International Developments in Insurance Regulation
Speech by Hector Sants, Chief Executive, FSA
at the Insurance Sector Conference
8 April 2008
Good morning and welcome to our annual Insurance Sector Conference. I last addressed this conference two years ago and I am pleased to be back here today to discuss some of the important international regulatory developments that affect the way you do business. As Sarah has mentioned, we have quite deliberately chosen to divide the day into two; to discuss the important issues of international policy this morning; and debate emerging insurance risks in the afternoon. So you will not hear me speak today about domestic issues, such as treating customers fairly or commission disclosure. But be reassured that we have not lost interest in our domestic agenda, and you can look forward to what I hope will be a lively and frank debate, on these and other domestic issues, later today.
I also do not intend to give a "Northern Rock lessons learned" speech, although I appreciate there is a lot of interest in the outcome of our internal audit report; and as regulated firms you will of course be interested in the impact of our supervisory enhancement programme on your relationship and interaction with the FSA. So if I may just say a brief word on the topic. Firstly, it is important to reinforce the point that we do believe the events of the second half of last year reinforce rather than detract from our view that a principle and an outcome-based philosophy of regulation is the way forward.
The key failure of Northern Rock management was to fail to focus on the consequences of their actions and to fail to fully understand and mitigate the risks of their business model. The key message for boards must be just that, namely the importance of understanding the risks inherent in their business models and fully addressing the degree to which they should mitigate them.
For us as supervisors, there are lessons and we will learn these, but, as importantly, you should understand we are not seeking to remove all risk from the system nor moving away from placing responsibility on firms' senior management for the final outcomes. We will, however, increase our supervisory challenge with management on this important issue and be willing to be more directive when warranted.
Such increased focus on these difficult issues will require further improvements to the quality and intensity of our supervisory processes and we will deliver these through the Supervisory Enhancement Programme I announced two weeks ago. This programme will deliver the required changes by the end of the year.
Turning to today's agenda, perhaps the most important piece of EU-driven work we are involved in, and certainly a large commitment for us – and you – over the next few years is the development of the Solvency II Directive. I want to take the opportunity this morning to outline what the key issues are from the FSA's perspective. I will also comment on the development of international solvency standards, the competitiveness of the UK insurance markets and finally, very briefly, on the proposed review of the Insurance Mediation Directive (IMD).
Market turbulence
Firstly, I would like to briefly reflect on the impact of the credit crunch on the UK's insurance markets. I will keep my comments brief – you will have the opportunity to hear the views of Callum McCarthy on this topic later this afternoon.
2007 was undoubtedly a difficult year, for firms, investors and regulators alike. We have seen a fundamental repricing of risk, and the financial sector is subject to material strains. Into 2008 the operating environment remains tight, and it is likely that stressed financial market conditions will persist for some time.
As such, I believe that analysis of events supports our move towards a more principles-based approach to regulation with an emphasis on the consequences of firms' actions rather than on rigid adherence to specific rules. Principles assume more importance and relevance in turbulent times when the environment that firms face can change quickly. Firms should expect that over the coming year we will be looking at how they ensure continued compliance with our 11 Principles for Businesses. This includes, importantly, dealing with us in an open and cooperative way and notifying us of anything we could reasonably expect to be told.
In the insurance sector the adverse market conditions have had the most significant impact on bond insurers, or 'monolines'. And more traditional insurers will have experienced falls in the value of their equity and property portfolios. Some of you have also been affected by issues around the valuation of illiquid assets, the widening of corporate bond spreads and exposures to structured credit products. But for all the changes in priorities called for by the new economic circumstances we face, work continues in the insurance sector on some important aspects of international insurance regulation.
Solvency II
First I want to turn my attention to Solvency II. The objective of this directive is to introduce a pan-European solvency framework that provides appropriate protection for consumers across Member States, while at the same time helping the Single Market in financial services function better and improving capital allocation across the EU's financial markets. One of the key ways it will achieve this is by addressing the dislocation between regulatory capital and insurers' own assessment of capital. But it is not just about capital requirements; no amount of capital can substitute for a firm's capacity to understand, measure and manage risk, and no formula or model can capture every aspect of the risks an insurer faces. The new framework should promote higher quality risk management, and help to ensure the integration of capital assessment, risk management and business planning processes. It should also foster the international competitiveness of the insurance sector, ensuring it can respond to rapidly changing consumer and business demands, and contribute to employment and productivity growth in the EU.
