The role of the regulator and the responsibility of the buyer in the insurance chain
Speech by John Tiner, Chief Executive Officer, FSA
AIRMIC Annual Conference
13 June 2006
Introduction
I am delighted to be here in sunny Bournemouth at AIRMIC's 2006 Conference. You have certainly chosen an excellent location for this summer event and I hope you have a productive and enjoyable couple of days here. I should perhaps emphasise just how delighted I am to be here: I have had the good fortune and pleasure of spending a few days sailing around the English Channel. That I made it here today, in good time and without reverting to a satellite 'phone somewhere in the mid-Atlantic, is perhaps evidence that the winds and waves were on my side! And of course I am very pleased to have this opportunity to give you my views of why we consider AIRMIC members to be such an important part of the insurance market, a market which is of great significance to us, as its regulator.
First, a bit of history. The FSA last addressed AIRMIC members in January 2002 when our former Chairman, Howard Davies, spoke at your annual lecture. So much has happened in the world of insurance since then, that it is certainly timely that I address you today. I think it is worth recapping on the events of the past four or so years.
Back in January 2002, we were all coping with the aftermath of the tragic events of 9/11, wondering indeed if the insurance industry would survive, and if it did, for how long, given the significance of the losses arising from that man-made catastrophe.
Followed closely by a global economic downturn and the associated plummeting of share prices, it was with some relief to us all that the market came through in reasonable shape. Having raised in excess of $35bn of new capital post 9/11, it continued to provide insurance capacity to those industries that depend so heavily on the transfer of risk away from their own balance sheets – like those of many of you here today.
More recently, the hurricanes of 2005 wreaked havoc on both the lives of people of the US Gulf states and on the balance sheets of insurers and reinsurers. However, the insurance markets – in particular the London Market and Lloyd's - demonstrated once again their social and economic importance by getting people and businesses back up and running in relatively short order.
In this period, we have seen the development and growth of other insurance markets, such as those of Bermuda and Ireland. We have witnessed the fallout in the US from the Spitzer enquiries into bid-rigging, and we have seen the impact closer to home of changes to the broker business model.
So, a great deal has happened to change the shape of the global insurance markets since Howard's lecture some four years ago.
In parallel with these market developments, regulation of the insurance industry has changed beyond recognition over this period. Following the failure of Independent Insurance and problems at Equitable Life, we embarked upon a significant programme to reform our approach. We are now well into the implementation of the new regime at the heart of which resides a risk-based approach to both the adequacy of insurers' capital and our approach to supervision. We have also introduced conduct of business requirements for general insurance companies and, perhaps most importantly for you, in January last year we took on the regulation of insurance brokers, following our implementation of the Insurance Mediation Directive. This means that UK brokers have now been brought into the regulatory fold and as such are subject to the same statutory framework of regulation as their insurer counterparts.
It is vital that, in regulating this important market, the correct balance is struck between, on the one hand, the role of the regulator and, on the other hand, that of the professional buyer of insurance. This balance must take into account the need to protect insureds in so far as they cannot protect themselves. It must provide a sound regulatory platform that facilitates growth, innovation and competition, thus giving you choice. And it must give you the confidence that this is a market to which it is both safe and beneficial to transfer your risks. We each have our own respective roles – and responsibilities - in striking this balance. It is these that I will consider today.
Regulatory aims
Not surprisingly perhaps, I will start on home turf by outlining the regulator's role in this difficult balancing act. The FSA's philosophy is that the best results for any market are achieved for all participants through the efficient working of the market, and not by regulation. When markets do not work efficiently, the first priority should be to focus on improving efficiency, best of all by relying on market solutions, rather than go into a frenzied round of rule-making. Regulation should always only occur when there is both an identified inefficiency in the market – the market failure as the academics would call it – and when regulation would deliver benefits that would clearly outweigh the costs. A 'no brainer' you may say.
