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Speech by Sarah Wilson, Insurance Sector Leader, FSA
Westminster and City Conference
26 April 2006

Introduction

Good morning and thank you for your invitation to speak this morning. As mentioned, as of Monday, I will be the FSA's new Sector Leader for Insurance. As some of you may know, the incumbent, my colleague David Strachan has been a regular speaker at this event for the last couple of years, and commended it to me as an extremely worthwhile opportunity to engage with key players in the market.

I am therefore delighted to be here this morning and hope to give you my perspective of how the life industry is progressing with embedding the new regime. Bar the ongoing negotiations on Solvency 2, from here on in, the prime objective for us is to see the new regulatory regime become an operational reality. This means that while you can expect to see a marked reduction in the number of headlines announcing new policy initiatives, it does not mean that you will be enveloped in regulatory silence! Instead, you can expect us to be spending quite a bit of time giving feedback to the industry – through conferences such as these, through our newsletters and through the Sector Briefing series that we publish. It is critically important that feedback is symbiotic – it is just as important to us that we hear from you about your experiences of the new regime and what it means in practice. This type of engagement with you also goes hand in hand with our commitment to become even more principles based in the way that we discharge our statutory duties.

But this morning, and to do my bit to ensure that Westminster and City do not stand accused of breaching the FSA financial promotions rules, as billed I will focus my remarks on a number of key elements to the new regime for life insurers, namely the new capital adequacy regime, and – in the particular case of with-profits – the moves to ensure fairer treatment of consumers through injecting greater transparency generally and safeguarding the interests of those in closed funds more specifically. Almost by definition, therefore, I will say very little about the design and distribution of new products. This is not of course to imply that such issues are of little importance – indeed with my own responsibilities for the FSA’s TCF initiative, you would hardly expect me to say so; rather I am conscious that they are the focus of the second day of your conference.

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ICAS and risk management

Let me start with the new Individual Capital Adequacy Standards framework. It is now 16 months since we introduced the new regime, and I think it is fair to say that in that time some valuable lessons have been learned, both by you and by us. Designing and then implementing a new approach to capital adequacy was always going to be a challenge and I am under no illusion that the period of learning will continue for some time to come. For our part, we commit to continuing to give regular feedback on practice – both good and less good – that we see at appropriate junctures. And, as some of you may be aware, we have also established two sub-groups of our Insurance Standing Group, comprising industry practitioners and where ICAS issues are discussed and feedback from both sides shared. The work of these groups has been progressing well and we will look to report back later in the year.

To date, we have received 35 ICA submissions from life insurers, and completed reviews and given ICG for 20 groups and firms. You will be well aware of the process here: firms submit their ICA, we review it and then issue Individual Capital Guidance – ICG – which sets the regulatory required capital. Although we clearly have many more ICAs to review, our ICG to date covers around 40% of liabilities in the life sector. Our experience grows by the day and we are improving the review process, including getting quicker. As we have said previously, our aim is to complete each review within 6 months and we are now regularly achieving this and better. Ultimately, our aim will be to complete reviews at the same time and within the same timescale as ARROW II risk assessments and we are working towards this for all second round reviews.

Our Individual Capital Guidance is of course a regulatory judgement that is informed by our view of a firm in the widest sense – including taking into account our risk assessment (i.e. ARROW), including the impact of planned future developments such as organisational and strategic change. There have been – and no doubt will continue to be – cases where our view does not accord exactly with a firm's own view of appropriate capital. These instances arise where we take a different view from the firm of the risks of a firm's business or how well they are being managed.

Where there is a difference of view on the scale of risk, this might reflect a judgement on our part that the methodology used for identifying or quantifying risk is not sufficiently robust, but more often we have found that we differ in approach when confronted with limited data or other modelling obstacles. In general, as we have made clear, standards in ICA work have been high but, while sometimes warranted, on occasion we have also been a little surprised by firms that argued that extra capital must mean that we take a negative view of their modelling competence and capability. Three examples will perhaps illustrate the spectrum of situations we face. First as a general point, we are faced with ICA numbers that vary significantly across similar firms in respect of the same issues – this at the very least must cause us to assess at some level the relative merits of different modelling assumptions or approaches. Second, it is often the case that differences of view occur in relation to the quantification of operational risk. We accept that sometimes this comes down to the fact that the measurement of operational risk has some intrinsic difficulties and is less well developed generally than other risk areas. And so, not surprisingly, we have seen a wide range of practices ranging from the very sophisticated that match the best in any financial services sector to the crude, such as simply taking a percentage of income or capital. We have had to ask for additional capital in this area from a number of firms to reflect modelling limitations. Third, we have asked firms to hold some extra capital for the risk that correlations break down in stressed scenarios, an area where data limitations affect the reliability of the answers that models produce, however good the methodology.

