Address to the ABI 2009 Conference
Speech by Adair Turner, Chairman, FSA
ABI 2009 Conference
9 June 2009
This is my first speech to an insurance audience since becoming Chairman of the FSA. Looking through the agenda for today’s conference what is striking is how hugely varied the insurance sector is. It covers savings products, life insurance, and all the categories of general insurance. In the course of today you have discussed climate and health and motor cars: issues of financial stability and issues of retail distribution. The insurance industry plays vitally important functions throughout the economy and never more so than in these uncertain times.
The fact that this is my first major speech to an insurance conference to a degree simply reflects that this is the first ABI conference since I started as Chairman. But also that, as you will appreciate, I have been heavily engaged on banking issues. Indeed it is nice to talk to a sector of the financial industry which has not been responsible for destroying any chance of weekend relaxation.
In the banking industry, it is clear that there have been huge challenges, huge problems and a need for radical change. The Turner Review proposals, mirrored by other reports from across the world, amount to a revolution in our approach to the regulation and supervision of banks, investment banks and shadow banks. We need major changes in our approaches to capital adequacy, liquidity, hedge funds, remuneration, and credit rating agencies. We have extremely difficult issues to address in the regulation and supervision of large cross-border banks. And we need to decide whether changes in capital regulation of banks should be combined with changes in accounting approaches.
In insurance there is no equivalent need for a revolution. That reflects two facts.
- The first is that major changes, amounting themselves to something of a revolution, came earlier. In 2004 the FSA introduced very major changes in the capital regime for insurance companies. Those changes amounted to a shift from approaches focused on formalistic definitions of capital to definitions focused on the real economics of risks run by insurers and on understanding extreme circumstances. They have helped put the insurance industry in a stronger position to meet the challenges of the current economic environment. Insurers entered this recession with a better understanding of risk than before; and insurers have been better prepared to deal with market volatility.
- The second key fact is simply that insurance companies are not banks, and they differ from banks above all in the much lower importance of liquidity risks, which have played such a central role in this banking crisis. As a result, the insurance industry has not suffered a general worldwide crisis over the last two years, even while banks have suffered their worst for seventy years. That doesn’t of course mean that insurers have been unaffected by the events of the last two years: life insurers have been exposed to falls in asset values and widening bond spreads; and in the general insurance sector the need to underwrite for profit has become even more important. These conditions have had to be monitored and managed carefully. But the way in which risks crystallise and the time scales over which they crystallise are quite different in insurance companies from banks. So the regulation of insurance companies needs to be different from the regulation of banks, even while we identify and track carefully all the potential knock-on consequences from one sector to others – a key theme of the ABI’s own report on “Restoring Market Confidence” and one I’ll return to later.
But while there is no need for a revolution, there will still be major changes, because the context for all of financial services has changed significantly. And that requires response from the industry across its very many different facets.
The economic context which your industry now faces creates major opportunities and challenges.
- On the savings side, – pensions, life insurance based savings, medium term savings products – the context ought to create an opportunity because the savings rate is rising. After a period in which personal savings was heavily focused on the accumulation of housing equity, with the relative importance of financial assets accumulation declining, the savings rate has already significantly increased, up from -1.2% at the beginning of 2008 to 4.8% by the end. Of course the savings rate increased significantly in previous recessions, only to fall back subsequently. But it may be that after this recession, we will see a more sustained change in attitude, a more sustained caution about putting too many eggs in the risky basket of house price appreciation. But so far most of the new savings are going either into bank deposits or into paying down mortgage debt, rather than into the longer-term savings products which this industry sells.
- The challenge is therefore to design and distribute products which enable people to develop a more diversified form of wealth holding than has characterised the last several years. To be successful the industry will need to overcome its long-standing structural issues, the problems of poor persistency and high distribution costs reducing pensions’ profitability; the legacy issues arising from antiquated IT systems. Above all perhaps, it must respond to consumers’ call for less complexity.
- On the protection side, there are many products the value of which should be more apparent in these difficult times. And whilst demand in areas linked to the housing market has clearly fallen off – with mortgage related term assurance down from 1.2 million in 2007 to 700,000 in 2008 - demand in other areas has been steady or expanded. Historically the treatment of consumers has been an issue in some parts of this market. On a broad definition of protection, we have of course seen major problems in the PPI market. And while Mortgage Payment Protection insurance has not previously been a major focus of our concerns, it may become one in an economic downturn. As the likelihood of unemployment-related claims increases, some insurers are responding by increasing premiums or reducing cover for existing policyholders. Whilst it is natural for the industry to respond to changes in risk, this raises issues with both unfair contract terms, disclosure and our TCF Principles. How many consumers would have taken up this cover if they had known that at the very time they needed the protection the most, the price of it could significantly increase or the amount of cover decrease? This is an area where insurers must expect us to intervene to address poor consumer outcomes. And more than that they must think strategically about the impact of their actions on the sector’s reputation.
