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Speech by Sarah Wilson, Director TCF and Insurance Sector Leader, FSA
Institute of Economic Affairs
5 November 2008

Thank you to the Institute of Economic Affairs and Marketforce for inviting me to speak today. In May, I spoke at the Institute's Future of Life Assurance conference and shared my thoughts on the continuing importance of robust risk management.

This should also be an important focus for the general insurance sector, who may be less immediately affected by the financial market volatility, but for whom robust risk management will be key for dealing with the challenges of 2009 and beyond. I will focus my comments around what robust risk management in the GI sector means in the context of:

• current dislocation in financial markets;
• the prospect of a downturn in economic conditions; and
• two important regulatory initiatives reaching key stages of development: Solvency II; and TCF.

In doing so I recognise that there are other issues – namely around commission disclosure and conflicts management, and the Retail Distribution Review (which although not directly relevant to you, may be of wider interest) – that I do not plan to focus on today. Not because they are not important, but because we are planning announcements on them later this month.

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Current dislocation in financial markets

Let me start by saying that as a whole the insurance industry is in a stronger position than it was in the early part of the decade when equity markets fell dramatically.

First, insurers are subject to a strengthened Pillar 1 capital regime – the enhanced capital requirement for general insurers and the realistic balance sheet for the larger with-profits companies. Second, insurers are also subject to the Individual Capital Adequacy Standards (ICAS) regime, which requires insurers to calculate the capital requirements that reflect their own business risks and hold capital commensurate with this.

The industry embraced these changes, and the ensuing challenge to take a more integrated approach to risk and capital management, and as a result firms are demonstrating:

• a better understanding of risk and the capital implications of those risks;
• the development of more sophisticated risk management techniques to identify and mitigate risk; and
• evidence of resilience against a range of stress tests and scenario analyses, specifically geared to the individual risks each firm faces.

It is also true to say that the health of the GI sector as a whole is more closely linked to underwriting risks than market risks, as most firms have conservative investment strategies – investing in lower risk instruments more carefully matched in their maturity to meet claims as they fall due. Of course this distinction is slightly blurred in those firms who have accepted credit risk through their core underwriting activities – the so called 'monoline' insurers. But the risks here are already crystallising and are widely known, so I do not plan to focus on this today.

So returning to the more traditional GI sector, risks arising directly from the events of the last 12 months or so seem likely to be limited to potential claims on financial liability lines business, such as Directors and Officers, Errors and Omissions and Professional Indemnity insurance. The size of these potential claims is difficult to quantify, and will be long-tail in nature, and there is some evidence to suggest that UK firms took a more cautious approach in writing this class of business following the high-profile US corporate failures of 2001/02.

But there is no doubt that we are entering more challenging economic conditions, so let me spend a few minutes sharing my thoughts on how this may impact on the challenges already facing the general insurance market.

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The prospect of a downturn in economic conditions

In an economic downturn, where there is uncertainty, where unemployment may rise and where people may struggle to meet their costs of living, firms are likely to experience higher claims volumes. The firms most affected are likely to be those offering products that protect against unemployment or sickness, including employers' liability insurance. Based on past experience, we also know that firms offering household cover may also experience increased theft, arson and fraudulent claims. Arguably the impact of claims inflation on firms' financial position is unlikely to be material, nevertheless it is important that firms consider the extent to which this trend should affect their underwriting strategy. It is also important that firms take this into account before taking decisions on end of year reserve releases.

In an economic downturn, firms also need to consider the likely impact on new business volumes. While the extent of the downturn is an unknown, future strategic planning must take into account the possibility of falls in demand from both business and individual customers as they seek to cut their costs. In this context you can expect greater focus from us on the sustainability of your business models, the credibility of your strategic planning, and the adequacy of your stress testing and scenario analysis. Likewise some classes of business may become more popular – such as protection products linked to unemployment and mortgage repayments. And while there might be opportunities here for firms, you can expect us to be interested in their ability to manage the associated risks.

Views are varied on what affect a change in economic conditions will have on the impact on the underwriting cycle, which has been in the softening stage of the cycle for an extended period.

For catastrophe business, preliminary estimates for recent hurricane losses do not suggest they would be sufficient to trigger corrections in rates. But, as we have said before, firms need to be very clear about their appetite for catastrophe exposed business and ensure that they are not over-reliant on catastrophe models for understanding their exposures. Given the huge amount of uncertainty in catastrophe risk profiles, firms must take particular care to ensure they have the appropriate amount of capital to support it. This will be a key issue in an environment where capital is likely to be much more difficult to raise, and we have yet to see whether this will feed through to hardening rates. Turning to non-catastophe business, in expectation of a fall in demand for products, rates might expect to soften further. However, given that capital may be more difficult to raise, and a lack of new entrants to the market may reduce the competitive pressures – some commentators are predicting a hardening of rates. And they are saying that hardening could be dramatic and quick. So firms' approach and discipline to pricing and managing the underwriting are going to be critical, and may be tested in the coming months. As we have said before, insurers need to actively and dynamically manage the risks associated with the underwriting cycle through the operation of clearly articulated risk appetite, underwriting, reserving and business strategy, and through appropriate oversight of their business activities based upon them.

