Regulation of Insurance Business
1. Why regulate insurers?
The insurance industry in the UK is vast: there are approximately six hundred insurance and reinsurance companies, two hundred Friendly Societies,1 as well as Lloyd’s of London insurance market and around 40,000 firms which act for and advise customers and insurers. Insurance companies (although, as will be seen later, not insurance intermediaries) have long been subject to a greater degree of regulation than most other types of business. This began with the Life Assurance Companies Act in 1870 and gradually spread to other parts of the industry until by 1946 the whole sector was regulated. At first the main focus of regulation was solvency. The insurance contract is unusual in that, while the insured is required to perform by paying the premium, the insurer is only called on to perform (if ever) at some distant point in the future. This means that, unlike other trading businesses, the solvency of insurers is not immediately obvious on looking at the accounts. The problem is particularly acute in life assurance, which as a long-term business means policyholders must have greater confidence that the insurers will be in a position to pay out when the risk eventually matures than is required in relation to those companies that write short-term policies on, for instance, property fire and theft. The solution adopted was simple: life insurers were required to lodge a deposit of money in the Court of Chancery as a sign that they were ‘substantial people’.2 This strategy was later used in other aspects of insurance business. But a large premium income may not indicate a secure company if that income has been obtained by offering policies on terms that prove too advantageous to the insured when it comes to the payment of claims.3 The Companies Act 1967, therefore, required assessments of the financial state of the company, the adequacy of its reinsurance cover on the risks carried and the fitness of its principal officers and main shareholders. The act gave the Board of Trade the power to intervene in the operation of the company after its initial authorisation.4 This more comprehensive approach to authorisation and supervision was extended by subsequent legislation.
The history of insurance regulation might be seen as reform prompted by the failure of an insurer. The statute of 1870 followed the failure of some life assurance companies; the provisions in the Companies Act 1967 were included after the collapse of the Fire, Auto and Marine Insurance Company; and the Insurance Companies Amendment Act 1973 was passed in the wake of the failure of Vehicle and General. Yet, while this pattern continues, over the last 30 years other factors have led to, and, therefore, shaped, reform. Some understanding of these will provide an insight into the objectives of the system now in place.
In the first place, increased competition at home and internationally has forced firms operating in the financial sector to cut costs, develop new products and find new markets. As insurers have found it more difficult to make profits in their traditional areas of business, some have moved into non-insurance business, such as banking. At the same time, other companies such as banks and supermarkets have developed insurance products for their customers. A lot of huge financial conglomerates have emerged and prospered in this environment, but inevitably many firms have been unable to compete and have been swallowed up or disappeared, while others have struggled as a result of entering lines of business or markets in which they have little experience.
There has also been pressure for better consumer protection that has, in part, found its expression in a clamour for improved consumer rights. In the area of financial services, this reflects growing prosperity, but it is also an expression of the fragility of that prosperity. Following its election in 1979, the Conservative government under Mrs Thatcher took a good deal of interest in private investment and, as a consequence, in the financial services industry. For various reasons government wished to promote private investment by, for instance, encouraging people to buy their own homes and to acquire shares. In addition, the government made no secret of its wish to reduce the welfare state. This was presented as a policy aimed at reducing taxation so that people would be able to make their own choices as to how to spend their money, but it was also a response to the alarming prospect that expenditure on the welfare state seemed set to rise beyond the ability of the country to pay for it: for instance, as birth rates fell and people lived longer, the number entitled to state pensions was expected to increase, while the size of the working population, whose taxes funded those pensions, shrank, and at the same time progress in medical science resulted in increased costs of funding the National Health Service. Of course, the danger in giving people a choice to invest for periods of unemployment or ill health or for their retirement is that some may choose not to do so. The government, therefore, encouraged personal investment and insurance to cover events of life, such as unemployment, ill health and retirement, which had previously been seen as largely tasks for the welfare state. Competition in the financial sector was seen as a way of improving efficiency, prices and performance, and of providing investors and consumers with better protection and rights. It also fitted in with the belief that the market—not government—was the most efficient means of allocating resources. From the point of view of those investors, much of the enthusiasm for investment in the 1980s was fuelled, not by ideology or improved consumer protection, but by the expectation of profit through buying shares or houses which then seemed almost inevitably to rise in value. Nevertheless, investment was also motivated by a concern about the consequences of not investing or insuring in a post-welfare state: ‘How long must I wait for health care through the state system? What will happen to me when I become old if I do not make provision for myself?’
