Select Committee on Regulatory Reform Sixth Report


Appendix 2

Letter from HM Treasury to the Inquiry Manager of the Committee: response to request for information (Footnotes are Treasury footnotes)
IssueAnnex
General questions on the package
1. Why have the governance and market reforms been presented as a package that must stand or fall together, when on the face of it the market reforms (which seem to be the more controversial of the two classes of proposal) are self­standing and could form part of a more extensive and fully debated private bill for more wide-ranging reform of Lloyd's?
2. How does the Treasury answer the criticism made by some consultees that the proposed governance changes are merely an expedient to extend the chairmanship of the current Chairman? Will the Treasury confirm the origin of the proposals, whether they have been amended since inception and, if so, in what way and by whom?
3. Please provide a comprehensive table indicating the aims and functions of each of the various bodies representing individuals, associations and organisations with an interest in Lloyd's (including, for example, the major informal associations of underwriters and names), to allow evaluation of whether the consulted parties represent a proper cross­section of interested bodies. Annex 1
Proposal-specific questions
4. What are the powers of the Lloyd's Chairman compared with the Deputy Chairman, and of each compared with the Council? Can the Council overrule the Chairman and Deputy Chairman acting together or separately and, if so, by what mechanism? Does either the Chairman or Deputy Chairman have a casting vote in Council? Annex 2
5. Given the potential position of nominated members in casting deciding votes in the Lloyd's Council, how does the Treasury respond to the argument that the FSA should have more than a mere rubber-stamping duty in relation to their appointment if it replaces the Bank of England as the body with responsibility for endorsing such appointments?
6. What is the formal mechanism of delegation of power to the Franchise Board and the precise reasons why the current Committee could not be reconstituted as the Franchise Board.
7. How does the Treasury justify the abolition of the current restriction that only Lloyd's brokers can act as intermediaries in the placing of business with underwriters, given that the financial part of the cost-benefit analysis with respect to that proposal has now effectively been removed as a result of criticisms made during consultation? There is an assumption that review of the implemented proposal after two or three years will show benefits, but at least one consultee has challenged that assumption. What is the concrete basis for it?
8. How does the Treasury respond to the criticism that the proposed means of managing conflicts of interest will not adequately replace the divestment provisions that were a crucial element of the 1982 Act and that the draft Order should be modified to attach a specific code for managing conflicts of interest? In particular, how does the Treasury respond to criticisms in consultation that the FSA will not be able properly to monitor conflicts and that the proposed code is inadequate?
9. Please provide a detailed comparative explanation setting out the equivalent divestment/ conflict of interest provisions and intermediary restrictions that apply to Lloyd's major competitor bodies and jurisdictions and any current proposals for reform thereof. Annex 3

Q 1  Why have the governance and market reforms been presented as a package that must stand or fall together, when on the face of it the market reforms (which seem to be the more controversial of the two classes of proposal) are self­standing and could form part of a more extensive and fully debated private bill for more wide-ranging reform of Lloyd's?

Answer

The Government believes that both the governance and market-related reforms will benefit Lloyd's in terms of helping Lloyd's maintain its competitiveness. The consultation paper was drafted in such a way as to allow respondents to comment on the proposals separately on their merits, or to comment on some but not all of the proposals.

In the event, the consultation feedback confirmed that a significant majority of respondents wanted all the proposals to go forward. None of those responding suggested that the market reform proposals should be split from the governance proposals or subject to a different procedure. (This was consistent with the feedback from the pre­consultation, where none of those whose opinions were sought suggested consultation should be split in this way.)

It is also worth noting (see also question 2 below) that there was consultation and debate within Lloyd's about options for reform (both to the market and to governance arrangements) prior to the Treasury's involvement in developing proposals for a Legislative Reform Order. In particular, there was debate in Lloyd's concerning the role of brokers (prior to the introduction of the Insurance Mediation Directive) and again, in relation to the proposals of the Chairman's Strategy Group (CSG). The CSG report, which was sent to all members and was approved by an EGM in 2002[29], recommended that as part of its strategy for reform, Lloyd's should seek to remove requirements in the 1982 Act that constituted "unnecessary business interference", and that this should include looking again at the role of brokers and seeking removal of the divestment provisions. This means the ideas for reform in these two areas had already been subject to discussion at Lloyd's among the membership before they were considered by the Government for inclusion in the draft Legislative Reform Order.

