving feedback to the industry on how we feel two of our headline reforms are being implemented; and second, by responding to the all important question: what difference to the consumer does all of this actually make?
PPFMs
To start with - and marking our real intent to move the conversation forward - I am pleased to announce that we will shortly be publishing the first in what I hope will be a series of publications giving feedback on 'how' we feel firms are getting on in implementing the new PPFM regime, and our take on that. As well as signalling the start of this new style dialectic, today's publication is also a first, in that we are naming firms from our sample that we feel have made good progress with our requirements.
Since April 2004 all life insurers with with-profits books of business have had to produce a publicly available account of how they run their with-profits business in a document called the Principles and Practices of Financial Management (PPFM). These are designed to address concerns over transparency and governance arrangements in with-profits business. Earlier in the summer, we reviewed a sample of these documents, and are today publishing our findings. It is fair to say that in broad terms we are satisfied with the progress that has been made. But, notwithstanding this progress, some significant concerns remain.
First, the quality and clarity of some aspects of firms' PPFMs leave much to be desired. Our review found that no firm satisfied every rule. Given the arrival of consumer friendly versions of these documents by the end of the year, it is all the more pressing that any shortcomings are addressed promptly so that they are not carried over into the documents that will be given directly to policyholders. It is, in part, for this reason that we have decided to use actual extracts from the PPFMs in our sample which we feel meet our requirements, and to name which firms produced these. This is not, I hasten to add, because we wish to see the extracts we have published replicated throughout the industry. Our intention is that this will help spread good practice amongst those who have some way still to go.
The second area of concern, which I will only nod to in passing due to time constraints, relates to my ongoing concern that the advisory community is still not sufficiently engaged with these documents. Being a realist though, I recognise that it is unlikely that PPFMs will be well-thumbed documents in this community until they are widely regarded as a useful – and readily accessible - source of information that enables advisers to compare and contrast with-profits funds. This is becoming increasingly important in the closed funds context, where hundreds of thousands of consumers need to access to advice on their own position.
ICAS
Conscious that the delegate mix today is from both sides of the industry, I am also pleased to announce today that we will follow up the PPFM publication with a subsequent Sector Briefing on ICAS. Although I am constrained to some degree on how much I can share with you today, I would like to give you a preview of some of the issues in the document that may serve to whet your appetites in the meantime. First, some generic points.
Under the ICAS regime firms are required to assess what level and quality of capital they need to maintain so that there is no significant risk that they are unable to pay liabilities as they fall due. Having reviewed the firm's assessment, we then issue Individual Capital Guidance (ICG) taking into account other information available to us. Nearly one year on since its introduction, we have now given ICG to seven life and 20 general insurance groups or firms and are well advanced with many more.
Clearly it is still early days, but I can say that so far, most ICGs are higher than the firm’s ICA and we are working with firms during the process to minimise the differences. Where we include capital add-ons we aim to be transparent about the reasons for these and strive to be as clear as we can about what firms need to do to reduce the ICG.
I can also report that we have been encouraged to see evidence of improving risk management systems. This will become an increasingly important focal point as we complete our review of a firm's ICA and move to reviewing its progress in embedding the ICA within the management of the business. In addition, we have (on the whole) been pleased by the level of engagement in the process by firms' senior management, up to – and including – Board level. Clearly the actuaries have an important role to play, there are others in the organisation who should also be involved. We expect the senior management team to "own" the ICA and to understand what it means for the way in which they manage the business.
Operational risk
Before moving on to some specific life and general insurance issues, I'd first like to touch on quantifying capital for operational risk. This is one of the most difficult challenges for both life and general insurers. Consequently it is not surprising that this is one of the least developed areas within firms' ICAs. But for risk and capital management to be properly integrated, the rigour of this assessment must improve, and as such we are very interested in hearing how firms plan to develop their processes in this area.
The hardest decisions are often around whether loss scenarios fall within or outside of the 99.5% confidence level. This is quite clearly a judgement call, but our expectation is that firms will be able to explain how they arrived at their decision.
Life insurance
Moving on to some specific points for life insurers. Here I'd like to mention two: 'non linearity' and stressed correlations.
Many firms are using a correlation matrix approach to aggregate the results from individual stress tests. One significant drawback of this though is that it fails to explore the interaction between risks occurring at the same time within the business model, which can lead to a material understatement (or possible overstatement) of the capital required.
