Speech by Dr. Thomas F. Huertas, Director, Wholesale Firms Division, before the FSA Insurance Conference

7 April 2005

Shortly before the new millennium and the advent of the FSA, some firms in the general insurance industry were sowing what would be the seeds of their own destruction.  Many insurers were chasing volume by reducing premiums.  Many insurers' reserves would prove insufficient for the volume of past liabilities, such as asbestos, as well as allowing their capital position to erode. Many general insurers had invested a disproportionate amount of their assets in equities.  To top things off, some general insurers and brokers had, to put it mildly, questionable business practices.  Regulation was all too often reactive.  It was no longer fit for purpose and, consequently, regulation was seen by some to be lax.

Today, the general insurance industry is much more resilient.  The industry has not only survived the natural catastrophes of 2004, but it is also enjoying the final stages of a hard market.  Investment portfolios are more balanced, and balance sheets are stronger.  Reserving is more realistic.  Managements appear to be concentrating on underwriting for profit.  Managements have seen the light on cost control and are making progress in reducing expenses, either directly or through outsourcing arrangements.  Managements also recognise more broadly the conflicts of interest to which they are exposed, and managements are – or at least should be – starting to take the necessary steps to avoid abusing these conflicts.

Following our extensive programme of reform, insurance regulation is now risk-based and, we believe, much more proactive.  We have had responsibility for the regulation and supervision of general insurance including the Society of Lloyd's and its managing agents for some years now.  With effect from 14 January 2005, our remit extended to general insurance brokers.  This has given us, for the first time, the ability to supervise, analyse and understand more clearly the issues affecting the entire general insurance market.

Although it would be alluring to assert that the advent of the FSA has much to do with the improved health of the general insurance industry, I would suggest that the true test of the regulatory regime and firms' ability to operate effectively and compliantly within that regime is yet to come.  How will the industry perform when the insurance cycle softens, as it inevitably will at some time in the future?  Will insurers be better prepared to withstand the lure of premiums now versus underwriting losses later?  Will management and boards resist the temptation to boost returns by resorting to financial mis-engineering or by abusing conflicts of interest?

Where possible and appropriate, the FSA works in partnership with the senior management of the general insurance industry to promote an efficient, orderly and fair market in general insurance as well as to help retail consumers of general insurance achieve a fair deal. 

Under "efficient, orderly and fair", we aim for a market that is both sustainable and free from abuse.  For a market to be sustainable, the participants in it must have sufficient capital and liquidity to meet their obligations at all times.  That in turn presumes a business model that is capable of generating an attractive return on capital.

Capital regulation and prudential supervision

Our principles-based approach to regulation and our risk-based approach to supervision are fundamental to the design of our insurance reforms.  Most notably for general insurance companies firms must maintain adequate financial resources – a requirement of Principle 4.  To demonstrate to the FSA that they meet this requirement, from 1 January 2005 firms have been required to use the Individual Capital Adequacy Standards (ICAS) regime – a regime developed by the FSA with significant input from the industry.  The ICAS regime for the Lloyd's market is broadly consistent with the ICAS regime for the companies' market.  The ICAS regime supplements the minimum capital requirement of the EU Solvency 1 Directive and the Enhanced Capital Requirement.

To summarise ICAS, the insurer states to the FSA the risks that it incurs in running its business and the level of capital that the firm believes it needs to support these risks.  Once received by the FSA, we review the submission and set an Individual Capital Guidance (ICG) for the firm.  Should the firm fall below its ICG, we may intervene so that the firm can restore its capital position to the ICG level.  In this way we hopes to limit the probability that firms will become insolvent and pose a risk to policyholders.

We aim to make the ICAS process practical for firms and we aim to be practical in our implementation.  In our view, the ICAS regime formalises what firms should be doing internally as part of best practice.  The ICAS submission and the resulting ICG should be proportionate to the nature, scale and complexity of the firm's activities.  Over time, we will integrate the ICAS regime with our overall ARROW risk-assessment process – indeed they should be two sides of the same coin.    

To date we have requested about 60 firms to provide us with their Individual Capital Assessments, and we have received about 20 submissions.  Although this is still very early days, we have fed back our preliminary observations in recent publications. These can be summarised as:

 

  • The best of the submissions contain a clear, concise but comprehensive register of the risks that the firm incurs, as well as a succinct and realistic business plan that explains the conditions under which the firm will assume risk and the reward that the firm expects to generate.  The overall emphasis is on business management, not on perfection in mathematical modelling.
  • There is a wide dispersion among the submissions.  Many are excellent.  Some fall short of best in class.  The gravest shortcomings lie in the area of risk awareness.  Some submissions do not make clear the risk that the firm is assuming.
  • To varying degrees, firms have outsourced the preparation of the ICAS submission to third parties.  Although we can readily understand why firms might wish to do this, we would remind firms that it is the responsibility of Senior Management and the Board to understand the risks that the firm assumes and to assure themselves that the firm has sound risk management policies in place as well as capital and liquidity that is adequate even under stressed conditions.  This responsibility cannot be outsourced.
  • If the ICA is done well, the ICG is likely to be approximately equal to the capital estimated by the firm itself.  However, we would note that our review will place the firm's ICA into the context of the firm's wider control environment as well as what else is known about the firm's risk profile. 

