The wholesale insurance market and the regulatory platform of choice
Speech by Hector Sants, Managing Director, Wholesale Business Unit, FSA
Insurance Sector Conference
20 March 2006
Introduction
Thank you, David for that introduction. It is a pleasure to be here at our second Insurance Sector Conference. So far this morning you have heard about the FSA's strategic aims: John has given you the FSA's 'view from the top' on our principles-based approach to insurance; and Clive has given an update on our work on Treating Customers Fairly in the insurance context. Given my role at the FSA, it won't surprise you then that I will focus my remarks on the wholesale markets and, in particular, the wholesale insurance sector.
A wholesale market is one in which financial transactions are undertaken between professional counterparties – for me this includes securities and derivatives firms, wholesale banks, insurers, and asset managers, as well as market infrastructure providers. But of course for you this means the wholesale insurance sector: the insurers and brokers that make up the Lloyd's and London Market.
The London Market has long been respected around the world for its ability to understand, price, accept and manage speciality risks and is perhaps the most international of all insurance markets. This market enables satellites to be launched, aeroplanes to fly, buildings to be built, and ships to sail. London Market insurers handle in excess of £26bn of premiums and brokers generate some £2bn of invisible earnings to the UK economy each year. Around 50,000 people are employed in the industry and support functions. The wholesale insurance market is, therefore, of great importance – to us as regulator and to you as market participants.
Regulatory aim
At the FSA, our aim is to promote a wholesale market which is well regulated, efficient, orderly and fair. We seek to ensure that the wholesale market is internationally attractive and sustainable. That is our aim for all wholesale markets and as such our aim for the London Market. These characteristics are essential for the continuing competitiveness of the UK insurance market bringing clear advantages to the buyers, providers and brokers of insurance.
Our aim is consistent with our Statutory Objectives and with the Principles of Good Regulation. In particular, FSMA requires us to have regard to the international character of financial services and markets and the desirability of maintaining the competitive position of the UK.
Regulators and markets have their own respective roles to play in achieving this aim. Necessarily, those roles differ in places. As John mentioned earlier, in a wholesale arena, market-driven solutions must prevail wherever possible - regulatory intervention should occur only when the market's own solutions do not, or cannot, succeed. That is the basic test that regulation of any sector or of any type must pass.
It is the relative rôles of the regulator and the regulated that I want to talk about today. In doing so, I will explain how the FSA provides a regulatory platform which strikes the right balance between regulatory intervention and market-driven solutions; a platform which is attractive internationally; a platform which brings benefits to firms, consumers, capital providers and regulator alike. The regulatory platform of choice.
The regulator's role
So let me start by outlining our responsibilities in achieving these important aims. I promise not to give you a line by line account of our regime but to highlight our five key functions -
- First, we act as the gatekeeper, making sure that only those that are fit and proper can enter the regulatory arena, thus protecting the reputation of the wider market;
- Second, we set the Principles which set out our fundamental requirements and provide an 'if in doubt' guide to our regulatory expectations;
- Third, we identify areas where detailed rules are required – such as prudential and capital standards. We look to propose rules only where justified on cost benefit grounds (though some European requirements, over which we have no choice, may not meet that test). And we consult with you about those rules and work with you on implementation.
- Fourth, we act as referee by supervising against the principles, supplemented by rules, and where we identify widespread failures, such as firms' compliance with client money and conflicts management requirements, we fill those gaps through a combination of risk assessments and dedicated sectoral reviews. The allocation of our resources to our supervisory work is based entirely on the risks posed by a particular firm or issue to the achievement of our statutory objectives – that is our risk-based approach;
- And fifth, when things go wrong, we take swift action to address the issue. That may be by encouraging industry action. But where necessary it will include proportionate, though formal, regulatory steps including enforcement where appropriate. Thus we can reduce detriment to consumers and protect market confidence, including the reputation of the compliant parts of market.
There are a few additional points to note.
All regulators need to remember that while regulation should bring benefit, it is also a source of cost to the financial sector. We are determined to keep costs to a minimum wherever possible but are aware that this is not always the case. In response to concerns expressed by the industry, our joint study with the Practitioner Panel is designed to identify the costs of our regulation to parts of the financial services markets. The results will be published in the second half of this year.
Further, in doing all this, we must have regard to the competitive position of the market and not stifle innovation. We must do that because it is required of us by FSMA. But there is a wider imperative too, for this is essential if we are to deliver an efficient, orderly and fair wholesale insurance market and one that is internationally attractive and sustainable. I will say more about this later.
Finally, our integrated structure, coupled with our risk-based approach to regulation, gives us the ability to regulate through high level standards and within a common supervisory framework. Firms regulated by the FSA, whether provider, introducer or distributor can have confidence that consistent and transparent standards are applied – differentiated to take account of the size, nature or risk of an individual firm. This approach is, I believe, unique when compared to other international insurance regulators.
