Speech to the Association of Friendly Societies Annual Conference
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Speech by Sarah Wilson, Director and Insurance Sector Leader, FSA
at the Association of Friendly Societies Annual Conference
4th October 2007
I would like to start by thanking you for the opportunity to come and speak here today.
Let me start by outlining what I plan to cover. I thought I would set the scene by setting out our view of the challenges facing firms and consumers in the market for retail financial services and how we are responding to those challenges. I will then turn to consider further common themes arising in the supervision of friendly societies – picking up in particular the key themes of strategy, governance and finances from Ian Tower’s speech two years ago.
You will be aware that the FSA takes the view that the retail financial markets in the UK too often fail to deliver good outcomes for consumers. Indeed, I think that is now a view that many of our stakeholders, including many from industry, share. That is not to say that we believe that this is universally true, or that when it does occur it is the result of deliberate decisions of senior management in firms. The position is rather more complex and varied than that; but our wide ranging supervisory experience leads us to start from the perspective that there is a problem.
Against this backdrop, we work at the FSA (and particularly in our Retail Business Unit) to deliver a retail financial market where there are:
- capable and confident consumers;
- clear, simple and understandable information for, and used by, consumers;
- soundly managed and well capitalised firms who treat their customers fairly; and
- risk- and principle-based regulation, through firm specific and thematic supervision and policy.
And there are two over-arching programmes of work that we have in place and which are designed to deliver much of the necessary change. These are our Financial Capability Programme and the Treating Customers Fairly (TCF) initiative. So, I would like to start my comments today by speaking about each of these.
First, financial capability. Clearly, one of the fundamental problems of the retail market for financial services is the information asymmetry between customers and those who provide and distribute financial services and products. We and our partners in the national strategy for financial capability are implementing a programme that focuses on laying firm foundations for sustainable improvement in people's financial capability across a range of groups. This work includes financial education seminars in the workplace. We have now delivered material to over 340 employers and over 200 of these have had our Make the Most of Your Money seminars run in their workplace. Independent evaluation shows that 82% of employees intended to take action as a result of attending a seminar. And of those sampled employees called three months later, 60% had turned intention into action or still intended to. So this work is making a real difference and amongst the friendly societies, I would like to take this opportunity to thank, in particular, the efforts of Police Mutual, where the FSA through the partnership with this society is delivering a bespoke CD Rom to all police officers. We would like to engage in similar partnerships with many more of you – please do get in touch with my colleagues working on financial capability to discuss how we can help you bring similar benefits to your Society’s staff or members.
Second, Treating Customers Fairly. Here, as I hope you are well aware, while we continue to take the view that what needs to change varies significantly between firms, it is very notable that we know of very few firms indeed (large or small; proprietary or mutual) that have not concluded as a result of proper thought and analysis that there are significant improvements they need to make in order to treat their customers fairly. As you know, by March this year all firms were expected to be at least implementing Treating Customers Fairly in a substantial part of their business. Our aim in setting this deadline was to stimulate action in firms that were slow to take action; and to maintain momentum in those firms that had risen to the challenge. We were pleased to find that an encouraging number of firms successfully met our March 2007 deadline – showing that they were at least part way through the work that they needed to do. But this initiative isn’t ultimately about change programmes. Rather it’s about improved outcomes at the coalface. It’s about senior management instilling a culture such that the staff know and expect that the fair treatment of customers will be routinely monitored, that it will be reflected in decision making, and that they will be rewarded accordingly. That is why the deadlines for next year – in March and then in December – focus first on having the right management information in place, and then on actually demonstrating to yourselves and to us using that information that you are consistently treating your customers fairly.
I should say at this point that we do recognize that the friendly societies movement has a history of helping its members to help themselves and in many cases societies still serve a wider role than simply the provision of insurance services. I would however stress that, in common with other sectors, you still have challenges to meet in relation to Treating Customers Fairly. While we are encouraged by the improved understanding of the initiative and the progress in implementing change that we have observed, we will continue to challenge you through our supervisory work. I would also stress the importance of thinking about Treating Customers Fairly in its widest sense – including in areas such as strategy on the use of the mutual fund and governance, each of which I will come to later in my remarks; and in the development of your relationships and communications with your members.
