Principles-based regulation - looking to the future
Speech by John Tiner, Chief Executive Officer, FSA
FSA Insurance Sector Conference
21 March 2007
Good morning Ladies and Gentlemen. I am delighted to see so many of you here today, at what will be my last opportunity to address the Annual Insurance Sector Conference, in my capacity as CEO of the FSA. The UK insurance industry continues to play a vital role, not just to the well-being of the domestic economy, but also to the international capital markets. But in today’s world of financial innovation, social, and climatic change, the need for the insurance industry to adapt is paramount, to ensure that it fully understands and manages the risks to which it is exposed and that UK consumers are adequately protected. Therefore, today's programme centres not only on the challenges to our domestic agenda but looks further afield to the impact of changes in the global market. I hope in setting our agenda for today we have focused on the areas that are of most importance to you.
I would like to concentrate my remarks this morning on our emerging regulatory approach – principles-based regulation – and some observations of how this is developing in the insurance industry. Before I close I would like to touch on how this approach is helping us influence the shape of Solvency 2.
More principles-based regulation
Let me set the scene for this morning's session by stating what we mean by this approach? Put quite simply our eleven Principles articulate the actions and behaviours that we expect from firms. This probably sounds quite appealing if this means that as regulators we have decided to give firms a stronger hand in their own regulation! There is an active role for all of us in moving to this approach.
Indeed, we recognise that this shift in emphasis from the 'how' to the outcomes is not an overnight process and it will certainly take time for the industry – and for us – to become familiar with this approach. I firmly believe that firms who genuinely commit to a set of outcome-based principles are in the best position to judge the detail of how to deliver those outcomes in the marketplace. In other words, principles place the responsibility squarely on the shoulders of firms' senior management.
That is not to say that we have adopted a 'laissez-faire' approach to orderly and efficient markets. On the contrary, for those of you who are reluctant to move away from the comfort of prescription there will still be detailed rules aplenty! Indeed, principles-based regulation is not solely about a reduction in the weight of the Handbook. I take the view that it is an audacious step – and some may agree - which allows firms, consumers and the FSA to co-exist in an industry that not only inspires innovation and fosters competition but is committed to treating its customers fairly. But it is important to note that it is the industry and its representatives who have the lead role in this particular production and we have the director's chair in helping to deliver this change in philosophy.
So let me turn to some observations of how a principle-based approach - in the form of market led solutions – is developing in practice. Clearly the delivery of a solution to contract certainty in the wholesale insurance market is testimony to this approach. Indeed, it was a landmark achievement for the UK insurance industry, if not globally, and one that I was pleased to have observed at close quarters. But before you hail victory to the tides of change the flow appears to have stemmed somewhat in the case of transparency of commission earned in the sale and intermediation of wholesale insurance contracts.
And so we have to decide how to tackle this issue. To help us with our analysis that we have appointed independent consultants, CRA International, to conduct an objective analysis of whether there is in fact a market failure in the distribution of wholesale insurance and if they find there is to do a cost benefit analysis of mandated commission disclosure. CRA will be talking to a good number of firms throughout the supply chain and we will be able to let you know the outcome of this work later in the year, together with our thoughts on what, if any, policy steps we should take.
More generally if the market could find workable solutions to remove inefficiencies then regulation could, and should only be used to deal with areas where the right outcomes can not be achieved by the industry itself. We have a strong desire to work with the market wherever possible, and as such have adopted this approach in relation to the Retail Distribution Review. We are pleased with the work of the industry groups so far, who have a difficult task, but are identifying possible solutions which, if adopted by the whole market, show signs of addressing the root causes of the problems we have continued to see.
As I alluded to earlier, industry representatives also have a 'speaking part' in this production and we welcome the contributions from the ABI and other trade bodies in developing our new ICAS sub-principles and the industry guidance which the ABI published last month. This underlines the value of a framework of benchmarks and standards to guide firms without undermining the essential individuality of the approach. Undoubtedly, this takes ICAS even further into the territory of principles-based regulation.
So turning the spotlight on to work we are driving.
One of the ways we have sought to engage with the industry on our retail agenda is through the formation of the Retail Savings and Strategy Group which offers a unique opportunity for key industry figures to interact with our strategy and ensure its cohesion.
Our work on the relationship between product providers and distributors – under the umbrella of Treating Customers Fairly - and the Retail Distribution Review are just two of our key retail initiatives which we hope will address some of the issues on the supply side, by clarifying the responsibilities of the parties in the chain as well as tackling the inherent inefficiencies in the market. Our work to improve financial capability is clearly designed to enhance the role of consumers of financial services and make them a better force on the demand side. Taken together, these three initiatives – Treating Customers Fairly, the Retail Distribution Review and financial capability – are consistent with our overall aims: namely to help retail consumers get a fair deal and in promoting efficient, orderly and fair markets.