As investment grew, so the consumers of financial services in their various guises (insureds, bank customers, pension holders, shareholders, etc) became politically significant by the sheer weight of their numbers. This meant that when the risks involved in investment emerged (the value of houses or investments fell, or financial companies failed to deliver on their promises or simply failed) the voices of these consumers were heard loud and clear. This is best illustrated by comparing a newspaper of 30 or 40 years ago with one of today: business news is no longer confined to a small section and addressed to those who work in the industry; it is a matter for all and is, therefore, something that frequently appears on the front page—as for instance with the scandals over the collapse of the investment firm of Barlow Clowes, the insurer Equitable Life, the plundering of the Mirror pension fund and, more recently, the financial crisis that emerged first in the UK with the collapse of Northern Rock bank in 2007.5 While life insurers have benefited by a shift from public to private pension provision, they have suffered as a result of a drop in share prices that has affected their ability to deliver the level of performance expected by customers. There has also been sharp criticism of their products and allegations that some employees were improperly advised about shifting from company pension schemes into private pension schemes or were encouraged to purchase endowment life policies in the expectation that they would produce returns adequate to pay off mortgages on properties. The result has been that customers now have less confidence in long-term savings, such as with-profits insurance contracts. The financial crisis has increased this uncertainty among investors and has reduced the amount available for investment.
Investors have often regarded financial failure as the fault of government or a regulator. Not infrequently, the result, as has been seen, is reform or a bail-out, which although often justified does create both the impression that government acknowledges its responsibility and the expectation that it will step in when problems arise. In other words, the problem is characterised as a failure in regulation rather than as an acceptable risk of investing in a free market. Investors–including those who take out insurance-may, therefore, be encouraged to the belief that investment carries no risk and this may also affect the behaviour of the insurers (‘moral hazard’), which is rather dangerous since the assumption of risk (that is, the potential for an investment to fall as well as rise) by both parties is regarded as fundamental to the proper functioning of the free market. The financial crisis emphasised this problem, and, while it was most evident in banking because that is where most of this state support was focused, the rescue of AIG, a US insurer, by the Federal Reserve demonstrated that it could also affect insurance. How does government balance the free market, which requires winners and losers and in which all must bear the consequences of their own choices, with a system where all will be winners or, at least, none will be substantial losers—private pensions will be paid, the sick will be cared for? The consequence of this dilemma has been that those ministers who championed the free market and sought to roll back the state have introduced an unprecedented level of regulation: for instance, the Banking Acts 1979 and 1987, the Building Societies Act 1986, the Lloyd’s Act 1982, the Insurance Companies Act 1982, the Financial Services Act 1986 and the Financial Services and Markets Act 2000.6 This has led to complaints from the industry about the cost of compliance, although this does not mean the industry opposes regulation: some financial firms clearly welcome regulation where it has reassured customers, and so encouraged investment, and has excluded those firms which, through insufficient skill or poor quality products, are viewed as damaging the reputation of the rest of the market (and perhaps of undercutting the better established firms).
The difficulty has been to translate all these issues into regulation. The central concern of the Insurance Companies Act 1982 remained the financial viability of insurers rather than direct protection for the insured, although the Policyholders Protection Act 1975 did establish a fund to compensate certain categories of insureds in the event of the failure of an insurer.7 Moreover, insureds were given additional rights: for instance, insurers were obliged to provide certain types of information, particularly, as with some life assurance, where an element of investment was involved; cooling-off periods were instituted allowing some insurance contracts to be cancelled by the insured;8 and simpler, cheaper and quicker complaints procedures were introduced. Significantly, although some of these changes were the result of law reform, it was the industry itself that introduced the most important measures of consumer protection, such as the ombudsman scheme and the Statements of Insurance Practice, which were self-imposed limits on the contracting power of the insurers, although, to some extent, these were the result of pressure from government and consumer organisations and a fear that legislation might be introduced.
Further scandals and changes in the financial services industry made it evident to many by the late 1990s that a rethink was required. The regulatory structure had become too complex, it had also failed to keep up with developments in the industry and it was perceived as not providing protection to consumers. The method of regulation used was to divide financial services into different sectors—insurance, deposit-taking, building societies, pensions and so forth—and to give each sector its own supervisory regime and its own supervisor: for instance, insurance business was regulated under the 1982 Act by the Department of Trade and Industry, banking under the Banking Act 1987 by the Bank of England, the building societies under the Building Societies Act 1986 by the Building Societies Commission, and the investment industry under the Financial Services Act 1986 by a number of regulators. This had been the result of the piecemeal development of regulation. By the late 1980s, there were ten financial regulators (more, depending on which bodies were included in the count). This fragmented system of regulation did not work because, as has been seen, the financial industry did not operate in neat, self-contained segments: multi-functional financial conglomerates had emerged. A single financial institution or group was subject to several regulators and the inquiry into problems at Equitable Life indicated some of the difficulties this caused when it noted that two regulators had quite different interpretations of the facts leading to the company’s problems.9
2. International regulation
In addition to purely domestic issues, by the 1970s there were calls for international agreement on the regulation of financial services firms, which led to reforms that have had an important impact on regulation in the UK. Concerns had emerged as a result of the growth of multinationalism (firms operating in more than one country through branches, subsidiaries or direct cross-border selling) and of globalisation (the interconnectedness of financial markets in different countries). In a global market firms are not constrained by the same national boundaries that limit the authority of regulators. The failure of two large international banks in the 1970s brought a realisation of the interdependence of national financial markets and led to efforts to improve (or, in many countries, to establish) regulation and to develop co-operation between regulators. Central bankers and bank regulators from the richest nations set up the Basel Committee on Banking Supervision in 1974, although its membership has subsequently expanded. This committee has no formal legal authority, but the economic and political power wielded by its member countries means that its proposals on bank regulation have acquired a powerful influence over national laws. The committee developed the idea that the supervisor from the state in which the bank is authorised (the home state) should take the lead in supervising that bank’s global operations. Left without qualification this would have rested a little too much confidence in the home supervisor for the liking of many countries and so Basel recognised that the host nation (the place where a bank operates) should have a role; in particular, it should be able to restrict the bank’s operations if not satisfied about the quality of the supervision. The committee also emphasised the importance of encouraging the exchange of information between supervisors. By the 1980s the committee had become more ambitious, setting out minimum standards for various aspects of bank regulation, in particular, in relation to capital adequacy.