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Whether or not we agree on the scale of risk, we have also - and will continue to – use ICAS to secure additional capital where we have concerns about risk management and where extra capital is the appropriate regulatory mitigant. Here there are obvious reasons why our view might differ from that of the firm – as we might be reflecting concerns over issues such as governance, management and control functions, systems or strategy. The corollary of this is once these issues are addressed, we can immediately reduce the additional capital we are looking for.

There have been some robust discussions between our staff and firms on the ICG numbers. We would acknowledge that we have learnt lessons about how to handle these, including the importance of being open and clear early on about the scale of extra capital that we have in mind. More importantly, our process has now evolved to give greater opportunity for senior management – as they should – to ‘own’ the final capital figure. We are generally comfortable with having a dialogue with firms throughout the process, allowing then to explain and justify their ICA calculation – and where appropriate to make necessary changes to enhance their submissions. This means that firms adopt and own changes to their assessment in response to the points that we have made rather than simply waiting for us to conclude on an ICG number. The points we make include areas where we think there may have been particular prudence in the calculation of the ICA as well as areas where we think the ICA number may be insufficient. Partly as a result of this change in approach, we have reached a point with some firms where the final ICG is equal to the ICA - although clearly other firms have received and continue to receive ICG that is significantly in excess of the ICA they submitted. This process of course works best where the ICA submission is sound and where the quality of the debate between FSA and the firm is similarly high.

We are also continuing to work hard to strike the right balance between delivering outcomes for firms through ICG which are consistent across the sector and at the same time reflecting the individual circumstances of firms. So, while we do have benchmark methodologies – and in some cases benchmark numbers - it is important that these be seen as a starting point for further enquiry and not an end in themselves. Where good arguments can be made, we are open to these and have a tolerance of results that come in around what we would ordinarily expect. We do, of course, take account of the quality of wider risk management around the generation of these numbers, but clearly we have to be alive to questions over consistency and to ensure that we have sufficient comfort that the target solvency standard, which as you know we express as a 0.5% risk of ruin – or 99.5% confidence interval - over one year is being met.

All in all, we have seen, as a result of ICAS and wider developments in capital modelling which ICAS is supporting, significant improvements in firms' ability to quantify the risks of their business and hold commensurate capital. We hear the same story from most firms and from their advisers. We also observe and hear that much of the development has been in the measurement of risk. Firms must not lose sight of the importance of improving the management of those risks as well of course. It is here, I would argue, that ICAS should be viewed as a tool that not only makes your regulator happy, but also one that can help keep shareholders happy (or, of course, policyholders in the case of mutuals).

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As we have said on previous occasions, ICAS is not regulatory delicacy. ICAS is a process which should incentivise firms to improve the management of their risks. Actuarial, management judgement and other expert tools and information assist with deriving sensible calibrations and assumptions to better quantify and assess risk. But to serve its purpose ICAS must become part of the bread and butter of day to day risk management practices in the firm. And while we hear positive feedback that ICAS is making a real difference to way in which firms approach risk management, this is very much driven by anecdote. All well and good, but in order to gather some facts, as announced in our Business Plan, we have now started our thematic review to look at the extent to which the ICAS regime has delivered real improvements in risk management processes.

Some of you may recall that back in 2003, we carried out an industry survey to ascertain industry practice in risk management. Though perhaps not terribly surprising at the time, it would be generous of me to say that the results were not terribly comforting. Many firms treated risk management as a compliance matter rather than as a vital business process; there was often a lack of segregation between risk-controlling and risk-identifying activities; many firms had not defined their risk appetite; and overall the use and embedding of modelling was patchy. Final analysis back in 2003? Must try harder.

