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Good afternoon and thank you to the Institute for inviting me to speak at today's lunchtime lecture. It is an honour to be opening the pre-Christmas programme in the London Institute's Centenary programme year. As I'm sure Robert will agree, the prospect of addressing an audience of such seasoned practitioners on a blustery autumnal day here at Lloyd's – the nerve centre of the wholesale insurance market - has no comparison – and not even sunnier climes and pink sandy beaches could persuade me otherwise! It must be 3 or 4 years since I was last here and I am delighted (or perhaps I should say surprised) to see so many of you here today, and I want to begin by recognising the efforts of the market to raise standards which in turn will help ensure that London remains for many the platform of choice for international insurance.
I am, however, enough of a realist to recognise that the status quo will not necessarily deliver that outcome and that without modernisation London's position as the place to do business is by no means assured. There are, of course, a whole host of reasons why other jurisdictions may appear attractive to wholesale and commercial insurers – chief amongst these is tax, but I think cost and process efficiency (I heard recently that in the US it takes 30 days between the premium leaving the insured and arriving at the underwriter; 60 days in Germany, 90-120 days in the UK) are key factors and I recognise too that regulation tends to feature in the debate. Typically, this is in the broadest sense, encompassing all types of regulation that companies are required to comply with in the UK – not just those mandated by us in Canary Wharf. That said, we are alive to the fact that we have a role to play in maintaining the competitiveness of the UK – and indeed are required to take account of this in all that we do. It is for this reason that earlier in the year, we decided to reallocate resources so that we are able to authorise new insurance entities within 4 weeks at times of high market activity – without compromising our robust standards - so as to help maintain London's attractiveness. Many of you will be aware that we have also announced our intention to introduce a new regime for ISPVs at the end of the year. In another part of the insurance forest, we announced a couple of weeks ago our intention to move the capital solvency standards of the non-profit life insurance market to a proper risk basis – releasing some £4bn of capital for reinvestment or distribution to shareholders or members.
And indeed we continue to challenge ourselves as to whether there are further improvements/changes we can make to the UK regulatory regime to optimise London's attractiveness - as an efficient, orderly and fair market. There is, of course, a very fine balance to be struck here and the regulatory decision on whether - and how - to help deliver such a market is no easy task. We recognise that – particularly in the wholesale and commercial market for insurers – some market practices have far outstayed their welcome. And while these practices may sentimentally hark back to a golden age when deals were struck between two or more parties in the coffee houses of Edward Lloyd's day, it must surely be clear to all that they are fundamentally incompatible with London remaining the world-class centre for insurance that I believe it is today, and can continue to be tomorrow.
While Adam Smith's discourse on the primacy of market forces in The Wealth of Nations was not penned until nearly a century later, the fingerprints of the market's 'invisible hand' are, I think, clearly discernable in those early days of Lloyd's. And so in one sense, it is only right that market forces at least have the opportunity to take centre stage in bringing forth solutions to the challenges of global competition and the pressures of working in ever more efficient and productive ways. More broadly though, to my mind the case for regulatory intervention can only ever be made if the following three tests can be satisfied.
First, is there actually a failure in the market that needs to be addressed? Are market sources failing to do a good job in protecting consumers of insurance and/or building confidence in the market? Clearly, if there is no market failure then there is no need for intervention as the market can take care of itself. Second, if empiricial evidence indicates there is indeed a market failure, then what type of intervention is necessary: is regulatory intervention necessarily the most efficient and cost-effective form of correction or can the market be encouraged and trusted to act to rectify the problem? And finally, third, if regulatory intervention is justified, would it inhibit creativity, innovation and competition over the longer term? A short term regulatory plaster may result in longer-term difficulties: rule-make in haste and repent at your leisure.
Even if these three tests are satisfied, there then comes the difficult quesiton of what form regulatory intervention should take and at what time. I don't want to prepare you for lunch with a discourse on regulatory theology so let me spend the rest of my time on two issues which I think are key to the future of the London and British insurance market -- contract certainty and commission disclosure.
Contract certainty
First contract certainty, and to follow-up on the comments of my colleague, David Strachan, here in the Library at this time last year. As many of you will be well aware, we were concerned about the risks arising from this age-old inefficiency – insurers were happily going about their business without really knowing what their exposures amounted to; brokers were being exposed to untold operational risks including legal action by their customers; and buyers, were not really being sure – or certainly were not able to demonstrate – that they had actually transferred risk they had thought. As always, the only winners of this arcane system are the lawyers. Given the deeply entrenched nature of this inefficiency, if ever there was a case of market failure, this was it - just as one might shrug off the rather eccentric behaviour of an ageing relative at a family gathering because it is "just how they are" or "part of their charm". Where the analogy breaks down of course, is that mild eccentricity is rarely real cause for concern or harm, unlike the reputational damage on the insurance market caused by a practice that to those not acquainted with the world of insurance is nothing short of astonishing.
