ABI Annual Conference
Speech by John Tiner, Chief Executive Officer, FSA
ABI Annual Conference
10 May 2007
Good morning ladies and gentlemen. This is my final insurance speech before I step down as Chief Executive of the FSA in July. I hope you permit me, therefore, to make some rather personal reflections on an extraordinary six years in both the life and general insurance markets before looking forward to some of the opportunities and challenges for the industry in the future.
I joined the FSA in June 2001 as the Managing Director responsible for the Consumer, Investment and Insurance Directorate, having spent 25 immensely enjoyable years in the Financial Services practice of Arthur Andersen, latterly as the global head. The practice I led covered the landscape of the financial services industry – but my experience had been mainly in banking, capital markets and, in particular, derivatives. It was something of a joke in the firm that my knowledge of insurance was rudimentary to say the least.
On arriving at the FSA, I was confronted with some major challenges: the equity market was in free fall causing life offices severe strain, Equitable Life and its policyholders were in a state of crisis following the House of Lords decision and, on 17 June 2001 (just 17 days after my arrival), Independent Insurance collapsed seemingly out of the blue. All was not well on the insurance front.
And the regulatory environment was in a state of flux. The insurance supervisors from the Treasury and the actuaries from the Government Actuaries Department were the last of the former regulatory structure to be moved operationally to the new FSA, with the final transfer taking place in April 2001.
I had a steep learning curve and I quite rapidly realised three things.
- First, that the vocabulary of insurance bore no resemblance to terms used in any other part of the financial forest.
- Second, that the principles of insurance accounting and financial risk management defied the practices which had been developed in other financial markets during the previous two decades.
- And third, that transparency was a dirty word.
These combined to create a kind of mystique about insurance making it impenetrable to all but those who had been brought up on a diet of reversionary bonuses, hidden margins and three year accounting. It dawned on me that my distinct lack of experience of the insurance industry could be used to great advantage. I could ask the 'stupid' question others were too embarrassed to ask and it quickly became apparent that in fact it was the answers that were stupid and not the questions! I recall these interesting times simply to provide a context for what developed over the ensuing months and years.
The Tiner Project
Following the publication of the Baird report into the FSA's supervision of Equitable Life up to the date it closed to new business in December 2000, the FSA Board asked me to lead a fundamental review of insurance regulation taking into account the lessons for regulators identified by Ronnie Baird. My team insisted we give the project a name - and I came up with the snappy title of "the future regulation of insurance". But the tedium of repeatedly writing this long winded title was not lost on my team and so they decided to rechristen it 'The Tiner Project'. Personally, I could only ever see the downside risks of having my family name associated with something as dangerous as this mandate!
We submitted our first paper to Ruth Kelly, the Economic Secretary to the Treasury in November 2001. We were candid about the problems we faced:
“The current prudential regime does not take adequate account of the nature, diversity and scale of risks in insurance firms.
The FSA's prudential regulation of insurance firms has tended to be too reactive and over-reliant on desk-based analysis of returns.
There has been insufficient coordination between prudential and conduct of business regulators of insurance firms.”
Looking back, I am happy to note that we were ahead of ourselves in promoting a more principles-based system as we said "The FSA does not see the new insurance regulatory regime as creating a large number of new rules…..".
Life Insurance
As you will all remember, the market conditions prevailing at the time were highly relevant to the speed of our reforms. During the project in late 2001 and throughout 2002, stock markets around the world had continued to slide. In the UK, with-profits funds, with some £500 billion under management, were heavily invested in equities. Policyholder bonuses, which had enjoyed years of growth, were being slashed by most life offices. Reported capital surpluses of life offices were declining and they had become forced sellers of equities, as the regulations at the time required firms to maintain capital sufficient to absorb a 25% fall in the market – the so-called resilience test. Prior to the sell-off, the UK Life Insurance industry held some 20% of the market capitalisation of the FTSE 100 and so the systematic sell-off maintained and added velocity to the downward spiral in UK equity markets. This came as a gift to the hedge funds which were able to short the FTSE in the full knowledge that the life companies would have to go on selling equities until, in theory, the index reached a level of zero.