The Basel Committee’s work encouraged the establishment of the International Association of Insurance Supervisors (IAIS) in 1994. The IAIS has a broader base than Basel with members from around 100 countries supplemented by a large number of observers from the industry and professional associations. Like Basel, the IAIS has issued 28 core principles as benchmarks for an effective supervisory system.10 These are supplemented by sets of principles on particular issues, such as co-ordination between supervisors, the supervision of reinsurers, internet insurers and cross-border companies, and solvency. The expectation is that national supervisors will use these standards, and certainly the International Monetary Fund employs them when undertaking its Financial System Stability Assessments.11 The IAIS has also co-operated with Basel and the International Organisation of Securities Commissions through the Joint Forum, which deals with issues of mutual interest, such as the regulation of financial conglomerates.
The European Union has been involved in these initiatives, although the reforms it has introduced have often exceeded the requirements imposed by membership of the global organisations. There have been EU directives on life assurance and general insurance, and on narrower issues, such as motor vehicle liability insurance,12 legal expenses insurance,13 aviation insurance,14 credit and suretyship insurance,15 accounting16 and the insolvency of insurers.17 Much of this legislation has been enacted with the objective of establishing a single market in the European Union.18 The single market seeks to give EU citizens access to a wide range of insurance products and to enable insurers authorised in one Member State to operate freely in other Member States, although it has been suggested that this project often appears more concerned to facilitate access to markets for insurers than to provide consumer protection.19 The single market requires the breaking down of regulatory and tax barriers, which inhibited free access to markets, but, at the same time, each state is required to have in place certain minimum standards.20 This has been prompted, in part, by fear that there might be a ‘race to the bottom’ in which countries would encourage firms to set up by offering weak regulation and that this might have disastrous consequences if poorly regulated firms were able to operate throughout the EU. In practice, the tendency has been towards greater harmonisation through the intervention of the EU.
In establishing the single market European law has used separate measures for non-life and life insurance because of the fundamental differences between them, and, in particular, the role of life insurance in long-term investment. The first wave of directives on non-life insurance in 1973 and on life insurance in 1979 gave insurers established in one Member State the right to undertake business in other Member States.21 The directives also prohibited new insurers from offering both life and non-life business,22 although existing insurers that undertook life and non-life business were permitted to continue, subject to certain requirements with regard to their life business.23 These directives still obliged insurers to obtain authorisation to operate outside their home state, but prevented a Member State from discriminating against insurers from another Member State. The Second Directives were influenced by a series of decisions of the European Court of Justice in 1986 that had aimed to combine liberalisation of the market with consumer protection.24 These directives developed the passport idea in which an insurer authorised in one Member State would be permitted to supply insurance services in all states. Supervision of the insurer was to be conducted mainly by the home state, although the host state retained a role. The directives also sought to focus on consumer protection by distinguishing consumer from commercial insurance. This was achieved in respect of non-life insurance by separating large risks, which are, broadly, large-scale commercial risks, from mass risks, which are consumer products.25 In life insurance a distinction was drawn between those policies that originated from an approach made to the insured through, for instance, advertising, and those policies that were initiated by the insured, with consumer protection measures being targeted mainly at the first type.26 The Third Directives extended the notion of the single passport based on minimum harmonisation of rules and mutual recognition of supervision regimes.27 An insurer, which is authorised and has its head office in one Member State, is permitted to sell its products in another Member State, either directly or by setting up a presence in that state, without requiring fresh authorisation. For instance, if an insurer from another Member State undertakes business in the UK through a branch, the establishment conditions must be satisfied, which in essence means that the consent of the home state must be obtained to the branch being established in the UK; if the intention is to provide services in the UK from offices outside the country, the service conditions must be met, which merely require the home state to be notified by the insurer of its intention to provide such services.28 The UK regulator will be informed of the home state’s consent to the establishment of a branch or will receive notification from the home state of the insurer’s intention to provide services in the UK. Since the Third Directives, the Financial Services Action Plan has been established to speed up the completion of the single market.29 Some of the changes introduced as a result of the plan are specific to a particular sector,30 while others are broader in their impact.31 In 2001 the Commission sought to improve customer confidence in the single market by establishing a network (FIN-NET) to help consumers, who are dissatisfied with a financial service, obtain an out-of-court settlement where the supplier is established in another Member State.32