Q 2  How does the Treasury answer the criticism made by some consultees that the proposed governance changes are merely an expedient to extend the chairmanship of the current Chairman? Will the Treasury confirm the origin of the proposals, whether they have been amended since inception and, if so, in what way and by whom?

Answer

The purpose of the draft Order as a whole is to help Lloyd's maintain its competitive position, by modernising the governance arrangements at Lloyd's and removing unnecessary restrictions on how Lloyd's organizes its affairs.

There are two proposals that impact on the positions of the Chairman and Deputy Chairmen (out of six governance reforms). The aim of these proposals is to give Lloyd's greater flexibility over recruitment to the roles of Chairman and Deputy Chairmen (proposal 1), and to remove restrictions in the election rules to permit greater alignment with the Combined Code on Corporate Governance (proposal 2). While the second proposal has a bearing on the position of the current Chairman (although its effects are much wider) and Lloyd's has clearly and publicly explained the effect on the current Chairman; the first proposal is of at least equal importance and does not affect the position of the current Chairman, who is a working member of Council. It will be for the Council of Lloyd's to decide, by passing an annual special resolution, on who it wishes to see as Chairman or Deputy Chairman.

In terms of the origin and development of the proposals, the Treasury can confirm that the proposals originated with Lloyd's. There have been many consultations at Lloyd's on governance and market matters. However, the immediate history of the proposals is as follows:

  • 2002: Following a consultation process begun in January 2002, the Chairman's Strategy Group published a report in July 2002 which was sent to all members and laid out a programme of major changes for Lloyd's.[30] As part of this programme, the CSG recommended that Lloyd's should seek a wide range of amendments to Lloyd's Act 1982, including extensive reforms on governance and business arrangements, but also more fundamental aspects of Lloyd's constitution such as voting rights. The route envisaged at this stage was a Private Bill as Lloyd's had not considered whether a Regulatory Reform Order (RRO) could be used to amend local Acts and of course the Legislative and Regulatory Reform Act 2006 was not in force at that time. The CSG proposals were approved at an EGM on 12 September 2002 by a vote of 78.9% (on a capacity weighted basis).

  • March 06: Lloyd's approached the Treasury to ask if the Government would promote an RRO to cover a limited set of reforms in relation to governance and market arrangements at Lloyd's, and made some preliminary suggestions as to what such an Order might contain.

  • September 06: Following discussions with the Treasury, Lloyd's revised its proposals. It decided it did not wish to pursue three of its preliminary suggestions, two of which would have involved more fundamental changes affecting the membership of Lloyd's (which Lloyd's did not wish to consider further without detailed discussions with stakeholders), and the other of which sought the repeal of Schedule 2 to the 1982 Act (which sets out an illustrative list of the purposes for which byelaws can be made). In addition, these proposals were not felt to be appropriate for inclusion in an RRO.

  • January 07: The Association of Lloyd's Members (ALM) wrote to the Treasury to explain that Lloyd's had consulted the Association on its outline proposals and that the ALM was supportive.

  • June 07: The Government announced its decision to develop proposals for a Legislative Reform Order.

  • Autumn 07: Development stage of proposals: at this stage, the Treasury concluded that one of Lloyd's proposals (that section 9 should be amended to remove the requirement that bankruptcy or insolvency results in automatic cessation of membership of the Society) should not be taken forward, and made amendments to eight of the remaining nine proposals to ensure all the proposals met the pre-conditions of the LRRA 2006 and catered for potential sensitivities in the market.

  • Pre-consultation: As a result of the pre-consultation, one proposal (to provide greater flexibility for arrangements dealing with arbitration concerning membership classification), was dropped, and further amendments were made to proposals concerning the Chairman (LRO proposal 1) and re-elections to Council (LRO proposal 2). Proposals for increased disclosure on the repeal of the divestment provisions were developed further (LRO proposal 8).