So if this is the vision, how much progress has been made? Based on the Commission's timetable, we believe that political agreement on the Level 1 text – that is, the high level Framework directive – should be achieved by the end of this year. In our view the Level 1 negotiations have been progressing relatively well; and the Proposal that the Commission published last July was, on balance, a good text.
We are also directly and very actively involved in CEIOPS – the European Committee of Insurance Supervisors – which is developing advice to the Commission on the more detailed Level 2 standards. One of the greatest potential dangers is that Level 2 is over-used and over-detailed, to the exclusion of allowing Level 3 a proper chance at delivering appropriate regulatory convergence. In particular, we will be keen to try and ensure that Level 2 does not impose unnecessary burdens on firms or unnecessarily restrict the range of supervisory tools available to us. There must be room for intelligent reaction to uncertain future events and the flexible application of a variety of supervisory tools is, I believe, the best way to achieve this.
The next 18 months will be critical in determining the shape of the new regime, and for ensuring that the new legislation builds on the many advances and improvements that we have already implemented domestically through the Individual Capital Adequacy Standards regime.
CEIOPS is currently running its fourth quantitative impact study (known as QIS 4). Like other QIS exercises, the intention is to assess the financial impact and the suitability and practicality of CEIOPS' proposals. 85 UK firms volunteered to participate in the QIS 3 exercise, representing around 70% of the market (by annual premium income). I would encourage all firms to participate in QIS 4 – it will undoubtedly be key in fixing the calibration of Solvency 2, and offers firms a very good opportunity to begin to prepare for Solvency II implementation.
One of the objectives of QIS 4 is to start to collect information about firms' internal models. In the UK, we will supplement this with a 'parallel exercise' that is, in part, the start of a process to prepare firms that wish to use their internal model under Solvency II. Satisfying the 'use test' and gaining regulatory approval to use the model will require multidisciplinary involvement from firms. Later this year we will publish a Discussion Paper to assist firms' in their planning for implementation.
Before I finish with the topic of Solvency II, I want to make some remarks on the subject of equity risk, over which there have been protracted discussions. Technically speaking, the strength of the required stress for equity risk in the Standard Capital Requirement (SCR) and the assumed relationship between equity and interest rate risk are Level 2 details. But they are key Level 2 details; and if they are not right the integrity of the overall framework is called into question. Recent market events have shown that equity prices and bond yields can and do simultaneously fall. So it is critical that firms have adequate capital to withstand such a scenario. We also believe that the QIS 3 equity stress test was too low, and so under QIS 4 we will be asking UK firms to apply a 39% stress. We are encouraged by the recent discussions in CEIOPS on these issues and anticipate further discussions when the QIS 4 results are known.
Development of international solvency standards
At the global level, the work on solvency standards is led by the International Association of Insurance Supervisors (IAIS), which has members from over 190 jurisdictions in nearly 140 countries. Those of you who choose the session later this morning on solvency standards have the opportunity to hear from the Chair of the IAIS, Michel Flamee, so for now I will just say a few words about the progress that is being made.
For obvious reasons we have always sought to encourage the compatibility of international and European solvency standards. The UK's insurance market is the largest in Europe, and the 3rd largest in the world behind the US and Japan. Insurance is also a global business, with many insurers organised as a group of companies. We therefore have a strong interest in international financial services continuing to flourish and an important factor in this is to reduce, and – if possible – eliminate, unnecessary differences in financial regulation between geographical areas. The greater the international acceptance of a common supervisory standard, the more effectively cross-border activities can be supervised. The challenge, as always in international fora, is reaching a consensus when so many of the stakeholders have different starting positions. But the IAIS is making good progress, and many of the principles published within their guidance papers are consistent with the direction that the UK and Europe aim to travel.
Competitiveness of the UK
My final comments are around issues of competitiveness.