Perhaps I could use member communication as an example of the level of our concern? Over the past six months, we have published two significant reviews of the quality of communication relevant to your market – last week on point of sale disclosure (Key Features Documents); and in May on post sale disclosure.
We have reviewed a sample of just over 200 Key Features Documents – drawn from a cross-section of products from 64 large and small firms (including friendly societies). We were disappointed to find that there was significant lack of compliance with Principles 6 and 7 (to treat customers fairly and communicate information to them in a way which is clear, fair and not misleading). In fact only 15% of the sample matched up to our view of the standard necessary to meet both Principles.
The main areas of concern identified are poor explanations of risk and charges, and the quality of general information about the product itself and its aims. Jargon is also a significant problem, and key information is often not prominently communicated. It can be difficult even to grasp the type of consumer a particular product might be right for. We have also observed a marked contrast with some of the accompanying promotional literature that we have seen. Firms often seem to pay more attention to making other documents consumer friendly, clear and engaging, rather than the Key Features Document.
Similarly, on post-sale communications, we published the results of a review of communications from a number of insurers (including friendly societies) in an Insurance Sector Briefing in May this year. Here, our review found some good examples but there was again a significant proportion where firms failed to comply with FSA Principles 6 and 7. These failings were across all types of firms – large and small. Key failings were:
- valuable product features such as Market Value Reduction (MVR) free-dates and
- Guaranteed Annuity Rates (GARs) were not always mentioned and/or clearly explained;
- some used complex terms which were not adequately explained; and
- some documents lacked explanation about how the actions or practices of the insurer may affect the policyholder.
For both the KFDs and the post sale communications, most firms in our sample had not undertaken any consumer testing on the effectiveness of their post-sale communications. While this is not a requirement, and firms will choose review methods proportionate to their size, we were disappointed with the general sense of a lack of care in preparing these communications. You will be aware that we have asked senior management of all insurers to review their consumer communications in the light of these findings, and to ensure that necessary changes are made no later than December 2008 – the TCF deadline.
Looking forward, we are clear that the reason for failings such as these is rarely a lack of good intention on the part of senior management. Rather, in many firms there is a frustrating gap between good intentions and actual practice. Sometimes, this reflects a lack of breadth of consideration in areas very directly under senior management control – such as strategy which I will come to. But at least as commonly, we think senior management need to take a searching look at the organizational, cultural or behavioral barriers within their firms which impede progress with TCF. You will be aware that we published a framework for thought on these issues in July – a so-called ‘culture framework’, covering matters such as leadership, controls and reward. And of course a key part of the cultural challenge is moving to a point where senior management visibly use good and comprehensive management information on the way the firm treats its customers. Using the framework, we will be challenging the senior management of firms to prove to us that they have embedded long-term cultural and behavioral change where necessary. Where appropriate we intend to integrate the culture framework into our ARROW risk assessments and thematic work and you may therefore come across it in the near future.
Finally, and although we are showing forbearance in accepting that some firms are taking time to get to a point where they can demonstrate compliance with Principle 6, we will continue to act proactively where we become aware of significant risks to consumers. We will continue to challenge individual firms as a result of our ARROW reviews or thematic work. Actual or potential consumer detriment is also one of our criteria for taking enforcement action.
Having mentioned the key over-arching programmes of work we are engaged in to improve outcomes for consumers in retail markets, I should like to turn to other aspects of our supervisory agenda which arise commonly with friendly societies. The context of course is that there are around 175 regulated friendly societies - supervised in either our Retail Firms or Small Firms Division, with the majority being sufficiently small to be supervised in SFD. However, the majority – around £13 bn – of the sector's £15 bn assets are supervised in RFD, where we use a relationship management model for supervision. Behind these figures we recognize there is very real diversity in the sector which includes incorporated, non-incorporated, directive and non-directive societies, those with fraternal benefits or distinct affinity/ niche markets and a very wide spectrum of size.
In his speech to your Annual Conference two years ago, Ian Tower cited three areas which arise commonly in the supervision of friendly societies – is there a strategy that reflects current market pressures and opportunities?; is the governance right?; and how strong are the finances?. We took stock earlier this year of the progress made by the sector since Ian Tower's speech. Our view was that although it was clear that progress had been made in some firms, we did not have sufficient information about the sector as a whole to form a rounded view and we decided we needed to do some more work.