General insurance effectiveness review
Under the banner of our post-implementation initiatives, we announced in September 2005 our intention to review our implementation of the retail conduct of business requirements for firms selling or administering general insurance. The main focus of this work was to determine if it had delivered the intended benefits for retail consumers.
After two years of regulation we have concluded that the market for most general insurance products works reasonably well in the interests of consumers and there are few instances of material market failure. Such products as motor and household insurance are typically less complex in nature, and purchased on an annual basis by consumers who often shop around for a good deal. Competition in these markets seems strong with new barriers to entry. In contrast protection products, such as payment protection and critical illness have a tendency to be more complex and we have found considerable evidence of market failure and potential for greater consumer detriment. This illustrates that there is a greater probability of consumers purchasing unsuitable cover which does not meet their needs. Consequently, we have formed the view that we need to find ways in which we can deliver more effective consumer protection for these types of products.
So it is by no accident of planning that we have today published the interim results of this review. I am also pleased to announce that we intend to consult on a differentiated and more principles-based approach to insurance conduct of business regulation in June of this year. My overwhelming sense is that there is scope for rebalancing the ICOB sourcebook and a strong case for moving to a differentiated regulatory regime taking away rules where the market works well and proposing additional protections for consumers where problems remain.
We envisage that the overall results of the ideas we are developing can be a slimmer and more principles-based ICOB sourcebook, with fewer detailed rules.
Solvency 2
Before I conclude I would like to examine briefly how our work on ICAS has helped inform our approach to Solvency 2.
So what were the outcomes that we set out to achieve?
- Firstly, we wanted to give firms an incentive to improve risk management generally by helping them move up the curve from risk measurement to risk management.
- Secondly, we wanted to reinforce the responsibility of senior management to manage the capital resources of the firm in line with its risks.
- Thirdly, we want to build on ICAS as one of the tools at our disposal to evaluate the overall capital position of firms in the form of Individual Capital Guidance.
- And finally, we wanted to foster the efficient allocation of capital in the EU insurance market.
So whilst ICAS has given us a head start towards risk sensitive levels of prudential capital, I think we need to regard this as a strategy post towards Solvency 2. It would be easy to be drawn into the comforting notion that Solvency 2 will deliver a mirror image of our ICAS regime – it will not.
However, the FSA strongly believes, and I hope and believe the Commission agrees, that the new Directive should reflect the objective of incentivising regulated firms to use modern risk management practices appropriate for the scale and complexity of their business. This is entirely consistent with the key tenets of our own ICAS regime. And we have been very pleased to work with the Commission, through CEIOPS, to deliver Level 1 text that is fundamentally principles-based, and we look forward to seeing the draft framework directive published in the summer. But that will not be the end of the story. On the contrary, there is a huge amount of work to do and the implementing measures, (to market level 2) and on converging reporting practice at level 3.
Solvency 2 also presents a unique opportunity to reform the approach to the supervision of insurance groups. Insurance groups are increasingly diversifying the risks of their business and managing these risks and capital across their groups on a more integrated basis, as is evident from our own ICAS regime. Therefore, it is important that a framework for supervision of insurance groups is developed under Solvency 2 that encourages these developments and enables groups to benefit from the diversification of risk. We see this as a key factor in delivering the objectives of Solvency 2, by not only improving the efficient use of capital and encouraging better regulation but delivering a high standard of protection for policyholders. As you may know, together with HMT we published our own proposals last year for a more consolidated approach to supervision based on a hard level – supervisor model with risk based capital being required to be held only at the group level. The Commission has sought to incorporate some of the principles of this proposal into the framework for Solvency 2 - we fully support and encourage this.
Before I close would just like to emphasise the importance of firms continuing to engage in the Solvency 2 discussions and participate in the next quantitative impact study (QIS3). I recognise this involves a huge amount of work for many firms and these will probably need to be a QIS4 and perhaps a QIS5 in due course. But I assure you it is worth it. The QIS's are absolutely key impacts to the formulation of policy. This is your chance to influence the shaping of Solvency 2. I recently met with the senior management of a firm who were lobbying for changes to The Capital Requirements Directive - the banking and investment firm equivalent of Solvency 2 – as recently as December last year, less than one month before its implementation across the EU. Needless to say that however strong their arguments for changes to the new prudential requirements, they came a little too late in the day. So grasp your opportunity while you have it.
Conclusion
When I spoke at this conference last year I hoped to kick-start the move towards principles-based regulation. I am pleased that this move is already under way and the industry has joined us on this journey. Our firm ambition is to promote the UK’s position as a world leading regulator through a regime that delivers our strategic aims of promoting orderly and efficient markets and helping retail consumers achieve a fair deal. Our efforts are particularly important in the context of Solvency 2 if we are to continue to tip the balance in favour of principles that refer to market-consistent and economic realities.
Thank you.