Prudential issues

Over and above this new risk-based capital regime, but in relation to ICAS, there are four important and very current prudential issues with which general insurers and brokers must be engaged and around which we will pay particular attention in our ICA reviews.

The first is the operational risk arising from the lack of contract certainty, our approach to which John touched on earlier today.  The other three issues are: financial engineering – building on John's general comments over lunch, reinsurance between related parties, and the treatment of firms in run-off.  I now plan to comment on each of the other three in turn.

When properly done, financial engineering strengthens the insurer and adds to protection for the policyholder.  The key criterion is a genuine transfer of risk.  For example, the insurer may raise debt in the capital markets, but need not repay that debt, to the extent that losses on a particular line of business exceed a certain level.  In effect, such alternative risk transfer mechanisms raise contingent capital and/or provide downside protection supplemental to traditional reinsurance contracts.  For third party investors, alternative risk transfer opens the way to a new asset class with attractive returns that may be uncorrelated with returns on more traditional investments such as stocks or bonds.

Unfortunately, not all contracts genuinely transfer risk.  In such cases, financial engineering must be renamed financial mis-engineering.  So what are the risks from financial mis-engineering?   If a company uses contracts to obscure its underlying financial condition and thereby misleads policyholders, debt-holders, equity holders and/or regulators, the company could be in breach of its obligation to hold adequate and suitable financial resources as well as its obligation to deal with its regulator in an open and honest manner.  If the company has issued listed securities, the company may also be in violation of its obligations as an issuer.

To mitigate these risks, last month we issued an information request to general insurers asking them to report by the end of April on the extent to which they had used financial engineering and to attest that they had adequate controls in place to prevent financial mis-engineering.  We also asked firms to report any transactions "where the economic value of the transaction differs materially from the value placed on the transaction in the firm's balance sheet".  Finally we asked firms to confirm that they do "not engage in financial engineering transactions or side agreements that might obscure the firm's financial position, or which could place [the] firm at risk of breaching any applicable regulatory requirements".   

In sum, financial engineering has appropriate uses, and we welcome it.  Financial mis-engineering endangers the insurer, its policyholders and the holders of its securities.  We are currently working to assure that firms do not stray over the line.  Our previous work – and the work of other regulators - shows how seriously we take financial mis-engineering: we have taken disciplinary action in the past and will do so in the future if we detect cases which merit such use of our powers.  In the meantime, we will in all likelihood, consult later this year on proposals to enhance our supervision of financial engineering through enhanced disclosure in public and regulatory returns.

The second topical area for consideration in the context of capital adequacy is the business of reinsurance: a proven method of transferring risk.  Properly placed, reinsurance strengthens the primary insurer and allows the primary insurer to write a greater volume of business whilst maintaining a more diversified portfolio of retained risk.  However, when reinsurance is concentrated on a particular reinsurer, a new risk arises, that of credit exposure to the reinsurer.  If the reinsurer is a member of the same group as the primary insurer, further risks may arise, at least as far as the primary insurer is concerned.  The increased risk to the primary insurer includes the risk that the reinsurance is not provided on arms' length terms, and/or the risk that the policyholders of the primary insurer may be structurally subordinate to the third-party, direct policyholders of the reinsurer.  Such problems may be further compounded, if the reinsurer is in a non-UK jurisdiction, especially a non-EU jurisdiction.  Consequently, in our risk-based supervision of UK general insurance firms, we are paying increased attention to the level of intra-group reinsurance and to the rating and governance of the group as a whole.  If necessary to protect policyholders of the UK primary insurer, we will consider placing limits on the amount of intra-group reinsurance that the primary insurer may take up and/or imposing other safeguards.

Third and finally, I turn to firms in run-off.   Run-offs are an effective way of winding down activity in a line of business, particularly long-tail business, which an insurer no longer wishes to write. The principal risk in run-off companies relates to the rate at which claims materialise with respect to the previously written policies.  Success in managing run-offs depends on achieving economies in claims administration as well as obtaining adequate  returns on the assets available for investment. 

Although insurers may elect to place certain subsidiaries into run-off, they should not regard run-offs as an opportunity to run away from their obligations to policyholders.  We expect solvent insurers placing companies into run-off to place and keep them in solvent run-off, i.e. to endow the run-off company with sufficient capital and reserves to meet its obligations to policyholders over time.  Although we recognise that run-off companies have limited liability, we would also regard any insurer that walked away from the obligations of one of its subsidiaries in run-off as a group that posed increased risk to policyholders and one worthy of increased scrutiny and possibly increased capital and/or regulatory restrictions.

