• FSA Library
  • Communication documents
    • Speeches

Speech by Sarah Wilson, Insurance Sector Leader, FSA
Institute of Economic Affairs
11 May 2006

Introduction

Good afternoon and thank you to the Institute of Economic Affairs for inviting me to speak today. I very much welcome the opportunity to give the regulator's perspective of the life industry today, not least because addressing a conference hall of senior industry practitioners in the very early days of a new role tends to concentrate the mind somewhat and accelerate the "reading in" process!

Of course, you do not need me to tell you that the ‘reading in’ shows an industry that has been through a very testing period. Both in terms of the environmental and commercial pressures, but also with respect to the root and branch reforms to the way in which UK insurers are regulated.

My focus is of course primarily on the latter, and I would observe that while a lot of the heavy lifting has been done in terms of developing the new modernised regime, it would be a mistake for you - and for us - to consider it job done, now that the new regime is in place.

To deliver real change, the details of the regime must not live on the pages of our rulebook alone. And while it is clear that we have come a long way – with reform of the requirements relating to with-profits in particular - I am under no illusion that we are still only at the start of embedding the new regime. Continued commitment and energy will be needed on both sides for some time to come.

What is also essential is that the dialogue between FSA and industry which first began back in 2001 at the start of the reform programme, continues. From the outset, we have been keen to listen to – and take account of - industry views, both individually and through the trade associations. During the policy development phase that engagement was essential. But arguably as we move into business as usual mode, that exchange of views is all the more important. A frank and open dialogue will be essential as we push ahead with delivering the wider FSA regime for the financial services industry that focuses on outcomes delivered, not prescription followed.

Indeed the unifying theme of my comments today will be the importance that we place going forwards on a more principle-based approach to regulation – and the progress already made in focusing on key outcomes for the sector.

The overarching outcome that our new regime was designed to deliver is an insurance industry that is adequately capitalised, soundly managed and that treats its customers fairly. And while the changes we have made are both numerous and far reaching, the common denominator is a greater focus on both transparency and fairness.

Some may say this is the stuff of commonsense – "motherhood and apple pie" even. It is, however, all too easy to lose sight of this goal in the day-to-day dealings between the regulator and regulated and so instead, I prefer to think of it as providing a useful discipline that makes for not only good business, but also good regulation. So, with this as my frame of reference, I will pick out a number of the regulatory milestones which we feel will help deliver a sector that is just that: well capitalised, soundly managed and that treats its customers fairly. Along the way, I will also give you feedback on how we consider the industry to be progressing in embedding the new regime so that it becomes an operational reality.

ICAS

I would like to start with some observations on ICAS – our new individual capital adequacy framework – which I think exemplifies the outcome focused approach. We have of course two outcomes in mind here – improvements in the way in which capital requirements are calculated so that we all have greater confidence that capital is adequate and improved risk management in firms.

So, in order to allow for use of fit for purpose techniques (some very sophisticated and others – perhaps for smaller firms – much less so) we do not prescribe the way in which the risks of a business should be measured, nor the way in which commensurate capital should be calculated. Instead, we expect senior management to take responsibility for measuring the risks inherent in the firm's business and allocating capital commensurate to those risks, and we expect then to have a dialogue about the judgements reached – both the modelling judgements and the strategic judgements. Where necessary, that process leads to us providing a contrary view in the form of Individual Capital Guidance.

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. Where there is a difference of view between us and a firm over the adequacy of capital, this might reflect a judgement on our part that the methodology used for identifying or quantifying risk is not sufficiently robust. But more typically, our view will differ when confronted with limited data or other modelling obstacles.

Three examples will perhaps illustrate the spectrum of situations we face and reasons why "add-ons" may be appropriate.

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. 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. In some cases, this leads us to ask for additional capital to reflect modelling limitations.

Third, we have asked firms to hold 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.

Whether or not we agree on the scale of risk, we 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.

It is, I think, fair to say that many of the discussions we have had with firms in coming to our view of the appropriate level of capital could be characterised as "robust". And rightly so. We recognise that we have learnt lessons about how to handle these, including the importance of being open and clear early on if we feel extra capital is needed.

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.

