Re-thinking life insurance
Speech by David Strachan – Insurance Sector Leader
Westminster
& City Conference
Thursday 21 April 2005
Introduction
1. Good morning ladies and gentlemen. I am delighted to be here today following on from what I gather was an excellent opening day yesterday. Looking at the programme, and indeed hearing from those who attended, yesterday focused largely on the new prudential and other requirements for the life industry. No doubt this gave you food for thought on some of the key challenges facing the industry as we move from design to delivery and implementation of our domestic reforms to the insurance industry. However, that is not to say that the FSA's work on insurance is by any means complete. We still have some unfinished business and challenges from the EU agenda grow ever closer.
2. Since 2001 regulation of the insurance industry has without doubt undergone nothing short of wholesale root and branch reform. Modernisation has been all encompassing. At the same time the industry has had to respond to a number of strategic and commercial challenges. We fully recognise the commitment that the industry has shown in helping us develop a modernised regime.
3. My time with you today is brief so I do not intend to give you chapter and verse on the entire reform programme, which we documented in our report published earlier this month. Instead I will focus my remarks on some of the key changes to with-profits, including two particularly pertinent areas right now: realistic reporting and the fair treatment of policyholders in closed funds.
Realistic Reporting
4. Speaking at this conference, just 12 short months ago, I looked ahead to the FSA's forthcoming package of reforms which was designed to introduce greater transparency and protection for policyholders, particularly in with-profits funds.
5. Since then, at the end of January we published our policy statement on treating with-profits policyholders fairly. This final phase of reform introduced new rules and guidance on what it means to treat with-profits policyholders fairly; the requirement for firms to publish a consumer-friendly version of their PPFM by the end of the year; the introduction of a policyholder advocate in the re-attribution process of inherited estates; and improved notification and information requirements should a fund close to new business. With our position on each of these important aspects of the new regime finalised, we are now on the brink of implementation. 2005 is the year in which our reforms are beginning to make a real, tangible difference.
6. A key milestone along the way to this ultimate goal has been the introduction of realistic balance sheet reporting for insurers. Having already transformed the way in which insurers evaluate their with-profit liabilities, the results of realistic reporting are now becoming publicly available with the end 2004 returns, marking two and half years of intensive preparation by the industry. And, although our actuaries are still knee-deep in returns, I can tell you that based on the quick and high level analysis of the 30 firms we have reviewed so far the picture that is emerging is encouraging. For year-end 2004, the aggregate realistic surplus for these firms stands at £24.6bn which favourably compares with £21.9bn at end-June 2004. In the coming months, we will of course feed back more substantively with our full analysis.
7. This is, of course, to be welcomed. Particularly so, because the passage to this destination has not always been as smooth as we might have hoped. As has been well documented, along the way some insurers realised that their financial strength was not as strong as they had perceived under the statutory regime. This, coupled with the move from deterministic to more sophisticated methods of calculating the costs of with-profits guarantees, has led to some firms taking action to strengthen their solvency position. Known as "management actions" these measures have sometimes involved a reduction in policyholders' benefits. Where this has been the case, we have been resolute in ensuring that the firm satisfies itself and us that any action taken – and indeed the resultant impact on policyholders - are both fair and consistent with what is disclosed in the firm's PPFM.
8. One of the most common forms of management action is a reduction in a firm's equity backing ratio or EBR. During the deep bear market many firms reduced their equity exposure as a means of improving their solvency position and although the markets have since stabilised, none has regained the levels of EBR that were commonplace in the halcyon days of soaring stock markets. This is, in part, due to the industry's recognition that if they choose to invest in riskier or more volatile assets then they must hold more capital to support the associated risk and that guaranteed liabilities are better matched by fixed income assets. From a regulatory perspective, quite clearly the question here should not be: how low can you go in terms of EBR? Rather, given the reduction in EBR, are you still treating your customers fairly and taking account of their interests? This is a particularly important question for closed funds.