Of course this philosophy has to be played out in the context of the statutory requirements imposed on us - by the Financial Services and Markets Act. Here, we have four very clear objectives: the protection of consumers; the maintenance of market confidence; the reduction of financial crime; and helping consumers understand the financial system. Our overarching strategic aim, then, is to promote efficient, orderly and fair markets and help retail consumers achieve a fair deal. This aim governs what we do, how we do it and, importantly, how we use our resources. There are, of course, some important points to note.
Our efforts to protect consumers must be appropriate and we must have regard to the general principle that consumers should take responsibility for their own decisions. In reality, and through our rules, this means that customers get differing levels of protection according to their financial 'savvy'. Whilst that does not mean that we have no regard to the treatment by firms of their commercial customers, it does mean that, as commercial customers, you should not expect to get the same level of information and protection as retail customers many of whom have scant understanding of the financial system. Similarly, we do not spend our time and money educating professional customers about the way the financial markets work: our financial capability work is dedicated squarely at helping those who cannot help themselves.
Furthermore, in seeking to promote efficient, orderly and fair markets, we also seek to ensure that the wholesale market is internationally attractive and sustainable. These characteristics are essential for the continuing competitiveness of the UK financial services industry and, importantly, the London insurance market. Competitiveness and dominance as an insurance market brings clear advantages to all parties in the insurance chain – benefits for underwriters, for brokers and for buyers of insurance.
The FSA's approach
So how do we go about delivering our high level strategic aim?
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. We also maintain a public register of regulated firms so customers can check that their counterpart is fit to conduct financial services business.
Second, we set high level Principles for firms. These Principles articulate what action and behaviours we expect, providing the backbone of our regulatory regime. They focus on what regulations are trying to achieve – expressed as outcomes – a helpful 'if in doubt' guide for the regulated community. In doing so, these Principles should also help you, as customers, see how we expect firms to operate in their dealings with you.
Third, we identify areas where detailed rules are required, such as prudential and capital standards; the systems and controls we expect firms to operate; and the way we expect firms to treat their customers and handle their money. 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 the industry about those rules, working with the market on implementation.
Fourth, we act as referee by supervising against the principles and rules. We assess the risks posed by individual firms and, where we identify shortcomings, we outline these to senior management and expect them to remedy the situation. Where we identify widespread failure across a number of firms, or sectors, we undertake dedicated sectoral reviews. A good example of this is our work with insurance brokers to improve their compliance with our client money requirements.
And fifth, when things go wrong, we take swift action to address the problem. That may be by encouraging industry action. But where necessary it will include proportionate, though formal, regulatory steps including enforcement action where appropriate. Thus we can reduce detriment to customers and protect market confidence including the reputation of the compliant parts of the market.
In doing all this, we must remember that while regulation should bring benefits, it is also a source of cost to the financial sector – costs which will ultimately be borne by the customer. We are committed to keeping costs to a minimum where possible and have a number of initiatives in play to remove unnecessary costs that cannot be justified when balanced against the benefits that regulation brings.
These five key strands to our regulatory approach are common to all sectors of the financial services markets, differentiated to take account of the size, nature and risk of individual firms. This is perhaps unsurprising given that we are an integrated regulator, operating under a single statutory framework. So let me drill down a little further into one key aspect of insurance regulation which will be of particular interest to you: our capital adequacy requirements. [Whilst our capital requirements for insurers are intended both to ensure the solvency of insurers (that is that insurers can pay your claims as they fall due) and to maintain confidence in the insurance markets overall, the sophisticated regime that we introduced as part of the reforms of insurance regulation goes far beyond this basic summary. Let me expand.]
Introduced at the end of 2005, our new capital requirements for insurers - Individual Capital Adequacy Standards –are the centrepiece of the regulatory regime. Our aim is simple: to ensure that insurers have enough capital to provide protection to policyholders whilst allowing insurers the opportunity to earn a rate of return on that capital that will be attractive to their investors.
