Is there a ‘culture of compliance’ which permeates, or should permeate, the operations of London Market firms, or can firms’ approach to business dominate their approach to compliance?

How should the London Market react to the FSA’s Final Notice dated 8 May 2012 in respect of Mitsui Sumitomo Insurance Company (Europe) Limited (“Mitsui”) (the “Mitsui Notice”)?

  • Does the notice reveal no more than an isolated example, of no statistical or thematic significance? 
  • Alternatively, does the Mitsui Notice simply reflect longstanding regulatory concerns about structural management controls in financial services markets overall, and it just so happens that Mitsui fitted the bill on this occasion?
  • Or should the case be seen as a watershed, even a wake-up call, for the London Market as a whole?

The general pattern of previous insurance market-related sanctions has comprised matters involving customer detriment (eg data or client asset compromises) or financial crime considerations (eg insufficient systems and controls around anti-bribery or money laundering).  However,  the Mitsui Notice sets out a wide-ranging critique of a firm’s strategy and governance, and goes on to infer that policyholders and market confidence were put at risk by these high level failings in potential contravention of the FSA’s statutory objectives.

Given the factual findings and regulatory judgments set out in the Mitsui Notice, as explained below, it may or not be a coincidence that a speech on 24 April 2012 by Hector Sants, the outgoing FSA chief executive, contained the following passage:

“A diverse board encourages creativity and is less likely to demonstrate ‘group think’ and ‘herd mentality’.

However, having just one non-executive with specific industry knowledge on a large insurance company board is clearly not adequate ...”

Further, Julian Adams, the FSA’s Prudential Business Unit’s director of insurance supervision, emphasised the importance of effective governance in speeches on 19 April and 15 May 2012, including the following words (in the context of model reviews under Solvency II, but with wider implications):

“The governance process needs to add value and challenge, and not simply be a box-ticking exercise through committees.”

The principal lesson of the Mitsui Notice is that major changes in business strategy, particularly involving moves into new markets (whether in terms of geography, business sector or product line) require “careful and focussed oversight” at board level. The FSA found that Mitsui failed to change its board and senior management to reflect its move into new markets, leading to ineffective control and oversight.

It now seems beyond doubt that firms will be operating at a very high risk of enforcement action unless they have:

  • A board and senior management with a thorough understanding of the firm’s business strategy, risk appetite and the regulatory culture of the markets in which their firm operates, and who can demonstrate that understanding when questioned (as they almost inevitably will be) by the regulator;
  • governance structures which include effective segregation of responsibilities, and checks and balances on executive power, including board members with the technical capability and personal character to debate issues with the executive;
  • robust systems and controls, and management information which is not only targeted but actually reviewed and acted upon;
  • a corporate willingness to recognise and resolve problems promptly;

and can demonstrate these characteristics to the regulator.

In addition to this broad message, there are some further points to take from the case  which are less immediately obvious, but nonetheless important.

  • The FSA categorised Mitsui as a “Medium to Low Impact firm” in terms of its systemic significance. Such firms have not been subject to the FSA’s “close and continuous” supervisory regime, but the Mitsui Notice shows that they can nonetheless expect a stringent and challenging approach from the regulator when issues are identified, and should operate their business on the assumption that close regulatory scrutiny is always a possibility. It would be a mistake to assume that the more intrusive supervisory approach which has been indicated by the Financial Conduct Authority (“FCA”) will be limited to High Impact firms.
  • Enforcement action will likely follow when the regulator discovers evidence of management failure even where there is no evidence of adverse outcomes, such as customer detriment, affecting anyone outside the firm – a sufficiently material risk of such outcomes is likely to be inferred and therefore become grounds for an enforcement action.
  • In reaching its conclusions the FSA appears to have relied upon the findings of an independent consultant commissioned by Mitsui’s holding company after a meeting with the FSA. Given the well publicised concerns of the insurance industry about the possibility that the new regulators will lack insurance expertise (a criticism which was also levelled at the FSA) at senior and front line levels, it may be that the new, more intrusive and assertive supervisory approach will require extensive use of such third party expert reports. Such reports may be wide ranging, detailed and, therefore, expensive.  If the new regulatory legislation will grant the FCA and PRA wider powers than those the FSA currently has to appoint third parties to investigate and provide reports into a firm, and to recover the cost from the firm, this may add to the regulatory costs faced by firms in the future.
  • There is an interesting connection between the focus on governance in the Mitsui case and Solvency 2. As is well known, an insurer’s decisions as to the levels and types of capital employed must result from a continuous process of identifying, evaluating and managing internal and external risk. The FSA decided to increase Mitsui’s Individual Capital Guidance to include a loading for the issues it had identified in its investigation. The case therefore offers a possible indication of the future approach of the regulator to the impact of risk management failure on capital allocation. Insurers should therefore take control of their risk management strategy and its alignment with their capital strategy, to avoid imposition of requirements by the FCA and PRA. The capital impact of unexpected developments was also something addressed in Julian Adams’ speech of 15 May.
  • The FSA has of course actively promoted ‘Treating Customers Fairly’ or ‘TCF’ as a business philosophy and methodology. While the bulk of the focus was on the treatment of private individuals, the principles underlying TCF were always capable of application to commercial customers.  The FCA intends to apply these principles more extensively, in particular by deploying the concept of “wholesale consumers”, which includes corporate purchasers of insurance which are not themselves regulated insurance risk-carriers or intermediaries. The FSA has also said, in its ‘Financial Conduct Authority: Approach to Regulation’ paper of June 2011, that it recognises

“that wholesale conduct can have implications, including systemic consequences, beyond the confines of the transaction or market in which it takes place … [so the FCA] will take a much greater regulatory interest in whether various wholesale markets have the potential to damage the interests of consumers and the wider economy.”

The Mitsui Notice is a portent of closer attention from the regulator to wholesale firms operating in specialist markets.  Has the London Market heard the wake-up call?