One of the first proposals emerging from the Tiner Project was that the balance sheet of a life insurance company should be prepared on a "realistic basis". Oddly, this introduced a novel concept to insurance – realism – or to put it more technically the principle of establishing liabilities for the amounts the company expects to pay out – a principle I recall learning during Part 1 of my accountancy course in the 1970’s. Previously there were so many margins hidden in liabilities it was impossible to assess the true financial position of a life insurance business.
We began collecting data on this basis from the largest 20 life insurance firms in 2002. Their enthusiasm for this approach reached fever pitch as the FTSE fell to 4000, since it was an opportunity to demonstrate that on the basis of realistic liabilities the life industry was solvent and had enough capital to withstand further large falls in equity values. We boldly made this reassuring statement in our second report on the Tiner Project published in October 2002. However, the market continued to be sold down, reaching 3520 at the end of January 2003. This became the turning point in changing the arcane solvency system we inherited to the modern, transparent and risk sensitive system we have today.
Before the markets opened on Monday 3 February, we published a letter from me to the CEO's of all life insurance companies announcing that we would formally introduce the realistic approach from the beginning of 2004 and, in the meantime, invited firms to apply to us for a waiver of specific rules to take the pressure off their statutory solvency position and so also the need to be forced sellers of equities. This brought into sharp focus the balance the FSA needs to strike between our objectives to maintain market confidence on the one hand and to protect consumers on the other. The market decided to call these “Tiner Waivers”!
I believe this decision to invite waivers was one of the most significant decisions, which was not without risk, the FSA has made since its creation. The market rose by 120 points on 3rd February and although there continued to be some volatility during the next month or two as the waiver requests were submitted and processed, the long bull run we have enjoyed for the last four years jumped out of the starting blocks. There has been much uninformed comment during the last four years about how the new FSA solvency system caused life insurance firms to reduce their holdings of equities at the bottom of the market causing detriment to policyholders as the market has risen. This is a fallacy. The change we introduced in 2003 was designed to achieve precisely the opposite and those companies which managed their financial position prudently and responsibly were able to break out of the vicious cycle of sell sell sell. Of course there were some companies whose weak capital position was severely exposed by a realistic assessment of their liabilities and they, quite rightly in the interest of protecting their policyholders, needed to adjust their portfolios. This was not a fault of regulation it was a consequence of poor management at some point in the past.
Another anomaly in the old solvency system was the approach to financial reinsurance and other forms of financial engineering. Tackling this issue was an early priority of the Tiner Project. In our 2002 paper, we emphasised the requirement for there to be a material transfer of economic risk to the counterparty and for the premium to reflect the economics of the transaction. As with many of our reforms, this proved prescient, as two or three years later, we have identified little financial engineering designed to arbitrage the regulations and UK insurers have not faced the kind of allegations about the manipulation of financial positions witnessed in the US.
Even before the equity crisis, there had become a worrying trend of more with-profits funds closing to new business. Firms were concerned about the capital needed to support the guarantees inherent in many with-profits products and policyholders were increasingly concerned about falling bonuses and the lack of transparency about how their money had been invested and how returns were determined. Firms were increasingly refocusing their business on unit-linked products. We decided to make extensive changes to the way with-profits business should be operated by firms. Following at times very difficult discussions with the industry and the actuarial and accounting professions, we made some fundamental changes: removing the Appointed Actuary role and creating new more distinct roles; introducing new governance arrangements through the With Profits Committee, creating a new role, the Policyholder Advocate, for when firms wish to reattribute orphan estates and improving communication to policyholders and their advisers - all designed to better manage conflicts of interest and protect the interests of policyholders. The tide of closures has ceased (the last closure being in 2003) and the lid has been lifted on this complex product which millions of people depend on for their long-term savings.
