Regulatory priorities in a principles-based world
Speech by Sarah Wilson, Director, FSA
ILAG Annual General Meeting
15 June 2006
Good morning and thank you to ILAG for inviting me to speak at your Annual General Meeting.
Although still relatively new to the role of Sector Leader, it has not escaped me that ILAG has a proven track record of engaging with the FSA in a considered way, focusing on spreading good practice amongst industry practitioners. Indeed, this is precisely the type of engagement that we look to foster with trade associations, particularly so as we move closer to a regime that is driven by principle, not prescription.
Of course, a constructive dialogue is entirely consistent with a challenging one, and such challenge is entirely right. As such, I very much welcome the opportunity today to address your membership, safe in the knowledge that your response will be both constructive and thought-provoking.
Perhaps unsurprisingly, I have been asked to focus my remarks on the FSA's key priorities for the coming period. But before getting into specifics, I would like to take a few moments at the outset to draw attention to the backdrop against which these specific topics feature.
While the life insurance sector as a whole has been through an unparalleled period of regulatory change in recent times (coupled of course - for a time - with very difficult market conditions), a further significant regulatory challenge lies ahead. I speak, of course, of the shift away from the current largely prescriptive approach to regulation (where senior management are held accountable for managing their firms but there are many detailed rules specifying how they should conduct much of the business) towards a regime in which outcomes-focused principles come to the fore, and there is a reduction in reliance on detailed rules as a result; the emergence of a regime that is single-mindedly focused on "what" we are trying to achieve and which limits its interest in "how" firms conduct the details of their business to areas where there is a particular case if desired outcomes are to be achieved.
This shift should be viewed as all part of the natural evolution of our regulatory approach; having brought together and integrated a total of nine regulatory bodies back in 2001, including all the work inherent in bringing regimes together so that level-playing fields are created as appropriate, and - in the case of insurance most particularly - having subsequently embarked upon a programme to modernise the regime, the move towards a greater reliance on principles can start from stable and well-considered ground. In practice, this shift will require both a different mindset and different skills – for us, for firms and for trade associations.
With that important context firmly in place, I want today to concentrate my remarks around Treating Customers Fairly – the clearest current manifestation of this new operating model. Here in addition to setting some overarching points on progress to date, I will pick out a number of "pinch points" that are of particular pertinence to the life insurance sector, including dependencies between provider and distributor and the quality of post-sale disclosure. I will then make some brief remarks with regards our new outcomes-focused capital regime and point up the role it is playing in helping us with the authorisation of new entrants to the bulk purchase annuity market. Finally before closing, I will expand on my opening comments on the role that we envisage trade associations playing in this new world.
Treating Customers Fairly
Progress to date
So first, some overall impressions on the progress we are seeing on TCF - and here my comments apply to all sectors and not just the insurance market represented here today. As the sponsoring Director of our TCF initiative, it is pleasing that in the main, voices of dissent over whether TCF is an "optional extra" (as opposed, of course, to an existing principle applying to all) are now decidedly in the minority. Most importantly, and at the highest level, the senior management of firms increasingly tell us that they recognise the need to embed Treating Customers Fairly as a behavioural and cultural change throughout their business, and that this is very much a senior management responsibility not simply something to be passed over to their compliance departments.
This is all well and good. But many firms are equally recognising the time and effort required if the senior management desire for cultural change is to be reflected in tangible actions that actually make a difference to your customers. There are excellent signs that the TCF initiative is making a difference – for example, products not now getting to market, and lessons being learned from complaints handling.
At the same time however, the findings of much of our thematic work suggests that, while there are also some good news stories here too (such as the feedback we recently published on critical illness), in many firms the Treating Customers Fairly initiatives begun by senior management have yet to deliver improvements further down the organisation, and are therefore yet to deliver benefits to customers. We see this for example in our work on disclosure, an area where compliance with detailed rules remains key. This overarching finding is supported, incidentally, by what firms are telling us they find in their own compliance and mystery shopping exercises.
