As the next wave of regulation approaches, the UK insurance industry has been increasingly concentrating on getting its house in order But the FSA regime is but one of many that impact and are changing the industry, says Andy King.

"Regulation won't go away

Regulation is here to stay

If you want to exist

You cannot resist

Shape up or

You'll get blown away!"

This was how Mike Spice, Senior Vice President and Chief Compliance Officer, AIG Europe ended his excellent and thought-provoking address to the annual general meeting of the UK's Chartered Institute of Loss Adjusters in April. In reality, these light-hearted words contain a number of serious and, for some, uncomfortable messages. But, as he pointed out, forward-thinking multinational organisations have been committing serious resources to the issues of regulation and governance for many years now.

As the world's largest insurer, AIG needs to address a constantly changing range of differing regulatory regimes, governance and legislative initiatives throughout the world.

The insurance industry has had its fair share of scandals over the years and, as part of the financial services industry, has inevitably been associated with (and sometimes been involved to a greater or lesser extent with) perceived failings of the financial sector. Wider still, as part of the general business community in a capitalist economy, operating largely through public liability companies, everyone is to an extent impacted when a major financial scandal or collapse occurs where the root cause is a systemic failure of systems, controls, management and supervision.

Those with long memories will no doubt recall the collapses of Fire, Auto & Marine in the 1960s, Vehicle & General in the 1970s, and the Sasse scandal at Lloyd's, also in the 1970s. These were followed in the 1980s by Alexander Howden, PCW, the LMX spiral, massive losses at Lloyd's and the subsequently litigation, and the personal pensions mis-selling scandal.

More recently, we have seen the collapse of Independent Insurance, endowment policies restitution rows, the Equitable Life affair and currently a savings and pensions crisis. In a wider context, there has been a whole host of corporate financial crises and failures, all of which have done their bit to heighten the mistrust and cynicism directed against financial services firms and business generally. Enron, WorldCom, Barings, Sumitomo, £1.1bn London market exchange loss, the Mirror Group pensions scandal and more have all contributed to a whole raft of new legislation and regulation.

More recently for the UK, the partial or total loss of thousands of pensions for workers in a variety of businesses, most recently at Turner & Newall and Ballast UK, has forced the Government into emergency legislation to try to shore up a pensions industry which is now openly distrusted by many. It is no coincidence that the UK's house price and 'buy to let' boom has been accompanied by poor performance, and in some cases failure, of many pension schemes. Rather than buy a financial product, people now prefer to take charge of their own affairs. Having contributed substantially to the poor performance of pension funds by his 1997 tax changes, UK Chancellor Gordon Brown's 'discussion paper' on taxing profits on house sales (hidden at the back of the single currency dossier) is being watched very closely and with much concern, not least because a house price crash will cause a further crisis of confidence in the financial system.

So, is it fair that the insurance industry now finds itself having to deal with a raft of regulation and governance issues? After all, many of the problems have been caused by changing global economic circumstances.

The problem is that the blame is laid fairly and squarely by the public at the door of the financial products providers. Thus it is with pensions that the fund members blame the company running the scheme, the trustees and also the fund managers, but the Government seems to escape censure.

Regulation is therefore being brought in to:

- regain the public's trust in financial services products and companies;

- protect the public, most of whom do not understand the financial products they are buying; and

- comply with the EU's Financial Services Action Plan as part of the journey towards a single integrated market.

Although much of the regulation coming in is prompted by the EU, given the recent sorry history of financial services and public mistrust, it is likely that the UK Government would have needed to impose some regulatory reform in any event.

The compliance and governance agenda

Clearly, the main concern for the sector leading up to the general insurance industry regulations has been compliance with the Financial Services Authority (FSA)'s rules as set out in the Integrated Prudential Sourcebook (PSB) which forms part of the 'Handbook of rules and guidance'. However, there is a whole host of regulatory and governance requirements currently exercising management, set out in Table 1. In addition, there are huge amounts of time and effort currently being spent on the adoption of International Accounting Standards and International Financial Reporting Standards.

Thus there are massive regulatory, governance and accounting change programmes underway concurrently, as well as a substantial volume of new measures currently being worked on.

Bearing in mind the lack of confidence in the market, the purpose of the Financial Services and Markets Act 2000 and the raison d'etre for the FSA are to:

- maintain market confidence;

- promote public understanding of the financial system;

- secure appropriate customer protection; and

- reduce financial crime.

The FSA is developing regulations to address particular themes, such as the fair treatment of customers and capital adequacy. The result should be a set of regulations which take into account the cost and benefits likely to be derived from them. It is this process that has led to the principles-based approach being taken and at a high level, leaving firms to apply the principles in a way that best addresses their business needs.