So, as many of you will be aware, we have started some thematic work to help us to further increase our knowledge of the current state of play – in particular we have sent out a questionnaire to a sample of friendly societies, and will follow this up with visits to a smaller number. We have included in our sample both large and small societies to ensure that we are in a better position to understand the issues across the sector. In particular, we have deliberately included several smaller friendly societies and we are keen to find out what key decisions they plan to take regarding their strategy and financial management.
Without prejudging the outcome of our thematic work, I would like to reflect on what our stock take earlier this year revealed in the three key areas: governance, strategy and financial management. Our thinking has also developed in some of these areas and I will share those thoughts with you too.
So governance. The Myners review and the Annotated Combined Code have clearly driven improvements in friendly societies' governance and we value the efforts of the AMI and the AFS in producing the Annotated Combined Code and in monitoring the adherence to the Code.
Our view is that friendly societies are getting on with implementing the Annotated Combined Code and many are aiming to comply rather than explain why they are unable or do not wish to comply with its provisions. While we have of course been following up these issues with some individual firms in the normal course of supervision, our current thematic work will allow us to test whether the changes are having a real positive impact at the societies in general and whether some of the governance weaknesses identified by our previous work have been resolved. In particular, we will be looking for evidence of Board engagement in key issues affecting the society. These include setting the risk appetite for managing the business, which is particularly important in the context of our ICAS work of which more later. They include ensuring the existence of appropriate arrangements for independent input into decisions affecting the with-profits fund, and proper review of arrangements for any funds in run-off. Each of these are excellent examples of TCF issues at governance level, and in each case we published mixed findings a week ago as a result of thematic work across the insurance sector. And Boards need to take responsibility for ensuring that the TCF deadlines I mentioned earlier are met.
Next, strategy. As with-profits business tails off, we have observed that there are some societies which appear to be struggling to find a way forward. Our anecdotal evidence suggests in particular that some smaller societies may have not formulated clear action plans and strategies for the future.
We recognize that you are operating in a difficult trading environment and face more competition from other savings products. In these circumstances it is even more important for Boards and senior management to focus on delivering against a clear strategy in the interest of policyholders. We are concerned to observe that a few societies consider that the appropriate way to deal with expense overruns is to acquire other societies. This may not be realistic in the short to medium term, and in such cases societies need to take additional measures to address expense overruns urgently. It is also appropriate to seriously consider whether new ventures present any material disadvantage to policyholders, given the expected risks and rewards, as against the prospect of an immediate estate distribution. These are important issues for you to consider in delivering fair outcomes for your policyholders.
But I should add that it may well be that there are new opportunities too. Some in the sector have already proved themselves adept at moving quickly to take advantage of new opportunities – I am thinking here of the move into the Child Trust Fund market. Looking more broadly, the proposals for change put forward by industry and published in our Retail Distribution Review in July introduced the concept of Primary Advice on which we would be very interested to hear your views. The notion is that Primary Advice would cover a wider group of consumers than the existing Basic Advice regime, with a wider range of products and without charge caps. It would be designed to serve the needs of those consumers that may not be able to access full financial advice, including some in the traditional market for mutuals. There are a number of possible ways in which this could be advantageous to you. There may, for example, be potential for firms to offer these advice services through employers at consumers' places of work. As many of you are affiliated to particular professions this may complement your business models. I do encourage you to send responses to the consultation.
And finally, financial management. Here I will start with experience gained through the ICAS reviews, which have applied of course to the larger friendly societies. As I will stress in a moment however, many of the general messages are relevant regardless of size. At the end of June this year we had issued Individual Capital Guidance (ICG) for all insurance firms and our Insurance Sector Briefing, titled ICAS – Lessons Learned and looking ahead to Solvency II, which will be published next week will set out the high level conclusions of this work.
Our findings show that the main component of life insurers’ own capital assessments was market risk (as we might expect) and the average ICG across these firms was 114%. Most firms received ICG within a range of 100-110% of their own assessment and over 50% of total assessments resulted in no uplift at all when compared with the firm’s own view.
One of the most common reasons for adding capital to a firm’s ICA is that we have not been satisfied with the degree of justification or supporting evidence for the key assumptions in the model. Other reasons for adding capital include operational risk and quality of capital resources.