As well as pointing up areas where we think the ICA number may be insufficient, we also indicate where a firm may have been too prudent in its calculation. 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.

And just as we are improving our processing of ICAs, firms too are raising their game. All in all, as a result of ICAS and wider developments in capital modelling which ICAS is supporting, we have seen significant improvements in firms' ability to quantify the risks of their business and hold commensurate capital.

There is still more to be done, but progress achieved so far in terms of ICAS being used as a risk management tool should not go unrecognised. For our part, in the coming months we plan to repeat the exercise we originally carried out in 2003 to explore risk management practices in the sector and to measure how much of a difference ICAS has made to risk management disciplines since its introduction.We will look to share our findings with you around the turn of the year.

The last point I would like to make on ICAS relates to the inherent tension we face between giving ICG which respects the individual nature of the framework and ensuring that our treatment of similar risks is consistent across the sector. To help ensure we are being consistent and fair we have developed benchmark methodologies – and in some cases benchmark numbers. But it is important to be clear that these should be viewed as a starting point for further enquiry and not an end in themselves.

As I indicated earlier, where good arguments can be made based on sound, thorough analysis, 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.

Realistic Balance Sheets

The second topic I would like to turn to, again focuses principally on ensuring that insurers are well capitalised. As many of you will know, the end of March 2006 marked the second year of publication of realistic balance sheets for life insurers that have with-profits liabilities in excess of £500m. You will recall that with-profits insurers are now required to make a realistic assessment of their with-profits liabilities, including discretionary benefits and of the associated risk-based capital on specified stress and scenario testing to determine whether they need additional capital to that required by the current EU Directives.

The previous regime effectively permitted firms to ignore some significant non-contractual promises, including policyholder expectations that they would receive a fair terminal bonus when their with-profits policy reached maturity. Again, the outcome we were seeking to deliver, is a straightforward one: quite simply, that in carrying out a proper valuation of all liabilities, firms hold sufficient assets to cover all of the liabilities, guaranteed or otherwise.

Last year was a first for the industry. Having spent near on two and half years in preparation, large with-profits insurers were required to disclose details of their realistic position as part of their publicly available regulatory returns. And, as we said at the time, it was pleasing to see that none were in breach of the new requirements.

In other words, the outcome - that firms have sufficient assets in excess of their liabilities - had been met. And today, I am delighted to inform you that based on data for the year end 2005, the sector continues to deliver that outcome, and has in fact further improved its capital strength. The aggregate results indicate a comfortably healthy picture for these insurers, accounting as they do for around 98% of in force business in the UK.

In comparison with the figures submitted to us for the mid year position for 2005, after allowing for stress and scenario testing and on a like for like basis, the figures indicate a realistic surplus of £22.8bn – an increase of 25% on end June. During the same period, the amount set aside to cover stress and scenario testing – the Risk Capital Margin - reduced marginally from £11.1bn to £10.8bn. (I should note here for completeness that these figures do not take account of the presentational change to the realistic balance sheet for closed funds where surpluses are shown as a liability. The impact of this change is that the realistic surplus (net of the RCM) is reduced by £2.5bn to £20.3bn.)

Clearly, a strong factor in the increase in surplus capital lies at the door of favourable economic conditions, with equity markets up by around 10%. Reflecting this more buoyant environment, the results also indicate that the realistic reporters were net purchasers of equities, with the marginal £0.4bn reversing the downward sales trend that had emerged since we started collecting this data in 2002. The aggregate Equity Backing Ratio for assets backing asset shares also increased over the full year moving from 39% to 43%.

All in all, these results are very encouraging and while the economic environment clearly has had its part to play, the industry has worked hard to deliver some long awaited stability. And, in terms of the capital with-profits insurers have at their disposal, the sector is in a far better position to ensure that policyholder commitments are honoured as they fall due, and as such that customers are treated fairly.

Treating Customers Fairly

I said that our overall desired outcome was an insurance industry that is adequately capitalised, soundly managed and that treats its customers fairly. My third topic this morning is the third of these – treating customers fairly.