  • Consultation: As set out in the Explanatory Document, further amendments were made by the Treasury to the proposal concerning re­elections to Council (LRO proposal 2) in the light of consultation.

Q 3  Please provide a comprehensive table indicating the aims and functions of each of the various bodies representing individuals, associations and organisations with an interest in Lloyd's (including, for example, the major informal associations of underwriters and names), to allow evaluation of whether the consulted parties represent a proper cross­section of interested bodies.

See Annex 1.

Proposal 1

Q 4  What are the powers of the Lloyd's Chairman compared with the Deputy Chairman, and of each compared with the Council? Can the Council overrule the Chairman and Deputy Chairman acting together or separately and, if so, by what mechanism? Does either the Chairman or Deputy Chairman have a casting vote in Council?

The powers of the Council, the Chairman and the Deputy Chairmen derive from Lloyd's Act 1982, and from byelaws made under that Act. Section 1 of the Act makes it clear that power to govern the Society lies with the Council. Under section 6(1):

"The Council shall have the management and superintendence of the affairs of the Society and the power to regulate and direct the business of insurance at Lloyd's and it may lawfully exercise all the powers of the Society, but all powers so exercised by the Council shall be exercised by it in accordance with and subject to the provisions of Lloyd's Acts 1871 to 1982 and the byelaws made thereunder."

In addition, section 6(2) of Lloyd's Act 1982 provides:

"The Council may -

(a) make such byelaws as from time to time seem requisite or expedient for the proper and better execution of Lloyd's Acts 1871 to 1982 and for the furtherance of the objects of the Society, including such byelaws as it thinks fit for any or all of the purposes specified in Schedule 2 to this Act and

(b) amend or revoke any byelaw made or deemed to have been made hereunder."

The Chairman and the Deputy Chairmen are not allocated specific powers under the Act, though the Council is given power to delegate powers to them under section 6(3) which are not required to be exercised by special resolution.

As set out below, any such delegation may be amended or revoked by the Council under section 6(10) of the Act, by special resolution. No such delegation prevents the Council from continuing to exercise the powers or functions delegated.

The Council has powers to make byelaws "for regulating the appointment, powers and functions of the Chairman and Deputy Chairmen of Lloyd's" under paragraph (8) of Schedule 2 to the Act. However, this power has been sparingly exercised. Generally Lloyd's does not seek to name in its byelaws specific office holders to take decisions and instead decisions are taken by or on behalf of the Council.

Annex 2 sets out the powers granted to the Chairman and Deputy Chairmen by byelaw. The majority of specific byelaw powers relate, as would be normal in any company, to ensuring the proper conduct of general meetings and meetings of Council. These powers (under the Annual and Extraordinary General Meetings Byelaw) are given to the chairman of the meeting, who may be the Chairman of Lloyd's, or a Deputy Chairman. The other powers referred to in Annex 2 are also given to both the Chairman, and to the Deputy Chairmen.

Can the Council overrule the Chairman and Deputy Chairman acting together or separately and, if so, by what mechanism?

Section 6(10) of Lloyd's Act 1982 provides

"A delegation under this section is revocable by special resolution of the Council and shall not prevent the exercise of a power or the performance of a function by the Council itself."

Where the Chairman or the Deputy Chairman is exercising powers delegated by the Council, the Council is therefore able to overrule them.

Does either the Chairman or Deputy Chairman have a casting vote in Council?

No.

Proposal 3

Q 5  Given the potential position of nominated members in casting deciding votes in the Lloyd's Council, how does the Treasury respond to the argument that the FSA should have more than a mere rubber-stamping duty in relation to their appointment if it replaces the Bank of England as the body with responsibility for endorsing such appointments?

Nominated members carry out a controlled function in relation to the governance of Lloyd's, and as such must be approved under section 59 of the Financial Services and Markets Act 2000 (FSMA). This requires an application for approval to be made under section 60 of FSMA. That application may, under section 61, only be granted if the Authority is "satisfied that the person in respect of whom the application is made … is a fit and proper person to perform the function to which the application relates."