- Turning to general insurance – both commercial as well as the household sector, and excluding the credit insurance monolines which are clearly a special case – this is probably the sector least directly affected by the economic environment. Rather it is the underwriting cycle that dominates fortunes. But downturns do tend to stimulate claims inflation and a shift to self-insurance – as the ABI’s figures published today demonstrate: 22% of people say they have not renewed their home contents insurance this year to save money; 17% say they have not renewed their buildings cover, and given the widespread falls across all asset classes, even the general insurance sector’s margins are being squeezed by falling investment returns. Economic developments have also led to concern about the availability of cover in the trade credit markets, and we have seen the government stepping in to address this.
So there is no shortage of business issues to which the industry needs to respond. But it is on the future of regulation and financial supervision that I’d like to concentrate today. Because while the crisis does not require a revolution in insurance prudential regulation in the way that it does in banking, it has brought to the fore public concerns about the financial system and about the effectiveness of financial regulation, which require responses which have implications both for you and for us.
So I will comment on four key changes either in context or in required regulatory and supervisory response.
- First an increased public focus on the overall effectiveness with which the financial services industry serves the real economy and consumers. The nature of that concern has shifted over the last few years – from retail financial services to banking and from conduct of business issues to concerns about financial stability. In the ten years before the crisis broke in 2007, most of the pressure on the FSA related to whether we were sufficiently focused on consumer issues in the retail distribution of financial services – whether we were dealing effectively with the mis-selling of particular products. It was those sort of issues on which the Treasury Select Committee usually criticised us; and parts of the insurance sector were often in the firing line of popular concern. Investment bankers may have excited envy and frankly bewilderment as to what precisely they were up to, but three years ago the FSA was not bombarded with political or press concerns about whether we were adequately regulating the CDS market, whether bankers’ bonuses were creating incentives for harmful risk taking, or even whether Northern Rock’s rapid growth was sustainable. Over the last two years there has been a major shift in focus, and public and politicians now want to know why we were not worried about those things, and how we are going to fix them in the future.
But I don’t think that means that popular concerns about the financial services industry are now going to be entirely focused on the investment banking activities and prudential concerns which have dominated the last year. I suspect indeed that there has been a cumulative effect on public trust in the financial services industry deriving both from the steady drip drip of conduct issues which characterised the years before the crisis and then from the crisis of confidence in the prudential soundness of the financial system which has been a feature of the last two. There is a danger of generalised public distrust of the financial services industry. Which means that the financial services industry, including insurance as well as banking, has a big job to do in rebuilding trust. And that the FSA has a big job to do in reassuring people that we have grip on all the issues involved. And that having been criticised for focusing in the past too much on conduct and consumer protection to the exclusion of prudential soundness, we need to make sure we don’t end up in five years’ time, being criticised for the inverse fault. That is why we are continuing to follow up all our recent work on the fair treatment of customers and ensuring that we focus on consumer outcomes as well as prudential soundness. - My second point then is that in response to that loss of confidence, more intensive supervisory approaches are unavoidable. The recent problems may have been primarily in the banking industry and that is where the most significant changes are needed, but in an era of heightened public expectations that the FSA will identify and prevent major problems from recurring, we need to reinforce our capability across all high impact firms. And we need to respond to people’s expectations that we will be more forceful in pursuing enforcement against reckless or abusive practices which cause customers harm. We certainly need to ensure that our responses are proportionate and are focused on what matters: that they are outcome focused. And we will also continue to look for market solutions where they are available, such as in addressing contract certainty and commission disclosure. And we are very aware of the need to ensure that the FSA is cost effective. This year we have increased our costs significantly as we have invested in more intensive supervision, more aggressive enforcement, and continued to improve our basic operating systems; but these are one off step change increases, and keeping costs together under control in future years will be a major priority. But there can be no return to light touch regulation and supervision, to supervision on the cheap. That era is over.
- Third, one of the features of the post crisis world is going to be much increased focus on the role of institutional investors, including insurance companies and pensions funds, in corporate governance. It was the banking system which blew up: but it was the institutional investors, some of whom are ABI members, who owned much of the banking system. There are major issues about whether in addition to applying greater regulatory oversight we can increase the effectiveness with which institutional investors exercise their ownership rights and responsibilities. The outcome of the Walker Review on corporate governance will have implications for the banks, the FSA and for institutional investors. And we are involved in discussions with major institutional investors – including those who are insurance companies, to identify what can be done to make shareholder relationships more effective.
- Fourth, the crisis has provoked major and important debates about the future structure of regulatory responsibility, the future division of responsibilities, in the UK and across Europe.