Here you will of course be aware that we have launched a specific initiative – challenging the senior management of all financial services firms to look again at their treatment of customers and to make a step change where necessary. We have adopted a principle-based outcome-focused approach - as with ICAS, being clear about the outcome we are seeking, without straying into the territory of prescribing how firms should deliver this. Similarly, as with ICAS, our supervisors are discussing with firms the approach they have taken to ensure they are meeting the TCF requirement.

By and large, the efforts of the life industry to engage with TCF, to think through what it means for individual firms and to start implementing any resultant changes are welcome. In addition, the sector is actively engaged in a major initiative designed to put the consumer at the heart of the business through participation in the ABI’s Customer Impact Scheme.

There are however two issues that I wanted to draw attention to today – both are relevant across financial sectors and not specific to life assurance.

First, there is a need for senior management to be thoughtful in its approach to the measurement of progress – recognising that, as financial capability is so poor for many UK consumers, there will often be little reason to assume satisfied customers have necessarily been treated fairly. It is much easier to measure satisfaction than fairness – and many firms are prone to measure the former.

Second, while the good intentions of senior management and indeed progress in reviewing business practices are often both clear, there remains much to do to ensure that this filters through to the coalface – i.e. the interaction with customers day by day. Given that we are talking of cultural and behavioural change in many firms, the existence of such a gap is not necessarily a surprise – change of this kind does not happen through large organisations overnight. But it is important to stress that the gap is there – and that this in itself is evidence of the amount still to do.

Two examples might serve to illustrate the point. First, firms' financial promotions. In a recent thematic review of a range of advertisements for investments for children, we saw promotions that described investment products as "savings plans", giving no indication to the reader that the product performance was linked to the stock market. Some promotions described capital-at-risk products as "safe" or "secure". Others were labelled "simple", "tried and tested" and "straightforward" ways of saving for children. We also saw promotions that described how the products would provide "nest eggs" or "windfalls" for children. In each of these cases, there were no indications that these investments might return less to consumers than had initially been invested.

The second concerns the other end of the product life cycle - post sale disclosure. Here you will recall that we published a sector briefing on the quality of PPFMs in the with-profits sector last year – noting a number of concerns. The fact that firms have had to set out the detail of the management of with-profits in a PPFM has proved a very useful governance discipline. However, these documents were also intended to be of use to third party commentators, including financial advisers.

We are strongly of the view that – to comply with the FSA’s principles including Treating Customers Fairly – both insurers and financial advisers need to raise their game in this area. We have said on previous occasions that the lack of engagement by the financial advice community is something that we have serious concerns over. We feel strongly that in order to be able to give their clients good advice, financial advisers should be taking into account – alongside other information – the PPFM of the fund that their client is invested in, and that therefore they should, if necessary, be asking questions about it to ensure that they understand it before advising. Equally, however, insurers need to play their part in the fair treatment of retail customers by considering whether the information they put out to assist distributors in advising those customers is clear and intelligible.

We have also now carried out a targeted review of firms' consumer-friendly PPFMs. This document should help consumers understand how the with-profits fund they have invested in is managed, but it was clear from the sample of firms that we reviewed that some needed a fairly major overhaul. Even though the documents are intended to cover the main subject areas covered off in the PPFM, some failed to do so. Arrangements on ceasing to write new business was also omitted from a number of CFPPFMs.

We were also disappointed to find that some CFPPFMs were not terribly easy to find on the providers' website. We have now fed back the findings of our review to the firms involved and expect to see some improvements as a result of this.

Of course, CFPPFMs are just one example of post sale information delivered straight to the customer by you. Whatever its form – annual statement of otherwise – a firm keen to treat its customers fairly needs to ensure that it complies with our principle 7 and "pays due regard to the information needs of its clients, and communicates information to them in a way which is clear, fair and not misleading". This is something we hope to explore with the ABI in the coming period, particularly in relation to the Good Practice Guide on post sale disclosure, supporting their Customer Impact Initiative.

Conclusion

In conclusion, we are looking forward to a future for the life industry characterised by adequate capital, sound management and fair treatment of customers. We think we are most likely to get there by adopting a more principle based, outcome focused approach to regulation. To a significant degree this is already happening in the areas that I have chosen to highlight today – the emphasis now needs to be on making sure that policy decision is turned into effective implementation.