Regulation of Insurers

‘In the United States and Germany, and to a lesser but considerable extent in many other countries, insurance is subject to close regulation. Interference with free activity in the insurance market is especially noteworthy in a business which is highly competitive, which is generally well-run along conservative lines, and which presents no striking problems of domination of economic life or subversion of political processes. It is perhaps not easy to justify such extensive regulation, at least in comparison with the freedom enjoyed by most other businesses of similar importance. If one seeks reasons, he is told that the parties to an insurance contract are not negotiators of equal weight in the marketplace, that insurance is an exceedingly complicated business selling a product which is difficult for its votaries to understand and impossible for most of its buyers, that the contract has long duration in many instances, that the uncertain payment coming at the end of the long delay is likely to be of crucial importance in the life of the policyholder. Although all of these things are true, it must be conceded that each of them is true of some other businesses as well. However, there is probably no other business to which so many of these characteristics apply in such large measure, and perhaps in the aggregate these factors justify the deep-probing supervisory activities of the modern insurance department.

All of these factors are in reality variations of the first, the disparity in bargaining power. This suggests that regulation exists to protect the weaker contracting party. It is not surprising, therefore, that marine and transport insurance and reinsurance have generally been subjected to much less control than other lines of insurance, for here the insurance buyer is likely to be as large as the seller, as expert, and as adept in the market-place.

While protection of the weaker of two contracting parties explains the intervention of the state in the insurance transaction, it does not explain the myriad forms taken by that intervention. Beginning with the most obvious, the requirement of solidity [by which is meant, broadly, solvency] is imposed because without it the business does not work at all, does not insure. This purpose is the first to be perceived after the decision has been made for government intervention; indeed, threats to solidity were the raison-d’être of the early insurance departments. Once intervention has begun, new purposes begin to emerge, and the goals of reasonableness, equity, and fairness become explicit. Finally, as the insurance enterprise becomes more and more crucial to the social fabric and as regulation acquires more sophistication, the manifold purposes of society at large come to have more and more implications for the processes of insurance regulation.

There is nothing inevitable about the growth of insurance regulation from a simple focus on the solidity of the enterprise to a wide-ranging concern for many purposes. English regulation, for example, seems to have gone little beyond the purpose of solidity. Clearly, in the case of England this reflects neither an undeveloped state of the insurance enterprise nor an undeveloped sense of responsibility for the welfare of the people. In part it reflects a greater emphasis than we place on certain of the objectives we have described, for the objectives are not all consistent with one another. In part it may reflect also an entirely different pattern of solutions which seek and achieve roughly the same ends. Thus the ease of access of new entrepreneurs into the American insurance market presents the American insurance departments with difficult problems of control — problems that do not exist in the English market, where few new companies are formed. Moreover, there is said to be a quality of sober restraint in English economic life that may make various kinds of regulation less necessary than here. Another relevant factor is the degree of self-regulation of the business. One may justifiably suggest as a hypothesis that the English pattern of regulation seeks the same goals as the American, but that the English social and governmental structure permits it to achieve the same goals with a lesser expenditure of effort than does ours. This would not be the first time that English society had managed to do a large job with a small investment in central government machinery. In its early centuries, the royal judicial machinery in England operated quite successfully with an investment in judicial manpower that was a mere tithe of that used on the continent of Europe. Before one concludes that the English are less effective in achieving most of the goals we have described, or are uninterested in some of them, one needs to make a close comparison between the English insurance system and the American or German systems — and in considerable depth. The differences one thinks he perceives between the purposes of English insurance supervision and those of either American or German supervision may be more apparent than real. The difference may instead be a difference in the extent of the need for particular governmental controls. But this question requires much exploration before one can venture an answer.

It is usually assumed that the purpose of insurance regulation is single and simple. In reality it is neither. There are many purposes, and they are in considerable conflict with one another. Insurance is a small world that reflects the purposes of the larger world outside it. It is not easy, therefore, to state a theory of insurance regulation in which every activity will neatly fit. Perhaps it is even impossible. It seems likely, however, that more attention directed to the purposes of insurance regulation would illuminate the field and render it more meaningful, not by making it simple but by explaining the objectives in all of their complex interaction and in all of their conflict. Only thus can a theory of insurance regulation be developed as a meaningful guide to practical, everyday activities in the insurance departments of the world.’