The criteria which the FSA consider in making this determination are set out in detail in the FIT section of the FSA handbook, and make it clear that the FSA's role is not limited to "rubber-stamping" applications for approval. The most important considerations (as set out in FIT 1.3.1) are the person's: (1) honesty, integrity and reputation; (2) competence and capability; and (3) financial soundness.

As noted in FIT 1.3.2, "In assessing fitness and propriety, the FSA will also take account of the activities of the firm for which the controlled function is or is to be performed, the permission held by that firm and the markets within which it operates."

In contrast, the Bank of England is not subject to a statutory duty to apply any particular criteria in considering whether or not to confirm the appointment of a nominated member. The Bank of England supports the reform proposed in the draft Order.

It is worth noting that the Fisher Report (1980), whose recommendations formed the basis of Lloyd's Act 1982, specifically envisaged that the process of confirming the appointment of nominated members might be carried out by "some other authoritative and independent confirming authority", if the Governor was unwilling to undertake the role. The Treasury believes that such an independent confirming authority now exists, namely the FSA, which did not exist in 1982, and which is now best placed to undertake this role.

Proposal 5

Q 6  What is the formal mechanism of delegation of power to the Franchise Board and the precise reasons why the current Committee could not be reconstituted as the Franchise Board.

The Council does not delegate powers to the Franchise Board. Instead, the Franchise Board acts as agent of the Council under section 6(7) of Lloyd's Act 1982—

"Nothing in subsections (5) and (6) above shall operate to limit the power of the Council or of the Committee to act by persons, committees, subcommittees or other bodies of persons, whose members may include persons who are not members of the Society, or by the employees of the Society."

This arrangement is unusual and often requires considerable explanation to those with whom the Society deals. Its operation and effect has, from time to time, given rise to challenges before Lloyd's Appeal Tribunal.

The Franchise Board was implemented following extensive consultation with Lloyd's members and the Lloyd's market and following the EGM held in 2002 (referred to in paragraph 6 above).

The Franchise Board comprises the Chairman of Lloyd's, Lloyd's Chief Executive Officer, Lloyd's Finance and Risk Management Director, Lloyd's Franchise Performance Director, 3 individuals who are insurance professionals connected to the Lloyd's market and 4 others who are fully independent of the Lloyd's Market.

The Committee could not be reconstituted as the Franchise Board because under section 5 Lloyd's Act 1982 the Committee of Lloyd's may only comprise working members.

Proposal 7

Q 7  How does the Treasury justify the abolition of the current restriction that only Lloyd's brokers can act as intermediaries in the placing of business with underwriters, given that the financial part of the cost-benefit analysis with respect to that proposal has now effectively been removed as a result of criticisms made during consultation? There is an assumption that review of the implemented proposal after two or three years will show benefits, but at least one consultee has challenged that assumption. What is the concrete basis for it?

The central argument for removing the current restriction at section 8(3) of Lloyd's Act 1982 was, and remains, that this rule is an obstacle to efficiency that impedes the future development of the market. This reasoning was set out in paragraph 1.35 of the consultation paper, where the Government stated that the current rule:

"…represents a potential barrier to further business development. Removal of section 8(3) and the limits on access would provide a more open competitive environment and potentially encourage the acquisition of new business at Lloyd's. This would allow further improvements in efficiency and productivity, and benefits Lloyd's and its members, as well as policyholders."

The same reasoning was noted in the Explanatory Document, see paragraph 5.5: "This creates an obstacle to efficiency and hinders free development of the market" and paragraph 5.16 "This is an obstacle to efficiency and productivity as it constrains the development of Lloyd's distribution arrangements …". At the very least, preserving the current section 8(3) will preserve a legacy of complexity and uncertainty which Lloyd's competitors do not face whereas by removing this provision Lloyd's will be better placed to determine and adapt its distribution arrangements according to market dynamics.

There is a wealth of economic theory to support the proposition that increased competition encourages economic efficiency, and leads to greater productivity[31]. However, quantifying benefits arising from future increased competition is not always easy: and in this case was difficult because of conflicting data from the industry.

