Reform: The Regulator's View

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Speech by Julian Adams, Head of Wholesale Insurance, FSA
Acord London Forum
20 October 2005

Introduction

Good morning. I'd like to begin by thanking Acord for giving me the opportunity to address you this morning. Looking at the programme which you have put together, you have clearly set a comprehensive agenda and correspondingly achieved a very high turnout. Thank you also for giving me such a brief but potentially wide-ranging title for my remarks: "Reform: the regulator's view".

But I thought before turning to explore various aspects of reform, it may be worthwhile reminding ourselves of the existing value of that which we might be trying to reform. Recent hurricanes in the Gulf of Mexico have highlighted once again the value of insurance and reinsurance and why risk must be transferred from individuals and corporations to those with greater financial capacity and expertise to bear them. Although the final impact of hurricanes Katrina and Rita is still the subject of much speculation, there is no doubt that the London Market will need to play a vital role in getting businesses and properties back up and running. More starkly, last year's Tsunami and the recent earthquake in India/Pakistan show how much more vulnerable society is without access to general insurance. And I believe that any reform agenda should not lose sight of the social value of our market and all aspects of reforms should ultimately be tested against the difference they make in terms of making our market more financially secure and efficient to enable end users to receive proper and fair treatment.

Reforms

I have grouped my comments around three aspects of reform. On our part, we have introduced major reforms to the regulation of the insurance sector; you have for some time now been reviewing business processes through the London Market Reform Group; and there is now – I hope you'll agree - a need for a major reform of behaviours and culture in this market if the other initiatives developed to date, either by the regulator or the market, are to have any real chance of long-term success.

So, I will consider in turn these three aspects of reform –

Regulatory reform
Process reform
Behavioural reform

Regulatory reforms

Over the past couple of years, the FSA has designed a new regime for insurance regulation that focuses on the fundamental importance of good risk management and of senior management taking responsibility for ensuring compliance with regulatory requirements. You will, I hope, be very familiar both with these words and with the detail of our regulatory reforms. The real challenge now is converting this theory into practice – turning the words into deeds.

The responsibilities of senior management sit at the heart of many of our new approaches. Not least to the setting of capital requirements for the insurance sector. The over-riding principle of our Individual Capital Adequacy Standards is that firms should make their own assessments – on reasonable assumptions – as to the level of capital and other financial resources needed to meet the risks and uncertainties of their business. I don't have time today to cover ICAS in sufficient detail to do it justice – indeed there are whole conferences dedicated to the subject. Last week, my colleague David Strachan announced that we will be issuing an Insurance Sector Briefing on ICAS next month which will provide you with a lot of detailed feedback about what we have found to date through our reviews of approximately 60 firms' Individual Capital Assessments.

I would however highlight that one of the major issues to emerge to date has been the need for engagement by the board and the rest of a firm's senior management with the ICAS framework. A number of firms appear to have seen the process as essentially a compliance requirement which has been delegated to the actuarial function rather than something which is embedded in the firm's business planning and operational management. We would rather the ICAS process was designed in line with risk management practices and used as an important management tool. For example, we expect the ICAS process would be useful in areas such as the purchasing of reinsurance, investment decisions, identification of concentrations of risk, performance monitoring and capital allocation. We believe it is important that senior management understand the uncertainties of their underlying business and we believe ICAS can assist with this.

We have also implemented a risk-based approach to our supervision of firms. This is now our modus operandi for all firms other than those which present a low impact to the FSA's objectives. This approach determines how we assess the risks across all parts of a firm's business, from the risk of mis-management, of poor governance, of financial failure to the risk that customers will be treated unfairly. We have now carried out [at least one - in some cases two] risk assessments of all insurers operating in the London Market and are now well into our programme of assessments for London Market brokers. It is clear that for many brokers the move to statutory regulation has forced them to strengthen their corporate governance framework as well as formalise key control processes.

You will be relieved to hear that I don't propose to spend long on the subject of Arrow – the name we use for our risk assessment process. I do, however, want to spend just a few minutes explaining what it is and what it is not – and to dispel some myths for those new to the approach this year.

It is deliberately a high level review of a business (or group of related businesses) that is mainly interview-based. We aim to speak to a firm's senior management – not just senior managers within a compliance function. It is a process for which we will require certain information ahead of any visit (typically organograms, business plans, descriptions of key committees, and financial information). It is also a transparent process. At the end of the assessment we will communicate to a firm our assessment of the risk that firm presents to our objectives, together with a risk mitigation programme where we will timetable either work which we require the firm to undertake or work we intend to undertake ourselves.

It is not a box-ticking exercise. Nor is it a detailed inspection visit, still less an audit. It is unlikely, for instance, that much work would be undertaken on the operation of detailed processes through detailed file reviews – unless of course our findings dictate otherwise. And it is not designed to 'catch out' firms or individuals.

This risk-based firm-specific approach also determines the areas on which we need to focus our efforts across the market. Consistent with focusing on what we believe to be the most important issues, it is also likely that we will cover our priority issues as part of our Arrow reviews of firms. And conversely, the findings from our Arrow reviews might indicate a need to undertake further thematic work across a group of firms.