More recently, the EU has introduced Solvency II,33 which is due to be brought into force in the Member States in 2013 and will mirror the standard on capital adequacy adopted in banking known as Basel II. The expectation is that it will bring the regulator’s view of what capital and solvency requirements are necessary closer to those that the insurer sees as appropriate to the task of carrying the business forward. This is to be achieved by regulatory measurement systems that are more carefully tuned to the risks each insurer runs and that acknowledge the measures a firm has in place to mitigate those risks. In addition, the discipline of the market is to be given a sharper edge through improvements in the supply of information about risks and risk management within a firm, and the firm’s management is to be required to put risk control at the centre of their day-to-day activities. Yet, even ahead of the introduction of these new systems, it has been estimated that the measurements methods in Solvency II together with the new International Financial Reporting Standards will increase capital requirements and may, thereby, expose a massive shortfall among the less capital-rich life assurance companies. It is suggested that companies will be forced to reduce their risk profile by, for instance, reducing equity investments and to change to more conservative products with lower guarantees. It may even push companies into extinction.34
In response to the financial crisis, a new set of pan-European supervisory authorities was proposed and became operational in January 2011.35 The European Systemic Risk Board has representatives from the central banks of all Member States and the European Commission. It will collate and analyse issues relating to systemic risk and financial stability. While national regulators will continue to supervise individual firms, their work will be co-ordinated through the European System of Financial Supervision (ESFS), comprising new European Supervisory Authorities for insurance (European Insurance and Occupational Pensions Authority),36 banking (European Banking Authority) and markets (European Securities and Markets Authority). The aim is to improve co-operation, and, more controversially, to centralise certain matters to develop consistency of practice among national supervisors. There will be a joint committee to oversee collaboration between the new authorities and to provide a mechanism for settling disputes between national authorities.
One danger with international ‘agreements’ is that they are controlled by the richest nations and reflect their interests. So, while such agreements have undoubted benefits, it is important that the role of regulation in protecting legitimate national interests is properly considered and not simply dismissed as an obstacle in the way of open markets. The objective of these meetings of international regulators must be to construct methods of regulation that facilitate economic growth and that provide legitimate levels of protection for international systems, for individual states, for firms and for consumers from the problems that can arise across borders through the failure of a firm, or of a financial system, or of a national regulatory process. It might be argued that stepping beyond measures designed to reduce global systemic risks should be resisted since it interferes with legitimate competition between the regulatory regimes offered by different countries and might affect the variety and price of products. On the other hand, differences between regulatory systems might end with consumers being seduced to buy products from a firm established in a state where regulation and consumer protection are weaker than might be expected. A separate problem with these international initiatives—including those in the EU—is that they continue to construct regulatory regimes based on a model of the financial services industry as composed of separate compartments: so, although there are initiatives to cope with multi-functional conglomerates,37 the form of regulation adopted in European directives and in initiatives from IAIS, Basel and IOSCO adheres to the traditional divisions of banking, insurance, investment and so forth.
3. Regulation of insurance in the UK
3.1 The Financial Services Authority
Shortly after its election in 1997 the Labour government began to reshape the regulatory environment of the financial sector. This led to the Financial Services and Markets Act 2000 (FSMA), which established the Financial Services Authority (FSA) as the regulator for most of the financial services industry and handed to it prudential supervision (by which is meant, broadly, supervision aimed at reducing the likelihood of a firm becoming insolvent) and conduct of business supervision (that is, supervision of the relationship between firms and customers). The financial crisis has, however, led to major changes in the regulatory structure. The FSA came in for much criticism as a result of perceived failings in its regulation of the financial services industry—in particular, the banks—and, while the Labour government proposed merely to reform some aspects of its work, on power transferring to the Coalition government in 2010, the abolition of the FSA was announced. The central criticism concerned less the FSA’s approach and more the structure of the regulatory system, in particular the decision to detach regulation from the Bank of England. Under the new proposals, there will be two bodies responsible for supervising the industry: the Prudential Regulatory Authority, which will be a subsidiary of the Bank of England, will supervise banks and insurance companies, and the Financial Conduct Authority, which will be independent and responsible for supervising other firms, including brokers, and for regulating conduct of business.38 The new structure will be in place in 2012, although there have already been informal reorganisations within the Bank of England and the FSA. What all of this will mean for the rules currently used by the FSA is difficult to say, but it may be less significant than might have been envisaged, particularly since much is now determined by the EU. The government intends to introduce the new structure by merely amending FSMA, which suggests that the intention is to retain much of the existing framework of rules. It may be more a matter of the approach taken by the regulators: the expectation is that they will be more intrusive and proactive than the FSA was in the run up to the crisis.39 All of this needs to be borne in mind when reading the following sections, which describe the rules as they stand in early 2011.