Within the UK, much of the debate has concerned the relationship between the FSA and the Bank of England, and rightly so, because in the years running up to the crisis, there was a crucial failure in that relationship, a failure to focus on the macro prudential and systemic trends which, far more than problems at specific firms, were the key causes of the crisis. The Bank of England tended to focus on monetary policy defined by the inflation target; the FSA, on the supervision of individual institutions; and the vital activity of macro prudential analysis, and the definition and use of macro prudential tools to constrain excessive lending and risk taking, fell between the stools, into what Paul Tucker, Deputy Governor of the Bank, has called the underlap between us.
We need to put right that problem. Some would propose doing so by returning bank supervision to the Bank of England. But it is important to realise that any structural change to fix one problem could simply create others. And any separation of responsibility for the prudential regulation of banks and insurance companies would undermine our ability to develop an integrated overview of all prudential risks, our ability to identify the knock-on consequences of stress in one part of the financial system for others, our ability to make sure key institutions do not fall between the cracks. The failures of the supervision of AIG - an insurance company with a huge capital markets operation which fell between the gaps of the US’s balkanised regulatory system – illustrate that danger.
It is these arguments – and the potential links between banking and insurance even as we also recognise the important differences between them – which lay behind the ABI’s conclusion in “Restoring Market Confidence” in favour of leaving the current division of responsibilities unchanged.
But if we do leave the division of responsibilities unchanged, it will be essential that the Bank and the FSA work closely together to identify and manage macro-prudential risks. The ABI, echoing the recent House of Lords Select Committee Report, suggests that this could be achieved by the creation of a joint Financial Stability Board chaired by the Governor of the Bank, but with membership drawn from the senior staff of both the Bank and the FSA. I believe there is much merit in that proposal: without that degree of joint working there is a danger that the underlap will continue in future.
In addition to these domestic issues there is a major international dimension of regulation. At the European level, it is clear that major change is required. From the FSA’s point of view, the key driver of the necessity of change again comes from the banking side. The failure of the Icelandic banks clearly illustrated to us that we cannot have a single market in European branch banking without a greater degree of coordination at European level. We need mechanisms to ensure adequate supervisory standards and to identify and mitigate prudential risks in cross-border banks; and this requires more European coordination than currently achieved through the relatively light cooperative role of the existing Lamfalussy Committees.
That is why in the Turner Review and associated Discussion Paper the FSA made a major shift in its policy, arguing for a European financial services regulator, not involved in direct supervision, which should remain a national level activity, but with an extensive coordinating role. The ABI’s report refers to the need for a “supervisor of supervisors”; this is very much in the spirit of what the FSA has proposed. The Larosière Report made recommendations which were different in detail, but not fundamentally. The Commission has now come up with detailed proposals which in many respects we can agree with, but in some others go beyond what we believe appropriate. It is clear that major change will now occur, and it is important to get the details right. Those changes will inevitably have consequences for the insurance sector as well as for banking.
But while there will be major changes in the European regulatory structure which will affect this sector, my presumption is that this crisis does not call for major new initiatives in the substance of insurance regulation – for instance in the approach to capital adequacy – of the sort undoubtedly required in the banking sector.
And I start with that presumption not least because of the huge amount of work already underway as part of Solvency II. The significance of insurance as part of the global financial system is also increasingly understood, and there are moves towards global solvency standards through the work of the IAIS, but it is European implementation of the Solvency II regime which will make a medium-term difference. The insurance industry has broadly welcomed the need for a greater European commonality in insurance regulation and we believe that we have got most of the features of the agreed way forward right. But there are remaining issues which illustrate the need for careful balance between harmonisation and the recognition of specific national circumstances.
One important area is the treatment of the annuity business, where the UK is somewhat of an outlier in the extent of private annuity provision and where that provision could become more important as defined benefit pensions continue to decline and defined contribution pensions requiring annuitisation grow in importance. A prudent approach to annuity capital requirements, with adequate recognition of the probability of bond default, is clearly important, but it is also important to recognise that the annuity business in particular is different from the business of banking, not subject to liquidity risk, and specifically focused on matching long-term liabilities with long-term assets. The new Solvency II capital regime therefore needs explicitly to recognise that there is an illiquidity premium in bond yields, while making sure that we do not overstate that illiquidity premium and understate probabilities of default.
We have to be realistic abut the extent to which the FSA, as a regulator, can influence this debate; at the moment it is seen very much as a UK-specific issue. The challenge for the industry is to get involved in the debate and ensure your European organisations understand and support the strength of the arguments in favour of an appropriate approach.
I started by referring to the banking crisis, but also by recognising that insurance is different, and I will end on that point. We need to recognise that the sheer scale of the financial crisis will create demands for the FSA to be more vigilant and at times more intrusive than before across all sectors; and that there will be changes in European and international approaches which will affect all sectors; and we need in macro prudential analysis to understand the complex and changing interlinkages between all the different sectors of the financial industry. But we also need to recognise the important differences between different sectors, with revolution in those sectors where it is needed, more gradual change and adjustment where revolution is not required. The FSA will strive to get that balance right.