However, despite the gravity of these concerns, we felt that instead of disappearing into a darkened room only to emerge with a more voluminous rule-book that we should look to the market to find a solution. That was back in December 2004. Now there are just 65 working days left until the deadline of the challenge, and I'm pleased to say that the market appears to have stepped up to the mark and is making good progress to the final goal of consigning the practice of "deal now, detail later" to the history books.
As you will be aware, we have been reviewing progress towards this goal roughly on a quarterly basis. Back in June, I remarked that the industry was making good progress and consequently, our plans for regulatory intervention are on the 'back burner'. Some people thought I was mad letting the brokers off the hook and had simply been seduced by their smooth talking Obviously, I don't think so. I am satisfied that in the subscription market first Nick Prettejohn, now Dane Douetil and in the non subscription market Duncan Boyle, now Bridget MacIntyre – have been and continue to be serious about their leadership responsibilities and are close enough to the action not to be seduced in this way. I am happy to back them. I am pleased to say that at our last staging post – just two weeks ago – I confirmed to a group of CEOs that we remain sufficiently confident of progress that we do not at this point see a compelling case for policy-making. That option, however, remains open to us should the market not maintain sufficient momentum, over these final few months.
With the final goal now fast approaching, it would be disappointing to say the least if the market allowed complacency to creep in and so I would urge all of you in the market to continue to keep focused on getting over the finishing line. You don't need me to tell you that lowering transaction costs, improving standards and service, and reducing the risk of litigation are not only essential but prerequisites if London is to retain its strong position in global insurance markets. Contract certainty will help. You will be well aware that achieving contract certainty through the way that your business operates is just a first, but important, leap towards a much more efficient London market.
As well as maintaining momentum – and not withstanding my confidence that you are able to achieve this - there remain a number of areas where more work is needed. These are three-fold. First, with regards the quality of data, firms must not only be able to demonstrate to us that they are achieving contract certainty, but also that they have appropriate systems and controls in place so that they can challenge and support the data that is presented to the market. Some firms have already developed mechanisms for checking the quality of the data they collect, for instance by way of 'four eyes' peer review or by sampling of files to provide assurance. This is something that we would like to see become more embedded within a firm's systems of control and, where a firm has the facility for more independent reviews by a strong compliance or internal audit function. Second, legacy issues – in other words, tidying up the back book, - remain problematic. Here, we expect to see marked progress by the end of the year in the Subsciption Market. And finally, third, the market must continue to focus on those policies that do not achieve contract certainty, assessing the value and complexity so that lessons can be learned and necessary improvements made. The job isn't finished in December. I want to see the residual tied up as soon as possible thereafter and for no back log to re-emerge.
There is also a question mark hanging over smaller brokers' commitment to delivering contract certainty – particularly those outside the London Market. We have underlined the importance of the Non-subscription Market identifing and implementing some practical solutions for those operating in the regional market.
With the end of the contract certainty challenge now in sight, we will continue to work with the Market Steering Group to identify at the turn of the year how it will demonstrate that the market solution is in place, works and will provide an enduring legacy for the future. We will be looking for both quantitative and qualitative evidence – so that's numbers and actions - that contract certainty has become embedded in the market's operations, and as such will help you achieve the efficiency gains you are looking for.
On our part, contract certainty will continue to be a supervisory priority for us in 2007 and we will be writing to all CEOs in the market providing feedback on our most recent supervisory experiences, including both good and less good practice. The letter will also highlight the areas that we think firms need to focus on in the coming months and on into 2007. Any firms that start lagging behind the rest of the market, providing a drag on those who have achieved contract certainty, will feel more heat from us through the full range of regulatory tools, including though enforcement and the use of section 166 reports where necessary. We will also continue to press the case for contract certainty in other insurance centres, and in Europe and North America in particular, so that this practice becomes commercially unacceptable and globally extinct.
The final point I want to make on contract certainty today is this: should you succeed, then London will be seen to be blazing a trail again, just as it did in the late seventeenth century in the coffee houses in Tower Street.