9. But it is not just management actions relating to investment mix that attract our attention. Wherever policyholders' interests are put at risk we have an interest. We have challenged firms to justify a number of proposed management actions, including excessive administration charges, investment management or consultancy fees; the inequitable sharing of any with-profit fund deficit between policyholders and shareholders; and unfair MVRs.
10. Those of you who study the full range of FSA output will have noticed recently a reference to closed with-profits funds in the report we issued jointly with the Financial Ombudsman Service as part of the so-called N2+2 Review. Without going into the detail, I should mention that we have agreed with the FOS how they will respond, with our input, to complaints from policyholders that may stem from management actions of the sort I have just described. In broad terms, we have agreed to let the FOS know whether the action that lies behind the complaint, such as reducing the risk profile of the fund, has been considered by us. This will enable the FOS to focus on policyholder complaints where there may be a case to answer, for example about misrepresentation by the firm of the likely risk profile, rather than having to take a view on issues that we have already agreed are consistent with the fair treatment of customers, taking into account the financial strength of the fund, what is set out in the PPFM and so forth.
11. Before exploring some of the fairness issues relating to closed funds in particular, I think it worth underscoring a key tenet of our regime: that the responsibility to treat customers fairly rests unequivocally with senior management. It is for senior management to consider what actions are needed to reconcile the diversity of interests that lie at their door. Conflicts abound – be they between different sub-sections of the portfolio of policies or between policyholders and shareholders. And although not quite requiring the judgement of Solomon, decisions taken must be fair. To help ensure that they are, we will have detailed discussions with firms over the actions that they propose to take.
Closed Funds
12. Our resolve to see fair treatment of customers is not of course limited to policyholders in closed funds. That said, we do recognise that there are specific fairness issues that arise in closed funds. We are quite clear that our regulatory regime and specific requirements on closed funds provide us with tools to help assess and address potential risks to policyholders within these funds. Notwithstanding this, it is an extremely difficult area, with complex judgement calls aplenty – not only in determining the magnitude of risk to consumers and the extent to which regulatory intervention is required, but also in striving to ensure that a balanced view is reached in determining what constitutes fair treatment of policyholders.
13. Consolidation in the life sector is of course nothing new. But the recent arrival of a number of innovative closed fund consolidators which are engaging in significant transactions adds a further dimension to the fairness debate. Not surprisingly, questions have been asked about the treatment of policyholders within these funds. These include, for example, whether the new shareholders will extract value from these funds to the detriment of policyholders through actions such as excessive charging and the unfair distribution of surplus assets. Some commentators have also raised concerns about what they regard as the relative ease with which the ownership of with-profits funds can change hands. In particular, they point to the absence of any court approval for the transactions, as there would be in, say, a Part VII transfer. Against this background I think it is worth taking some time and trouble to remind ourselves about what safeguards are in place.
14. When the ownership of a regulated business changes hands, the acquirer must gain approval from the FSA through what we call the "change of control process". This effectively provides us with our starting point for determining whether the new owners will be fit and proper to manage the interests of policyholders. There are two statutory tests – both of which must be satisfied for us to approve the acquisition of a closed book of business. First, that the acquirer is a fit and proper person to have control. And second, that the interests of consumers would not be threatened by the acquirer's control – as part of this, the regulated firm must continue to be able to meet the threshold conditions, the minimum conditions for authorisation. In relation to this second test, a large part of our role is to ensure that there is sufficient capital retained in the fund – or ring-fenced to support it – to meet policyholder liabilities as they fall due. Here, a careful balance must be struck between maintaining a strong capital position against other considerations, for example with a fair pace of distribution to policyholders.
