Principles-based regulation and what it means for insurers
Speech by John Tiner
Insurance Sector Conference
20 March 2006
Introduction
Good morning Ladies and Gentlemen. May I add my own warm welcome to you all here today. The insurance industry is a vital part of the British economy and of society more generally both through its ability to assume and price risks which consumers, corporations and governments do not wish to carry themselves and as a channel for the long term savings of the British population. Perhaps with the challenges of today’s society these services are needed more than ever. In setting our agenda for today we have tried hard to cater for all tastes, including those concerned mainly with domestic business as well as those who serve customers around the world.
I would like to cover four issues which I am sure will crop–up on a number of occasions during this conference: firstly, the FSA’s better regulation agenda and most importantly our intended shift to a much more principled and risk-based system of regulation and supervision; secondly, our take on the insurance industry’s progress on securing contract certainty; thirdly, collateral for reinsurance in the United States; and, finally Solvency 2.
Principles-based regulation is not new. The 11 high level principles for firms have been in place since 2001. They set overarching requirements for all financial services firms. These are the regulatory equivalent of 'First Principles' – a set of axiomatic statements that articulate what action and behaviours we expect from firms and which provide the very backbone of our regulatory regime. Critically they focus on what the regulations are trying to achieve and so are expressed in terms of outcomes rather than processes or procedures. In that way we hope they provide a helpful "if in doubt" guide to the regulated community.
But while these Principles have been in place since the FSA's creation, we have all lived with a rather unsatisfactory hybrid of thousands of detailed rules which sometimes prescribe requirements at a great level of minutiae sitting underneath these high level principles, which I would emphasise are rules in their own right. As we said recently in our Better Regulation Action Plan we see real benefits for firms, markets and consumers, as well as our own people, in tipping the balance more towards principles and away from prescription. Why is this?
First, we want to encourage and foster good business practice throughout the financial services sector recognising firms’ duties to their owners and their customers. We believe that providing firms with the flexibility to more often decide for themselves what business processes and controls should operate so compliance with the principles is secured, will better align good regulation with good business practice. This approach will provide greater clarity about the outcomes that really matter to us, and will engender a shared appreciation of the regulatory outcomes we are seeking to achieve. So the focus shifts from the means to the end. And, by taking a more overtly risk-based approach to our assessment of whether firms are operating in line with these principles we should create incentives for firms to do the right thing in return for a regulatory dividend – that is less regulatory intervention.
Secondly, we believe that firms who are seriously committed to treating their customers fairly (and as this is one of the 11 principles, this means all firms must sign-up to this) are in the best position to judge the detail of how they deliver fair treatment to their customers and to enable them to align that with their commercial objectives in terms of customer service and retention. Given the asymmetry of the retail market relationship between a firm and a customer, it will always be necessary for there to be more regulatory prescription than in the wholesale markets, but within the growing constraints imposed by EU regulation, we believe that more can be done.
Thirdly, in its policy making the FSA has a duty to have regard to the international competitiveness of the UK markets. I do not need to repeat here the phenomenal success of the City as a location of choice for international financial business, including wholesale insurance and reinsurance – although as my colleague Hector Sants will discuss later, recent trends show there is no room for complacency. Many independent surveys have attributed some of this success to the more pragmatic system of regulation we have operated in the UK and I believe this can be reinforced by this change in approach and further consolidate London’s position as the location of choice for international capital.
Fourthly, I recognise the importance of the FSA maintaining a high quality workforce and while this is not the place to cover this objective in detail, I believe the shift I have described, the success of which will be critically dependent on our people making good judgements based on a good business understanding and an ability to communicate clearly, will make the FSA an even better place to work.