Of course since then, the regulatory regime has undergone a rapid evolution; although new at the time, our risk assessment process has since matured and, of course, ICAS has also hit the streets. Given that a firm's own assessment of the risks of its business is the engine that drives ICAS, it follows that we have a keen interest in the underlying risk assessment and management being sound, and of course that firms are using the results of the capital assessment to prioritise risk management spending and activity.

Whilst we recognise that a firm's approach to risk management will depend on its size and complexity, we do expect all firms to have procedures to identify and manage their risks effectively. And, to give you a preview of what is to come, some of the areas we intend to focus on include:

• engagement by the board and senior management;
• the strategic planning process and whether this takes account of risk assessment and mitigation;
• management information on identified and crystallised risks and associated controls;
• whether risk-based capital assessments are guiding capital spending and capital allocation within the business; and
• whether appropriate systems are used to hold and analyse risk management information.

To explore firms' approaches and to establish how much of an impact ICAS has had in practice, we will be reviewing supervisory information that we already hold and visiting a representative sample of firms in the coming months – including smaller insurers - with a view to publishing feedback – including examples of good and less good practice – around the end of the year.

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With-profits

Having made some preliminary observations of how the life industry as a whole is faring in embedding the new capital adequacy regime, I now want to focus in particular on one key part of the sector and turn to with-profits. Now a lot of the time, the FSA is asked why it spends so much time on with-profits when – as I have already acknowledged - new business for this product has all but slowed to a trickle. The simple fact is that although new business for with-profits is not what it was in the 80s and 90s, there is of course a significant back book of business of just over £400bn in assets. In practice, this means that millions of consumers have a with-profits product of some denomination, be that a mortgage endowment, a with-profits bond or as an annuity.

Notoriously opaque in its operations and structure, with-profits has been centre stage in our reform programme. And while with-profits policyholders can now take greater comfort that product providers will have sufficient capital to honour their commitments to customers and so treat them fairly, alongside capital strength our programme of reform for with-profits focused in particular on injecting greater transparency into the way in which life insurers run their with-profits business. In this context, disclosure is therefore key.

I think it's helpful here to differentiate between the types of disclosure. There are, I think, three main categories in the with-profits context. First, information that is primarily used by the market, typically focused on capital strength. Second, information that financial advisers can use to help clients decide how to invest or what action to take on existing investments. And third, information that consumers themselves can understand and use to make informed decisions in their financial planning.

So, to take each of these in turn. In terms of disclosures that focus on capital strength, the main vehicle for this is the requirement for insurers with with-profits liabilities in excess of £500m [- equating to around 98% of the market - ] to submit a realistic balance sheet as part of their yearly return to the FSA. This involves making a realistic assessment of their liabilities, including discretionary benefits. This is the second year that firms have had to submit these to us. We are still in the process of analysing the balance sheets submitted to us in March for the year-end 2005, and we will be able to say more about the aggregate picture that emerges in the next couple of weeks. In the meantime, I would point to the results of the previous set of data, which indicated a comfortably healthy position for life insurers with with-profits business, indicating that capital strength has on the whole stabilised in this part of the sector. But, as I say, more on that to come in due course.

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Feedback from the market suggests that this information is used by the investment community and market commentators, including the rating agencies. It is also used by some financial advisers, but unhappily these tend to be in the minority and restricted to firms who have research departments.

The other key disclosure that is used by market commentators is the PPFM. For the last two years, firms have had to set out how they run their with-profits books of business in a document called the Principles and Practices of Financial Management.. Again, while these appear to be used by market commentators and the like, engagement by the financial advice community is the exception rather than the rule. As my colleagues have said on previous occasions, this is disappointing. We recognise that there is still some way to go on improving the quality of these documents so that advisers can use them to compare and contrast different with-profits funds, but those serious about giving good quality advice to clients whose investment portfolios include with-profits, will also be comfortable with the content of these documents.