The starting point is that there should be a 99.5% probability that a firm will remain solvent over the coming year, equating to a one in two hundred chance that a firm will fail. In rating terms, this is broadly equivalent to a 'BBB' rating – we believe that you, as corporate buyers, look for insurers with ratings at, or above, this level when placing your risks. It is also worth noting that, should an insurer incur a significant but not devastating loss, this 99.5% confidence level gives us an opportunity to take swift action and gives the firm a chance to raise new capital before it becomes insolvent. Indeed, as the 99.5% confidence level denotes, we do not operate a zero failure regime. Insurers will fail from time to time but we are confident that our approach will enable the orderly run-off of those that do. [As an aside, the number of UK insurers that became insolvent between 1996 and 2001 was 15, compared to just two since 2002. Although this gives some indication of the positive impact of our new regime, one of course need to bear in mind other facts such as the prevailing market conditions before drawing too hard a conclusion.]
Under ICAS, insurers then provide us with their view of the amount of capital required to support all the risks arising from their business – and I mean all, including those pesky risks that arise from the very operation of an insurer's business. We will then set the firm's capital at that level if we agree with the firm's assessment, or above if we do not. We have now completed capital assessments for around 90% of the UK general insurance market and, in general, we have set firms' capital at levels that are quite close to the firm's own assessment.
The discussions on the future capital requirements for European insurers – the Solvency 2 Directive - are very much in line with the UK's current approach. Indeed, the general trend in insurance regulation around the world is toward imposing capital requirements that are in line with the risks insurance companies run. In other words, moving ever closer to a happy alignment between economic and regulatory capital, making for not only good regulatory sense, but good business sense too. Another "no-brainer" you may say but an approach which you will without doubt support.
The buyers' role
Having focused on our role, I now want to turn to your role – and indeed your responsibilities – as buyers of insurance. You will not be surprised that we do not consider you to be consumers in the retail sense of the word. Indeed, you will know from experience of dealing with brokers in the past year or so that you are not provided with the same information when acting on behalf of your corporations as you do when, say, you buy your own personal insurance cover. This is because we do not believe that you need protecting in the same way when acting as commercial customers. I have set out already why that is and outlined the areas where regulation brings you benefits.
I would, however, like to encourage you to exercise your important position of power in the market. I strongly urge you to recognise this position and to use it to drive through efficiency and transparency in the market. Such pre-emptive action will help reduce the need for further regulation in certain key areas. And, taken together, improved efficiency and transparency coupled with a reduction in regulation will, ultimately, flow through and so reduce the burden of costs for you as customers. Another 'no brainer'. The corollarary, of course, is absent this influence, the case for regulatory intervention cannot be ruled out – and I'll come back to this shortly.
AIRMIC members are powerful, global players. You represent around 75% of the FTSE 100 companies and contribute £4bn of premium and fees each year to the insurance markets and captive insurers. Your counterparts in the US – RIMS members – and in Europe – FERMA members, make up a substantial part of the global corporate buying power for insurance. You are highly influential in the insurance market; your buying power enables you to secure the best relationships with brokers and the best deals for insurance cover.
You also have a choice about how to transfer risk from your own balance sheets whether through the open market or to your own captives. And in the open market, you have a choice between London and other global insurance markets. Your choices will be influenced by a variety of factors including, but of course not limited to, the security of the insurer whether determined through rating or regulation; the relationships you have with brokers and the knowledge they have of your business needs; your corporate structures and strategy; and the availability of cover.
In spite of this enviable position of strength and choice, I am continually surprised that you don't punch your weight more firmly in this market. After all, exercising your power seems to me to only bring you benefits, particularly when profitability and risk management are so high up on the corporate agenda. Let me illustrate this point by referring now to two key areas - both of which are priorities for the FSA in its supervision of the insurance sector.