The FSA is an extremely powerful body with a range of functions that seems to run counter to the idea of the separation of powers.40 First, it is a legislator. In broad terms, FSMA sets out the functions and powers of the FSA, and the FSA lays down the procedures it will follow and the considerations it will take into account in the exercise of those functions and powers (see Part X, FSMA for the rule-making powers). Secondly, the FSA investigates breaches of the regulatory regime and has powers to gather information. Thirdly, it is a judicial and enforcement authority ruling on breaches and imposing penalties (eg sections 205–11 and Part XXVI, FSMA). Fourthly, the FSA acts as a prosecutor with respect to offences under FSMA and related legislation (eg sections 401–02). Finally, it was given responsibility for establishing a compensatory mechanism to cover those who suffer loss when an authorised person is unable to meet claims (sections 212-24). The FSA subsequently set up Financial Compensation Scheme.
Attempts have been made to balance the omnipotence of the FSA, although the effectiveness of some of these is open to debate. The mechanisms created include an independent Complaints Commissioner to whom complaints against the FSA can be brought (schedule 1, paragraph 7) and the Practitioner and Consumer Panels with the FSA must consult (sections 8-11); the FSA has also established the Small Business Practitioner Panel, which will be put onto a statutory footing under the forthcoming reforms. The FSA is required to engage in public consultation before issuing rules, statements or codes of practice (eg sections 65 and 155). There have been criticisms of the delays that this rule-making procedure produces, which can hinder the FSA’s ability to react to problems, and it may be that changes will be introduced. The Treasury may appoint an independent person to conduct a review of the ‘economy, efficiency and effectiveness with which the Authority has used its resources in discharging its functions’ (section 12(1)), although this is specifically not concerned with the merits of the FSA’s general policy or principles in pursuing regulatory objectives (section 12(3)).41 The Treasury also has a limited power to appoint an independent inquiry (sections 14–18).42 Under FSMA, a person or firm that has been disciplined or refused authorisation by the FSA may seek a fresh hearing before the Financial Services and Markets Tribunal, which is an independent body43 and which can direct the FSA to take a particular course of action.44 The infrequency with which this right of appeal has been used appeared to confirm views expressed during the Bill’s passage that a regulated firm would be reluctant to avail itself of such an appeal because of the bad publicity it might involve and the consequent effect on its business.45 However, an appeal brought before the Tribunal by the Legal & General Assurance Society Ltd against a fine imposed by the FSA suggests that firms may not suffer the sort of reputational damage that had been feared; indeed the appeal seems to have been seen by Legal & General as a way of restoring its reputation, which it felt had been wrongly tarnished by the imposition of the fine.
The FSA’s rules, statements of principle, directions and general guidance are to be found in the FSA Handbook of Rules and Guidance (Handbook), which is available through the authority’s website.46 It is divided into blocks and each block is sub-divided into sourcebooks, which detail the FSA’s requirements and guidance, and manuals, which contain processes to be followed. The first block in the Handbook is High Level Standards, which are the standards that apply to all firms and approved persons. They consist of Principles for Businesses (PRIN), Senior Management Arrangements, Systems and Controls (SYSC), Threshold Conditions (COND), Statements of Principle and Code of Practice for Approved Persons (APER), The Fit and Proper Test for Approved Persons (FIT), Financial Stability and Market Confidence Sourcebook (FINMA), Training and Competence (TC), General Provisions (GEN), and Fees Manual (FEES). The second block is titled Prudential Standards, which set out the prudential requirements that apply to firms, and include General Prudential sourcebook (GENPRU), Prudential Sourcebook for Insurers (INSPRU), Prudential sourcebook for Mortgage and Home Finance Firms, and Insurance Intermediaries (MIPRU), and Interim Prudential sourcebook for Insurers (IPRU-INS). The third block is Business Standards, which are the requirements relating to firms’ day-to-day business. They include Conduct of Business Sourcebook (COBS), Insurance: Conduct of Business sourcebook (ICOBS), and Client Assets (CASS). The fourth block is called Regulatory Processes, which describe the operation of the FSA’s authorisation, supervisory and disciplinary functions and include Decision Procedure and Penalties Manual (DEPP). The fifth block is Redress, which sets out complaints and compensation procedures. It includes Dispute Resolution: Complaints (DISP), Compensation (COMP), and Complaints against the FSA (COAF). There are also the specialist sourcebooks, which include Professional Firms (PROF). Finally there are the Regulatory Guides. These are not mandatory, but indicate how the FSA will interpret and enforce its rules. They include The Enforcement Guide (ENF), which covers the FSA’s enforcement process, The Responsibilities of Providers and Distributors for the Fair Treatment of Customers (RPPD), which discusses the fair treatment of customers, The Perimeter Guidance Manual (PERG), which gives guidance on whether authorisation is required and on the activities regulated under FSMA, and The Unfair Contract Terms Regulatory Guide (UNFCOG), which indicates how the FSA will use its powers under the Unfair Terms in Consumer Contracts Regulations 1999.47 References to the sourcebooks and manuals in this chapter will be noted using these abbreviations.
