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Speech by Thomas Huertas, Director, Wholesale Firms Division
Insurance Day Summit
1 June 2006

The London Market is at the centre of the world's general insurance market. Some doubt that it will remain so, and point to a host of factors that could topple London from its position of prominence.

Regulation should not, in our view, be one of those factors. Indeed, we at the FSA are determined to provide what we would call "the Regulatory Platform of Choice" to participants in the insurance markets, a platform that will be fair to policyholders and fair to providers of capital. To do so, we are improving the FSA's capabilities and effectiveness.

In designing and implementing this platform, we will rely, where we can, on the market. We only intervene if there is a market failure, and we only create a new rule, if the market itself fails to come up with a way to remedy the failure. Indeed, new rules have to run a gauntlet, or a series of tests, before they can be implemented.

First, is there a market failure? If not, there need not be a rule. If there is a market failure, can the market find a solution to that failure, either on its own or with our assistance? If yes, there need not be a rule. If the market itself cannot overcome the failure, can a rule do so? In making that determination, we subject any proposed new rule to a cost-benefit test: will the benefit of the proposed new rule exceed the cost? In not, there need not be a rule. Only if the benefit of the new rule exceeds its cost, will we impose a new rule.

EU law imposes some limits on this approach. Although the EU is moving toward cost-benefit analysis as a precondition for new legislation, the basis for application is different. The EU is concerned about Community-wide benefits, and Community-wide costs, not benefits and costs to the UK. As a result, there may be some Directives that would not pass a UK-only cost-benefit test, just as there may be some provisions in UK legislation that would not pass a London-only cost-benefit test.

We do, however, subject our implementation of EU Directives into UK law to the same gauntlet. Our policy is to copy out the Directives, and to implement them conscientiously. We will not add any national provisions to the Directives, unless the benefits outweigh the costs of doing so. In other words, we will not gold-plate, and we will not become super-equivalent, unless there is a very good reason for our doing so.

A platform of choice has to be fair, both to policyholders and to investors. Fair to policyholders, if they are not, over time, to migrate to platforms that are. Fair to investors, if they are to continue to supply the capital necessary to support the risks underwritten by the policies.

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Fair to policy holders

Under fair to policy holders, we understand four things:

1. contract certainty
2. client money belongs to clients
3. conflicts of interest are managed appropriately
4. capital is adequate

Let me say a few words about in each in turn.

Contract certainty

Contract certainty strikes us as a must for the insurance market. Policyholders need to know what cover they have bought, and insurers need to know what exposure they have assumed. The longstanding practice of "deal now, details later" is no way to run a market, much less a market that aspires to be the world's centre for insurance.

The lack of contact certainty is a clear example of market failure, and, at the end of 2004, the FSA challenged the market to come up with a solution to this problem by year end 2006. The market recognised that this was an issue affecting, and requiring the cooperation of, insurers, brokers and insureds. The market has developed definitions of what constitutes contract certainty and has implemented detailed work programmes at the industry level and firm level to assure that insurance contracts are completely signed off at the inception of coverage.

This is a crucial time for the market. The challenge has approximately six months left to run. And the market must conclusively demonstrate by the end of the year that it is in fact achieving contract certainty.

It is beyond question that the market has made a very good start toward meeting our challenge. Participants in the various working groups have spent considerable time and effort in identifying the steps needed to assure contract certainty, and firms have made considerable progress in implementing the necessary changes in working practices. The market considerably exceeded its target for year end 2005 and appears to be on track to meet its target for June 2006. Accordingly, we have put on the back burner, but not taken completely off the stove, our so-called "Plan B" – a package of rules designed to achieve contract certainty.

There are still some complex issues for firms and the market to solve. These include handling late orders so that such policies also have contract certainty at inception. This is particularly important as late orders also tend to be larger orders covering more complex risks. Signed lines are also an issue – each insurer should know its allocation at inception.

The year end 2006 target for contract certainty is 85% of all policies at inception. We will want to be sure that firms and the market are measuring performance accurately, and firms should expect us at some point to kick the tyres on how they have satisfied themselves that they are in fact achieving contract certainty.