15. While the specific question of whether a firm continues to meet the threshold conditions is "absolute" in the sense that the required standards do not differ between funds, the broader test concerning policyholder interests has to be assessed relative to the current position of the fund. Factors that we will take into account, both individually and in aggregate, include:
- financial strength – whether the acquirer's plans satisfy us that the fund is at least as strong as under the existing owner;
- financing methods – in particular the risk that the means of financing the transaction will increase the likelihood of excessive capital withdrawal from the fund;
- governance arrangements – including the expertise of the incoming management and the extent of independent challenge;
- the investment strategy for the fund – whether the new owner intends to change the fund's exposure to riskier assets and what this signifies for the continuing fair treatment of policyholders;
- customer service standards, including ongoing communication to policyholders; and
- contingent liabilities.
16. This is not an exhaustive list. But it does cover the main issues and
should give you an insight into the degree of scrutiny we give to such transactions.
Our goal – to repeat myself – is to be satisfied that the interests
of policyholders are not threatened. This is an essential safeguard. But it
is important to be equally clear that our powers do not permit us to go further
and require new owners to enhance the position of policyholders. That some
new owners may choose to do so of their own accord is a matter for them.
17. We are also able to attach specific conditions to the change of control thereby providing an additional protective layer around policyholders' interests. These may, for example, restrict the amount of capital that can paid out and/or the timing of dividend releases to shareholders. A short time ago one such change of control included conditions that will ensure that the new controllers will maintain a margin of capital above their Pillar 1 requirements. As part of this we agreed an indicative schedule for any capital release and restrictions determining when dividends could be paid.
18. The example I have just given is clearly very specific, but I hope it goes some way to illustrate the extent of our reach in policyholder protection. I think it is also important to be clear that imposing what some may view as quite severe measures, does not in any way suggest that we are unresponsive to new ideas for the management of closed funds - or indeed new sources of capital. Innovation is something that we both welcome and advocate. But not, let me be clear, if the price tag of that innovation reduces policyholder protection.
19. Of course, the change of control process is just one mechanism to safeguard policyholders' interests. By closely examining the planned level of bonus payments after closure and any change in the investment mix of the fund we are able to surface issues which may impact adversely on policyholder benefits.
20. The sources that help us form this assessment include the Individual Capital Assessment; the PPFM which sets out how the firm intends to manage its with-profit fund; the With-Profits Actuary's annual report on compliance with the PPFM; and the scheme of operation which is produced on closure of the firm to new business or run-off plan produced on the closure of a fund. This rich seam of information covers all aspects of the current operation of the fund. And, more importantly, how management intends to treat policyholders going forward.
21. A lot of the ground I have covered this morning has focused on the need for firms to realign their approaches. But clearly, some re-alignment is necessary too on the part of the consumer. This is something that we fully recognise in our work on financial capability – designed to help consumers manage their financial affairs more successfully. We have also made our own efforts to improve FSA information for consumers – I'm thinking particularly here of our recent offering: 10 Questions to help with-profits policyholders. But we are not alone in this quest and others such as the ABI through its Raising Standards initiative are seeking to improve the quality of information that consumers receive so they are better equipped to make informed decisions about their investments.
Closing remarks
22. Some of you might by now be thinking that I have dwelt too long on closed funds. And that I should have looked more to the future than the past. If so, I would beg to differ. Closed funds are clearly here to stay. They are increasingly important. And the shape of this segment of the market is changing. In particular the closed fund consolidators are both re-thinking and re-shaping this part of life insurance. Although the change process has begun, it is by no means complete. The emergence in due course of a closed funds sector, characterised by policyholders who are able to make informed choices and who are treated fairly throughout an orderly and well managed run-off will constitute success. To my mind, this is neither an unrealistic nor unattainable outcome.
23. Let us consider for a moment what might happen if success is not achieved. Policyholders in closed funds are not isolated in some solitary confinement unit. They, and their families, will be active in other investment products and markets. There is no doubt in my mind that their attitudes and preferences will be coloured by their previous experiences, both good and bad. How many bad airline experiences have you sought to repeat? If the industry is to face the future with confidence, it must do its utmost to ensure that its policyholders can do the same. Justifiable confidence needs nurturing. That's why it was the theme of my remarks last year. And that's why it remains a core issue for all of us.