The FSA has set out the standards to be met in order to become authorised and to be maintained going forward. Very briefly these are:

- high-level principles covering integrity, skill, care and diligence, management and control, financial prudence, market conduct, customer interests, communication with clients, conflicts of interest, relationships of trust, client assets, relations with regulators; and

- capital adequacy rules based on risk management and assessment frameworks.

This is long-term work in progress and adapts to Basel Committee philosophy.

CP190 sets out the principles. Currently, insurers calculate a minimum capital requirement (MCR) known as Solvency I, which in time will be superseded by Solvency II. In the meantime, the FSA expects insurers to develop a new risk-based enhanced capital requirement (ECR).

In addition, the FSA is developing individual capital adequacy standards and will apply these to give individual capital guidance to firms.

How are firms coping?

A couple of studies have thrown up mixed messages for the insurance industry.

In its 'Review of UK Insurers Risk Management Practices', published in October 2003, the FSA concluded that many risk management systems have been designed for the purpose of compliance rather than for delivering effective risk management. Other findings from the study included the lack of division of duties between those taking on and contributing risks day-to-day and those involved in identifying and analysing risk. The study also noted that many firms had not set out their appetite for or tolerance of risk, and that risk reports did not form part of the general management information in a significant minority of cases. Although the use of modeling techniques for underwriting and reserving was found to be on the increase, the study found that these models were not subsequently used as benchmarks against actual results, and that few firms collected operational loss data for use in models.

In my opinion, that final point is indicative of UK insurers' approach to losses, which historically has been to treat losses and those who deal with them as a cost to be minimised. Given the principle of treating customers fairly, it should be of concern that the FSA's survey has revealed that this attitude still prevails.

Better news for insurers comes from the Institute of Financial Services' 'Hidden Value' survey carried out by Deloitte, HP and Oracle in February 2004, published in April 2004. This survey of the entire financial services industry found that "insurance companies seem to have created a more integrated approach to managing regulatory change. This is perhaps a reflection of the smaller size of the corporate centre of many insurers and the slightly lower number of regulatory changes they face - although those changes are impacting on the industry in fundamental ways. It could be that the insurance industry has learned lessons that some parts of the banking industry have not."

The industry is thus trying to get its act together and generally appears to be going down the right road of integrating a regulatory risk management and management information culture into everyday business life. However, there are a couple of areas which may suggest that the fundamental reason behind all this activity - the protection and fair treatment of the customer - is being forgotten.

The first of these is outsourcing. A paper by KPMG published in June 2004 entitled 'Avoiding the regulator red flag on outsourcing' highlights the concerns European, American and Asian regulators have in respect of outsourcing. These include concerns over the types of activities being outsourced, which have moved up the value chain from the back office to front-office activities much closer to the heart of regulated financial activities. This may be compounded by many outsourced activities being moved offshore. The concerns here are firstly the extent to which the specific risks of the locality have been fully considered, and secondly the extent to which the central management function is weakened. Finally, there is a question mark over the failure rate of outsourcing. Indeed, in a number of recent high-profile cases, financial organisations have brought outsourced activities back in-house. KPMG observes that, taken together, these developments have led to regulatory perturbation that there could be increased poor service for customers.

The second area is the matter of continuing poor service to customers.

A recent Financial Ombudsman Service report highlights the fact that a growing number of complaints continue to be made across all classes of insurance. In particular, the report comments that one of the fastest-growing areas of complaint is in respect of poor quality work by 'managed' contractors sent in by the insurers to carry out repairs. Furthermore, a recent survey undertaken by Deloitte highlighted the poor claims service brokers said they were receiving from insurers. All of this suggests that you can have the best management information systems and technology in the world, but without the right people to deliver the promise to the customer, or without fair fees or salaries for those in the frontline, then according to the FSA you will have failed and will be subject to sanction.

So what of the future? The delivery of a single market for financial services under the Financial Services Action Plan will lead to more directives.

For insurers, the recently formed Committee of European Insurance and Occupational Pensions Supervisors will become increasingly influential.

Solvency II will continue to be developed for insurers. And the FSA will become increasingly active with those insurers which continue to attract complaints from their policyholders. In this regard, senior managers should remember that they will be held accountable for their firms' breaches of the FSA's principles. Large investments in technology will not be sufficient to ensure that the customers are being treated fairly.

As Tim Kirk and Philip Middleton of Ernst & Young state in their paper on treating customers fairly entitled 'Is it Fair?': "Changing processes alone will not be sufficient to put fairness in place. While changes are likely to be required to processes covering product development, advertising and marketing, sales and advice, after sales service and complaints handling, equally important will be developing a culture that demonstrates respect for customers and staff and ensuring people management strategies and processes treat staff fairly - a pre-requisite if staff are going to treat customers fairly."

Some individuals in the insurance industry need to take that philosophy on board very quickly indeed.