Contract certainty
First, the importance of contract certainty. You will be only too aware of the risks associated with the lack of contract certainty, an unhappy inefficiency in the insurance market that has prevailed for decades. Without contract certainty, insurers do not have certainty about their exposure; brokers are exposed to operational risks including legal action by their customers; and you, as buyers, do not know and cannot demonstrate the precise details of the risk you have transferred. You do not have evidence that you have cover, and that you have in fact transferred the risks from the balance sheets of your corporations to the balance sheets of insurers. The 'deal now, detail later' approach to insurance buying.
Not only is it surprising that this has been the state of play for so long, but that it is the accepted state of play. Acceptable by you and by your boards. I cannot understand how this is the case. In recent years, standards of corporate governance and financial controls for UK corporations have advanced beyond recognition and shareholders have high expectations of what these will deliver. Yet the evidence of cover for insurance appears to have qualified for an exemption from this basic check and balance. I have spent some time wondering why this is the case and only managed to come up with unanswered questions: Is it (a) apathy on the part of you as the risk managers? Or is it (b) down to a lack of interest by your boards, internal and external auditors? Or is it a combination of the two, mixed up with tacit acceptance that this is how the market operates – a case of accepting the status quo.
And the problem is not limited to UK insurance business. A recent survey of RIMS members found that the vast majority (almost 1000) of those US and Canadian insurance buyers surveyed were dissatisfied with the time it took to receive their policies. Not surprising given that for most this took between 46 and 120 days.
You will know that we have challenged the insurance market to find a solution to the practice of deal now, detail later; to find a market solution to achieving contract certainty by the end of 2006. That's just six months away. Our challenge here is aimed at all parties in the insurance chain: the insurer, the broker and the insured. All have an equal part to play in eking out efficiencies in the insurance buying process, such a those secured through contract certainty.
In response to our challenge, the market has made good progress in the last 18 months or so. Agreeing a definition – acceptable to all parties – and delivering guidance, interpretations and help to practitioners have all led to a giant leap forward in the number of insurance contracts that have achieved 'certainty' in the first quarter of this year. Around 80% for both subscription market business and commercial contracts.
This progress is positive for the market as it means we have put our plans for new rules on the backburner - for now. It is positive for us as it looks like the market may itself solve this particular market inefficiency, assuming of course that momentum is maintained and some difficult issues are addressed in the remaining six months. And, importantly, it is also positive for you as buyers of insurance. But let's not be complacent. It is widely acknowledged that the market has 'picked the low hanging fruit'; that the easiest bit of the challenge has been achieved; and that the remaining 20% or so of commercial/wholesale transactions that don't meet contract certainty are going to be the real test. We have some concerns about the quality of data, about the commitment by firms in some sectors to provide the necessary data to the market bodies, and about progress in a number of important areas. We are discussing these concerns with those who are charged with leading the work for the market.
Going forward, it will be vital to ensure that progress does not falter with old habits creeping back in, either because there are too many transactions in the 'too difficult' bucket; or because the threat of intervention appears to have passed along with the end of 2006 deadline. Let me be clear, it will not.
We will look for changed processes to become changed behaviours and changed behaviours to become changed culture. Only then can the market be sure that getting contract certainty is an accepted, and expected, part of the insurance buying process.
You will need to continue to pull your weight in the months and years ahead – whether by starting the buying process earlier, or by making demands about terms and receiving evidence of cover - to ensure that brokers and underwriters do not slip back to their old ways.
We were encouraged from your survey last year to see that you are seeing significant improvements: AIRMIC's executive has been a key player in the market response [and I see your guide to contract certainty is a handout here today]. I am also greatly encouraged that RIMS and FERMA are now also taking an interest in the subject. On our part, we are discussing this with our fellow regulators whenever possible to ensure that the global insurance industry is mobilised into action and that the UK market gets the benefit of greater efficiency without losing out to competitive markets as brokers take their business to markets where it is quicker and easier – but not necessarily safer or more efficient – to do business.