Commission Disclosure
Given the market's solid progress so far – and the likelihood of an industry led solution to the contract certainty challenge – this approach may seem like an obvious way to tackle another potential inefficiency in the market – that of market transparency or lack of transparency around commission earned in the sale and intermediation of wholesale insurance contracts.
There can be no doubt that pricing transparency can prove an important catalyst to increase competition, and which in turn can deliver greater efficiency. One of the FSA's three strategic aims is to promote efficient, orderly and fair markets. But we are not a competition regulator, nor a price regulator; these are the domain of the OFT. We are always careful not to stray into areas beyond our remit, we have quite enough to do already, but I am satisfied that we do have a locus over commission transparency through our aim to promote efficient markets and our responsibility to protect customers. In light of this, it perhaps won't surprise you to hear that before deciding whether regulatory action is necessary – in whatever form - we have been keen to explore in some detail the various views of clients, insurers, brokers – big, small, London market, regional market – and, importantly, understand what are the financial and business incentives that lay behind these perspectives. We need to analyse and understand what effects any regulatory interventions may have on market structure and how these inform the type and timing of policy making. For example, notwithstanding their specialist skills, I understand there are trends emerging in some lines of business to disintermediate the business flows with buyers going direct and cutting out the brokers, particularly at the smaller end of the market. Clearly, these are issues that are in the hands of the market and any intervention whether regulatory led or market led will need to recognise this.
Having been thrust into the spotlight by the Spitzer investigations in the US, commission arrangements have been the subject of much discussion, but over the last six months or so, it has become palpably clear from our discussions with carriers, brokers and buyers that not everyone is talking about the same thing.
To unpack that a little, as a first step it is important to distinguish between the different – and indeed polarised – perspectives about the benefits of mandatory commission disclosure. These vary between broker, insurer and buyer and between those in the London Market and those in the regions.
There are, it would seem, three potential market failures that market participants point to.
First, the emergence of an unlevel playing field between those brokers that have chosen to provide full disclosure and those that are apparently taking advantage of the lack of regulatory imperative to do so. We recognise this is an issue for both the major brokers and the larger insurers operating in the non-London market who, either because of Spitzer agreements or voluntarily, have moved to full disclosure and claim that this has created opportunities for regional brokers to arbitrage against them and win business from customers.
Second, the lack of transparency to the customer. What are they paying for – for their risks to be covered or for some other services? Why do they need to worry – it is not the cheque they write that matters most, not where it goes? Personally, I don't think so. Our prime concern here is customer protection and the wider question of the management of conflicts of interest. A secondary aspect to this are the benefits that may be brought about by increased competition and the resultant price pressures forcing elements of the distribution chain to demonstrate that they add value. As you know, we already have an unequivocal rule that firms must disclose commission if asked to do so by their commericial customers. And this is supplemented by a requirement that all firms must disclose any fees charged to the customer. Under these rules, whereas commission payments are amounts paid out of the premiums, fees include anything else negotiated with, and charged on top to the customer. When we introduced these rules nearly two years ago, we felt that taken together these safeguards should enable the buyer to form a view as to whether they were comfortable with the level of remuneration received by the broker.
However, in practice, in spite of these controls, it would seem that disappointingly few buyers are exercising their right to request disclosure and, as a result, there is an absence of transparency to the customer. Some firms have suggested to us that customer interest rarely extends beyond the premium and the cover itself, and while some buyers do seek positive declarations from their broker that they are not earning contingent commissions seldom do they request actual commission disclosure. I would venture though that with good governance, risk management and profitability so high up the corporate agenda that buyers should be more interested in the remuneration that the broker receives in relation to the contract of insurance they have purchased. And, as I have said on previous occasions, I am not a little surprised by the lack of customer-power that is exercised in this market, especially among the lesser corporates. We are not talking here of the acute asymmetries that can - and do - exist in the retail market and, I would accept in the SME business market. This market is about sophisticated buyers looking to transfer significant risks in a market that they know and understand. And so once again, I would urge those corporate buyers in the market to recognise their position of influence, punch their weight and in so doing, drive through greater efficiencies and transparency in the market.
Perhaps more worryingly for us though, on the rare occasions that a buyer does ask for disclosure, word reaches us that there is little consistency in what is disclosed, with not all brokers including commission from profit shares and/or payments from premium finance arrangements. Just as importantly, where the profit share cannot be indicated in cash terms, we would remind firms to instead disclose to the customer the basis of its calculation.