For some time now, we have differentiated our regulation of retail and wholesale firms, because the rationale for regulation differs. Information gaps of the kind which exist between the seller and buyer of retail products do not, generally, exist in a wholesale market. But the need to guard against financial failure through strong prudential supervision remains crucially important, especially where firms provide a vital function to the proper working of the market – as in the London Market.
A wholesale market is one in which professional buyers meet professional sellers, often using the skills of an intermediary to help deal with the complexity of transactions. Our approach to regulation must reflect the nature of the players in the market – one size does not fit all.
Finally, all this must be seen in the context of the Better Regulation agenda as outlined by John earlier this morning.
The role of the market
I have given you my view of our approach to regulation within the broad context of our overall aims for wholesale markets. In achieving these aims and to benefit from a proportionate regulatory response, the market also has responsibilities: the flip side of the regulatory coin. An efficient, orderly and fair wholesale insurance market is an objective which is shared by many of you, the players in the market; and a market which is internationally attractive can only bring commercial benefits to you, your customers and your investors.
The reputation of the London Market must be preserved if global corporations and insurance buyers are to continue to transfer their risks here and if capital providers are to believe that they will get a decent return on their investment, in hard cycles and in soft cycles. Improved risk management techniques and better controls over underwriting are beginning to emerge. Better management of conflicts of interest is needed, as we reported last year following our reviews. You have an opportunity to find your own solution here. And the safety of client assets held by London Market brokers is equally important given the vital role that the larger brokers play in the settlement of insurance transactions in this market. So reputation protection through the absence of failures - compliance, underwriting or otherwise - is also your responsibility.
The London Market must continue its efforts to improve efficiency and, therefore, reduce costs. This must be your primary objective if you wish to compete for business with other global insurance centres. The progress you have made in improving contract certainty, as acknowledged by John earlier this morning, is evidence that you are both willing and able to move toward a more efficient operating model if you can see the benefits of so doing. The Market Reform Group's efforts to improve accounting and settlement processes – and delivery of these reforms - will be further testament of a real desire to modernise market practice and move away from old behaviours such as 'deal now, detail later', treacle in the back office, and reliance on personal relationships as a way of managing operational risk. It is clear that both underwriters and brokers need to consider their cost base and service offering. The world has moved on. Many of you share the desire to move on. But this is a market in which a collaborative effort is vital to success.
So, what balance have we struck so far in the respective roles of regulator and regulated? I have set out how the regulator sets the standards with which those operating in the market must comply. The regulator also sets challenges to the industry to find solutions to problems where detailed rules and requirements would not be proportionate, and where it believes market solutions have a real chance of success. In return, the market needs to meet those standards to protect its reputation and competitive position, and it needs to ensure efficiency to remain cost effective. As a result, more business will come to the market and everyone – buyer, seller, broker, investor and regulator – will be happy. In this perfect world, the balance between regulatory intervention and market solutions is struck.
Frictional issues
But it is just not as simple as that, I know. There are frictional issues which mean the balance can be difficult to strike; there are external influences which affect where business is done and where capital is raised; and there are other insurance markets which compete for business. The London Market cannot be complacent about its position in the global insurance market and the FSA must have regard to the competitiveness of London in fulfilling the regulatory functions I've described. Whilst these frictional issues need smoothing, high regulatory standards cannot be sacrificed. Financial centres with strong regulatory systems are better able to protect reputations which, whilst hard to win, are easily lost in the event of regulatory failures. We hope that this is widely recognised, both by the regulated and by other regulators.
In the last quarter of last year, following the US hurricanes, around $20bn of new capital was raised globally by the insurance industry. New capital was needed to rebuild balance sheets and secure ratings. New capital was raised to finance new business and take advantage of what was hoped to be significant increases in rates in classes most affected by the hurricanes. It has not escaped anyone's notice that just under 90% of that new capital raised went to support business outside of the London Market, primarily to Bermuda.
One of the most visible indicators of the competitiveness of the London Market is the preferred location of start-ups when new capital becomes quickly available to take advantage of changing market economics. In recent years, a number of insurance companies, including UK companies, have chosen to locate off-shore – in Dublin, and Bermuda to name two.
The location of choice for new business will necessarily be based on management's decision taking into account numerous factors: the fiscal environment; access to customers; supply of specialist labour; and, of course, the regulatory landscape.
Understanding the true impact of different countries’ tax systems is a complex matter. Tax is, of course, the Treasury's territory so I will limit my comments suffice to say to say that we are working with colleagues at HMT to ensure we have a collective understanding of the frictional issues.
Nevertheless it is already clear that tax is a major factor influencing firms' decision-making in this area - the market seems to be indicating that this is the principal: but clearly not the sole driver.