We will also want some explanation from firms and the market of what is contained in the remaining 15% -- is it all concentrated in a particular line of business or at a particular firm or group of firms? In addition, we will want to know what firms and the market are doing to bring contract certainty up toward 100%. Finally, and perhaps most importantly, we will want assurance that the improvements are permanent – that the market will not slip back in 2007 or later years from the high levels of contract certainty that it seems on track to achieve in 2006.

In our view this challenge is proceeding well. It is a good example of how regulators and industry can work together to achieve the right outcome. There is ample recognition – both by the FSA and by firms themselves – that progress to date has been harvesting the low-hanging fruit. The rest is higher up the tree and more difficult to reach.

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Client money

According to Principle 10 for authorised firms, each firm "must arrange for adequate protection of client assets when it is responsible for them". Proper segregation of client assets is important in the wholesale market since it helps assure that the market settlement system operates efficiently and that moneys belonging to customers are allocated correctly and settled on a timely basis.

I regret to say that a disconcertingly large number of insurance brokers are not adequately protecting client assets. There are still far too many insurance brokers who regard client money as just another form of working capital. And, much to our surprise, insurers are somewhat lax in controlling the practices that brokers employ, even where the insurer has agreed to "risk transfer" (i.e. irrevocably providing coverage to the policyholder in advance of receiving funds from the broker).

This is a clear example of market failure. We are sceptical whether there is a market solution to this problem. The failure of a firm to protect client assets is generally a firm-specific issue, and it exposes policyholders to the risk of loss as well as the risk that they will not in fact benefit from the coverage that they reasonably believe to have paid for.

Accordingly, we have written to insurance brokers across the UK stressing that senior management of such firms have a clear responsibility to ensure that insurance broking accounts function properly to protect the interests of clients.¹ Although we have seen some improvement in the wholesale sector, the overall level of compliance with the principle on client money still leaves much to be desired. We therefore announced in early May that we are providing firms with more detailed information on what the client money rules are designed to do and on how these rules work.

At the same time we announced that we would be conducting later this year a thorough review of compliance with the client money rules across the market. We consider that we have given firms ample warning of our intentions and ample information to enable them to comply. I would therefore strongly recommend that each firm be sure that it is in fact complying with the client money rules and that each firm be sure that it does not have a deficit in its client money account – unless of course the firm wishes to gain the prompt and undivided attention of colleagues in our Enforcement Division.

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Conflicts management

According to Principle 8 for authorised firms, a firm "must manage conflicts of interest". In our supervision of insurance firms – both brokers and insurers – we devote considerable time to discussions with firms as to how they are in fact doing this. The most basic step is for the firm to complete a catalogue of the conflicts to which it is exposed and lay out how it is managing each of those conflicts.

What is apparent from these exercises is that the issue of conflicts is far broader than the conflict posed by contingent commissions and that commission disclosure is one, but by no means the only, way to manage conflicts of interest. Just as there are injuries for which sunlight is not a cure, there are conflicts for which disclosure is not an adequate remedy.

Our rules currently provide that a broker must disclose commissions to customers, if and when the customer asks for such information. As a matter of fact, the wholesale market is moving away from commissions. A greater and greater proportion of insurance is being placed on a fees basis – by definition these fees are disclosed to the customer and the insurance is quoted on a net basis.

Where commissions are still being used, the market is moving toward standards for disclosure of commission. Brokers' associations have formulated what they consider good practice in this area and are signing up their members to adhere to these standards.

Accordingly, we believe that there is a reasonable chance that the market itself is finding a solution to the issue of commission disclosure. It is not clear that the FSA needs to impose a rule, or that such a rule would pass a cost benefit test. Should players feel that the market is not finding a solution, or should players have the magic rule that will in fact generate social benefits in excess of cost, we would be happy to listen and, if necessary, review our conclusion that we need not make a new rule. But at this stage I would say that the burden of proof is on those who would wish to impose a new rule.