Each sourcebook and manual opens with an explanation of the types of firms and persons to whom it applies and its purpose, and similar information is provided throughout the text. The sourcebook or manual is divided into chapters; the chapters are divided into sections and the sections into numbered paragraphs. Each paragraph has its regulatory status indicated by a letter in the margin. The most common are ‘R’ and ‘G’. ‘R’ stands for rules made by the FSA under FSMA, section 138 or sections 140–47 and breach of a rule may render the firm liable to an enforcement action. ‘G’ usually indicates guidance issued under section 157 and is used, among other things, to explain the implications of provisions and to recommend particular courses of action. However, guidance is not binding on those to whom FSMA applies or the courts, nor does it have any evidential effect, so that a breach of the guidance does not mean there has been a breach of a rule, although the FSA will presume that a firm which follows guidance is in compliance with the relevant rule.48 The General Provisions (GEN) manual in the Handbook states that, ‘Every provision in the Handbook must be interpreted in the light of its purpose’ (GEN 2.2.1). That purpose is to be gathered from the provision itself and its context. This manual also notes that all communications required by the Handbook to be ‘in writing’ may, unless a contrary intention appears, be given through electronic media (GEN 2.2.14).
Looking at this description (and it should be noted that there are other parts relating to non-insurance aspects of the financial services industry), it may be hard to believe that the Handbook has gone through a simplification process under which large parts have been deleted, either because they are adequately covered elsewhere in the Handbook or because the rules and guidance have been relegated to Regulatory Guides and advice pamphlets: so, for example, the Authorisation manual has been deleted and much of the material is now in advice given to those seeking authorisation and in PERG.49
3.2 Regulatory objectives
The FSA must discharge its functions, ‘so far as is reasonably possible’, in a way ‘which is compatible with the regulatory objectives and which the Authority considers most appropriate for the purpose of meeting those objectives’ (section 2(1)). The regulatory objectives are listed in section 2(2), as amended by the Financial Services Act 2010, sections 1(2) and 2(2)(a): (a) market confidence; (ab) financial stability; (c) the protection of consumers; and (d) the reduction of financial crime. These objectives are so broad as to render them impossible to translate into precise responses to particular situations, but that is not their purpose. Their purpose is to set a direction for the FSA. The FSA does not have an entirely free hand in seeking to achieve the regulatory objectives since it is required to have regard to the following considerations (section 2(3), as amended by the Financial Services Act 2010, section 2(2)(b)):
(a) the need to use its resources in the most efficient and economic way;
(b) the responsibilities of those who manage the affairs of authorized persons;
(c) the principle that a burden or restriction which is imposed on a person, or on the carrying of an activity, should be proportionate to the benefits, considered in general terms, which are expected to result from the imposition of that burden or restriction;
(d) the desirability of facilitating innovation in connection with regulated activities;
(e) the international character of financial services and markets and the desirability of maintaining the competitive position of the United Kingdom
(f) the need to minimize the adverse effects on competition that may arise from anything done in the discharge of those functions
(g) the desirability of facilitating competition between those who are subject to any form of regulation by the authority
(h) the desirability of enhancing the understanding and knowledge of the public of financial matters (including the UK financial system).
Each of the regulatory objectives is explained in sections 3-6 (as amended by the Financial Services Act 2010, section 2) in fairly broad terms. Market confidence is hardly defined at all: FSMA refers only to ‘maintaining confidence in the financial system [of the UK]’ (section 3(1), (2)). Nevertheless, it is clearly regarded by the FSA as a key regulatory objective.50 Financial stability is covered in section 3A (inserted by the Financial Services Act 2010, section 1(3)),51 which defines it as contributing to the protection and enhancement of the stability of the UK financial system and which obliges the FSA to take into account certain considerations, including the effects on the growth of the UK economy of anything done to meet that objective and the impact of events inside and outside the UK. By protection of consumers is meant ‘securing the appropriate degree of protection for consumers’ (section 5(1)).52 This means balancing protection from the risk involved with recognition that it may be appropriate for customers to bear some or all of that risk: FSMA refers to ‘the general principle that consumers should take responsibility for their decisions’ (section 5(2)(d)). In construing what is appropriate in this context the FSA must consider the degrees of risk involved in different types of transactions and the degrees of expertise possessed by different types of consumers and their needs for advice and information (section 5(2)(a)-(c)). The reduction of financial crime objective relates to the extent that it is possible for a business53 to be ‘used for a purpose connected with financial crime’ (section 6(1)). This addresses the risk of people–those on the inside and outside–stealing from the firm, or manipulating company accounts in order to create a false impression (‘financial engineering’), or using a firm for crime, such as money laundering. The objective of enhancing public understanding of financial matters is discussed in section 6A (inserted by the Financial Services Act 2010, section 2(5)).
