UK: The Future Regulation of Insurance

Last Updated: 26 April 2002

Following the well publicised problems at Equitable Life, the Board of the Financial Services Authority commissioned a report by its Director of Internal Audit into the FSA’s regulation of Equitable. The Baird Report made various recommendations regarding the regulation of life insurance and the Government requested a further report from the FSA covering the action it has taken, and intends to take, to implement these recommendations.

The FSA recently published its report titled "The future regulation of insurance". The report is made against the background of a period of intense regulatory change, particularly the coming into effect of the Financial Services and Markets Act 2000 and the new FSA Handbook on 1 December 2001 (N2).

This article summarises the main proposals in the report, a number of which could be significant to the insurance industry. John Tiner, the Managing Director of the FSA’s Consumer, Investment and Insurance Directorate, will take forward the work to strengthen the regulatory regime for insurance companies and is due to have completed this project by September 2002. The Tiner Project will need to have regard to relevant recommendations emerging from other external reviews such as Lord Penrose’s enquiry into Equitable and Ron Sandler’s review of the long term retail savings market.

Securing a fair deal for consumers

The FSA is looking to help secure the fair treatment of consumers by improving the regime for disclosing relevant information throughout the life cycle of a product, from its promotion, to its point of sale and through the period after the point of sale.

The FSA has already commenced a wide-ranging review of with-profits products (having produced, for example, issues papers on with-profits disclosure and governance). In addition the FSA has issued guidance to life companies that have sold with-profits policies with guaranteed annuity options which explains how they should assess any exposure to an Equitable-type situation and the action they may need to take to address the position of affected policyholders.

The FSA has also published a consultation paper proposing changes to the current rules on polarisation which state that advisers on life insurance, personal pensions and unit trusts either have to be independent and advise across all products and companies on the market or, alternatively, have to represent just one company and sell only its products. A limited exception was introduced last year in relation to stakeholder pensions. Options under consideration include the creation of a new category of multi-tied firms; please see the box on the next page.

As well as improving the disclosure of key information after the point of sale, the FSA aims to bring about a lowering of barriers that prevent consumers from switching products to secure a better deal.

Ensuring that insurance companies have sound management and adequate financial resources

Significant changes to the prudential regime for insurance companies took effect on N2, including the introduction of group solvency requirements. However, the FSA intends further strengthening of this regime by improving the basis on which solvency requirements are determined, by placing more explicit responsibility on firms’ management to maintain proper systems and controls, and by improving public and regulatory reporting.

Inevitably one of the major changes which lies ahead for the insurance industry will be the introduction of the integrated prudential sourcebook, currently programmed for 2004. Other possible changes relating to the financial soundness of insurance firms include a review of the use of financial reinsurance, which will pay particular attention to the arrangements that do not result in a material transfer of risk to the reinsurer, new guidance tightening the requirements on firms to demonstrate the existence of future profits and better disclosure of subordinated debts and contingent loans creating a charge over future profits.

The European Union is currently reviewing the solvency margin requirements for insurance firms. The FSA states that it is encouraging other regulators to move towards a system which is broader in scope, more transparent, has minimum capital requirements that are more responsive to the risks which insurance firms face and changes the minimum requirements to a more realistic but proportionate level. This review - known as Solvency II - is not expected to be completed before 2005.

The FSA recognises that accounting standards are also crucial to the assessment of solvency and the report states that the FSA supports the move towards a fair value model for insurance accounting.

The second element of the FSA’s approach to prudential regulation relates to sound management.

The FSA intends to take a significantly closer and more active interest in the role of the Boards of insurance companies. Firms will need to ensure that they have a sufficient range of skills and experience on their Board to provide both proper control and independent challenge, including suitably qualified non-executive directors. The FSA recognises that this is not a new area of supervisory attention but states that it will be given increased weight under the new regime.

It is recognised that the role of the appointed actuary is important for the proper corporate governance of life insurance companies. The FSA has issued a consultation paper on the future of the appointed actuary’s role. This examines issues such as the best way to achieve independent external review of the work of appointed actuaries and concerns about the potential for conflicts of interest. It also appears likely that proposals will be made to prevent the appointed actuary having other responsibilities as a director or senior executive of the company.

The FSA intends to strengthen its requirements for senior management arrangements, systems and controls by requiring insurance companies to maintain risk management teams, including actuarial, legal and financial skills, to apply appropriate controls over the business. There is a recognition that legal risks have assumed increased importance in recent years and the report states that firms should maintain the necessary resources to identify legal risks on a timely basis and should determine their strategy in respect of such risks. Insurance companies will also have to determine and document policies for dealing with risk and demonstrate how combinations of risk have been aggregated and mitigated. Firms will be required to have a written business plan documenting the policies, methods and assumptions used.