I would suggest further that past experience has taught us that a regulatory solution with a heavy reliance on ex-post rules to address market misconduct, is one that sets us firmly on the path to an ever burgeoning handbook, full of detailed rules to prevent further misdemeanour. Such an approach would suggest that we are only treating the symptoms of market failure and perhaps neglecting the root causes. As such, a more principles-based approach challenges both us and you to keep our sights firmly fixed on the things that matter and getting those right, rather than putting our finger on a hole that persistently reappears in the dyke.
Of course, in the world of insurance regulation, so much of our and your attention has been focused on the detail of the new rules of the regime – and, as is so often the case when focusing on the minutiae of the detail, it is all too easy to lose sight of the wider picture – in this case the Principles and what they are designed to achieve. An unfortunate consequence of this is that a crop of misguided beliefs have emerged, chief of which is the misnomer from the retail general insurance side of the market that segments of the insurance industry should be granted special dispensation from one particular principle or another. I hear too, again from the retail general insurance market, that some are confusing our principles-based regime with other regulators' in the UK, where principles are considered aspirational rather than mandatory. These unhelpful misconceptions must not be allowed to fester and take root. To be unequivocally clear: the principles you see behind me apply all of the time, to all of your firms.
On the face of it, I imagine you may find this shift to principles as sounding attractive, but I am aware that a number of firms and their trade associations worry that they would be entering a period of greater regulatory uncertainty and risk. I well understand these concerns and realise that the FSA has a key role to play in establishing an environment which firms find reliable and predictable, where communications from the FSA are relevant, clear and timely and that, as I have mentioned already, our people have the experience, expertise and skills to make sensible, informed and proportionate judgements. There is work for us to do on each of these, but I can assure you that I and my senior management team are determined to pursue them relentlessly - and vigorously - over the coming months and years.
So, how does this all translate? First for the retail customer. Over the last eighteen months or so, few of you will have failed to notice the attention and effort that has focused on one particular principle – No 6: that a firm must pay due regard to the interests of its customers and treat them fairly. Clive is going to come on to this topic in some detail next, so I shall confine myself to an observation that I confess to being somewhat nonplussed by – that this is one such example of a principle that some in the retail market believe to be somehow less important for certain lines of business due to the degree of competition in that market. I couldn't agree more that in several lines of business UK consumers enjoy the benefits of a highly competitive and innovative general insurance market. But that does not absolve each market participant's duty to treat their customers fairly.
The application of principles to the wholesale market is more intuitive – information is generally better distributed (although I continue to be puzzled and disappointed that buyers of insurance which are significant businesses in their own field seem reluctant to punch their weight in the market – a matter I will return to in a moment) and market-based solutions to problems can more readily be made to work.
So what is the reality? As anyone operating in the London Market will be only too aware, our test-case for this approach in the insurance industry is to find a market led solution to the "deal now, detail later" pandemic that has resulted in a lack of contract certainty for generations. In fact I would say that this is just one symptom of the general malaise which has prevented the London market from seeking competitive advantage from sensible, fit-for-purpose application of modern business processes and technologies. It seems to me that the market needs to move swiftly to lower the cost of doing business, improve efficiency and reduce operational risk.
So where are we on contract certainty? We promised to give feedback once data had been collated. We have now received the results and there is no doubt that the market has made good progress. The figures provided by the Steering Group indicate that the market has exceeded both its targets and our expectations. And members of the Steering Group have told us that they believe the market is on track to deliver on contract certainty by the end of 2006. So, today, I am pleased to inform you that to demonstrate our good faith in the market's ability to reach its goal, we will not be pressing ahead with our work on the contingency plan of regulatory intervention. We are putting it on the back-burner, although we are not taking it off the stove altogether. This means that those in the market tasked with delivering the solution – in other words, many of you – will be able to focus fully on that delivery without being distracted by our consultation on new rules and cost/benefit analysis.
