This issue of Insurance and reinsurance news is an update on the first three months of the UK’s new regulatory regime as it affects the insurance sector. We highlight some of the most important trends that have become apparent or have continued to develop over this period. We have considered the regulatory policies of both the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA).
The new regulatory regime came into force on 1 April 2013. It replaced the unified regime of the Financial Services Authority (FSA).
To recap briefly, macro-prudential oversight is now vested in the Financial Policy Committee (FPC). The PRA has responsibility for the prudential regulation of (re)insurers, banks and the more significant investment firms, while the FCA has responsibility for conduct regulation and for prudential regulation of the remaining UK regulated firms.
The PRA and the FCA have distinct regulatory objectives and responsibilities. This split was anticipated for a considerable period by divisionalisation within the old regulator but even now it is not fully accepted by some parts of the industry. The Smaller Businesses Practitioners’ Panel remarked:
‘The new structure of two regulators has an inherent danger of overlap and underlap. Although there is an overall statutory duty to co-ordinate, we believe that this split will introduce additional risks and greater costs into the system, which will not necessarily be better for the significant number of smaller firms which will be dual regulated.’
The FSA as a single unified regulator, however, struggled to cope with the banking crisis. This may have been partly because the then regime did not focus adequately on the macro-prudential perspective. It remains to be seen whether a tri-partite regime is more successful.
On the positive side, however, the split has allowed the FCA and the PRA each to focus more firmly on their respective priorities and new approach to regulation. In this respect they perhaps now have more flexibility than would have been possible during the FSA period.
In the insurance sector the split has proved most difficult to define in relation towith-profits business, where prudential and conduct supervision are most closely linked.
Under the government’s initial proposals the PRA was to have had (as between itself and the FCA) primary responsibility for the fair treatment of policyholders. Ultimately, however, most of the with-profits expertise within the FSA migrated to the FCA. Under the PRA/FCA memorandum of agreement the PRA is primarily concerned with firms being adequately resourced to meet their obligations to policyholders, although it retains the right effectively to veto action by the FCA. Fair treatment of with-profits policyholders is now the responsibility of the FCA.
It remains to be seen how co-operation between the two bodies develops as regulation of with-profits is adapted within Solvency II. The FSA’s first attempt at a Solvency II compliant with-profits rulebook, in CP12/13, was criticised for going beyond what was necessary for that purpose. The next draft is unlikely to appear until 2014 at the earliest.
Recovery and resolution
Speeches since the beginning of this year by Andrew Bailey, CEO of the PRA, indicate that recovery and resolution will continue to be an area of focus, particularly in relation to with-profits business. So the firms concerned will need to develop recovery and resolution plans. This initiative will be influenced by, but independent of, the current work of the International Association of Insurance Supervisors and work carried out by the European Commission.
Solvency II is due to create a new prudential regime for European insurers and reinsurers. It is still deadlocked by a number of issues, most particularly the treatment of long-term guarantees. The European Insurance and Occupational Pensions Authority (EIOPA) has now made its recommendations on the regulatory treatment of such guarantees. There are still concerns, however, that the outcome could be lower annuity levels for future pensioners.
The European Commission is unwilling to commit to a new date for the regime to come into force. It is unlikely that it will be before 2016, although some commentators now anticipate a 2017 start. Firms will, however, be able in the interim period to make some use within Solvency I of the work they have done on developing internal models for Solvency II.
The PRA has adopted a new line on Solvency II which contrasts with the policy of its predecessor. It is now echoing industry criticisms of the expense of the project and the burden it has placed on industry and consumers. The PRA has emphasised the need to ensure that, even within a ‘maximum harmonised regime’, it should retain a judgment-based approach to supervision, and the same flexibility that it currently has to require firms to retain additional capital, where it believes that to be justified. This may be difficult to reconcile with the Solvency II directive text.
Meanwhile the European Insurance and Occupational Pensions Authority (EIOPA) is arguably pushing in the opposite direction, calling for an increase in its powers, to include a role in the supervision of the major European insurance groups.
