The Financial Services Authority (FSA) published its paper Principles-based regulation – Focusing on the outcomes that matter on 23 April 2007. The paper is the latest stage in the FSA’s move towards principles-based regulation and clarifies its approach in this area, which has been defined as ‘placing greater reliance on principles and outcome-focused, high-level rules as a means to drive at the regulatory aims we want to achieve, and less reliance on prescriptive rules.’ The paper also considers the implications and challenges arising from principlesbased regulation for the FSA and for the firms it regulates. Principles-based regulation and enforcement are not new concepts for the insurance sector to grapple with. The wholesale insurance market has already successfully responded to the FSA’s principles-based approach to contract certainty. Industry bodies such as the Market Reform Group played a lead role in shaping the wholesale sector’s solution to the problem and in providing guidance on how contract certainty could be applied by firms in practice.
The retail insurance sector has also been in the front line of principles-based enforcement, particularly in the context of the FSA’s treating customers fairly (TCF) initiative (for example, in relation to the sale of payment protection insurance (PPI) products). This trend looks set to continue given the FSA’s continued work in this area. The advantages of principles-based regulation for consumers, the FSA and firms are widely accepted. It will undoubtedly give firms greater flexibility and freedom from slavish compliance with detailed rules; however, it does give rise to a number of challenges.
The FSA’s consultation on a differentiated and more principles-based approach to Insurance Conduct of Business Rules (ICOB) regulation will be a crucial next step for insurance firms in the move towards principlesbased regulation. The consultation paper is due to be published in June, with rules changes taking place in December 2007. The FSA has already given indications, following its interim review of the general insurance markets, that it is considering grouping general insurance products into two broad groups where the risks of consumer detriment are different. It has identified that greater risks of consumer detriment are found for those buying personal protection products such as payment protection and critical illness cover than for those buying more commoditised, general insurance products such as household or motor policies. For such commoditised products, the FSA has found that markets work reasonably well in the interests of consumers. The results have led the FSA to question whether some of the detailed rules and guidance are proportionate to the limited risk of detriment that consumers of these products face.
It is therefore looking at removing most of the ICOB requirements for firms that go beyond the minimum necessary to comply with the Insurance Mediation and Distance Marketing Directives requirements. This would not result in a reduction of consumer protection or a relaxation of the standards that the FSA expects of firms as the FSA has stated that high-level standards set out in its Principles for Businesses (Principles) and a small number of high level rules would continue to provide the protection that consumers need.
For personal protection products such as payment protection and critical illness, the FSA’s review has found that existing regulation of firms’ selling practices has an important role in reducing the risk of consumer detriment for those buying personal protection products. Reflecting the greater risks with personal protection products and their sale, the FSA is considering a small number of measures to improve selling practices of such products and to enable customers to receive better information about the nature of the sale and the product. The FSA is also exploring whether it can delete detailed rules and guidance on unfair inducements and financial promotions and instead rely on its Principles. The FSA has already emphasised in the context of general insurance financial promotions that firms’ focus should be on the outcome to be achieved and not on compliance with detailed rules. For example, in January 2007 the FSA warned insurance firms to stop using savings claims in their advertising that could mislead consumers, or face regulatory action. The warning followed an FSA review of press advertisements from 57 firms selling motor, home and travel insurance. The review showed that 57 per cent of motor advertisements and 25 per cent of home advertisements failed to provide any evidence as to how claimed savings would be achieved. Firms’ senior management were expected to review their current promotions and decide what action, if any, they needed to take. Where they concluded that their promotional material was not ‘clear, fair and not misleading’ they were expected to withdraw or amend the promotion. The FSA warned that it would continue to keep general insurance advertising under close watch and would take appropriate regulatory action against firms where appropriate.
The cultural challenge of principles-based regulation
High-level principles have been part of the FSA’s regulatory regime since its inception; however, its move to focus on principles and outcome-focused rules, rather than detailed rules prescribing how outcomes must be achieved, is a significant cultural shift for insurance firms. The role of senior management The FSA has stated that its more principles-based approach to financial regulation gives firms the flexibility to determine how best to align good business practice with good regulatory outcomes and that ‘senior management teams naturally play a more central role in this type of regulation.’ For financial promotions the FSA has stated that the major challenge for firms’ senior management is to take more of a lead in ensuring that effective systems and controls are in place around their advertising and marketing and that they receive and act on quality management information. The FSA recognises that how this will be done will vary from firm to firm but that the outcome is the same – senior management must be capable of satisfying themselves that promotions for their firm’s products are clear, fair and not misleading. This approach is echoed more generally in the FSA’s recent paper: ‘firms will have increased flexibility in how they deliver the outcomes the FSA require… Responsibility for key regulatory decisions will move to more senior levels, challenging firms’ compliance, risk management and internal audit functions as they provide the necessary support to senior management and Boards’.