We set out our priorities for this 'thematic' work in our Business Plan and, for the London Market, we have now completed this year work on –

client money
contract certainty
financial reinsurance
conflicts management
managing the underwriting cycle
business continuity planning
corporate governance within the Lloyd's market
and are in the process of completing reviews of run off business and binding authorities.

We have already reported the results of our work on client money (in July through a Dear CEO letter); finite reinsurance (in a press release last week); and will shortly to be issuing a Dear CEO letter on conflicts management. So I do not propose to cover these again today.

But I would like to highlight some of the findings from our work on managing the underwriting cycle.
We have been following the state of the insurance cycle over the course of the last year and it was increasingly apparent to us that rates were softening (particularly on new business) in most lines throughout the year; this was before Katrina.
Falling prices per se are not necessarily a matter of concern to the regulator. We are not aiming to deprive policyholders of competition in the general insurance market. We know that the cycle can't be eradicated, and we don't want to interfere with market forces and the natural functioning of the market.

However, we are keen to ensure that all firms have (and adhere to) risk and cycle management strategies when competition for business becomes very tight. And that is of particular relevance in an environment when investment returns are lower and cannot be relied upon to make up for underwriting losses.

To that end, over the course of the summer, we carried out a short piece of thematic work involving a sample of ten firms in the London Market operating across a broad range of business classes. As I said, it is important to note that this work took place before the recent US hurricanes, so clearly could not take account of the possible implications of those events for the cycle.

The focus of our work was to understand:

whether the board had a clearly articulated policy on business strategy, risk appetite and underwriting; and
how senior management were (a) monitoring that underwriting practice was consistent with the agreed board policy and (b) what systems and controls were in place to mitigate the risk of underwriting outside of their declared risk appetite.

Albeit of a small sample, we found that most firms had a reasonably clear board policy on underwriting which typically set out the firm's risk appetite, required rate of return and overall approach to managing the cycle.

Many boards had delegated the routine monitoring of business to a sub-committee and we saw good examples of informed challenge and review taking place at this level. However, we felt that in some cases the board itself could strengthen its own monitoring by demanding more informative management information which would enable more effective challenge to executive management.

We also found that firms had developed their systems and controls through their experience of previous cycles and were using a variety of controls which they believed in combination would help reduce the risk of inappropriate underwriting.

As the cycle develops and pricing pressure intensifies we would expect the risk of control failure to increase. So we are reminding firms – through their senior management –of the importance of independent checks and monitoring to ensure all controls operate effectively and that underwriting is consistent with declared board policy.

We will continue to monitor board policy on cycle management including how firms respond to this year's hurricane losses. In the coming months, we will carry out further work to monitor how firms are managing the underwriting cycle – both through our firm-specific supervision and similar selective reviews. This will also cover firms writing retail insurance business where we recognise that the challenges and risks differ from those firms in the wholesale sector.

Planning for 2006

We are now planning our business priorities for next year, based on a combination of risk identification and experiences to date from our business as usual work. We will be setting out the risks we believe are prevalent in the wholesale insurance sector in the Financial Risk Outlook – a document the FSA publishes each January – and publishing our high level priorities in February in the FSA's Business Plan. Given the current operating environment, I envisage that this is likely to focus on, among other things, the ability of firms to manage a single or series of major events, either from further natural catastrophes or from man-made catastrophes or terrorist attacks. And in line with our emphasis on good risk management, our interest here is in how firms identify exposures and manage and mitigate such risks.

This work will include a review of firms' use of catastrophe models. It would be a matter of concern to us if some firms were relying on the output of their cat models without proper consideration of the inputs. Again, there is a clear role for senior management here. It is not sufficient to rely on mathematicians, geoscientists and actuaries to produce a 'black box' which only they understand – invaluable though their input undoubtedly is. Whilst this is a necessary starting point, we are keen to assess how far senior management understand what the models are designed to achieve and what other criteria – in addition to models – they use in assessing aggregate exposures. The common sense check if you like. We will be interested to know how you, as managers rather than technicians, understand, challenge and respond to the results produced by your models.

Finally, and recognising that a truly global market such as London is not only exposed to UK regulation, I'd like to touch briefly on some important regulatory developments outside the domestic reforms I have already covered. Having introduced our own new risk-responsive capital requirements, on the European front the introduction of a pan-European solvency regime continues to be a key priority for the FSA. Although still some way off, we hope that in time the Directive will help deliver a regime under which insurers across the EU are well managed and financially sound, so that policyholders' interests are adequately protected. It is pleasing to see that progress is now gathering pace with CEIOPS having issued all three waves of Calls for Advice. Going forward, active industry involvement - particularly via the Quantitative Impact Study - will be crucial for the Directive, and we urge firms to engage with developments now to help ensure that the resultant legislation is proportionate and takes full account of robust cost benefit analysis.

Next year will also be an important year for European reinsurers with the introduction of the Reinsurance Directive. Whilst reinsurance companies are already regulated in the UK, this Directive will help establish a sound and prudent regime across the EU that does not impose additional requirements on pure reinsurers that are not justified on prudential grounds. We expect to consult on the implementation of the Directive in 2006, with a view to implementing changes to rules by the end of 2007.