‘At the opposite extreme from using the definitions as a guide in delimiting the scope of regulation, there is the possibility of simply asking whether there is need for regulation or not…The reasons for submitting certain activity to regulation coincide mainly with the general reasons for supervising insurance. Although these reasons are not identical for all countries, as appears from fact that the rules and facts of supervision differ considerably one country to another, some main reasons can be stated. They include the need for protection against fraud, the need for technical skill and caution in conducting a sound insurance business, the need to collect and protect adequate funds (most conspicuous in long-term insurance, such as life insurance), the general desire to assure a fair and equitable treatment of the insured, the need to protect the insured against his own inability to understand the value of what he gets in exchange for the premium, and the great social importance of insurance that has as a principal object the task of providing assistance in time of need.

If we accept these reasons for supervising insurance as our primary guide for delimiting regulation, the outcome would differ considerably from that reached by starting from the definitions of insurance. Instead of examining whether there is assumption and distribution of risks, we should ask whether there is a need for a complicated technique which calls for a special skill. Instead of asking whether the promisee gives any special consideration for the promise, corresponding to a premium, we have the question whether the value of the promise is difficult to estimate. Instead of asking whether the risk attaches to a fortuitous event, we should rather ask whether there is a need to collect and maintain special funds. Furthermore, we should ask whether there is any need for protection against fraud and for ensuring fair and equal treatment of the promises, and whether the promise has less social importance.

Against using the need for regulation as a test it can, however, be argued that general policy objectives are not suitable means for deciding questions of applicability of law. If we should ask simply whether an activity is in need of regulating, we might conclude that a certain enterprise does not need to be supervised, because it is well managed without supervision. But this would be inconsistent with the policy which imposes regulation even on the best-managed insurance companies. At the other extreme we might impose regulation on any enterprise whose activity calls for accumulation of funds and where the value of the benefits is hard to estimate. It is necessary to find some more concrete and limited circumstances on which to base the decisions.

A more rational use of the idea that regulation should be imposed where there is a need for it consists in deducing from the rules of insurance law those particular dangers to the public an enterprise must create in order to be a legitimate subject for regulation. The decisive factor is not whether the business is well managed in the particular instance but whether the activity is of a type which requires regulation as insurance. If an enterprise operates on the basis of such risk-taking as requires the accumulation of funds, careful rate-making, and holding safe and liquid assets, it presents those dangers that are contemplated and counteracted in the rules of insurance law. If the dangers to the public are only those of usury or of unfair competition, or of deficient performance of professional services, there is no reason for imposing regulation as insurance, even if it may be assumed that as a secondary result of such regulation these deficiencies would also be eliminated.

However, this is certainly not the whole solution of the problem. The fact that an enterprise offers dangers that are typical of insurance and counteracted by rules of insurance law does not imply that it must be regulated. To comply in all respects with the rules of regulation — whether these are stated in a statute or depend on the discretion of the supervising authorities — will often be so great a burden that useful activity might be suppressed. We must therefore take into account also those considerations that argue against regulation.

We are now back at the same result as was implied in the criticism of the approach through a formal definition; we should examine whether an activity is of such a type that it should conform to well managed insurance. We then do not look at each single feature of the activity separately but consider the whole structure of the business as an entity. This view is also justified by the fact that there is often a close connection between the relevant aspects of an activity. If an enterprise is simple, unbusinesslike, and provides services in kind rather than in money, there is generally (but not always) little need for the collection and preservation of funds. Instead of comparing the details of the activity one by one with the elements of a definition, we should therefore examine the whole of it on the basis indicated by the insurance laws.’

Maugham J:

‘An insurance company differs in its nature from almost every other trading concern. It starts, in the first instance, without liabilities. It obtains premiums sometimes to very large amounts, and, as risks mature and its debts begin to figure in its balance sheet, premiums which are received ought in general to be set aside for the purposes of paying not only the not unsubstantial costs of carrying on an insurance company business but also the claims which are inevitable. The solvency or insolvency of an insurance company has to be ascertained, as everybody knows, by, among other things, a most careful scrutiny of the funds which have been set aside out of premium income for the purpose of meeting claims. Inasmuch as the claims come in in every case after the premiums have been secured, there is always a risk that an insurance company may, by offering what look like very advantageous terms to the public, obtain a very large premium income which, as the result of the practical working of the company, proves to be an insufficient income for the purpose of meeting claims.’

‘1.1  In order to place the regulatory reforms into context, this chapter describes the economic, social and strategic importance of the insurance industry and the present challenges it faces. It then sets out what might be the key characteristics of the insurance market in the future and, finally, it explains the influence our reforms will have in that context.