The FSA has developed its method of working from the regulatory objectives and the principles of good regulation.54 First, the FSA rests its authorisation and supervision procedures on an assessment of the risks posed by a firm or individual to the regulatory objectives: what is the probability that a risk will materialise and what impact would there be if it did materialise? If permission is granted, this risk assessment process will also enable the FSA to be proportionate in its allocation of resources to supervision of the firm (SUP 1.3).55 Secondly, the FSA ensures that a firm meets certain standards in the conduct of its business. These are explained in the Principles for Businesses (PRIN): it must conduct its business with integrity, maintain adequate financial resources, deal with regulators in an open and co-operative way, and treat customers fairly.56 Much of the FSA’s approach is found in this important document and its eleven Principles; indeed, the other parts of the Handbook can be seen as working through the implications of these Principles. Thirdly, the FSA places responsibility on the firm’s management for ensuring that the firm complies with the regulations: ‘It is senior management and not the regulator who is engaged in their business day in day out and it is right that they should accept the regulatory responsibility which comes with managing their business.’57 The FSA is primarily concerned with the firm’s management of the risks it poses to the regulatory objectives set out in FSMA. This is separate from the firm’s interest in its own profitability, even if there is much overlap between these two matters. Fourthly, the FSA does not seek to achieve a zero-fail regime: firms will fail and insureds will be sold the wrong products without there being a flaw in regulation. The FSA is seeking to support a competitive market place, which will encourage insurers to innovate and to be efficient, and to establish a prudential environment in which insureds feel reasonably safe and yet are able to take risks. As Howard Davies put it when he was chair of the FSA, it comes down to the issue of ‘just how safe one wishes to make the industry’.58 The aim of regulation is not to prevent insurers from taking risks with investment or to shield insureds against market risk. So ‘a corporate failure is not necessarily a failure of regulation. It may simply be a sign that market forces are working.’59 The problem with this approach was that it was always likely to be challenged by the common reaction among investors to loss of money following the collapse of a firm, namely, that it should not have happened, and therefore the regulator must have failed in its duty by allowing it to happen. Moreover, the financial crisis has shown that merely stating that firms could fail was not enough, and much effort is being put into ensuring that this is possible without creating damage to the financial system.60 Fifthly, the FSA places a good deal of emphasis on tailoring its work to different circumstances. For instance, the FSA is more likely to step in to protect consumers than to protect participants in the wholesale insurance market where the parties are skilled. In relation to the latter, the view is taken that a greater reliance can be placed on the market developing solutions to problems as they arise so that the FSA need only intervene if there is clear evidence of market failure. Finally, as has already been seen, the FSA is obliged to be transparent in its work: so, for instance, it must consult and engage in a cost–benefit analysis before implementing rules.
The financial crisis brought criticism of the FSA’s working methods and has led to a significant shift in its approach, as outlined by Hector Sants, the FSA’s Chief Executive:
In the UK, significant progress has been made on improving supervisory effectiveness. The FSA has radically changed over the past three years and is now operating a more ‘intensive’ approach to supervision, which is designed to deliver proactive, not reactive, ‘outcomes-based’ supervision. The new outcomes-based approach is centered on intervening in a proactive way, and taking forward-looking judgements about firms, based on business model and other analysis and comprehensive and rigorous stress testing.61
3.3 General prohibition and authorisation
Section 19 of the Financial Services and Markets Act 2000 contains the general prohibition: no one, who is not an authorised62 or exempt person,63 may carry on (or purport to carry on) a regulated activity in the UK (see section 418).64 An authorised person is someone who has obtained Part IV permission,65 or a European Economic Area (EEA) or Treaty firm that qualifies for authorisation,66 or someone who is otherwise authorised by a provision of FSMA. A regulated activity is an activity that is within the list in schedule 2 of FSMA, that is specified by the Treasury and that is carried on as a business (section 22).67 The list in schedule 2 includes a contract of insurance (paragraph 20) and under the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 effecting or carrying out a contract of insurance is a specified activity.68
A person, who is acting in the course of business and who is not either authorised or acting with the approval of an authorised person, may not invite or induce another to engage in an investment activity (section 21),69 and breach of the general prohibition contained in section 19 is a criminal offence (sections 23–25). An agreement made by someone in breach of the general prohibition is unenforceable against the other party. That other party is entitled to recover any money or property paid or transferred under the agreement and to be compensated for any loss caused by parting with it (sections 26–28; see also section 30(2)–(4)). Where someone, who is authorised under FSMA, undertakes a regulated activity that lies outside the limits of their authorisation, this amounts to a contravention of the Act, but, while they may be liable to a disciplinary sanction imposed by the FSA, it does not render them guilty of an offence, or make any transaction void, although it may give rise to an action for breach of statutory duty (section 20(1), (2)).70
Both the framework within which the FSA must work when granting, suspending, varying and withdrawing authorisation and the rights of applicants or authorised persons affected by decisions on these matters are set out in Part IV of FSMA. The FSA is empowered to give permission (known as ‘Part IV permission’) to carry on a regulated activity (section 42(2)), but is required to ensure that the authorised person ‘will satisfy and continue to satisfy, the threshold conditions in relation to all of the regulated activities for which he has or will have permission’ (section 41(2)).71 These threshold conditions are contained in schedule 6 (see section 41(1)) and are the subject of a sourcebook in the FSA’s Handbook titled Threshold Conditions (COND).