The changing role of compliance
The role of compliance departments will need to change to support senior management in making decisions and to ensure that the decisions taken by senior management are reflected in the way a firm’s business is conducted. Compliance personnel will need to acquire a deeper understanding of the way a firm’s business works and of the FSA’s expectations.
Studying FSA/industry guidance and other communications
Understanding the FSA’s expectations will be increasingly challenging, as guidance will be set out in a variety of sources, including industry publications and FSA communication documents (such as Dear CEO letters, newsletters, case studies and statements of good and less good practice) and in the FSA’s Handbook. Recent examples in the insurance context already include:
- the FSA’s guide to brokers on client money requirements;
- statements of good and poor practice on consumer friendly statements on the use of discretion in withprofit funds, on selling general insurance products through call centres, and on advertising general insurance products; and
- various guides to what constitutes good practice when selling or advising on PPI.
Guidance developed by the insurance industry, designed to meet FSA minimum standards and help firms in areas where they want more detail to provide them with a ‘sturdy breakwater’ (but not a ‘safe harbour’) will also increase in importance. Although the FSA has not yet formally introduced its confirmation process for industry guidance, it has in effect already adopted this approach in the insurance sector. A recent example is the Association of British Insurers’, in partnership with others, Guide to the Individual Capital Assessment Process for Insurers (published February 2007), which provides commentary and examples of how firms may achieve FSA standards and objectives for individual capital assessments.
Embedding principles-based regulation throughout the firm and across all business processes
Firms must ensure that all their staff, particularly those who make decisions about product design and who deal with customers, understand the outcomes the firm and the FSA expects them to achieve. Where, for example, systems such as remuneration structures encourage or provide incentives to staff to act in a way that might not be compatible with the FSA’s objectives, those systems will need to be carefully reviewed. Again, senior management will bear responsibility for ensuring that the cultural change is embedded throughout the organisation.
The FSA has made clear that the effect of these changes should be to break down distinctions between business and compliance decisions so that many firms ‘will find a closer fit between meeting their business objectives and meeting regulatory requirements’.
Dialogue with the FSA
The relationship between firms and their FSA supervisors will also change. Principles-based regulation will be inherently less certain than a regulatory system based on detailed rules. Firms will therefore need to engage in a much closer dialogue with the FSA to ensure that they understand the outcomes it expects them to achieve and that it is content with important decisions they take to achieve those outcomes. The FSA has said in its recent paper that relationship-managed firms will have a supervisory team with the necessary skills and knowledge to make sound judgements, based on good business understanding of the firm and the sector in which it operates. Quality and training of FSA staff will not only ensure consistency in approach across the supervisory teams but will be key to ensuring that this works successfully in practice.
If principles-based regulation succeeds in embedding a new outcomes-focused culture in firms, levels of enforcement action should drop. However, the FSA has indicated that it is prepared to take enforcement action based on breaches of principles or outcomes-focused high-level rules and a number of recent enforcement cases, particularly in the TCF context, are already examples of this.
A number of concerns have been raised relating to the use of principles-based enforcement and, in the view of many firms, these have not yet been fully addressed by the FSA. These include concerns that the FSA should compare a firm’s conduct against the standards and guidance accepted and available at the time of the conduct and not at the time of the enforcement action. The FSA has given assurances that it will take enforcement action only where it was reasonably predictable at the time of the conduct in question that the relevant rule or principle would be breached. Some firms fear that this may be difficult to apply in practice. The FSA also needs to provide greater clarity on the role that its guidance (or industry guidance endorsed by the FSA) will play in enforcement action. On the one hand, the FSA has indicated that firms can adopt a ‘take it or leave it’ approach to guidance. It has stated that guidance is a ‘shield not a sword’ so that, while action will not be taken against firms that comply with relevant guidance, firms that comply with a particular rule or principle without following relevant guidance will not be subject to enforcement action on the basis of failure to comply with the guidance. On the other hand, the FSA has indicated that guidance may be used in enforcement cases as ‘background’ to show prevailing standards of the time or to show the significance of a regulatory issue. Many firms may choose to adopt the cautious approach of complying with guidance, rather than attempting to achieve regulatory outcomes in alternative ways. This may inhibit the innovation and flexibility principles-based regulation is intended to achieve and allow informal guidance issued by the FSA and FSA-approved industry guidance to operate as a rule without the consultation and cost benefit analysis the FSA is required to undertake before creating formal rules.
Firms that wish to avoid enforcement action should, as well as developing a new outcomes-focused culture, keep an eye on the extent to which the concerns discussed above are addressed by the FSA. In the meantime, firms should keep a record of how difficult or important decisions concerning principles-based regulation are taken to protect their position if the FSA later calls into question those decisions.