1.2  The insurance sector is a key part of the UK financial services industry. It is important, both from an economic and a social perspective, that the UK has an insurance market that operates effectively, remains competitive in European and world markets, and in which all participants have confidence. The insurance industry allows consumers, both retail and commercial, to transfer risk, to buy protection and to save (for example, for retirement). An effective savings industry has become all the more important given both the public policy objective to shift responsibility for retirement provision away from the public purse, and trends in the occupational pensions market towards defined contribution schemes.

1.3  In addition to providing an important service to individual consumers, the insurance industry underpins almost all forms of economic activity and contributes directly and indirectly to wealth generation and social wellbeing. For example, the insurance industry:

—   enables businesses to pool risks associated with future uncertainties, and to sustain higher levels of activity than they could otherwise. This increases levels of economic activity and reduces costs, assisting UK firms in competing both in domestic and international markets;

—   allows organisations, both public and private, to ensure that their employees, those who use their products or services and other third parties who may be adversely affected by their operations are protected financially in the event that they suffer injury or loss. In some cases, such protection is required by law;

—   is a major means through which savings are channelled into investment in industry (the life industry accounts for about 20 per cent of shareholdings in UK industry). Through these investments, the industry helps drive growth across the whole economy; and

—   is a major direct contributor to UK GDP and foreign earnings and is a major source of employment.’

‘In the UK market the boundaries between financial services are becoming increasingly blurred. This is particularly evident in relation to life insurance, but in non-life insurance alternative forms of risk transfer and securitisation of risk are also developing. Add to this the formation of complex groups and conglomerates — amongst other things to exploit market opportunities for cross selling — and the interactions between insurance and other financial services are clearly growing. The establishment of the FSA was not a case of the regulators leading the market, but of the Government recognising that developments in the market required a more co-ordinated approach to supervision across financial services.’

Institutional and macroprudential setting

157. The British insurance industry is venerable and large, contributing importantly to UK employment and overseas earnings. With net premium income in 2000 of £174 billion or approximately 10 per cent of the world market, it is the third largest after the US and Japan (although considerably smaller than either). It includes the most important cross border non-life insurance markets in Lloyds and the London Market, which together account for 65 per cent of approximately US $20 billion of annual global cross border general insurance premium flows…and is a significant source of life insurance product for people resident in other EU countries. Insurance penetration at 15.8 per cent is the highest in the world, South Africa excepted. UK insurers are also well represented in foreign markets.

158. UK based insurers are, with self-administered pension funds, the most important repositories of individual financial sector wealth. Of total FY2000 financial assets of households and related non-profits of £3 trillion, more than 50 per cent is represented by insurance policy-holder-related liabilities…Total investment assets under management at the end of 1999 amounted to slightly over £I trillion and the life and pensions sectors were easily the major providers of finance to government and private borrowers.

159. An analysis of the long term (life) insurers by capital strength shows a distinct bimodal distribution, with a large number of insurers having 100 per cent to 300 per cent of minimum required statutory solvency and a smaller, but significant group of very well capitalised insurers. From a stability and efficiency point of view the main danger is that if investment returns remain depressed, some long term players under stress will engage in risky business and investment strategies and tactics in an attempt to improve their market positions. This has already been observed in a number of other leading industrial markets, and FSA management has advised that they are aware of and monitoring this trend.

160. The general insurance industry does not face fundamental questions of the type facing the long term sector; however it does have its own challenges. These relate largely to operating in a world of low investment returns, much fatter and less tractable claims tails than were previously thought to exist and, in the near future, a more demanding recognition of liabilities and capital allocation under a risk based prudential regime.

161. Overall the assessors did not identify any immediate systemic risks arising from the insurance sector. However the linkages between insurance and banking appear to be growing and warrant close monitoring. Broader risks arising from the potential rationing of insurance classes essential to the operation of key sections of the economy also appear to be low, but the assessors were advised that if the general insurance sector suffers additional severe shocks, this could become an issue.

General preconditions for effective insurance supervision

162. The UK…has a well-developed judicial system with a reputation for probity and professionalism. The professions important to the financial sector are also well developed in the UK and are subject to full liability for breach of duty. There is no insurance accounting standard aside from the regulatory reporting requirements, which serve a different role to published accounts. Instead there is a Statement of Reporting Principles (SORP), largely worked out by the insurance sector on a modified regulatory reporting basis, but informed by general company reporting requirements, and “negatively approved” (not objected to) by the Accounting Standards Board (ASB). The assessors were advised that the imposition of IAS [International Accounting Standards] in the EU in 2005 will to a large extent supplant the ASB role.

