14 December 2005
Life & Pensions Conference
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Opening Comments
1. It’s a pleasure to be here this morning – let me thank Life & Pensions Magazine for inviting me to say a few words.
2. Now, I’m not an insurance specialist, but I do have a strong interest in the area. As a Treasury minister, the insurance market is a key part of my brief, and I do appreciate the importance to our society of dealing with insurance risk.
3. And I very much see my role being to listen, learn and lead.
4. So let me welcome the recent launch of this magazine, which clearly responds to a need for greater understanding of risk management by life and pensions providers.
5. Risk management is a crucial part of the efficient operation of insurance. It is a vital part of effective consumer protection.
6. And what I want to do this morning is put some of this in a wider context. I’ll say a little about financial services in general, and on the importance of insurance to our economy as well as our approach on existing insurance directives, and on Solvency II.
Financial Services Landscape
7. Clearly, one of the major developments in risk management over recent years has been the shift to a more holistic approach.
8. Such ‘enterprise risk management’ has led to the wider adoption of Chief Risk Officers, even.
9. Whilst the Treasury has yet to adopt one, we certainly have a holistic approach to financial services. For example, we don’t see insurance as a simplistic silo but as a landmark feature of the financial services landscape in general.
10. I doubt anyone here to do would disagree that the global economy is in the midst of a radical transformation. And this has far-reaching and fundamental implications for the underlying pattern of economic activity.
11. Such changes pose deep challenges and real opportunities for both the UK and for all advanced economies – and clearly the financial services sector has a central part to play.
Treasury Approach
12. Now, at the Treasury we recently identified five major trends in the global economy that are changing the demand for financial services.
13. First, growth in emerging economies. Second, tougher global competition. Third, technology and the increasing rewards from innovation. Fourth, demographic change. And fifth, technology and the liberalisation of financial markets.
14. These are all driving structural changes in financial markets themselves, and they all represent a challenge for the sector and for policy makers.
15. And to address them, we need to promote further financial integration – a means to deliver growth as part of European economic reforms.
16. We have to allow the financial services sector to meet the changing needs of both the economy and society.
17. And we must ensure the EU financial services sector remains globally competitive.
Insurance Sector in the Economy
18. Within this, the insurance sector plays a key role, matching savers and investment opportunities through the investment chain.
19. Insurance is also a vehicle for pooling and managing the risks faced everyday by consumers and firms.
20. Today, the UK insurance services sector fulfils all of these functions – nationally, regionally and globally. And this reflects its importance within such an integrated marketplace.
21. Visibly, the contribution to our wider economy is impressive. Last year alone, UK insurance firms had almost £1.2 trillion of assets invested on behalf of the millions of savers and general insurance customers.
22. The insurance sector was the largest single contributor to net exports of the UK financial sector, with net exports contributing £6.4 billion to the £19 billion total.
23. And it provides employment – directly and indirectly – to almost 340,000 people. For Europe as a whole, the statistics are also impressive, with almost €6 trillion of assets and employment to over one million people.
24. Given this, we believe that such a key area must have the most efficient system of prudential regulation. This is why we’ve supported and pursued the Solvency II directive which will affect economic welfare in some pretty profound ways – from the type of products on offer across the EU to global competitiveness of the industry.
Existing Insurance Directives
25. Why do we need to update this regulatory regime? Well, the current approach to prudential regulation dates from the 1970s, when the pressures were far different.
26. The main features included a simplistic volume-based capital requirement and detailed asset allocation limits. While this has served us reasonably well – providing consumers a minimum level of confidence in long-term savings – the world has moved on.
27. Financial markets are more liquid and deep than they were thirty years ago. We’ve seen countless innovations in financial instruments. And there’s been material progress in the industry’s understanding of risks – and so a widening gap between regulatory capital and economic capital.
UK Reforms
28. The case for reform is, therefore, a strong one – and in the UK, the FSA has already made a good start, departing from the one-size-fits-all model.
29. This is challenging and I know it comes in addition to other key requirements such as implementing the Insurance Mediation Directive.
30. But I also think this industry benefits strongly from implementing the FSA’s reforms – from developing knowledge about risk management faster than your competitors.
Solvency II Directive
31. This brings me to one of the major challenges in the field – the implementation of Solvency II. Now, the Commission expects to adopt this directive by July 2007.
32. And the proposals will be shaped by the European Commission’s Better Regulation initiatives as well as through the Lamfalussy process – of which this government is a keen supporter.
33. Crucially, the Commission has made real progress in the last 12 months on Solvency II.
34. It has added further clarity about the aims, which now includes improving the competitiveness of EU insurers – not to mention the allocation of capital resources in addition to consumer protection.