For the LRO consultation, however, the Treasury decided that as well as the potential benefits (such as increased business) which could be expected from the reform but which were not quantified, the partial impact assessment should offer a monetised estimate of potential cost savings, based on figures provided by Lloyd's, as a point for discussion. The savings were expressed as a range (from zero) and it was noted these estimates were very sensitive to assumptions.

However, further discussion with the brokers confirmed that there were conflicting assumptions regarding the assessment of potential efficiency savings against existing brokerage patterns in relation to the US part of the Lloyd's market on which the consultation estimates had been based. Working through the estimates with the brokers (as is required under the LRO process[32]) therefore led to the conclusion that there was no settled evidence which could be agreed for a monetary estimate for cost savings.

However further feedback also confirmed some qualitative assessments: in particular, that the reform would allow for greater play of market forces and that this would lead to greater efficiency and potential new business for Lloyd's.

The conclusion the Treasury drew from this was that the principled basis for this proposed reform (in terms of removing an obstacle to efficiency) was accepted and therefore stood.

In terms of timing for assessing benefits, on the basis of feedback received, the Treasury also concluded that it would be appropriate to adopt a more conservative assumption regarding the timeframe in which benefits could be expected to materialize.

The final impact assessment therefore suggests a review point of 5 years (see A.28) rather than the 2-3 years suggested in the partial impact assessment. This length of time would also be consistent with the lead time past experience suggests is necessary to measure the results of opening new platforms /facilities.

Finally it is worth reiterating that it would be Lloyd's intention that managing agents be required to apply the same prudential standards required of Lloyd's brokers to all non-Lloyd's brokers placing business into the market. These standards (for Lloyd's brokers) were last revised in 2007, following full market consultation and were introduced with the support of both managing agents and the London Market Insurance Brokers Committee ("LMBC").

Proposal 8

Q 8  How does the Treasury respond to the criticism that the proposed means of managing conflicts of interest will not adequately replace the divestment provisions that were a crucial element of the 1982 Act and that the draft Order should be modified to attach a specific code for managing conflicts of interest? In particular, how does the Treasury respond to criticisms in consultation that the FSA will not be able properly to monitor conflicts and that the proposed code is inadequate?

The proposals for repealing the divestment provisions in favour of the introduction of a new transparency mechanism were developed in close consultation with the FSA (as in fact were all the proposals). They reflect the Treasury and FSA view that:

  • the FSA's principles-based requirements regarding management of conflicts of interest are suitable and apt to cover all issues concerning management of conflicts of interest within the Lloyd's market (absent the divestment provisions);

  • adequate protection would certainly be achieved if these rules were supplemented by an appropriate disclosure regime, that provided both pre- and post- transaction transparency in relation to transactions with associated brokers (for more detail on the current proposals, see paragraphs 5.54 to 5.55 of the Explanatory Document, and the proposed amendments to Lloyd's byelaws set out at Annex 2 to the Society of Lloyd's response to the Consultation Document[33]); and that

  • the principle of FSA oversight would be in keeping with the way the regulatory regime works for all other financial services firms and markets, where the regulatory framework requires risks to be managed rather than eliminated.

Respondents generally endorsed this view, with some noting that the proposal could potentially allow conflicts to be managed better than they are now.

The Treasury has chosen not to pursue the proposal suggested in consultation by one of Lloyd's members' agents for an additional Code, enforced through the LRO for two principal reasons.

First, it is not clear how the proposed Code of Practice would provide greater protection for names in relation to conflicts of interest which may arise as a result of the repeal of the divestment provisions than the disclosure regime which is already proposed. What the Treasury proposal does is:

  • establish the principle that the divestment rules should only be repealed on the basis of the introduction of an appropriate disclosure mechanism, and

  • establish a baseline for what that mechanism must involve (as implemented in byelaw and through syndicate accounts and annual report, provided under Insurance Accounting Directives (Lloyd's Syndicate and Aggregate Accounts) Regulations 2008). This will include post transaction disclosure in the syndicate annual report made to members and pre-transaction information relevant to monitoring conflicts of interest will have to be given in the syndicate business plan and will be available to the members of the syndicate, the Franchise Board, and the FSA.