Probable EU Developments

It is difficult, if not impossible, to talk about ICAS without making some reference to developments in Europe and, in particular, Solvency 2.  In many ways, the ICAS regime anticipates the capital regime that we expect the EU to develop over the coming years.  The Commission has indicated that it intends, over time, to bring insurance solvency regulation more into line with banking regulation as expressed in Basel II.  The Solvency 2 Framework Directive is now under discussion and may be introduced in 2006 for implementation prior to 2010.  This would substantially revise the current Solvency 1 Directive.  We anticipate that Solvency 2 would take a much more risk-based approach to establishing the minimum capital requirement (Pillar 1) for insurance firms.  An important intermediate milestone is the development of a harmonised standard on technical provisions.  We further anticipate that the individual capital requirement for insurance firms (Pillar 2) will have similarities with the ICAS regime.

In the shorter term, the Reinsurance Directive will bring about a single market in reinsurance, allowing reinsurers to operate throughout the EU on the basis of a "passport" and harmonising how much capital reinsurers must hold.  The European Parliament is expected to approve the Directive in the coming months.  EU Finance Ministers may adopt the Directive as early as June this year.  We welcome this development as the UK already applies the same standards of regulation to pure reinsurers as those undertaking primary business. Given the global nature of the reinsurance market, we see this is a further step in strengthening reinsurance regulation - in line with the overall aims of other international bodies such as the International Association of Insurance Supervisors.

Conduct of business regulation and supervision

As I stated earlier, an orderly, efficient and fair market should be free from abuse.  Unfortunately, we cannot as yet say that general insurance is entirely free from abuse.  Our principle-based approach is relevant equally to our view of how insurers and insurance intermediaries treat their customers.  One of the FSA's strategic objectives is to help retail customers achieve a fair deal.  Although our formal Treating Customers Fairly project has, to date, been designed to address risks and weaknesses in the retail investment market, there is no doubt that this Principle has informed our programme of supervision for retail intermediaries in the general insurance market. 

We have set out our priorities for supervising wholesale insurance intermediaries on a number of occasions.  These include the proper handling of client money, binding authorities, improving contract certainty and conflict management, notwithstanding our focus on general compliance with the rules in ICOB.  Conflicts in general insurance are rife, particularly where brokers act both for the insured and the insurer.  As John said earlier, we have issued guidance on this subject and we will be concentrating much of our supervisory efforts on assuring that firms – both brokers and insurers – are in fact complying with the relevant rules.  Although we will not apply these rules retrospectively to contracts or practices in place before 14 January 2005, we will certainly apply the rules to any activity taking place after that date.

Our priorities for supervising retail general insurance intermediaries have been set out in detail today by my colleague Stephen Bland who is speaking at the BIBA conference.  Those of you with a particular interest in this market will want to read his speech which will be available on our website later.   The priorities sit within our overall principle of ensuring the fair treatment of customers and are based on our view of the key areas for potential detriment.  They include:

  • the proper disclosure of significant and unusual exclusions in policies as set out in the policy summary;
  • higher risk contracts - such as payment protection and critical illness policies;
  • claims and complaints handling as we believe that paying legitimate claims promptly is the hallmark of good insurance practice; and
  • controls by insurance networks over their appointed representatives.

Let me give you a few thoughts on how we have determined our priorities here and why it is in your interests to comply with our new requirements.

As we are all aware, insurance is a complex product.  Customers pay premiums up front for protection against possible losses arising from events insured against under the terms of the policy.  Deductibles, exclusions, and requirements to demonstrate loss before claims can be paid are but a few of the features that make insurance difficult for the man in the street to grasp.  In contrast to banking products such as savings or mortgages, pricing is opaque.  Few people aside from underwriters and actuaries have an innate sense of whether the premium per thousand pounds of cover for homeowners' insurance or motor insurance 'sounds right'.

Although increased competition in the selling of insurance (for example, through new direct writer entrants selling over the 'phone and via the internet) has increased the ability of consumers to get quotes for their specific coverage needs, the average consumer is still, in our view, far from adequately understanding what he is buying and what he should be paying.  This creates the scope for unscrupulous operators to take advantage of unwitting consumers.  Eliminating that scope is not only in the interest of consumers, but also, I would submit, in the interest of the vast majority of the participants in the general insurance industry who view treating customers fairly as a way to win business and increase profits.

Conclusion

In conclusion, the general insurance industry and the regulator have come very far in recent years.  The commercial and regulatory environments have changed substantially – in my view for the better.  With significant input from you, and in line with our increased responsibilities, we have have established the framework for modern, risk-based regulation and supervision.  We now need to implement that framework.

 

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