And of course there are firms in all sectors (including this one) relatively behind in their response to the TCF initiative - firms that have not addressed their product design procedures for example, or which clearly need further encouragement before they think about the information they provide to their distribution channels, a topic I will return to in a moment.
Further, we have found firms where staff remuneration continues to be dominated by commissions and other volume-related incentives, and where no attempt is being made to consider and manage the resulting conflicts of interest. And there is still a long way to go before many firms develop convincing management information to show whether they are indeed treating their customers fairly - as opposed to trying to ensure only that they are satisfied, a standard which is insufficient if not mi-leading in a world where so few consumers understand sufficient to judge for themselves. None of this is intended of course to diminish the good intentions that are clearly in evidence in the board rooms of this and other sectors, but the translation of these intentions into actions that really make a difference to consumers is becoming increasingly pressing.
Interface between provider and distributor and consumer
Turning next to a couple of issues and areas of concern specific to life insurers. First, I would like to share some of our thinking on the interface between product providers, distributors and the all important consumer. In the interest though of being "clear, fair and not misleading", I should make it clear that I am not today in a position to share with you the detail of our thinking on the respective TCF related responsibilities between product provider and distributor. Our statement on this important issue will be published before too long. What I would like to explore today though are some of the dependencies throughout the chain from insurer through to distributor and on to the consumer.
It is of course the case that a product provider may not in isolation be able to ensure the fair treatment of customers. Your products are marketed and distributed through a range of channels including retail intermediaries – financial advisers or mortgage or GI intermediaries. Responsibility may often therefore be shared – and this as you know is precisely the subject of the statement which we plan to publish.
Product provider firms do however typically stand at the beginning of a chain of actions that lead to a product offering to customers. As such they need to consider whether their products are properly designed, targeted and tested, and whether they are providing clear and accurate information to their distribution chain about the nature of their products and the risks associated with them.
It also seems to us inevitable - whether for regulatory reasons or otherwise - that product providers should take an interest in the overall quality of their distribution - not by proactively monitoring the behaviour of individual distributors but rather by considering what the aggregate statistics tell them about the quality of sales and (crucially) acting on the results.
It is surprising to us however that many product providers are cautious about this - putting their reputation in the hands of others who "own" the relationship with customers without necessarily either providing clear accurate information or actively considering distribution quality. It is a harsh commercial reality that much brand damage can be incurred in this way - the customer remembers the insurance brand when it comes to complain and not the smaller local distributor. And in a time when concerns are being aired over the profitability of some lines of business and over some insurers' preoccupation with new business at the cost of retaining the existing customer base, providers should be asking themselves some tough questions about their distribution channels.
I should also take this opportunity to stress that it is not our intention to provide detailed rules in this area. Clearly, that would run contrary to our commitment to move to a model driven by outcomes and so instead, we will be looking for providers and distributors alike to consider their own responsibilities in how to treat customers fairly at all points of the distribution chain - where these should reflect the content of our Principles.
This principles-based approach requires firms to take reasonable care to organise and control their affairs responsibly and effectively, with adequate risk management systems. But given the interest that I suggest you should be taking in distribution, it will be of significance to you that - as we fed back in April - we have seen a range of problems in small and large retail intermediaries (and other firms) that neglect corporate governance and high-level controls, including financial controls.
A common problem we found in our work is the absence of good quality management information to help identify and analyse issues and trends. Strategies are sometimes poorly documented, with limited analysis of business plans or downside planning, so firms may fail to spot weaknesses in their business models and downward trends, for example in financial resources or customer retention. More fundamentally, such weaknesses undermine the ability of the board and senior management in those firms to identify and act on priority issues, and this may put their customers at risk.