Main findings

163. The UK is developing a very advanced, indeed leading edge, approach to financial sector supervision. The FSA’s approach for the future appears to be to build on existing strengths, but with more focus on risk level and likely macro impact, and further emphasising the responsibilities of management’s and boards of entities which come within its remit. To some extent the approach cuts across the Core Principles, which incorporate a range of supervisory styles.

Nevertheless, the FSA and its supporting regulatory infrastructure comfortably accommodate most requirements of the IAIS assessment methodology. When the importance and special features of the UK market are considered, and appropriately more demanding standards are applied, a number of opportunities for further refinement become apparent. In particular, under the UK risk-based approach, not all financial intermediaries will be inspected (unless they are selected for a thematic investigation), and even in the larger institutions, the more routine supervisory visits will generally operate at a high level, although skilled persons may be utilized when required. The assessors judged that there is scope for a more hands-on approach to inspection, using specialist skills where appropriate while still not threatening the risk-based model.

164. Insurance supervision in the UK is in a transition phase, and the assessors strongly agree that greater emphasis will need to be placed on staff training and development as the new risk-based methodology is rolled out. In addition, the disposition, quantity and quality of actuarial, non-lifelong tail claims assessment, and reinsurance skills needs to be carefully reviewed with a view to further strengthening.

165. The UK is a world leader in corporate governance; however the assessors recommend that the FSA require firms to strengthen or formally adopt the risk manager function. In addition, there is a general perception that on site inspections by the supervisor could be more testing. The modalities currently being developed should largely deal with these concerns.

166. The assessors believe that there is scope for a more explicit statement of solvency requirements. Regulatory minimum solvency levels are officially set at EU levels or somewhat higher, which tend to be less demanding than risk based capital methodologies. While the assessors acknowledge that more demanding standards apply in practice in the UK through the informal rules that have been applied, these ideally should be codified…’

(i)   as a legislator it makes rules, statements of principle, codes of practice, gives directions and issues general guidance (eg see sections 64, 69, 119, 124, 138(1), 141–42, 158(5), 210, 316, 318, 328);

(ii)   as an investigator it has powers to gather and demand the information required to undertake its work (see, for example, sections 165–77, 284, 340, schedule 15);

(ii)   as a judicial and enforcement authority it rules on breaches and imposes penalties in the form of fines and the refusal, variation, suspension or withdrawal of authorisation (see, for example, sections 205–11 and below, and Part XXVI);

(iii)   as a prosecutor with respect to an offence under the Act or subordinate legislation (eg sections 401–02);

(v)   as a compensatory mechanism it has established a scheme, funded by the industry, to compensate those who have suffered loss in the event of an authorised person being unable to meet claims (sections 212–24). The FSA set up Financial Compensation Scheme, which replaces the Policyholders Protection Fund.

One theme running through the structure of the Act and the FSA’s own procedures is the need for regulatory transparency and accountability. The mechanisms include an independent Complaints Commissioner (FSMA, Sch 1, para 7), the Financial Services Ombudsman Service (FSMA, section 225 and Sch 17, Parts I and II), Practitioner and Consumer Panels, with whom the FSA must consult (FSMA, sections 8–11). There also elaborate provisions for public consultation, which the FSA must undertake before issuing rules, statements or codes (see sections 65, 155). These have led to criticism about delays and paperwork. Moreover, while a person or firm that has been disciplined by the FSA may seek a fresh hearing before the independent Financial Services and Markets Tribunal, the publicity that may be generated is not likely to be welcomed by the industry. The paucity of hearings before the Tribunal seem to confirm the view expressed by Lord Hodgson during the progress of the bill through the House of Lords:

‘Regulated firms, knowing that there will be publicity whatever the outcome, will inevitably be reluctant to avail themselves of their full legal rights…Even if the defendant is found not guilty, the aura of being so referred will take a long time to dispel…Such recollections would make a significant dent on any firm’s operations for a long time.’ (quoted in A Hayes, “Open Justice at the Tribunal?” [2002] Butterworths Journal of Banking and Financial Law 427)

19 (1)  No person may carry on a regulated activity in the United Kingdom, or purport to do so, unless he is—

(a) an authorised person; or

(b) an exempt person

 2 (2)  The regulatory objectives are—

(a)   market confidence;

(b)   public awareness;

(c)   the protection of consumers; and

(d)   the reduction of financial crime.

    (3)   In discharging its general functions the Authority must have regard to—

(a)   the need to use its resources in the most efficient and economic way;

(b)   the responsibilities of those who manage the affairs of authorised persons;

(c)   the principle that a burden or restriction which is imposed on a person, or on the carrying on 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 minimise 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.