As regards regulatory reporting, the FSA has issued a discussion paper on improvements to regulatory returns for with-profits business. A more fundamental review of regulatory reporting is also under way.

Smarter regulation of insurance

The Baird Report was critical of the FSA’s prudential regulation of insurance firms as tending to be too reactive and over reliant on desk based analysis of returns. The FSA intends to deliver a more proactive and challenging risk-based approach to regulating insurance. It has also made a number of structural and management changes to improve internal co-ordination and communication within the FSA.

The FSA has already decided to adopt a risk-based approach to regulation under which resources are prioritised to focus on the most significant risks to the FSA’s statutory objectives. This approach includes a comprehensive and structured way of assessing material risks in insurance companies and the selection of tools (such as the use of skilled persons reports and specialist visits to firms) to mitigate the specific risks within a firm.

This approach depends on the FSA’s assessment of the impact on its statutory objectives if risks within a firm materialise and of the probability that these risks will materialise. A higher proportion of the FSA’s resources will be devoted to supervising those firms that pose a higher risk to the FSA’s statutory objectives. This includes those posing a risk to the FSA’s consumer protection and public understanding objectives. The FSA states that it has a close and continuous relationship with higher risk firms, while, at the other end of the spectrum, it maintains routine oversight of the lowest impact firms.

The FSA also looks to identify firms that have particular characteristics which may be a cause for concern. Such characteristics include unconventional corporate governance or business models, growth which is more rapid than the rest of the sector, premiums or loss ratios that are out of line with the market, and firms which have already experienced material prudential or conduct of business failures.

The FSA is looking to develop more effective working relationships with higher impact insurance firms. The FSA’s key focus will be on forming judgments on the competence of management, whether the firm’s business strategy poses risks to the FSA’s statutory objectives, the culture and controls which the management establish throughout the business and the strength of the control processes.

Supervisors and FSA risk specialists will spend more time on site at insurance firms (with a greater proportion of that time spent at higher impact firms). Greater use will be made of skilled persons (such as external auditors or other external specialists) in insurance supervision. This mirrors the approach that has been used in banking supervision for a number of years.

One change that will already have been seen by a number of larger insurance companies is the switch to supervision by the Major Financial Groups Division in order to allow a common approach to regulating large financial services groups.

The FSA also wishes to make greater use of market intelligence. The FSMA already includes provisions relating to whistle-blowing by auditors and actuaries, but in the report the FSA encourages members of theindustry to inform the FSA of doubtful practices, or concerns about particular firms or individuals, of which they become aware. The FSA also intends to use former senior industry executives – called insurance "grey panthers" - as advisers to insurance supervisors.

Finally, there is a recognition that there must be cultural change within the FSA. Supervisors need to be proactive, apply judgement, think laterally, challenge the behaviour and assertions of firms (including "thinking the unthinkable") and act quickly whenever they identify a potential issue.

It is recognised that these changes in approach and the implementation of recommendations from the Tiner Project will require more resources, which will have to be paid for through an increase in fees. The FSA is required to conduct a cost benefit analysis when bringing forward proposals for amending insurance regulation but, at the moment, it seems inevitable that the priority will be avoiding another Equitable or Independent Insurance rather than restraining the rate of increase in expenditure on regulation.


The creation of the FSA as the new regulator of the financial services industry and the introduction of the FSA Handbook has meant a great period of change in the regulation of insurance companies. Even though N2 has now passed, the insurance industry must expect a large number of changes to its regulatory regime over the next four years.

The end of polarisation?

The FSA published a Consultation Paper in January 2002 which sets out the FSA’s proposals in relation to polarisation. The FSA’s research indicated that most consumers would go to a tied adviser of a known product provider, rather than an unknown independent financial adviser. The FSA has found that this often meant that consumers ended up with a less than suitable product, or a product which offered poor value.

The FSA has proposed, therefore, that polarisation should be abolished and new, enhanced disclosure should be introduced. Accordingly, the cost of advice would be "unbundled" from the cost of the product.

As regards independent financial advisers, it is proposed that they should charge their customers fees for advice, rather than taking commission from product providers. Also, the "better than best" rule would be disapplied. (The "better than best" rule is the requirement whereby an independent financial adviser can only recommend a product of a product provider connected with the adviser if that product is more suitable than other products which are generally available.)

As a result, the FSA recognises that product providers might wish to invest in independent financial advisers; this might help firms adapt to a fee-based (rather than commission-based) environment. Consumers would, it is thought, be protected from the disapplication of the "better than best" rule by a full disclosure requirement in relation to any stake which a product provider has in the independent financial adviser.

The FSA considers that an overall effect of the proposals would be that some tied advisers and independent advisers would choose to give up their tied or independent status and, instead, become distributor firms for a limited range of product providers ("multi-ties").

© Herbert Smith 2002

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

For more information on this or other Herbert Smith publications, please email us.

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