35. It has also added further clarity about the means for achieving these aims. For example, adopting a risk-based approach with quantitative and qualitative elements.
36. Using a three pillar approach derived from the Basel model – with Pillar One as minimum capital requirements, Pillar Two as supervisory review, and Pillar Three as disclosures.
37. This amounts to a real step change in the prudential regulation of insurance, and I welcome this wholeheartedly.
Five Practical Objectives
38. Now – the next phase of the project starts in February when the Commission and Member States being to discuss how to deliver practical and proportionate policy solutions – solutions that deliver a risk-based approach for Solvency II.
39. With around 18 months to go to meet the Commission’s own deadline, I believe that – with clarity and determination – both the Commission and Member States should embrace five practical objectives for the project.
40. One – transparency.
41. Two – alignment of regulatory and economic capital.
42. Three – incentives for improved risk management.
43. Four – principles based regulation.
44. And five – effective supervision.
Transparency
45. Transparency is a key part of any risk-based approach – particularly with Solvency II. Because insurance companies are complex businesses, assessing their financial strength and the risks they carry is far from straightforward.
46. But these difficulties are only accentuated by a lack of transparency – and this can arise from the so-called hidden prudence emanating from overly conservative estimates of liabilities or assets.
47. Market-consistent valuations supplemented with an appropriate capital requirement are likely to provide the required transparency for Solvency II.
Alignment
48. The next objective is aligning regulatory and economic capital. This is, in part, about taking account of risks on the assets and liabilities side of the balance sheet.
49. But it goes wider than that. The more that insurers diversify their risks, the greater the underlying security for policyholders.
50. And I believe that Solvency II can give appropriate recognition to demonstrable diversification benefits – as well as for a firm’s risk mitigation efforts.
Incentives
51. Our third objective is providing incentives for good risk management. We must recognise that capital requirements can only be a second line of the regulatory framework’s defence.
52. The first and best defence against firm failure is a management team which understands – and can manage – the risk the business faces.
53. This is challenging because some of the elements of good risk management are not quantifiable and some are subjective. But there is no way to escape the need for a judgement by the regulator of how much capital a firm needs given the risks it has taken on and the strength its risk management.
Principle-Based Framework
54. Let me quickly turn now to the fourth objective – a principle-based framework. The focus on the quality of risk management naturally leads to a principle-based approach to regulation.
55. This also encourages management to develop their own assessment of business risks, rather than restrict them through sets of rules.
56. And fundamentally, principles rather than rule-based requirements are far more likely to support innovation in financial markets.
Efficient Supervision
57. The fifth and last objective is efficient supervision across national borders.
58. Cross-border groups represent a challenge for regulators – they give rise to benefits and to risks. Benefits, where belonging to a group, for example, increases diversification.
59. But also risks, where an insurance subsidiary could be affected by unrelated events elsewhere in the group.
60. I believe that a risk based approach for the prudential regulation of insurance means that insurance firms’ management should be able to allocate capital efficiently across EU subsidiaries.
61. This means solvency requirements must be consistent with the principle of ‘same risk, same charge’ that the European Committee of Insurance Supervisors has suggested.
62. So clearly, Solvency II needs to puts in place mechanisms that ensure sufficient supervisory cooperation.
63. Their absence reduces the benefits of prudential regulation and results in avoidable compliance costs.
Partnership Working
64. All of this amounts to a step-change in the prudential regulation of insurance.
65. The next question is how we can deliver such change. Clearly, embracing the five practical objectives I just outlined may well not be enough.
66. So in a union of 25 states, delivery also means strong cooperation with all other Member States – and vitally, with industry too.
67. Both the Treasury and the FSA are wholly committed to working with our respective counterparts to achieve this. But it will still be difficult for UK authorities to deliver the right framework for Solvency II without a strong and sustained commitment from the insurance industry.
68. In particular we believe that to exercise it’s influence – to the fullest extent – the industry should speak with one voice.
Closing Remarks
69. So let me finish by saying that insurance makes a vital contribution to economic welfare in the UK and to other Member States.
70. While there are significant forces changing financial services, including the insurance industry, it is crucial we have an adequate system of prudential regulation in the EU.
71. And with Solvency II, we seek to introduce a risk-based approach to prudential regulation. This will be a step-change.
72. I’ve outlined some of the actions needed to make this possible – but delivering this step-change also requires genuine cooperation between Member States. And it requires strong and sustained support from industry – maintaining our invaluable tradition of partnership.
73. Thank you.