General Insurance
Although the Tiner Project was commissioned on the back of the Baird report into Equitable Life, it was evident to me that we should not pass up the opportunity to modernise the regulation of general insurance as well. Here also the regime had become hopelessly out of date and so we tackled two major issues – the solvency system and the regulation of Lloyd's of London.
The approach to solvency was very simplistic, being based on percentages of written premiums and claims. There were no incentives to invest in leading edge risk management practices and the minimum capital requirements bore no relation to the risks to policyholders. Like the life insurance industry, we realised that by reforming the system we would be moving at a faster pace with potentially more onerous requirements than other countries. However, we felt that it was only a matter of time before a properly calibrated solvency system would be introduced across the EU and in the meantime, we could not satisfy ourselves that the approach was consistent with our objectives to maintain market confidence and protect policyholders.
It is a remarkable achievement by the insurance industry – both life and general - that in just four years firms have been able to support the transition from a formulaic, basic approach to solvency to a more sophisticated risk-based approach through their Individual Capital Assessments. During the past two and a half years the FSA has evaluated the ICAS of over 150 firms or groups across the whole market (life and general). Models are continuing to improve and we have been able to confirm firms' own assessment of capital in around 25% cases. One insurance company CEO said to me recently that the reform of prudential supervision has been the single most important reason behind firms modernising their business models, focussing on the efficient allocation of capital in their business and better understanding risk and reward. This is, I suggest, an exemplar of how by working with the industry, regulation can promote market discipline and improve competitiveness while at the same time protect consumers.
For decades (or perhaps centuries) Lloyd's both ran and regulated the market – a similar position to the London Stock Exchange. We agreed with the leadership of Lloyd’s that this was an untenable position to sustain and that, consistent with the proposals of the Chairman’s Strategy Group, the FSA should assume all regulatory responsibilities for the market. So we now perform a full ARROW risk assessment of Lloyd’s and the managing agents. This has been a key development in our ability to properly exercise our responsibilities for maintaining confidence in the UK insurance market and in protecting policyholders.
Whilst on the subject of Lloyd’s, I would like to pay tribute to the Trustees, Board and management associated with Equitas. Through their management of the run-off of liabilities over the past few years and by closing the deal with Berkshire Hathaway, they have significantly reduced the risks – to names, policyholders and Lloyd's – from one of the darkest chapters in the history of Lloyd’s.
The most recent set of regulatory changes in the general insurance market were at the beginning of 2005, when the Insurance Mediation Directive became effective. Thank goodness this directive formed no part of the Tiner Project – for there is much about the directive which in my view is excessive, unwarranted and would never pass a proper cost/benefit test. But leaving such criticisms aside for a moment, I believe that bringing the broker community into the formal regulatory net has served to raise standards and provide the impetus for the market to address the issue of contract certainty and to use this as a lever for improving the operating efficiency of the UK general insurance market.
While most of our reforms were designed to improve standards in the insurance industry, there was also a critical need for the FSA to raise its own game. We have made sweeping internal changes – transferred around 25 supervisors from the banking sector to insurance, recruited over 50 people with experience in the insurance industry, introduced a core curriculum of training for our insurance supervisors, reorganised to develop deep expertise in the different segments of the insurance market, introduced world leading risk-based supervision of insurance firms, strengthened our actuarial capabilities which are now integrated into supervision and taken enforcement action.
So, both we and you have come a long way. The life insurance industry today is unrecognisable when compared to 2001 and the general insurance industry has survived two of the largest losses on record – 9/11 and Hurricane Katrina. I believe both parts of the industry are well placed to tackle the many challenges and opportunities that still lie ahead.
Future challenges
And the size of those challenges and opportunities should not be under-estimated – be it climate change, market efficiency or legacy systems. Before closing, I would like to touch on three areas: longevity, Solvency 2 and collateral and then to finish on an issue which impacts another aspect of the ABI's membership – as institutional investors.