Of course, we are considering all these areas closely in our supervisory work with retail intermediaries. And indeed, these and other issues will be addressed in the review of retail distribution that John Tiner announced just yesterday. But notwithstanding our important responsibilities, product providers too should consider their own ability to improve distribution and avoid reputational damage - by enhancing information to distributors and by considering and acting on high level information about distribution quality. At the risk of repeating myself - while customers will remember that they bought one of your products, the distributor in whom you place confidence and trust to sell your products may well be the stronger determinant of whether your customer feels that he/she has been treated fairly.
Post-sale disclosure
I now want to turn to an area where you can have a more direct and immediate impact on your customers. I have already touched on the importance of retaining in force business and to my mind key to this is clear and understandable policyholder information – post sale. While it is, of course, of paramount importance that information given to consumers at the point of sale is clear, fair and not misleading so that they know what they are buying, so too is it essential that policyholders are given information post-sale that enables them to determine whether the policy continues to meet their needs. There are, of course, two types of post-sale disclosure – those which are mandated by our requirements, and those which are voluntary driven by trade association initiatives. Sadly, too often post-sale information of both types fails to pass the "clear, fair and not misleading" test.
Taking each of these in turn, I first like to reiterate comments I have made on previous occasions with regards the quality of firms' PPFMs and the correlative consumer-friendly versions. Now, I accept that the PPFM document is unlikely to be read by the typical consumer, but given that the consumer-friendly documents are based on the key areas included in the PPFM, it is right that we focus our energies on stressing the importance of these documents being as clear and accessible as possible.
We know that the financial adviser that faithfully reads through the various PPFMs that he or she advises on – for both new sales and to clients who already have with-profits policies - will be the exception to the rule. While we continue to stress the importance of advisers raising their game in this regard, we also know that one of the reasons for their poor engagement is that these documents are not always of a high enough quality.
More effort is needed in this area then for two reasons: first, to help ratchet up the quality of information that you send to your policyholders by way of the Consumer Friendly PPFM; and second, so that you are confident you have done your bit to help ensure your distribution chain has appropriate tools to understand, and then be in a position to give quality advice on, your products.
Turning to non-mandatory disclosures. Again, as I have said previously, we very much support the concept of annual statements being sent to with-profits policyholders. But we are concerned that their potential value is diminished as in many cases what is actually sent is difficult, if not impossible, for the average policyholder to understand.
To help illustrate this, I would point to the letter a colleague received from a former (and reputable) IFA, enclosing a copy of his wife's annual statement from a very well known insurer. He was concerned that if he couldn't understand what the impenetrable data was telling him, what hope was there for the average consumer – who, let's not forget, struggles even with the concept of percentages, let alone how terminal or reversionary bonuses are calculated. Again, I reiterate that we support the initiative, but think that the execution leaves something to be desired.
Given the seriousness of these misgivings, we feel that this is one area where a closer look is warranted. And as such, I am pleased to be able to announce that we will be carrying out a thematic review of firms' post-sale disclosure documentation to identify examples of good and less good practice. Our intention is to publish our findings later this year, and as with our publication on PPFMs last year, in a bid to help spread good practice we will look to "name and praise" those firms that we consider are delivering quality documentation to their policyholders – mandatory or otherwise – which in turn enables them to decide whether a product continues to meet their needs.
ICAS and risk management
Before moving on to my final topic this morning – the important role that trade bodies can play in this new order – in a session focusing on regulatory priorities in a principles-based world, I would be rightly charged with negligence if I did not carve out at least a few words on our new risk-based, outcomes focused capital regime. Indeed, adequate capital is absolutely fundamental to our new regime. Without it, firms are not even in a position to consider how to treat their customers fairly. The absence of good risk management disciplines is also key.
As such, and as some of you may have heard me say on previous occasions, embedding the new capital adequacy regime continues to be a priority for us. In the context of Solvency 2 it is all the more important that we, FSA and industry working together, demonstrate that the new regime works well – for all firms of all size – and is delivering a sector which has appropriate capital commensurate to the way in which it operates and the business it writes.
The outcomes we are looking to secure here are two-fold: first, improvements in the way in which capital requirements are calculated so that we all have greater confidence that capital is adequate; and second improved risk management in firms. And, again, focusing on the "what" not the "how", 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.