As the Explanatory Document notes, there is nothing to prevent the FSA and Lloyd's adding to the protection this mechanism provides, when Lloyd's consults on the byelaw, if detailed regulatory review suggests this is necessary.

Second, the particular Code proposed by the members' agent appears to range quite widely over the field of conflicts of interest. For instance, one of the examples of conflicts cited by the members' agent in its submission (p10) concerns conflicts between capital providers[34] rather than the conflicts of interest that could arise as a result of associations between brokers and managing agents which is the subject addressed by the divestment rules. However, the Treasury is concerned that the proposed transparency mechanism should be relevant to the rules under review and accepted in all quarters of the market (by members, managing agents and brokers). It is less clear that a wider Code such as that proposed would maintain focus on these specific concerns or receive such widespread support. Further, a wider Code would introduce additional burdens on managing agents not directly related to the repeal of the divestment provisions. It is not clear that such a Code could be introduced under the powers given in the Legislative and Regulatory Reform Act 2006.

Q 9  Please provide a detailed comparative explanation setting out the equivalent divestment/conflict of interest provisions and intermediary restrictions that apply to Lloyd's major competitor bodies and jurisdictions and any current proposals for reform thereof.

The provisions applying to Lloyd's under sections 10 to 12 of Lloyd's Act 1982 are unique. The Treasury is not aware of any provisions under the law of the United Kingdom, or under EU law which impose equivalent requirements for divestment on the insurance companies which are Lloyd's main competitors.

However, all insurance companies, and insurance intermediaries, in the UK are subject to rules made by the FSA under the Financial Services and Markets Act 2000, governing, inter alia, the management of conflicts of interest. Insurance companies in the European Union are also subject to laws made by EU states implementing the provisions of Directive 2002/92 on insurance mediation which sets out the minimum requirements which must be imposed on insurance and reinsurance intermediaries. Insurance intermediaries are also subject to fiduciary duties under the law of agency to those for whom they act to avoid conflicts of interest.

The relevant provisions of the FSA handbook and of Directive 2002/92 are set out in Annex 3.

The Treasury has not undertaken an analysis of provisions governing the management of conflicts of interest and intermediary restrictions applying in other jurisdictions. It is difficult to obtain full and accurate information on the applicable laws in other jurisdictions, and information on the relevant laws in the UK appears to be of most assistance in determining whether the divestment provisions or the alternative arrangements proposed by the Government are most appropriate in today's environment to deal with the relevant conflicts of interest.

Under the Treasury's proposals, the FSA will be responsible for oversight of how Lloyd's manages conflicts of interest. In coming to its views, the FSA will need to consult and take account of feedback. The FSA is required, in carrying out its functions to meet its statutory objectives and to have regard to a number of principles, including the impact on competition and the competitive position of the UK financial services sector

14 August 2008


29   See reference in Explanatory Document paragraph 5.13. Back

30   The CSG was established by the Council to examine the major strategic threats and opportunities facing Lloyd's. Its specific objective was to determine: "The future vision and strategy for Lloyd's which will maximise the wealth of capital providers to Lloyd's over the next 10 years". The CSG's membership was drawn from all the major market constituencies, and it was chaired by Sax Riley, the then Chairman of Lloyd's. Back

31   A series of papers by BERR and HM Treasury identify competition as one of the five economic drivers of productivity growth. See for example (i) HM Treasury; "Productivity in the UK 6: Progress and new evidence", and (ii) HM Treasury and DTI; "The 2005 productivity and competitiveness indicators". The OECD has also undertaken several studies on product market competition and economic performance: www.oecd.org/eco/structural/competition. Back

32   The LRO process requires officials to ensure there is as much consensus as possible on the financial implications of any reforms before reforms are presented to Parliament. Back

33   Response number 52. Back

34   This is the potential conflict that exists between individual third party capital providers and corporate capital providers over capacity transfers, which are governed by Lloyd's Major Syndicate Transactions byelaw. As noted in the Explanatory Document, Chapter 6, the Treasury received several submissions requesting amendment of this byelaw by the LRO. Back


 
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