The final point I want to make here is a general one on the areas where we are pressing all insurers to ensure they are prepared for the challenges of operating in uncertain market conditions. We published these in an Insurance Sector Briefing in September, and I think it is useful to briefly recap three of them here.

The first is on ICAS, and in encouraging continuing progress towards fully integrating risk and capital management. Based on our observations, the firms making the most progress share three things in common:

• the greatest level of senior management oversight and governance in the ICA process;
• the use of the ICA in wider decision-making – including exploring strategies for mitigating risks that exceed risk appetite; and
• keeping the ICA model up-to-date with significant firm or market events.

These kinds of developments have even more value in the current challenging economic and market conditions. They will also be useful to insurers in their preparations for Solvency 2, which I will come back to later.

The second issue is of managing risk in less benign market conditions. As you know, this kind of environment reduces the room for error; but it is also exactly the time when all kinds of risks may be exacerbated. And in making these comments in the context of the GI sector I am thinking very much in terms of non-financial risks such as strategic risk, the resilience of business and pricing models, financial crime – including data security and employee fraud – as well as operational risks. I am also thinking in terms of how prepared firms are for managing risk in sharply changing market conditions. When I say 'prepared' I mean practical arrangements; the systems and controls firms have in place for measuring and managing risks and the governance framework around this. In our discussions with firms it is clear that in at least some cases they have more to do.

The third issue is stress testing and scenario analysis, which insurers need to fully utilize so that they understand their resilience to both the current financial market dislocation and a more challenging economic environment. And in our briefing we give some examples of scenarios that you might consider.

So I hope I have set out:

• why I think the direct issues arising from the current dislocation in financial markets are less immediate for this sector;
• more importantly, what longer term issues might arise from a change in economic conditions; and
• finally, the areas of risk and capital management where we are pressing insurers to remain focussed.

But of course risk and capital management are not just domestic issues, and ultimately Solvency II will have a very great influence on the long-term landscape of the insurance sector. So I want to spend a few minutes reflecting on progress to date and the challenges that lie ahead.

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Solvency II

The Solvency II vision is of consistent requirements for regulatory capital, supported by a supervisory regime that encourages – and rewards – improved risk management. Importantly, it will also improve the transparency of the position of insurance groups outside the UK, which currently operate under a variety of regimes – not all of which are risk-sensitive.

We expect the European institutions to approve the Solvency II Directive by early 2009.  It has been a huge effort, and an even greater achievement, for the 27 Member States to get close to final agreement on the principles of Solvency II.  Some people have questioned the relevancy of Solvency II in light of recent market events.  We have supported Solvency II from the beginning and recent events only reinforce the need for strong risk-management and an adequately capitalised insurance industry, and Solvency II, if adopted in line with the Commission’s Proposal, will deliver just that.  Market consistency, risk-sensitive capital requirements reflecting economic reality, adequate systems of governance including the forward-looking risk identification and solvency analysis through the Own Risk and Solvency Assessment are key building blocks of Solvency II that will be an important part of ensuring the future stability of the industry.

Solvency II will require insurers to operate risk management from the boardroom and throughout the firm.  It introduces a new, risk sensitive regulatory capital measure, and provides for increased scrutiny of firms’ internal models through a formal process of approving models for use in calculating regulatory capital requirements.  UK firms are in a strong position to take the additional steps necessary to prepare for Solvency II, given their experience of our existing ICAS regime, which combines a principles-based framework with risk-based capital requirements.

In September, we published a Discussion Paper that represents the start of a programme of preparation for Solvency II for the UK insurance market.  It highlights and explains key elements of the Solvency II regime, and identifies the actions that insurers need to take. A simple but important step is to identify an individual responsible for preparing a plan for Solvency II implementation. Another is to get Solvency II preparations onto boards' agendas, and the key messages chapter of the DP is designed to facilitate this. We are also asking firms to review their overall systems of governance framework, including risk management and to assess the impact of the new 'standard formula' for capital calculation, as tested in the recent QIS4 exercise.

On internal models, the DP indicates how firms might progress their development towards Solvency II requirements.  It also lays out a timeline for the internal model approval process, and by June next year we are asking firms to confirm whether they intend to follow the internal model route.  This is an important decision for firms and those wishing to use internal models under Solvency II will need to further evolve their risk management so that it is effective and fully integrated with capital management. Approval of an internal model under Solvency II will only occur if the supervisor is confident that the firms’ risk management function is adequate.

For many firms there is still a great deal to be done and they should not underestimate the level of effort that will be required.

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TCF

Finally, I would like to share some thoughts on an issue that will endure long after the present difficulties have diminished; will be a key consideration in how insurers respond to the longer-term challenges of a change in economic conditions; and should affect the very way in which risk is managed: TCF.

