With the industry preparing to adopt the FSA’s principles-based approach to regulation, Colin Smith, James Schacht and Lynne Prescott Hepler look at its feasibility and ask if such a scheme could work in the US

Earlier this year John Tiner, chief executive of the UK Financial Services Authority (FSA), delivered a key-note speech at the FSA principles-based regulation conference in London. He used the event to emphasise to the delegates that principles-based regulation was more about principles and high-level rules than prescription of processes, confirming that it is the outcomes on which the FSA will focus. The processes and procedures which deliver the required outcomes, meanwhile, are the responsibility of senior management.

On the surface this appears to be a laudable effort to tighten up an industry by a man keen to leave a lasting legacy when he retires this summer. Whether the market is ready to adequately respond to such a challenge at this relatively early stage in its regulatory development is questionable though. Either way, principles-based regulation presents a challenge for both the regulator and regulated.

Widening gap

It is worth remembering that the FSA’s regulation of general insurance began only two years ago in January 2005. By its own admission, the FSA does not fully understand the insurance sector, but to its credit, it continues to work diligently to foster a better understanding. Yet the same is also true of insurance companies regarding their efforts thus far towards embedding regulatory requirements into their business culture over that same period.

Almost inevitably, while many firms have made great strides towards embracing principles-based regulation, many more have not, or have only undertaken the minimum action required. This will enable them to appear compliant, based on minimum standards, but they are likely to struggle somewhat. Some rely upon the knowledge that that they fall into the FSA’s lower risk category and are therefore much less likely to receive an ARROW (compliance/risk assessment) visit. A good example of one of the principal issues for those firms is undoubtedly enterprise risk management. This is perhaps surprising for an industry which exists for the express purpose of managing its customers’ risks. However regulatory risk should be high on all firms’ agendas – and any high-level failing is the direct responsibility of senior management.

After two years of general insurance regulation and with re-drafted “insurance conduct of business” rules pending, the FSA is underlining, through principles-based regulation, its original intention to rely upon senior management to interpret its rules and to ensure that appropriate practices and processes are in place to deliver the respective outcomes.

Size matters

In larger firms, senior management is traditionally responsible for just the company. But in many smaller firms senior individuals are also heavily involved in service delivery to their customers. This can be viewed as both an advantage and a disadvantage. Hands-on involvement may make them more aware of the practices and processes which are customer-facing, which therefore have the highest impact on outcomes. But it also means they will have less time in which to carry out all of the necessary management activities to ensure they are, and remain, fully compliant. Senior management of larger firms is more likely to have the resources and/or ability to secure assistance or advice to ensure their responsibilities are being fulfilled. Perhaps more importantly, they are thus able to demonstrate this to the satisfaction of their regulator. Where insurers of all shapes and sizes must start is to ensure they can translate the FSA’s “11 principles for business” into the meaningful outcomes.

“Whether the market is ready to adequately respond to such a challenge at this relatively early stage in its regulatory development is questionable

The challenge for everyone is to find the related outcome. For example, “principle two” requires a firm to “conduct its business with due skill, care and diligence”. Although not immediately obvious, contented shareholders and happy customers might be considered fair indicators of fulfilment of this principle. The challenge with keeping investors and customers happy is that the two often require diametrically opposed actions. And even if a firm does keep its customers happy most of the time, can it easily demonstrate that fact? Is business retention, or lack thereof, a fair indicator? The latter is probably not in a highly commoditised area such as motor insurance, which is largely price-driven. In any case, the regulator may not agree that “happy customers” is a sufficient outcome for this or any other principle.

Having decided what the outcomes of the 11 principles are, the board then has to ensure these are suitably reflected in their business plan (although surprisingly, it is thought that a number of firms at all industry levels either still don’t have a business plan or don’t regularly undertake updates – with the same being true of policies and procedures). From there the relevant procedures, including those of internal audit, risk management and compliance departments need to be reviewed, developed and coordinated to ensure they too incorporate a focus on the outcomes-driven aspects of the firm’s activities.