Instead of writing new rules on commission disclosure, we will devote our time to the broader issue of how insurance intermediaries and insurance firms are in fact managing their conflicts. In particular, we will focus on how far firms have taken on board the points that we raised in our Dear CEO letter of last autumn and how far their own arrangements have improved.²

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Adequate capital

Let me now turn to the issue of capital. Here we aim to be fair to both policyholders and to investors. We want to assure that firms keep enough capital to provide protection to policyholders, whilst allowing firms the opportunity to earn a rate of return on that capital that will be attractive to internationally active investors.

ICAS, or the Individual Capital Adequacy Standard, is the way that we do this. The standard we expect firms to meet is simple: there should be a 99.5% probability that the firm will remain solvent over the coming year. This equates to a one in two hundred chance that the firm will fail. In rating terms this is roughly equivalent to a 'BBB' rating. Our observation is that most large corporate buyers of insurance look for firms with ratings at or above this level and that most insurance firms in the wholesale markets in fact maintain ratings above this level.

From a policyholder perspective, it is relevant to remember that, should the firm incur a significant but not immediately catastrophic loss, such a 'BBB' standard gives us an opportunity to intervene and the firm an opportunity to raise new capital before the firm actually becomes insolvent. This cushion of comfort is in our view about right – requiring all firms to maintain capital to a 'AAA' standard would be excessive; allowing firms to keep minimum capital equivalent to a 'BB' standard would leave little or no room for recovery, if something were to go wrong.

Under ICAS we effectively ask firms to tell us what risks they run and what capital they feel they need in order to support those risks. We place extensive reliance on firms' own models and risk management procedures.

We have now completed ICAS reviews for 90% of the UK wholesale market for general insurance, including the Lloyds market. The initial submissions varied immensely in quality, ranging from one that was literally on the back of a postcard to complete risk registers along with quite concise and sophisticated discussions of each of those risks, the correlations among those risks and accurate models of the capital required to support those risks.

Generally, we have set firms' Individual Capital Guidance (ICG) – the level of capital that the firm must keep -- at levels that are quite close to the ICA proposed by the firm. The differences between the two stem from various causes. In some cases, we have adjusted the capital downwards from the ICAS submission; in others, upwards.³

We are very much aware that our ICAS approach may differ from that employed in other Member States of the EU and from that employed in some other markets. However, we do believe that the trend in insurance regulation is toward imposing capital requirements on insurance firms that are in line with the risks that insurance companies assume.

In particular, the EU discussion on the so-called Solvency 2 Directive is very much in line with this philosophy. The FSA is working closely with firms in the industry to determine the impact that the proposed new capital regime would have, and we are grateful to the firms that are participating in this work. In addition, the FSA is working with the Treasury as well as with regulators from other Member States in forums such as CEIOPS to assure that the Directive is consistent with the approach that we have taken under ICAS. To date that remains the case.

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Fair to investors

To be a platform of choice a regulatory regime must be fair not only to policyholders, but also to investors. ICAS regime is but one aspect of that approach. Provided companies maintain adequate capital, investors should be able to take any 'excess' capital out of the industry, if they perceive that the capital will no longer earn an adequate return. Without the appropriate arrangements for exit, capital will not enter the industry.

The Reinsurance Directive affords us the opportunity to put this precept more fully into practice. Under this Directive, each Member State is allowed to implement a regime of Insurance Special Purpose Vehicles (ISPVs). As our Consultation Paper later this month will more fully describe, we plan to implement a regime where investors can establish an ISPV under a streamlined authorisation process. The ISPV will be authorised as a reinsurance company so that it can take full advantage of reinsurance treaties and provide reinsurance to primary insurers or, for that matter, other reinsurance companies.

The ISPV must have positive net assets, i.e. the market value of its assets must exceed the gross amount of the exposure that it has underwritten. Funding for the ISPV will come from premiums paid by ceding companies as well as the proceeds of securities issued by the ISPV to investors. Claims will be paid through liquidation of the assets of the ISPV. Investors will earn a return consistent with the risk that they have assumed. We anticipate that many ISPVs will choose to fund themselves via a capital structure akin to that used in securitisations – a senior or super senior tranche rated AAA, supported by one or more junior tranches with a limited amount of equity.