By the end of December 2008 we expect all firms to be able to demonstrate to themselves – and to us – that they are consistently treating their customers fairly. To be clear about what this means, I will unpack some of the statements we made in the June about culture and performance, and highlight the issues we are expecting firms to resolve in order to meet that deadline.

In June this year, we said that by December firms should be able to demonstrate four things. First, they should demonstrate that senior management have instilled a culture whereby they understand what the fair treatment of customers means; where they expect their staff to achieve this at all times; and where (a relatively small number of) errors are promptly found, put right and learned from. We explained what we meant by ‘culture’ in the context of TCF last year, when we published a ‘culture tool’ – designed to help senior management identify areas of risk to TCF outcomes in the culture of the firm. Leadership is central - where there is strong leadership with a clear vision of what treating customers fairly means for the firm, it is more likely to have a culture which is geared towards delivering fair consumer outcomes. The firm's strategy is relevant – and insofar as current market conditions cause firms to alter their strategic direction – senior management should consider the implications for customers as an integral part of their planning. Decision-making at all levels within the firm will also impact. And controls, including management information, are important so that senior management in the firm can satisfy themselves that the customer is being treated fairly. And then there are the people issues. Recruitment, training and competence - firms can influence the delivery of fairer outcomes by recruiting staff with appropriate values and skills; training staff effectively; and assessing and monitoring their competence. And very topically at present of course, reward strategy is key. Those firms that showed good practice against the March deadline had treated TCF as something which needed to be built into the firm's culture.

Second, and integral to a good culture, we expect firms to be appropriately and accurately measuring performance against all customer fairness issues materially relevant to their business, and be acting on the results. The key is development of evidence and measures that are really used by senior management. We don't want to see firms generating management information just to satisfy a visit from the regulator. We understand completely that a file badged as TCF MI is not worth anything unless it really is used by senior management as a way of measuring how the firm is behaving and whether outcomes are being met. Just as we did in March, senior management can usefully check whether they are measuring performance against the outcomes rather than simply conformity with internal processes; and whether they are measuring fairness rather than customer satisfaction. And, as with any other information relied upon, senior management will want to satisfy itself that information on performance against TCF outcomes has integrity – for example, that those measuring suitability of advice are qualified to do so, and that their work is overseen or checked at least periodically in some way. 

Third, the measures are just one part. We also expect firms to be demonstrating through those measures that they are delivering fair outcomes. After many years of work, we would expect you to be delivering a very strong performance. This does not mean 100% delivery on all occasions, but – on rare occasions when things go wrong – we would expect senior management to have put in place clear accountabilities and timelines for taking action.  And specifically for this sector, the ICOBS transition period ended in July and we fully expect that all firms are meeting the standards set out in the Handbook, which aim to achieve TCF in retail GI markets

Finally, we expect firms to have no serious failings – whether seen through MI or known to us directly– including in areas of particular regulatory interest previously publicised by the FSA.

I know that firms are keen to meet the deadline and that a huge amount of work is on-going with a great deal of commitment.  It is also important to remember the very large amounts paid out by this sector to consumers at times of great need – including when handling very large numbers of claims arising from flooding for example.  Unfortunately, there are also some very significant issues in parts of the marketplace which, where they are allowed to persist, will demonstrably mean that the firms in question have not met the December deadline. These will be familiar to you, so I will not spend long on them here, but they are critical to your success in delivering on TCF and I will mention just two examples.

The first example is PPI, where we continue to believe that poor sales practices are resulting in poor consumer outcomes. PPI can provide important protection for consumers, but they are entitled to expect that they will be treated fairly by firms when they buy it. They must be told how this product works, what it covers, and how much it costs. Tackling poor PPI sales practices remains a high priority for us.  We will intervene to ensure consumers are protected and we are escalating our regulatory intervention in this market.

My second example is the failure to resolve issues concerning firms' promotional material and using unfair terms in customer contracts. Insurers should make their consumer contracts as clear and understandable as possible, especially when drafting exclusion clauses. To help firms achieve this we published, for example, a statement outlining our views on the use of exclusions for 'consequential loss'. In our view most consumers would not understand what this phrase means. So, for example a consumer that lost their keys might try to claim under their insurance for the cost of replacing locks. Yet such a claim might be rejected if the firm deemed it to be a loss not directly associated with the insured event and therefore a 'consequential loss'.

A real risk of failing to treat customers fairly materialises when consumers do not understand a phrase in their contract which firms might then use to their disadvantage.

Furthermore, unclear and unfair contract terms pose a risk to firms because if a court took the view that an exclusion clause was ambiguous it could result in the firm having to make payments for a loss it had sought to exclude.

I hope I have given a sense of what more might need to be done to successfully reach December. We continue to believe strongly, not least in current market conditions, that progress is both essential and hugely in the interests of the industry. I hope you do to.

Conclusion

In conclusion, I started by noting the implications of current market conditions for the general insurance sector and the need to ensure that risk and capital are particularly well managed.  But it is also important to prepare for longer-term changes to capital requirements (as a result of Solvency II) and to ensure throughout that customers are fully taken into account and treated fairly.  Thank you.

 

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