It is essential that financial advisers have the tools at their disposal to be able to give good quality advice to their clients on with-profits investments, and so an additional source of information that this community is now able to access is the new reporting requirement to include details of how specimen policies have performed. In addition to the realistic balance sheets, for the first time this year, with-profits insurers have had to include this in their regulatory returns. As many of you will know, industry surveys on payout data have been produced for many years. These have provided valuable disclosures in the public domain, but suffered from one major flaw. Because submitting data for such surveys is an entirely voluntary act, year on year firms who had a less positive story to share with the market were notably absent from the survey. We believe that full disclosure of such information provides policyholders and advisers with important information that will help inform their investment decisions – both in terms of whether to invest in a new product or whether to keep or surrender an existing policy. As such, we hope that in mandating this new requirement advisers and third party commentators use this information to gain a better understanding of the performance of investments and thereby facilitate better financial planning and decision making. It is still early days, but we have been encouraged by the positive response in the media to the availability of the new source of information. For our part, we are currently considering whether we will publish an aggregate account of payout data across the sector.

In terms of what information is available for consumers to use, I would point in the first instance to the introduction of consumer-friendly PPFMs. Life insurers have been required to produce these since the end of 2005. In the next couple of weeks we will be saying more to give some feedback to the market on our first impressions of these documents. Of course, many – but by no means all - consumers also receive information direct from their product provider by way of annual statements. This is of course not a regulatory requirement, but something driven by the ABI's previous Raising Standards initiative. We are pleased to hear that this will continue under the new Customer Impact Scheme being run by the ABI and look forward to discussing with them in the near future how these statements can be made more user friendly and helpful for customers.

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Closed funds and ongoing advice

Finally, before closing I would like to make a few remarks about the closed funds sector. It is important first to reiterate that in many ways the contrast that commentators often draw between the merits of closed and open funds is overly simplistic – on the one hand many open funds are actually ‘nearing closure’ and operate accordingly, and on the other empirical analysis does not bear out the notion that policyholders are always better off in open funds. Nevertheless - closed funds continue to be a key focus for us, both in terms of the treatment of policyholders through our ongoing supervision of life insurers who have funds that have closed to new business, and in approving any further changes of control where the ownership of these funds switches hands. This is because, while our capital and transparency requirements apply equally, there is, I think, a strong argument to suggest that when a life insurer decides to close its with-profits fund to new business the commercial incentives driving the way in which the fund is managed change in ways that increase the risk that customers are not treated fairly. Accordingly, we set out what might be termed our "supervisory challenge agenda" in our Sector Briefing on closed funds published towards the end of 2005 – where this focused on firms’ investment strategy, management of the inherited estate, outsourcing and, of course, policyholder communication.

I mentioned our role in transfers of business. While there was a flurry of transactions in 2004 – 2005, those involving larger blocks of business appear to have slowed. We will of course, keep a watching brief on market developments here and should further transfers be proposed, our role will continue to be one where we seek to safeguard the interests of policyholders in the funds involved. But while activity seems to have slowed on one front, I'm sure it will come as no surprise to hear that we have been watching with keen interest recent developments in the bulk annuities market. Again, as with any transfer of business, we will be working closely with market players to ensure that policyholder interests are safeguarded.

Finally, a few words on policyholders feeling equipped to make decisions about their investments. The results of our recent baseline survey into over 5,000 consumers showed only too clearly the levels of financial capability in UK consumers of financial products. Set against this context, for the millions of policyholders who hold with-profits products the role of financial adviser is a powerful one. However, as we announced last year, it is of real concern to us that, despite improvements in disclosure already mentioned, policyholders may not be able to access good quality advice on whether they should keep or surrender their policies. To give us a clear picture of what advice is actually available, we are currently carrying out some research to explore this issue in some detail, including identifying any barriers to advice and what might help alleviate the situation. We expect to be able to publish our findings in the next couple of months and at the same time, any next steps that we consider necessary.

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Conclusion

As I said in my opening comments we have reached a point in the reform of insurance regulation where – with the important exception of Solvency II - the key is now a focus on successful implementation rather than on new initiatives. In the areas I have covered I think we would now summarise progress as follows:

• ICAS - a good start with successful learning on both sides, and a great export for our colleagues abroad;
• With-profits transparency - improvements now bedding down but with a lot more to do in persuading financial advisers to use information and the jury still out on whether it is successfully translated for direct use by consumers
• Closed funds - improved understanding of the risks and challenges but continued vigilance necessary and more to do again in ensuring that consumers can obtain necessary financial advice.