The market's efforts so far are to be applauded and momentum is, of course, key. But while you have tackled successfully some difficult issues such as signed lines, I reckon you may have picked the low hanging fruit and the really heavy lifting (to mix my metaphors) is still ahead of you – if you are to attain a target closer to 100%. So, I would strongly caution against complacency in these next few crucial months; the market must continue to stretch itself to guarantee that the challenge is met by the end of the year. In this context I imagine you may wish to reconsider the targets you have set for both mid and end 2006, as these appear somewhat of a breeze given progress so far. On our part, we will continue to assess progress beginning in the next quarter, not least to see how the market has performed against the challenging 1/1 renewal period. We will continue to work with the market in our rôle as over-seer and facilitator, and will not hesitate in consulting on new rules should progress falter. I am sure I am not alone in looking forward to the day when we can say with confidence that having issued the challenge, the market responded and as a consequence, no regulatory intervention was needed. That would be the right regulatory outcome for all concerned.
I would also suggest that the market should take heart from the impressive progress on this test-case, and consider how this can be translated across to concerns over transparency and disclosure of commission in the general insurance market. As some of you may recall, this time last year, I made clear that we do not believe regulatory intervention to be an appropriate response to these concerns.
That remains our position. To repeat: making commission disclosure mandatory will not necessarily address the conflicts themselves that arise from commission sharing arrangements. In line with Principle 8 – firms must properly manage conflicts of interest, these need to be actively managed by firms. In last year's Dear CEO letter, we gave feedback on a number of shortfalls that had been identified. We will take another look in the coming months at how intermediaries manage these conflicts in light of the feedback published. And, we will take account of what we find then when considering our policy response. In the meantime I would stress, once again, my strong preference for a market-led solution.
As I alluded to a few moments ago, I am disappointed that more commercial customers are not demanding commission details, as our rules enable them to do. Perhaps many such customers don’t know this rule exists and perhaps the broker doesn’t feel it's their place to tell them. I should, however, like to recognise the efforts of the LMBC which has written to all Lloyd’s brokers recommending that they introduce a statement into their client Terms of Business Agreement that: "prior to the conclusion of each insurance contract or upon renewal, brokers will [advise you] or [discuss with you] or [remind you of your right to be notified] of the level of commission which they receive from underwriters”. It then refers to their entitlement to receive such details. I am aware that the major Lloyd’s and London market brokers are operating in a fully transparent manner and I urge the brokers who seem to be seizing on some short-term competitive advantage from this, to follow suit.
I hope I am not tempting fate by saying that progress towards contract certainty would suggest that the market is more than capable of generating workable solutions to conflicts management and transparency. Indeed, encouraging smoke signals are to be seen, suggesting that market forces are already at work in some parts of the market to address the failure. As I have said, it is clear that some of the London Market players are already using their own solution to enhancing transparency and the recent IUA/LMA survey suggests that 60% of corporate buyers of insurance have already switched to fees. This is all very encouraging, not least because market led solutions are our preference, but also because this particular playing field must be levelled. I do not relish the prospect of playing chaperone to consenting, adult parties, but if our review indicates that little progress has been made, then this will clearly influence our regulatory response.
If over the next several months we do not find any discernible improvement in transparency, then we will consider seriously mandating disclosure – but I have to say this would be a last resort and necessary only because the market and its clients had failed to sort out its own issues, which does not bode well for addressing some of the other challenges you face in maintaining London’s leadership position in the international insurance and reinsurance market.
So, I have covered two areas – contract certainty and commission disclosure – where working within the principled-based approach I hope that industry codes and standards will provide the solution. This will be a recurrent theme as market failures are identified and I ask for your support in helping me to reduce the size of the FSA rulebook and the cost of regulation. I am acutely aware that some of you feel that the FSA has “gone over the top” on certain issues and is not supervising on the basis I laid out at the beginning of my remarks and I invite you to inform me personally of any practices which you feel are in conflict with the points I have made today. The FSA will also look for better and more creative ways of helping firms with the new approach, including the use of case studies to illustrate good and less good practice, such as those which we will publish on our website later this week.