Taken together there is no doubt that all these regulatory initiatives present us and you with a full agenda for the year ahead. We are committed to promoting an efficient, orderly and fair wholesale market and seek to ensure that it is internationally attractive and sustainable. The regulatory reforms and supervision priorities I've outlined play a vital role in achieving this aim.

Process reform

I turn now to process reform, a fundamental contributor to the London insurance Market's position – and future position – as one of the largest and most important in the world. I know that process reform has been the key theme of this week's London Forum with, no doubt, some powerful presentations and discussions on the subject. There do not seem to be many dissenting senior voices about the need for fundamental reform of the way in which the market does business, although commitment to reform across all levels within firms is less easy to discern. The messages are clear; the ability to turn these messages into actions remains a huge challenge.

But our challenge to the market to achieve contract certainty by the end of next year – yes, just over twelve months away – is as important as ever.

The absence of contract certainty – that is the lack of agreed terms at inception – exposes all participants in the placement of insurance to significant risk –

Insurers do not have an accurate view of the risks they write so may not hold appropriate levels of capital;
Brokers face considerable reconciliation issues and risk of errors and omissions;
Insureds do not have certainty as to the details of cover they have bought.

This is not an ideal scenario – far from it.

We are pleased to see that the industry, after years of stalling, has now managed to move the debate forward. In the last month or so, Market Codes have been agreed by both the Subscription and the Non-subscription markets. A definition of contract certainty has been agreed. And guidance is being issued to help determine what this means in practice. Furthermore, the major buyers are now recognising that they too have a role to play in speeding up the transaction – in particular the need to provide details of cover required much earlier in the process.

So the tools to achieving contract certainty appear to be in place. However, let's not be complacent. We recognise that much progress has been made. We hear consistent noises of support for meeting our challenge, at least from those who are given the platform to air their support. But what of those who are committing firms at the coalface; underwriting and placing the business? Do they know what this really means and do they feel incentivised to change their ways?

We are keen to assess this last point to help us determine how far the market has really moved forward and to that end intend to undertake a quick review of the subscription market – in the first half of November – to determine what is happening on the ground. This will contribute to our formal stocktake of progress - to be taken in December after the next meeting with the market CEOs. We recognise that early November is a busy time for the market as it approaches 1/1 renewals, but in a sense this will be a true test of whether change is happening. The market has agreed a target for contract certainty of one third of transactions for this renewal period. We will follow up our review with a more detailed analysis in late January.

So my message to you today is clear. Well done to those who have achieved much to get this far. But the real test is still to come: can the market deliver the change that is needed to achieve contract certainty by the end of next year. It has proved it can work together to agree the process change but can you also deliver what is needed to achieve behavioural change?

Behavioural reforms

This leads me to my final remarks about the need for behavioural change in order to deliver the regulatory and process reforms.

Those close to the contract certainty debate have been unanimous on one point: that much of the change needed to deliver contract certainty is about behaviour and culture. Just because something has been done in a certain way for some time doesn't necessarily mean that change isn't required. The world and the environment changes and the legal and operational risks which businesses might be exposing themselves to by not changing are getting more considerable.

This is a sensitive area and one in which the regulator needs to tread carefully. Our predisposition is to work with the grain of the market but it seems, to me at least, that there are some clear areas where behaviour and culture can get in the way of efficiency and hinder the competitiveness of the London market in an international context. I would highlight the following as areas in which the market might chose to explore in order to engender behavioural change-

attract new talent to the market and deepen the skills base of the existing staff– although it is good to see the efforts made by bodies such as the CII here;
learn from other sectors – I won't commit the cardinal sin of comparing the insurance sector to the banking sector! But it's difficult not to think that some areas might not benefit from looking at how other types of firms address similar issues; and
manage more effectively than present the conflicts inherent in your business (disclosure alone is not the panacea).

Conclusions

Now the responsibilities of senior management run like a spine through all areas of reforms – regulatory, process and behavioural. After all, people are the backbone of all businesses and only through the effective management of people can businesses deliver and operate efficiently and effectively.

There is just over a year to go to meet the contract certainty challenge – we're watching closely; we're working closely with market; regulatory intervention is no-one's ideal scenario but it is a reality. Management pressure and effectiveness is vital to delivering change in this market.

Regulatory pressure can help but no-one believes in the value of doing something because they've been told to – it's much better to decide yourself that this is the right outcome.

We recognise that, in addition to regulation and process reforms, there are a number of other drivers and influencers on your business – be they catastrophes, tax issues, the demands of shareholders or global management. Working in partnership we can move forward to address inefficiencies and market failures where they exist and build on the strengths of the London market.

The London Market remains a sector of particular interest to us at the FSA and more specifically to the Wholesale Business Unit. Our aim is to promote a well regulated wholesale market which is efficient, orderly and fair. We also seek to ensure that it is internationally attractive and sustainable. That is a goal which is of equal importannce to you and one which I hope we both share.

Thank you for your attention this morning.

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