The first threshold condition is that, if the regulated activity involves effecting contracts of insurance, the authorised person must be a body corporate, registered friendly society or member of Lloyd’s (schedule 6, paragraph 1(1)).72 Secondly, where the authorised person is a body corporate constituted under UK law, its head office and registered office, if any, must be in the UK (schedule 6, paragraph 2(1); COND 1 Annex 1 and 2). This aims to prevent problems of supervision caused by a company having its head office in the UK while being authorised elsewhere. There is no definition of ‘head office’ in any of the relevant legislation, however, the FSA has taken the view that it need not refer to the place of incorporation, or where the firm conducts most of its business, or to the place where its central management and administration are located (COND 2.2.3). If a firm authorised in the UK is carrying on motor vehicle liability insurance business, it must have a claims agent in each of the other EEA states (schedule 6, paragraph 2A).
The third threshold condition is that, if the authorised person has close links with another person, the FSA must be satisfied that this will not inhibit effective supervision and that, if the other person is subject to the laws of a country outside the European Economic Area, those laws will not prevent effective supervision. By ‘close links’ is meant that the other firm is the parent or subsidiary of the authorised firm, or is the parent of a subsidiary of the authorised firm, or is a subsidiary of the parent of the authorised firm, or the other firm controls 20% of the voting rights or capital of the authorised firm, or the authorised firm controls 20% of the voting rights or capital of the other firm (schedule 6, paragraph 3). It is worth noting that the FSA may have regard to anyone who has, or is likely to have, a relationship that is considered relevant with an applicant or with an authorised person when determining whether to grant permission or to vary or cancel an existing permission (section 49(1)). A key concern here is that the FSA receives adequate information from all these parties to enable it to assess whether the regulatory requirements are being met (COND 2.3 and 2 Annex 1).
The fourth threshold condition requires the FSA to be satisfied that the authorised person has adequate resources to conduct the regulated activity (schedule 6, paragraph 4). By ‘adequate’ is meant ‘sufficient in terms of quantity, quality and availability’, while ‘resources’ refers not only to financial resources but to, for instance, the systems, staff and anyone related to the firm, such as directors, controllers or those with close links (PRIN 3 and 4, see below). As part of this condition, the FSA will expect an applicant for authorisation to present an appropriate business plan (COND 2.4). Fifthly, the FSA must be convinced that the authorised person ‘is a fit and proper person’. Consideration is given to any relevant circumstances, including connections with any other person, the nature of the regulated activity and ‘the need to ensure that his affairs are conducted soundly and prudently’ (schedule 6, paragraph 5). Obviously, the ability of a firm to satisfy this condition will be affected by the fitness of those who work in the firm and those who are closely connected with it so that, for instance, an unfit director may render the firm itself unfit. A firm will be expected to conduct its business with integrity and in compliance with the relevant standards of the FSA and of any other regulatory bodies. It must have competent and prudent management and must conduct its affairs with due skill, care and diligence (COND 2.5). The sixth threshold condition is that an insurer from a non-EEA state must appoint an authorised UK representative. The non-EEA insurer must be a body corporate formed under the law of the place where its head office is located and the person carrying on insurance business in the UK must comply with the requirements on assets held in the UK; if it wishes to conduct insurance business in other EEA states it must have such assets in those states as agreed between the FSA and the supervisor in those states.73
To elicit the information required to make a decision about authorisation the FSA has designed an application pack.74 After receipt of the application the FSA may visit premises and arrange discussions with the management. The FSA may grant or refuse permission, or may grant a narrower permission than is sought,75 and it must describe the regulated activities for which permission is being given, although it may also specify limitations to that permission and requirements that must be fulfilled.76 The FSA maintains a public register of those to whom it has granted Part IV permission (FSMA, section 347).
3.4 Approved person
An approved person is an individual within a firm who carries out a controlled function and is approved by the FSA as being fit and proper to carry out that function (FSMA, section 59). The holders of certain posts in an overseas, non-EEA company, which has UK branches, do not require approval by the FSA, although there must be notification to the FSA (‘notified posts’): the worldwide chief executive of a firm where that person is situated outside the UK; the person within the overseas firm who has purely strategic responsibility for the UK; and the authorised UK representative of an insurer.77 A controlled function is one that the FSA regards as key to the obligations under Part V of FSMA, which deals with the performance of regulated activities. The controlled functions are listed in SUP 10.4.5 (section 59(3)), and these are divided into categories. They involve the management of the business (SUP 10.5): governing functions (SUP 10.6), required functions (SUP 10.7), systems and controls functions (SUP 10.8) and significant management functions (SUP 10.9).78