The FCA’s agenda
Since ‘legal cut over’ in April the FCA has continued to drive forward its regulatory agenda. It aims to anticipate problems within the financial sector rather than just reacting to them as the FSA is considered to have done. Key aspects of its agenda include:
- further emphasis on the need to achieve suitable customer outcomes, not only at the point of sale but also at the point of design and distribution by the producers themselves;
- engineering a change in culture within firms which puts fair customer outcomes at the heart of firms’ business models and demonstrating that culture to FCA supervisors;
- applying governance requirements to the development of products, coveringthe features of the product itself, howit is distributed and post-sales responsibility; and
- articulating the FCA’s new competition objective so that firms anticipate and address indicators of concern which may give rise to regulatory action, such as a product that has excess profitability, cancellation charges that are too high or where consumers are regularly buying products which are unsuitable.
The FCA’s powers
The FCA’s agenda will be backed up by extensive use of its existing powers. These include requiring skilled persons reports under section 166 of the new Financial Services and Markets Act 2000 (FSMA), regular articulation of its expectations through guidance and letters to CEOs (often a more flexible means of communication than its rulebook) and greater focus on requiring firms proactively to offer redress to customers who may have been the victim of mis-selling or poor claims practices.
The FCA’s new tools under FSMA now allow it to prohibit the sale of inherently flawed products or apply specific requirements to them. The FCA expects to use these new tools rarely. Instead it hopes that the threat of these new tools will be sufficient to encourage firms to make the appropriate changes to their products.
Thematic reviews have emerged as a key FCA tool in the insurance sector. The FCA’s first thematic review report, in June 2013, covered legal expenses insurance (LEI) sold in conjunction with motor insurance. It identified a number of practices which the FCA regarded as undesirable, including the inclusion of LEI in offers of motor insurance cover on an ‘opt out’ rather than an ‘opt in’ basis. The FCA has pledged to revisit its work in 2014 to see how the industry has responded.
Two further ongoing thematic reviews are aimed at addressing potential problems and establishing whether there is a case for the industry to answer, rather than reacting to identified mis-selling trends.
The first of these covers the sale of annuities. It will consider whether there are any impediments to consumers exercising their ‘open market option’. This option allows consumers to buy their annuity from a firm other than their pension policy provider. There is evidence that the open market option is not exercised as often as it should be, where consumers might get a better annuity rate by switching provider at the point of purchase.
The second current thematic review is focused on general insurance selling, with particular regard to household and travel insurance. It will consider how customers are being treated in the claims processes including whether the resources that firms devote to those processes are reasonable by comparison to resources devoted to the sales process.
Other areas to which the FCA may turn its attention in the medium term include products which have generated significant increases in complaints to the Financial Ombudsman Service. Medical insurance complaints have increased by 85 per cent in the last year and critical illness complaints by 68 per cent.
Significant influence functions
The maintenance of appropriate systems and controls in regulated firms and across financial groups continues to be an area of focus not only for the PRA and the FCA, but also for the Society of Lloyd’s in its own regulatory capacity.
The regulators expect approved persons discharging significant influence functions to take full responsibility for those systems. This expectation may also be influenced by Parliament, where Andrew Tyrie, Treasury select committee chair, has suggested that bankers who are guilty of wrongdoing should be put in ‘orange jump suits’ to act as a deterrent.
In recent enforcement action by the FSA, the FCA and Lloyd’s, prohibition orders have been made against senior management even in cases where the individuals concerned had identified and addressed systems and control problems, but where the action taken was not considered to have been adequate, or was not applied as quickly as the regulator expected.
A similar approach will doubtless be applied in the future where the FCA’s product governance expectations are not met.
The PRA has also indicated that it will take enforcement action, outsourcing the process itself either to the FCA or to outside professional firms. Its enforcement agenda can be expected to extend to its own approved persons in insurers and banks. It may also extend to other areas of its prudential rulebook which have tended not to feature historically in FSA enforcement action.
Apart from approved persons exercising significant influence functions, both the PRA and the FCA have published policy statements, broadly in similar terms, indicating how they expect to use their new powers in relation to parent companies under Part 12A of FSMA. These powers allow them, among other things, to take action ‘where one or more directors of the parent company appear not to be fit and proper, or suitable’.
This applies regardless of whether the director concerned is exercising a controlled or significant influence function in any regulated subsidiary of the parent company. Indeed a number of episodes within the financial crisis have shown that problems within financial groups can arise regardless of the relationship, if any, between those responsible for the problems at parent company level, and the individual corporate members of the group.