We will accordingly provide capital relief to primary insurers which utilise such ISPVs. Insurers will need to model the effect of transferring liabilities to an ISPV in their ICA to ensure that sufficient capital is retained so that policyholder security is maintained. The transfer of business to an ISPV will be subject to an effective risk transfer test to ensure that credit can only be taken in the balance sheet where risk has actually been transferred.
We believe that the introduction of ISPVs will allow primary insurers to diversify their sources of capital, specifically to attract capital that may wish to take certain types of insurance risk without the need to take firm-specific risk on the underwriter. This should enable UK primary insurers to manage their own capital, especially their equity capital, more efficiently.

Other aspects of the Reinsurance Directive include

• the passport: UK-incorporated London Market firms will be able to conduct business on a branch or services basis in other EU Member States without having to establish separately incorporated and separately regulated subsidiaries.
• the elimination of collateral requirements that are currently imposed by some European regulators. We hope the harmonisation of approach and increased standards will encourage the US regulators to follow suit.
• a potential reduction in Pillar 1 capital requirements for some firms.

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FSA capable and effective

The final component of the platform of choice is a capable and effective FSA. We are undertaking a number of steps to achieve this objective.

The first is a shift to more principles based supervision. Under the new Arrow approach to supervision that we unveiled at the start of April, we are moving to provide firms with a holistic assessment of the risks that they pose to our statutory objectives in language that is relevant to the ways in which firms manage themselves. In particular, we will evaluate the good with the bad and use a four point probability score (low, medium low, medium high, high) to rate the firm in three major areas:

• business risk
• the effectiveness of the firm's controls
• the quality of oversight and governance

In our dialogue with firms we will focus on whether the firms are complying with the Principles for authorised firms, and we will provide some commentary on how firms stack up against their peers. And, we will conduct one-on-one feedback sessions with a sample of the larger firms to get industry's views on how we are performing our job as supervisor.

To execute this programme, we require market-savvy supervisors who know the insurance industry and who are capable and ready to exercise appropriate judgement. We acknowledge that we have some ways to go before we can fulfil this goal, and we are stepping up both our internal training and our recruitment from the market to assure that we can meet this objective. Although there are some things, like stock options, that we cannot offer employees, what we can offer is an unparalleled overview of the industry as a whole, the opportunity to work on big issues and a diversity of tough problems.

Finally, we are stepping up the effectiveness of our routine operations. In particular, we are speeding up the authorisation process. Where we know the management of the proposed new firm, we have committed to turning around the application in about four weeks. If we do not know the management, we have committed to providing a response within 10 weeks. This should allow investors to create new insurance companies and/or ISPVs very quickly indeed. In addition to speeding up authorisation we are also speeding up our response to routine queries as well as with respect to other 'regulatory transactions' such as a change in control.

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Other considerations

Regulation is only one factor among many that firms consider when they decide where to do business. We are acutely aware that other factors also play a role. We are also acutely aware that we do not control these other factors.

One is tax. This is matter for Her Majesty's Government, specifically the Treasury, and Parliament as a whole. We can merely note, as we have to Ministers, that capital is mobile internationally. Financial capital moves in response to better returns and so, over time, does the human capital of the skilled professionals who comprise the global insurance market. But this is a case that the industry must put to Government and public opinion, as I know that you are doing.

Another is cost. London is a costly place to do business, and the insurance market has organised itself in a costly way. There is much that the industry and the firms are doing to remedy this – the question is whether the remedy will be quick enough or thorough enough.

What we can do is offer a robust regulatory platform. We believe that we have the framework for this in place and look forward to working with the industry to promote London as an orderly, efficient and fair market for insurance.

Footnotes

^1. We wrote to CEOs of all insurance brokers on this subject in July 2005. (See Dear CEO letter: Client money)

^2. See Dear CEO letter: Conflicts of interest.

^3. For a fuller discussion see Insurance Sector Briefing: ICAS – one year on - November 2005