We are committed to having completed ICAS reviews for all firms by mid-2007, and with one year off till that deadline, I can inform you that having received ICA submissions from 41 firms and groups, we have reviewed these calculations and issued ICG for nearly two thirds of the industry, measured by liabilities.
Throughout this first set of reviews, we are having what could fairly be characterised as robust discussions with firms over the basis on which their ICA numbers have been calculated. And indeed, this is all part and parcel of a principles-based approach, where this is no single "answer" set out in the rulebook. 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 disciplines in this territory since its introduction.We will look to share our findings with you around the turn of the year.
ICAS then should be viewed as a tool for both regulator and regulated – for us in terms of determining the appropriate amount of capital a firm should hold and for firms leveraging better risk management disciplines in exchange for a lower capital requirement. Feedback from the industry would suggest that in large part, firms have found this to be a useful tool delivering real improvements in risk management disciplines. One new area where we have recently been putting ICAS to the test is in the authorisation process for new life insurers. Applications from new life companies are, as you will know, normally rare. But as the press has has picked up upon, we have recently been talking to several prospective new firms interested in getting a foothold in the bulk purchase annuity market. ICAS has been invaluable in helping us determine the credibility or otherwise of applicant entities' propositions.
As you will know, having played a supporting role to date, the BPA segment of the market has become increasingly attractive of late – both to new entrants and other existing incumbents in the wider sector. As a consequence there has been much discussion and commentary in the press and elsewhere over the extent to which growth opportunities exist. For our part, I would like to stress that if authorised, these new firms will be subject to the same rules – including capital and conduct of business requirements – as all other insurance firms that we supervise. As such, policyholders in schemes that are transferred to these new entrants will enjoy the same protections that all insurance policyholders enjoy, including of course, the requirement on insurers to treat their customers fairly.
Role of trade associations
As promised at the outset, a few words before closing on the role of the trade associations. It seems to me that at the heart of this new regulatory order, there is a deal to be struck between regulator and regulated. Our part of the bargain is to focus on the outcomes we are seeking to achieve – the "what" as I characterised it earlier. Your part is to decide "how" to deliver that. In some cases you may wish to act as individuals and use your different routes to the outcome - reflecting different institutional circumstances and history or as a competitive differentiator. In other cases, you may wish to pool ideas and agree a common way forward. Either way, without your contribution a principles-based regime will founder.
Turning to the role of trade associations within this deal. I should note, of course, that we plan to say quite a bit more on this topic later in the year by way of a Discussion Paper. As a prelude to that though I offer these thoughts. As I see it, the role of the trade associations is two-fold.
First, we would expect the trade associations to continue of course with the key role of representing their members' interests. And as I said in my opening remarks we welcome a constructive and challenging debate - characterised by meaningful and frank engagement, where concerns and disagreement can be aired and where challenge has a purpose and is not a means to itself.
Second, trade associations can act as the conscience of their membership. It is of course for the trade associations to assume whatever role they feel best serves their members, but in this new operating model, there is a bigger role for trade associations to help their membership keep their side of the bargain, typically, but not limited to, helping spread good practice. Of course, this is familiar territory already for some - including ILAG – but there is scope for more in the future.
Conclusion
I hope you have found my comments and observations this morning useful. As I said at the outset, the challenge ahead is great, for both us and for you. Inevitably, there will be moments of uncertainty ahead as we move forward without always the precision and detail of a rulebook to refer to. This means that a greater level of constructive dialogue between regulator and regulated will need to emerge and I for one hope that the trade associations will also play their role in nurturing that.
Finally, I would like once again to thank ILAG for not only inviting me to speak, but also for their engagement with the FSA. In particular, I would like to thank Malcolm Small for his efforts as chairman over the last year and I and my colleagues look forward to continuing in this constructive vein with the incoming chairman, Frank Fletcher, in the coming period.