At the FSA we call this the 'non-linearity effect'. Firms need to recognise the potential limitations of the correlation matrix approach, but clearly our requirement to use scenario tests is one way to mitigate this. In addition, the correlation matrix approach itself can be difficult because for most correlations there is limited data for stressed conditions. Despite this firms need to make some allowance for stress and consider carefully how resilient or sensitive their capital result is to changes in the stressed assumptions. Sensitivity tests are also important to identify which correlation assumptions are most material. Greater management focus on agreeing these assumptions and considering the impact of non-linearity this should give firms and ourselves more confidence in the results coming out of these models.
General insurance
For general insurers, there are two main issues that I would like to draw your attention to: reinsurance credit risk and management actions.
The issue of reinsurance credit risk is key to many firms, especially those operating in the wholesale market. Here, our concern is that many firms are estimating reinsurance bad debts using expected default rates, rather than the reinsurance default at the more extreme tails. The better firms have considered the expected timing as well as the payment of the recoveries which they anticipate under their reinsurance programme both from existing and new business. One way of doing this is to consider the probability of down-gradings of reinsurers as well as straight defaults. We also have some concerns over the treatment of intra-group reinsurance, which has typically been treated more favourably by firms in their ICA than external reinsurance. Again, we would expect a firm to consider the likely impact of both intra-group and external reinsurance defaulting.
Many firms are using management actions to mitigate possible risk charges within their ICA. For example, some firms have made no allowance for the underwriting cycle on the basis that management will take appropriate actions to fully mitigate this risk; such as to reduce premium volumes. Whilst we do not dismiss taking into account such management actions we would expect them to be discussed within the context of the firm's control environment and the wider competitive market. Further, a firm will need to demonstrate that the assumed actions will occur, particularly, where historic performance has indicated otherwise.
I have but skirted over some of the key issues that will given greater airtime in the forthcoming Sector Briefing, but hopefully for now this will have given you some food for though, and again illustrates our desire to push the dialogue with the industry further forward.
Conclusion: the regulator's existential question
Before closing, and with one eye on the time, I would like to spend a few moments on what I like to think of as the existential question that faces all regulators: what difference does it (or we) all make? Now I do not want to suggest that we regulators pass the time by indulging in abstract self-reflection on this particular predicament. But to the extent that "by our actions we define ourselves", it is right that we consider very carefully what courses of action we do take and accept full responsibility for them and their impacts.
It is in vogue to criticise regulators at present and it takes a brave commentator to buck the trend – although happily, some do exist. I accept that this goes with the territory. But more fundamental to the regulator's job is our statutory responsibilities, one of which is the protection of consumers. And so in that context, it is only right that we take time to reflect and take a reality check by asking: what difference does it all make to the consumer?
It is the inevitable lot of a regulator that many successes go unsung. This is fact. Unless we take a firm down the enforcement route which happens relatively infrequently, much of our day-to-day work is carried out beneath the radar and away from the public glare. In a proportionate regulatory regime, that is only right and proper in terms of respecting the relationship between regulator and the regulated entity which, in the main, is confidential.
But the corollary of this behind the scenes activity is that it is difficult - if not impossible - for the public at large to obtain a complete answer to the question of what difference the regulator makes. We absolutely welcome constructive debate and engagement over the way in which we discharge our statutory duties. But at present much of this is necessarily played out within a limited field of vision. People will know nothing of the cases, for example, where the FSA has secured significant shareholder support for firms' with-profits funds. Nor will they recognise the cases where following our intervention, firms have reviewed numerous sales to assess how much compensation should be paid to policyholders, benefiting tens of thousands of consumers.
We recognise too that we are not alone in asking the question of what difference it all makes. Now that we are well into implementation of the new regime, it is all the more pressing that this be answered. It is for this reason that we will in due course look to publish on our website a series of anonymised cases to illustrate how the new regime is actually making a real difference to policyholders.
At the outset, I spoke of my desire to see a new style dialectic emerge. This must be characterised by grown-up engagement: feedback from us on how the industry is doing, and input from you on whether our rules are working properly and having the desired effect. In the absence of this, and indeed without informed consumer input to the debate, we will not achieve our goals. The over-arching objective of the new regime is simple: soundly managed, adequately capitalised firms that treat their customers fairly. The two headline reforms that I've talked about today – PPFMs and ICAS – go a long way to tackling the sound management and adequately capitalised components of that goal. Both of these are enablers of 'fair treatment'. In other words, we want an industry that is soundly managed so that it can treat its customers fairly; and we want an industry that is adequately capitalised also so that it can treat its customers fairly. We still have some way to go until we reach this ultimate destination, but to my mind, this new phase of our dialogue has the potential to help speed our way there.
I'd be delighted to take any questions.