Commission disclosure
The second area that I would suggest you have a key role in influencing market progress relates to market transparency and the vexed question of commission disclosure. This is a subject which I know is of great interest to you as buyers of insurance.
Again, I have been surprised by comments that commercial customers cannot get the level of transparency desired in terms of the charges and commissions incurred in the buying process. As regulator, we are as keen as you to see transparency in the insurance market, as transparency leads to improved competition and efficiency. Whilst there has been some progress in developing market solutions to the disclosure of commissions, we are conscious that there is still some wrangling between the players in the chain to achieve this end, resulting in continued calls for the regulator to intervene and mandate commission disclosure.
I have made it clear on a number of occasions that we do not believe regulatory intervention to be an appropriate response to these concerns. But, just to repeat: making commission disclosure mandatory will not necessarily address the conflicts themselves that arise from commission sharing arrangements or deliver any other regulatory benefits. Treatment of a symptom is a poor substitute for addressing the root cause. Insurers and intermediaries must properly and actively manage conflicts of interest. Following on from our work last year, we will take another look in the coming months at whether this is being achieved. We will take account of what we find when considering our policy response.
Once again, I stress that my preference is for a market-led solution. And you have the power to drive this through. In contrast to the contract certainty debate, there is a specific regulatory requirement here already. Brokers are already required to provide you with details of commissions earned, if asked. I repeat, if asked. So if you are determined to get full disclosure of commissions earned, then you must ask for it. Quite clearly, the power – again – is in your hands. You simply need to acknowledge that – and then act on it.
I have steered clear of tempting fate in recent months by saying that progress towards contract certainty suggests the market is more than capable of generating workable solutions to conflicts management and transparency. Market forces are already at work in some sectors to address the failure. The largest brokers have stated publicly that they will provide full transparency in their dealings with their customers by offering full disclosure. The work of the London Market associations is to be applauded here. I am also pleased to see that very recently the rest of the broking fraternity, through the work of BIBA, have agreed to follow suit by including similar clauses in their Terms of Business Agreements. Your own 'questions to brokers', issued early on in the debate form an important part of these market initiatives and your recent survey suggests that improvements are being seen. All this can only be welcomed. The only obvious gap here is the SMEs [small and medium sized enterprises], and we are giving some thought as to how best to reach out to this insurance buying community. Anecdotally, I hear that some brokers are arbitraging against the transparency of other brokers and it must follow that the buyers of insurance are, in effect, facilitating this.
As I've said already, market solutions remain our preferred outcome. However, if over the next several months we do not find any discernible improvement in transparency, delivered either by market solutions or demonstrated by improvements in the management of conflicts, we will look seriously at whether the benefits of mandating disclosure outweigh the costs and then act accordingly. That would be a last resort and a disappointment, not least because the market and, importantly, its customers, had failed to sort out its own issues. It would not, I suggest, send a very good message about your ability – as a powerful and influential body of insurance buying power – to drive through change and deliver better outcomes for yourselves and for your organisations.
Conclusions
have outlined clearly how we go about regulation, both in terms of our strategic approach and, in more detail, what we do to give you the confidence that UK insurers and brokers are well-regulated and worthy of your business. As I said at the outset, regulation is not the only force at play in achieving efficient markets. Regulation must take account of the extent to which the end user – in this case the insurance buyer - is not able to take personal responsibility Regulation must be proportionate to the risks and capabilities of the players in the particular market. It has a role only in so far as consumers need protection and market solutions do not work.
As commercial buyers of insurance, you have a very strong role to play. If we all play our respective roles to the best of our abilities, we should achieve the correct balance between a market that is well-regulated but not over-regulated; one that is efficient and transparent; and one which enables competition and delivers efficiency for all participants.
Let me finish then by emphasising the importance of using your power to influence this outcome.
Thank you for your attention and I hope you enjoy the remainder of your conference.