Perhaps the most international of all insurance markets is the London Market. But since 2005, London has attracted a very small share of the new capital that has entered the general insurance sector. This, together with a few high-profile cases of UK insurers moving their (holding company) headquarters to Bermuda, has reignited the debate on the competitiveness of London as a global insurance centre.
Of course we recognise that regulation is far from the only matter that informs decisions about the location of capital; and perhaps the most important other factor is tax. But we have done a lot of work to minimise the role regulation is perceived to play, not least of which is our commitment to a more principles-based regulation, which I personally believe is the best way to achieve a regulatory platform that is attractive internationally and strikes the right balance between firms, consumers and regulators.
In my mind, however, two important regulatory issues remain outstanding; US collateralisation; and the outcome of the European inquiry into business insurance.
I am disappointed that progress has been so slow in the reform of the current US system, whereby so-called alien reinsurers are required to post one hundred per cent collateral to cover their liabilities to US cedents. This requirement applies regardless of the reinsurer's rating or the quality of its home supervision. The competition arguments in this area are well rehearsed, and they are in any case for others to make. It is our view, however, that the current collateral requirements in the US also do not make good regulatory sense, and it is for these reasons that we have been encouraging change.
The National Association of Insurance Commissioners (NAIC) is looking at how insurance supervisors might set collateral levels – potentially even zero – to reflect factors other than the domicile of the reinsurer. You may also be aware of unilateral action taken by individual states, such as New York. This is a useful development, but it appears that reinsurers who participated would fall foul of their funding requirements in other states, and therefore at this stage this is possibly more of a symbolic gesture. I hope the US will recognise that the present arrangements are likely create unnecessary costs for the insurance sector, and ultimately the consumer, and that it distorts the efficient allocation of capital and competition. I think there are strong arguments for allowing the market to decide when additional security is needed and we will continue to argue strongly for reform, both directly with the NAIC and through other bodies such as the IAIS.
The other issue I want to mention is the recent European inquiry into business insurance, which has raised issues around the competitiveness of practices in the London Market.
Firstly, the Commission has expressed concerns about the manner in which the final price of a risk is agreed during negotiations in the subscription market. Specifically, they are seeking hard evidence that the process does not operate to the detriment of the assured. Whilst the Commission's thinking continues to develop, it remains important that the market ensures that evidence is provided to the Commission to demonstrate that current practices work effectively and in harmony with competition law. Or that the market has given thought to how practices can be reformed to ensure future compliance. The market may also wish to think about what information it provides to clients, before the placement process starts, about how the placement will be conducted and the options available.
Secondly, the Commission have stated that they are not minded to renew the insurance block exemption. As you know, the block exemption provides the industry with safe harbour from competition scrutiny over industry cooperation on areas such as common policy wordings. Whilst this does not of itself raise any fundamental regulatory issues, we understand that the lapse of this exemption might cause real uncertainty for firms. Again, if firms feel that this uncertainty would create real business risks, the onus is on them to make a positive and evidenced case.
The final issue I want to mention is the proposed European Commission's review of the Insurance Mediation Directive (IMD). Inevitably, as with all new pieces of legislation, there are concerns as to whether the right balance has been struck between the aim of facilitating a single market and enhancing consumer protection. Some would argue that the IMD has succeeded in filling a void in financial services regulation and moved the Commission closer to achieving its single market and consumer protection objectives.
But we still have doubts over the reach of the directive in some areas, and question whether activities such as introducing insurance business, really gives rise to a material risk to consumers.
However, we are encouraged by the work of the CEIOPS Mediation Expert group (IMEG), which has been examining ways the directive might be amended and will contribute to the IMD review.
The Commission's commitment to developing a better regulatory environment by undertaking post evaluation reviews of new legislative measures is something we welcome. Indeed, it should be regarded as one of the guiding principles of good regulation, for any legislator or regulator. I believe this is the best means of ensuring, that in practice, the right outcomes have been delivered for firms, markets and consumers. I thus perceive the review of IMD as an excellent opportunity to acknowledge that a good regulatory environment is one that is constantly updated and a good regulatory structure is one which demonstrates a capacity to learn and adapt.
I will now hand over to the European Commissioner, Charlie McCreevy, who will comment from his perspective on the changing regulatory environment for the insurance sector.