Given that we have representatives from all sides of the insurance sector here with us today, before closing, I am sure you will forgive me for taking this opportunity to make a few brief remarks on matters beyond the domestic agenda.
In February, I was in Naples Florida attending the NAIC Commissioners' retreat where we discussed at length the global regulation of reinsurance, and in particular the US approach to collateralisation of exposures to non-registered, mainly "alien" reinsurers. I had the opportunity to explain in some detail how the FSA regulates UK reinsurers, suggesting that we take it just as seriously as our US colleagues and I called for mutual recognition of our respective regulatory regimes i.e. no systematic collateralised credit protection should be necessary either way. I am pleased to see that the NAIC has now announced that it will look again at alternative solutions to this discrimination between domestic and overseas reinsurers by the end of the year. The very fact that a number of countries, including the UK, have made great strides in the regulation of reinsurers, coupled with the imminent arrival of the Reinsurance Directive will, I am sure have influenced that decision to some degree.
The maintenance of collateral incurs costs which the insurance sector and ultimately the consumer need not bear and it distorts the efficient allocation of capital and competition. But it exists (and as the saying goes – possession is nine-tenths of the law) and there appears to be no shortage of inward reinsurance capacity to US carriers. But I think there are strong arguments for allowing the market to decide when additional security is needed and I will be visiting the US several times in the next few weeks to help the Insurance Commissioners and the US insurance and reinsurance industries appreciate our point of view and to continue to press for change.
Finally, it would be remiss of me not to give some mention to developments on Solvency 2 – the European directive on the prudential regulation of insurers which is currently in the design phase, and which will have a significant impact on the way in which EU insurance firms are regulated in the future. Based on the Commission's Roadmap for the project, we anticipate that firms will need to implement Solvency 2 around 2010. Although that seems a long way off, now is the critical time to influence the debate as the Commission will be drafting the Framework Directive that sets out the high level principles forming the architecture of the new regime over the next year and a half. Important discussion on the detail will of course continue thereafter, but by mid-2007, key decisions on the overall shape and direction will have been made.
The uncertainty that surrounds this project means that there is much at stake. Failure to make the modernisers' case successfully could even undermine the domestic regulatory advances made to date, as well as unduly restrict the business models that firms may wish to adopt. To remind you – the modernisers' case for which the UK is a major advocate, calls for assets and liabilities to be measured on a broadly market consistent basis with policyholders deriving their safety and protection from capital, held at prudent levels relevant to the risks the businesses faces and the impact of those risks in stressed conditions. Of course, this is a massive over-simplification, but delivery of this agenda will be important to retain the competitiveness of EU insurers in global markets in the future. The UK industry has an important, but all too often softly spoken, voice in this debate. I would draw to your attention the recently published Discussion Paper on Solvency 2, written jointly by the FSA and HM Treasury. We are keen to hear industry views on these issues and this paper is out for comment until the end of April.
In addition, CEIOPS, the Committee of European Insurance Supervisors, is an important party in this process as it first advises the Commission on the drafting of the Framework Directive and subsequently on the implementing measures. Starting in May, CEIOPS will be inviting firms to participate in a quantitative impact study (QIS). This aims both to gain some measure of the financial impacts of the proposals that CEIOPS is putting forward, and to gather practical information that will better inform the policy development debate. I would heartily urge firms to participate in this very important exercise.
Conclusion
29. As David signalled in his opening remarks, constructive, grown up dialogue is absolutely key to a successful relationship between the FSA and the financial services industry. For the insurance industry, this has two dimensions. First, in relation to the specifics of the new regime as it embeds. And second, in relation to our goal of moving towards a more principles-based regime. The first part of this conversation is, I think, already under way. I hope my comments this morning will help kick-start the second, and in complementing the specifics of the new rules, help deliver a principles-based regime, that makes for soundly capitalised, well-managed insurers that treat their customers fairly.
Thank you.