The impact of the FSA on the London market.
At last the end is in sight. The Government has announced that N2, the date on which the Financial Services Authority (FSA) takes on the vast majority of its new responsibilities under the Financial Services and Markets Act, will be no later than 30 November 2001. From that day, the FSA will have full responsibility for the supervision of insurance companies (rather than operating under contract to the Treasury, as it now does). We will do this under a new statutory framework. What does this mean for the insurance companies that make up the London market?
The new Act is quite different in structure from the old Insurance Companies Act. It gives the FSA a set of objectives: market confidence, public awareness, the protection of consumers and the reduction of financial crime. It also gives us a set of principles that we should take into account in pursuing them, such as facilitating innovation and competition, and using our resources efficiently and economically. Also, since the Act covers not only insurance but also banking, investment business and other areas, we shall be able to put in place a sensible and less bureaucratic regime for multi-sectoral groups, and to minimise the opportunities for regulatory arbitrage between different sectors. We shall have a common set of powers in areas such as rule-making, investigations and discipline, and the existing policyholder protection and insurance ombudsman arrangements will be replaced by the new Financial Services Compensation Scheme and Financial Ombudsman Service.
The Act gives the FSA very wide rule-making powers, but those powers are not unconstrained. Not only do we have to act in accordance with the objectives and principles already mentioned, we are also subject to various process disciplines, and all our rules are made after extensive consultation. As regards substance, we are constrained by international commitments, in particular the European Directives. These mean that the scope for changes in the core prudential requirements is limited in the short term, though there are some interesting longer-term possibilities.
However, the Act will involve more substantial changes in some areas. There will, for the first time, be disciplinary powers (including the possibility of fines) for general insurers and key individuals within them. There will be changes to the regime for approving individuals, including a requirement for pre-approval, and to the controllers regime. Perhaps most interestingly, the old ‘Schedule 2C' regime for transfers of business between insurance companies will be replaced by one requiring court approval, more like that which currently operates for life companies. The court will have wider powers to transfer rights and liabilities, including rights under contracts of reinsurance.
Scope for change
Even where the scope for change in the substance of the regime is limited, there will be changes in our approach to supervision. We intend to adopt a risk-based approach, looking at the risks to the FSA's objectives and considering all the tools at our disposal to respond to them. Our aim is to be a proactive regulator, one which tries to head off problems in advance rather than clear up the mess afterwards.
Many of the risks to our objectives are not specific to individual firms. Examples might be those posed by collapse in an overseas economy or by demographic change, so we intend to do much more thematic work, looking at issues across many regulated firms. The group may be as wide as the entire financial services industry or as narrow as the companies doing a particular type of business, for example employer's liability. We may respond to issues by using very broad tools such as consumer information programmes, or by dealing individually with the firms most affected.
For individual firms, we shall put each into a risk category based on our assessment of impact – how bad it would be if something went wrong – and probability – how likely that is to happen. For all but the smallest firms, we shall perform a detailed risk assessment embracing not only such things as underwriting and investment risks, but also strategy, management and systems. We shall then, with the firm, develop a risk mitigation programme which we shall monitor. The amount of resource that we put into all this will depend on our assessment of risk. I should emphasise that our concern, once again, is with the risk to our objectives. We recognise that insurance is a risk business, and that it would be quite wrong for us to constrain commercial risk-taking unduly or to aim for a zero-failure regime. But the riskier the business, the more important it will be that it is well managed and controlled, and that there is enough capital to support it.
This new style of regulation is being reflected in our structure. Since 2 April, a small number of major insurance groups with wider financial services interests have been the responsibility of our major financial groups division. The insurance firms division has been reorganised into a life department, a non-life department and a themes department, which in addition to thematic work will be responsible for run-offs and the lowest risk insurers. We have been joined by the actuarial team which previously advised us from the government actuary's department.
A further important development is the implementation of the Insurance Groups Directive, which will allow us to take a consolidated view of the finances of groups which include one or more insurance companies.
For those groups which cross European boundaries, it would clearly be foolish for each national supervisor to be performing its own consolidation and acting on it independently, so arrangements are being put in place for co-ordinating conferences of European supervisors with interests in a particular group, convened in each case by the supervisor with the largest interest – in many cases the FSA. This is an important step towards greater regulatory co-operation in a sector which has lagged behind other parts of financial services in this respect.
An important challenge for the future will be to widen the scope of regulatory co-operation outside Europe. There are some problems arising from the rather restrictive wording of the Directive's provisions on exchange of information. We do, however, want to make progress so that we have a wider appreciation of the risks our companies face, and also the ability to trust our colleagues to address the risks that fall most naturally to them.
In the slightly longer term we hope that, as an integrated regulator, we can use the perspective we have on the whole financial services industry to bring about a more modern prudential regime for insurance – and indeed for other sectors. There are already some encouraging developments within Europe, with the drafting of a Directive introducing small but significant improvements in the solvency regime now well advanced.
Further down the road we expect to be discussing more fundamental changes to the solvency regime, and also the introduction of a European regime for pure reinsurers. But in the longer term there are still greater prizes to be won in the form of sensible harmonisation across different sectors of finance, and international convergence of solvency standards.
A pre-condition of this is almost certainly agreement on international accounting standards, since it is difficult to have harmonised rules for the relationship between assets and liabilities unless you can agree how to measure them. Fortunately, we seem to be within reach of a new set of international accounting standards for insurance contracts and financial instruments more generally, including progress towards fair value accounting.
There is progress to be made in the meantime. Later this year we shall be publishing our proposals for the integrated Prudential Sourcebook, to be introduced some time after N2. Although it will not be possible by then to have full harmonisation of prudential standards, we can and shall adopt a common approach to considering the kinds of risk to which firms are subject, and the kinds of systems and controls they need to address those risks.
One element, mirroring the emphasis in other sectors on supervisory review of internal capital adequacy assessments and strategies, will be a proposal to require each insurance company to make its own assessment of the capital it needs to support its business. There will, of course, be underpinning minimums prescribed by the European Directives, but even the best-run non-life firms, engaged in the lowest risk business, typically need capital well in excess of those minimums. Our proposals will require companies to consider for themselves what is appropriate. We shall use their conclusions as a benchmark for our own regulation.
N2 will of course bring important new powers for the regulation of Lloyd's, too. One of our aims, reflecting Government policy statements when our new powers were announced, is to bring the regulation of Lloyd's closer to that of insurance companies, though the unique structure of Lloyd's inevitably requires some differences. The new Lloyd's Return has been modelled on that for companies, but we have also taken some opportunities to move forward, and the new prudential requirements for Lloyd's, at some points, provide a foretaste of what companies can expect to see in the draft integrated Prudential Sourcebook.
In the short term, the changes that London market companies will see are probably more of style than substance, though they will need to come to grips with new processes, new requirements for management systems and controls, and of course the new regime for transfers of business.
In the longer term, however, we can expect a much more modern regime, built on international standards and co-operation, and bringing insurance closer to other areas of financial services.