We are concerned therefore – as indeed we should be – if the UK regulatory regime also serves to discourage firms which write business responsibly from locating here. Whilst decisions may be based on the perception of the regulatory regime, as we all know, perceptions rather than reality often hold disproportionate weight. It is certain of these perceptions that I would like to come on to address.
Authorisation of new firms
The one area that is often cited in this context is the length of time it takes for the FSA to authorise new firms. It is true to say that four or five years ago, the FSA had a poor, and probably justified, reputation in this area. The whole process took a year and often longer. This was unacceptable for an organisation setting out to be a world-class regulator.
We recognised the need to make improvements in our authorisation process. We recognised that whilst the authorisation of firms is a key regulatory tool in maintaining market confidence, the process needed to be more efficient and more aligned to market needs. The result has been a marked reduction in the average time to process applications: from a year or more, to 17 weeks and significantly less in many cases where the group is known to us already. Insurance applications are among the most complex we receive and there will be cases where, for sound regulatory reasons, the process will take longer. But we have seen a significant shift from where we were.
We are continuing to reduce authorisation times further. We are working currently with a number of firms to project timetables in the 2-4 month range. Indeed, this is bearing fruit. One CEO recently admitted his surprise that the FSA was able to achieve a favourable timetable for authorisation; his perception had changed having lunched with someone who himself had been through the process very recently.
Against this background, it was disappointing to me that not one of the new companies established post-Katrina discussed with the FSA the option of setting up in the UK. Not one enquired as to the costs, the regulatory requirements, or whether we would be able to authorise firms in good time to take advantage of the important 1/1 renewal period. Perceptions, although flawed, do prevail.
I would like to change perceptions for good by announcing today an important change in our approach to authorising new insurers. In a period of market pressure, such as that experienced last autumn, we have decided that we will reallocate our resources so that we can ensure that we can decide an authorisation application – where we have prior knowledge of the group – within one month of receipt of the application and within 10 weeks where we don't. This will of course presume that we have been supplied with sufficient and robust information to allow us to meet our statutory obligations. We still need to be satisfied that an insurance company is fit and proper and has adequate resources, both in terms of money and people. There can be no relaxation of that very basic and fundamental regulatory requirement.
Reinsurance Directive
Looking ahead, the implementation of the Reinsurance Directive across EU member states presents some further opportunities for the UK market. As you know, the FSA already applies full regulation to pure reinsurance companies, however, the Reinsurance Directive largely adopts the non-life insurance directive requirements for both life and non-life reinsurance business. This could result in reduced pillar 1 capital requirements for some firms which we will be consulting on over the summer and which I'm sure you'll welcome. The Directive also brings with it three important developments for the London Market.
First, firms operating in one European jurisdiction will be able to take advantage of passporting rights into other EU states. This will reduce the costs of regulation for those firms which, to date, have had to establish regulated entities in each and every EU country in which they do business.
Second, other EU states have had to look carefully at the imposition of collateral requirements for 'foreign' reinsurers as these will not be permitted under the Directive. We hope that the harmonisation and increased standards of reinsurance regulation across Europe will further strengthen the arguments for the removal of collateral requirements for alien reinsurers – a requirement of the US regulators for many years. John has touched on this already.
Third, the approach to Special Purpose Vehicles. I am also pleased to announce today that, in implementing the Reinsurance Directive, we aim to facilitate the creation of Special Purpose Vehicles. Although clearly subject to consultation later over the course of this summer, our overall aim is to open up the SPV market. This will require an authorisation process which is fit for purpose and proportionate given the nature of the vehicle in question. In doing so, we believe we will be responding to market developments in this area, again, working with the grain of the market rather than stifling innovation.
Conclusion
I have today set out what I believe to be the respective roles of the regulator and the regulated in promoting an insurance market which is efficient, fair and orderly. I have also set out what I believe needs to be done to ensure this market remains attractive internationally and retains its competitive position. And a market that is transparent and highly competitive and shows that it works well is less likely to require intervention, whether regulatory or otherwise.
I have announced some important changes to our approach to regulating wholesale market players in a changing regulatory environment. Change that comes from the market's response to accepted market failures; change that comes as a result of developments in domestic policy; and change that comes in response to perceived regulatory frictions.
In concluding, I want to be absolutely clear that this flexibility in approach is about being able and willing to respond to the changing market needs. This is not about weaker regulation but about better regulation. This is about maintaining a regulatory platform which will rank as highly in insurance executives' minds when choosing location, as has been the case for the investment banking and asset management sectors for many years. A well-regulated environment, one that is efficient fair and orderly, is vital if it is to be attractive internationally and, ultimately, be the regulatory platform of choice. That must be an objective shared by us all.
Thank you for your attention.