An example of a key assumption is the approach that the firm takes to longevity. It is our view that the potential impact of unpredicted changes in life expectancy is an important risk facing insurers. As we commented in a letter to CEOs earlier this year, we are concerned that in applying our existing rules, some firms may not be giving sufficient weight to the possibility that their policyholders may live longer than expected. In setting your best estimate assumption for annuitant longevity, you may be able to demonstrate the reasonableness of a longevity assumption by referring to your own experience. However, there is a large degree of uncertainty surrounding future longevity experience. So we expect firms to reflect carefully on this uncertainty and include an appropriate margin of prudence as they move from their best estimate assumption. And we are pleased that the Board for Actuarial Standards has now launched a review of the assumptions about mortality made in actuarial calculations.
In addition to looking at the technical elements of a firm’s own capital assessment we consider how it is used. One of the aims of the ICAS regime was to provide the industry with a better set of tools and incentives to encourage a greater risk management culture within firms. It is encouraging that the capital assessment is increasingly being used as a key decision making tool and senior management’s knowledge of the results and methodology is improving. However, it is important that senior management challenge the actuarial judgments if they are to have the confidence to use the results of the capital assessment to manage the business.
Our view is that, while very major strides have been made, significant further work is commonly required to embed the capital assessment as part of the risk management framework within firms (by no means just friendly societies) , and we will be looking at this as part of our second round reviews. While our approach to the first round reviews was to consider the reasonableness of firms' calculation methodologies and the resulting output, in future reviews we will increase our focus on how firms are embedding the assessment into the business and put a greater emphasis on incentivising firms to use modern risk management practices appropriate to the size and nature of their business.
For smaller societies that are covered by ICAS, our forthcoming sector briefing will also include specific feedback to small firms which may be of interest to you. We found, for example, that a fair proportion of small life firms undertook their ICA to a reasonable standard, and that firms' Boards have been given training on the ICAS process. On the other hand, many small firms do not have an internal risk appetite that defines the criteria with which they manage their risks and small firms often do not make sufficient use of scenarios in calculating their capital requirement. We also found small firms tend to outsource their actuarial function. While this approach naturally has its benefits, firms' senior management should ensure that the ownership of managing risk and capital remains with them.
My comments on financial soundness have so far excluded the smallest societies who are of course not covered by ICAS. In these cases, we will continue to look at financial management as part of reviews of annual returns, as well as our regular supervisory work with firms. Regardless of size, societies need to put in place proportionate means of understanding and managing risk – and we will be looking at that as a part of our thematic review. I should also note that we have observed in a number of firms that the costs of acquiring new business are so great that firms may be paying more in costs than the value of the new premiums. We have been emphasizing the TCF implications in our supervisory work. Friendly societies that might be in this position need to consider all the options available to them to resolve expense overruns.
Focusing on financial management will remain a priority for us and this is set to increase with the implementation of Solvency II in the next few years. We hope that the ICAS process has helped societies affected by this to prepare for these developments. We were very pleased to see that seven societies participated in the most recent Quantitative impact study (QIS3), and we would like to thank you for your contribution to this important exercise. The information, both quantitative and qualitative, that was provided by these societies will certainly help us in the ongoing discussions about possible refinements to the proposed methodology and calibration for the Solvency II financial framework.
A key feature of this new framework will be the introduction of realistic reporting for all firms subject to the EU Directives (including ‘directive’ friendly societies), and not just for those firms that currently report their life insurance provisions on a realistic basis to the FSA. Indeed, we were very pleased to see that four of the QIS3 participants had applied realistic reporting for we believe the first time. We believe that this is indeed the way forward for all European life insurance firms. Nevertheless, we recognise that there are practical issues for smaller firms, and we shall be working closely with other European supervisors and the European Commission to try and identify suitable simplified approaches for smaller firms, that can approximate to a realistic reporting basis.
In conclusion, I am conscious that – although there are clear opportunities for friendly societies going forward and some notable progress to report too – I have presented a challenging agenda for the sector as a whole. Not least, of course, the current instability in the world financial markets and the recent turbulence in the UK banking industry have showed that market conditions can change quickly. There is a risk that the operating environment for firms and consumers will change, and this is a timely reminder of the need to strengthen risk management and evaluate possible responses in the event of a major shock. Thank you again for the opportunity to come and speak here today.