The Intelligent Quarterly from the publishers of The Insurance Insider

Spring 2012

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Politicians and policymakers were quick to argue that the recent crisis in the financial sector requires fundamental regulatory reform. While few would argue in favour of the status quo, it does not follow that all proposed reforms are sensible or proportionate responses.

The challenge for (re)insurers is to put the case in favour of more effective regulation, rather than just more regulation.

Transatlantic divide
In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act seems likely to eliminate many of the current inefficiencies in the regulation of surplus lines and reinsurance business.

In the UK and Europe, however, effective regulation seems to be assumed to mean tougher regulation. As part of this process, (re)insurers risk being lumped together with banks, but, in contrast to the banks, under-represented within the regulatory bodies.

With reason, one could simply point out that many of the proposed measures should not be aimed at (re)insurers since the sector proved resilient. While (re)insurers are, in a general sense, systemically important, experience shows that they do not generally fail in the same way as banks, or pose the same systemic issues when they do fail.

However, such arguments appear unlikely to gain much traction - the debate has already moved on to looking at the detail of reform, rather than whether (re)insurers should be part of it. Like it or not, (re)insurers need to focus on making the best of what is on the table rather than arguing that they should not be at the table at all.

An example can be seen in the UK coalition government's plans to change the structure of financial services regulation in the UK.

Before the general election in May 2010, th UK's Conservative Party grabbed the headlines with a policy of "abolishing" the Financial Services Authority (FSA). In July 2010, HM Treasury published a consultation document setting out in more detail what this means.

The key points of interest for (re)insurers are as follows:
A new Financial Policy Committee (FPC), part of the Bank of England, will be responsible for macro-prudential oversight of the financial system. The FPC will be dominated by bankers, although the government acknowledges that the five external FPC members should include people with "experience of... insurance", as well as macro-economic expertise.

Prudent supervision
The prudential regulation of banks, (re)insurers, broker-dealers and investment banks will move to the Prudential Regulation Authority (PRA), a new subsidiary of the Bank of England. The PRA's role will include authorisation and supervision of (re)insurers and policing the approved persons regime.

While it is claimed that the PRA will have "operational independence" from the Bank of England, its board will be chaired by the bank's governor, and the bank's deputy governor for prudential regulation will also be the PRA's chief executive (initially, Hector Sants, a former banker).

So it is hard to see how the PRA will be "operationally independent" with a board dominated by bank representatives. For (re)insurers, the concern will be whether in practice those leading the PRA will really understand why insurance is different from banking.
(Re)insurers should consider how they can best ensure that their voice will be heard and their position understood by such a banking-dominated body.

In the future many prudential regulatory decisions will in any case be made in Europe, not the UK. The PRA will represent the UK on the new European supervisory authorities for banking and insurance. Again, its ability to represent the interests of UK (re)insurers in Europe will depend on having people who understand insurance.

Lloyd's governance
The government is still deciding how responsibilities for regulating Lloyd's will be allocated. There may be more scope for Lloyd's to argue its corner, although it would be odd if prudential regulation of the Lloyd's market did not come within the PRA's remit as well.

Conduct of business will be regulated by a Consumer Protection and Markets Authority (CPMA), which will also be the prudential regulator for insurance brokers rather than the PRA.

The obvious danger with splitting regulatory functions into two bodies is a dysfunctional relationship between the two. While this risk is recognised, and even if the two bodies do co-operate effectively, (re)insurers are likely to find engaging with the regulators more complex and time-consuming than before.

"Like it or not, (re)insurers need to focus on making the best of what is on the table rather than arguing that they should not be at the table at all"

The government suggests it might be more cost-effective if the CPMA is formed from the rump of the FSA once the PRA's functions have been taken out. It adds that CPMA is a working title. It is tempting to wonder whether it might even be more cost-effective to retain the FSA name rather than spend thousands on rebranding.

The fact is that large parts of the system did not fail, including the insurance sector. The problems at American International Group (AIG) were unique, and caused largely by the fact that the relevant division within AIG was acting more like a bank than an insurer.

(Re)insurers are asking whether the UK's proposed changes will in fact provide a more effective and robust regulatory structure and, if so, whether the inevitable disruption caused is worthwhile.

No perfect model
In many respects, structure is of secondary importance; what matters most is the quality of regulation and those working for the regulators.

An analysis of different structures around the world at the time of the crisis shows no clear correlation between regulatory architecture and resilience when the crisis broke, as the FSA has been keen to point out.

The problem with assuming that regulatory failure must be addressed by structural change is that there is no perfect regulatory model.

For example, one of the key shortcomings of the UK architecture, which the government's reforms are trying to address, was that it was unclear which part of the tripartite regime was responsible for identifying macro-prudential threats to financial stability and taking away the punchbowl before the party got out of hand.

It clearly makes sense to remedy that deficiency, but it is worth bearing in mind that this regulatory blind spot was an international failure and not unique to the UK. One has to ask whether any regulatory architecture can guard against what might be more accurately diagnosed as failings of human nature.

Regulatory risks
The new approach to regulation - described in the UK as being more intrusive - is probably a more significant shift in terms of (re)insurers' day-to-day experience of regulation. The danger is that the additional cost of compliance suffocates the financial services sector, particularly at the retail end, reducing competition and discouraging innovation.

Indeed, perhaps the main regulatory risk for the next generation is not a repeat of the events of the last couple of years, but that too much credibility is given to those who claim to be able spot the next crisis, and that the regulatory brakes are repeatedly applied unnecessarily. The medicine may cure the disease, but kill the patient.

Mathew Rutter is a financial services partner at UK law firm Beachcroft LLP