Suppose, though, a firm has an incidence where it hasn’t been compliant with its own established procedures. Is that automatically a regulatory problem? Not necessarily, one would hope, especially if its procedures are reflective of a standard which is higher than the FSA’s minimum requirements.

Enforcement issues

The FSA has frequently stated that it will not be prescriptive about the procedures needed to deliver the required outcomes. However, clear guidance from the regulator will be essential during the development of principles-based regulation if the scheme is to be rolled out successfully.

The issue of enforcement seems to be a little uncertain too. Any legal enforcement would have to be on the basis of rules, even if those rules are really just principles. Surely any rule or principle which is to be legally enforceable will have to be clearly worded. It should be made clear what the accused has done that it shouldn’t have – or failed to do that it should have? These potential issues suggest that the FSA has some considerable work to do to provide clear statements of its outcome requirements.

There is a long and difficult road ahead and the UK?regulator has to lead the way, not just point the way. Senior management of regulated insurance companies who haven’t yet bought into the principles need to take decisive action to ensure that they and their entire staff embrace them in all that they do.

Colin Smith is associate director, James Schacht is managing director and Lynne Prescott Hepler is director in the insurance and claims practice of Navigant Consulting.

Would principles-based regulation work in the US?

With all the talk in the UK about principles-based regulation, one might wonder if a similar insurance regulatory approach could ever be successfully adopted in the US. There are some fundamental reasons why a move away from prescriptive rules to a set of general principles, that serve as the backbone of US insurance regulation, is nearly impossible. While the US shares common economic and legal traditions with its European counterparts, the regulatory approaches differ substantially.

The US has the distinction of being the world’s largest, most dynamic and highly competitive insurance market. Regulation of this complex financial sector has evolved in dramatic ways since the early 19th Century. Each generation has brought with it new pressures, and in response, new regulations and a growing bureaucracy.

In contrast to the UK, the US has no single integrated system of financial regulation, but rather a highly decentralised regulatory system that is influenced by other public and private institutions. Insurance regulatory policy in the US is formulated collectively by each state’s insurance commissioner, the legislature and the courts. The federal government overlays this entire structure, closely overseeing and reviewing the stewardship entrusted to the states for proper oversight.

In fact, it is believed that the success of state insurance regulation in the US demonstrates the best aspects of American federalism. This division of power between national authorities and state officials is really a hallmark of the US insurance regulatory system. The various constituencies in this system make it extremely difficult to garner support for the type of structural reform (ie consolidated regulatory functions with a focus on outcomes) that the UK has been able to achieve.

There is no question that in the US the insurance industry and insurance professionals serving the industry have preferred the certainty of rules to broad brush standards that might leave room for improvisation and interpretation. Looking back, history tells us that detailed rules have often resulted in response to the industry’s call to “tell us how to do it so we know how to comply”. Regulators in the US prefer the certainty of a rulebook to avoid being criticised for any unauthorised exercise of governmental authority. Regulators and professionals that are employed in the industry simply like specific rules to govern their work. The litigious and often combative environment in which the US insurance industry operates today demands a detailed statutory basis for not only regulatory action but also insurer conduct.

It is safe to say that the US has perhaps a more ambitious set of goals for its insurance regulatory responsibilities than is found in the UK. One need only look at the way insurance regulation in the US dramatically changed its focus in the 1960s from financial regulation to an equally important focus on market regulation and consumer protection. This continues to be true today. As a result, the US has developed a complex system of consumer protections that require an elaborate oversight and enforcement structure. Needless to say, this consumer focus has created yet another layer of regulatory compliance activity, making it even more cumbersome and difficult for the US to replace centuries of rules-based regulation with a set of overarching principles and axiomatic statements that articulate what “actions” and “behaviors” regulators would expect. Such a regulatory approach would be nigh on impossible to implement.