There is considerable debate amongst life industry professionals about future longevity experience. Men aged 65-74 in England & Wales have seen their prospects of living longer improve by as much over the past 15 years as was achieved over the previous 150. But what will the trend prove to be over the coming 30 years? Some argue that current projections are already out of date and substantially understate annuity liabilities. Such uncertainty is, of course, not new but the scale of the questions for the industry is increasing. This risk is even more concentrated for anyone wishing to enter the bulk purchase annuity market.
Of course it is not just market developments that provide a challenge, sometimes we regulators can set challenges of our own.
I am generally encouraged by the shaping of the advice provided by CEIOPS to the Commission on Solvency 2. Of course it has been necessary to make compromises here and there, but they do not in my mind detract from the essence that Solvency 2 will be a world leading standard based on sound economic and market-based principles and which rewards firms for the effective management of risk. There is, however, one issue in particular which I hope the Commission will be brave enough to address. The top 20 insurance groups comprise some 50% of the market share of European insurance business. One significant benefit of the Solvency 2 proposals is that they better align regulatory capital with the economic capital needs of the business and thereby reduce the costs of capital for well managed firms. Many groups manage risk through diversification and manage capital on a group-wide basis. We have a unique opportunity with Solvency 2 to break out of the old fashioned, some might say protectionist, system of single entity prudential supervision. Moving to a 'lead regulator' –as the UK has proposed – will reduce regulatory duplication and, hence costs, reduce the cost of capital, foster access to all markets across the Union and make our firms more competitive globally. Crucially this will require regulators to trust each other and to work together.
The terrorist attacks on 9/11 brought into sharp focus what is to my mind the unreasonable imposition of collateral required for inward reinsurance business in the US. Over the following several months, Lloyd's alone provided some $3.6bn of collateral. During my six years at the FSA, I have engaged at various levels in the US over this issue – Treasury Department, politicians, regulators, ceding companies and US reinsurers. There has been modest and at times painfully slow progress in the US in being willing to address this issue and to recognise the significant improvements have been made internationally in reinsurance regulation. I wonder about the real appetite and even ability of the NAIC to do so. I can only hope that political pressure, if not the NAIC's initiatives, can bring the matter to a sensible, global market-based solution as soon as possible. Surely this could increase reinsurance capacity in the US and reduce premiums, which ultimately will benefit American consumers.
Listing requirements for investment entities
I have focussed this morning mostly on our regulation of insurers, as you would expect. But you are also, of course, one of the largest investor groups in the country, so I thought I would take this opportunity to touch on our plans for the listing requirements on investment entities.
We announced last month, following the closure of a round of consultation, that we plan to proceed with a single platform of listing rules for all closed-ended investment funds. We are planning to publish a further CP, proposing further amendments to the chapter 15 – ie super-equivalent - regime set out in our earlier consultation paper. The aim will be to make that regime more flexible, enhancing the international attractiveness of the UK as a venue for the listing of investment entities, while maintaining appropriate protections.
Based on the feedback we have gleaned from the market, the CP is likely to ask questions about proposals to:
- relax the detailed board independence requirements, while retaining the principle that a majority of the board should be independent;
- relax the basis on which feeder funds can invest into “master” fund structures;
- simplify our previous approach to periodic disclosure of portfolio information; and
- simplify or relax requirements such as the detailed suitability criteria for investment managers, and the rules requiring shareholder approval for transactions between listed investment entities and investment managers.
Conclusion
Ladies and gentlemen, it has been a real pleasure working with the insurance industry, the ABI and Keith Satchell and his predecessors, Richard Harvey and Mike Ross, over these past six years. I really do believe that both the FSA and the insurance industry are fit to face the future, with you serving your customers and competing in a global market place. And I wish you every success in doing so. Thank you.