The third, and potentially most problematic, market failure cited to us is that the lack of full transparency in the market around commissions paid is hindering the market from operating at its most efficient. Here, views in the market are starkly opposed.
On the one hand, we have the underwriters who believe that transparency of broker remuneration to insurers as well as to customers is necessary for effective conflicts management and an efficient and effective market. And indeed, we understand from our discussions that part of the rationale behind the case for mandatory disclosure would be to enable the insurers to have a better control on acquisition costs in the market, which as you will know are the second largest expense after claims. It is clear that insurers must secure distribution and we recognise that one of the reasons that underwriters are reluctant to simply insist that commission is disclosed to them is because they fear punitive action from the brokers who may simply take their business to the next box. I have heard it said that some brokers are charging twice – both to their customer and the insurer – for the same services and/or that insurers are paying for services that they do not receive. I should stress here that we have yet to see evidence to support these claims, but it is nonetheless helpful to get a fuller understanding of the reasons why some would have us intervene.
On the other hand, bar those who are now offering full transparency, the broking community roundly contests these arguments and strongly objects to any attempts to identify broker acquisition costs in the subscription market, denouncing this as simply a means for insurers to improve their bargaining power and their position when negotiating directly with overseas buyers.
No doubt there are other, even more, subtle aspects to the respective arguments in the market, but given the strength of feeling behind each it should perhaps come as little surprise that the market has been unable to find a way through of its own accord.
I should, recognise here that some market solutions have begun to emerge – though notably only with regards to transparency to the customer. Here, the LMBC and BIBA have introduced a standard clause in Terms of Business Agreements, committing the broker to remind the customer of his or her right to requst information about any commission received in the placing of business, prior to the conclusion of the contract or on renewal.
Progress on market solutions to introduce greater market transparency has been more slow. The reason for this is, I think, precisely because the respective incentives of the underwriting and broking communities are locked in conflict. So polarised are these positions that it is difficult to see how market forces will prevail. Typically, my strong regulatory inclination would be to allow the market to reach its own conclusion, but in this particular case - given this polarity of feeling - I think it is worth pausing to reflect whether the outcome reached would necessarily be in the interests of either the market or its customers.
The insurers' response to this apparent state of commercial gridlock is to cry foul and demand that the FSA intervene to mandate the disclosure of commission to both customer and insurer. As you know, to date, we have resisted calls to do so. As I have said on many previous occasions, making commission disclosure mandatory will not necessarily tackle the conflicts themselves; recognising and being brave enough to say there is an elephant in the room does not somehow magically spirit the elephant itself away. Regardless of whether they are mandated to disclose commission, insurers and intermediaries must properly and actively manage conflicts of interest.
However, having allowed the market the space and opportunity for a solution to emerge, because of the diametrically opposed incentives of both sides, it has become increasingly apparent that an agreed industry-led solution is likely to be light years away.
As such, we feel the time has come for us to take a more objective and forensic look at the possibility of mandating commission disclosure. It is for this reason that I can tell you today that a more detailed exploration of the issues around commission disclosure will be highlighted as a priority for us in the FSA's coming Business Plan for 2007/8. This will include both an objective Market Failure Analysis and corresponding Cost Benefit Analysis, covering both transparency to the customer and to the market. This work will enable us to gather detailed and balanced evidence of the extent to which a lack of transparency is leading to customer detriment and/or impairing market efficiency, and whether mandating commission disclosure will lead to benefits that outweigh the costs of introducing it. Only – and only - if both the market failure analysis and CBA tests are met and the market has still not come forward with any industry-led solutions, will we consider whether regulatory intervention is the best way forward. In the coming period we will commission the market failure analysis and CBA and continue to gather views from the industry.
Conclusion
There are a lot of challenges for the London Market: increasingly acute competitive pressures; the dangers of not transforming the operating processes and cost structures of the London Market; and the challenges posed by regulators. I haven't spoken today about Solvency 2, but that will be looming large when the Directive is published next year. This should be an opportunity rather than a threat for British insurance companies. Our goal is a wholesale insurance market that is efficient, orderly and fair. Sometimes that goal will be achieved through market forces alone. Sometimes it will require a nudge from us – perhaps by way of a challenge thrown down to the industry. And sometimes it may require more explicit regulatory intervention. But whatever the means to the end, without these characteristics – efficient; orderly; and clean – it is difficult to see how London can retain its pre-eminent reputation as the optimal platform of choice for wholesale and commercial insurance.
Thank you for your time.
