Examination of Witness (Questions 449-488)
Q449 <Chair:
Thank you very much for coming before us this morning and for
helping us with our inquiry. I would like to get straight into
evidence and just begin by asking you why AIG did not happen here.
Mr McGovern: An
awful lot has been written about the causes of the collapse of
AIG, both here and in the US, and it has also been examined by
the UK regulator. There have been various inquiries in the US
by Congress, and I think I can best summarise how Ben Bernanke
described it—that the AIG collapse was caused by a small
but highly volatile division of AIG, which was financial products,
which was trading in credit default swaps, but that financial
products division was attached to an otherwise stable insurance
group. What has become clear is that the insurance operations
of the AIG Group were stable in the lead up to the collapse of
AIG, and have remained stable throughout. Most of the US operations
of AIG are regulated at a state level and those operations have
remained solvent; indeed, the UK-regulated company has remained
solvent throughout. Could it happen here?
Q450 <Chair:
Just before we move on, if I may. What you are saying is that
AIG was a solid, cash-cow style insurance business, with a small,
very high risk trading arm in credit default swaps. So there is
at least some theoretical mirroring of the criticism of the banking
sector, who argue for narrow banking.
Mr McGovern: Essentially,
the problems that were caused to AIG were through its non-bank
activities, not its insurance activities. There is a debate over
how complex groups should be regulated and there has been commentary
that AIG exploited gaps in the regulatory system. The Financial
Stability Board and the IMF are spending a lot of time trying
to get to grips with these complex global groups and how those
gaps in the system can be avoided. I think the other relevant
debate, in all of this, is whether or not core insurance business
creates systemic risk in the same way that it has been proven
that banks create systemic risk. I think there is a growing consensus
among regulators around the world, including the FSA, and Lord
Turner made a speech recently looking at the issue of systemic
risk in insurance. What is clear is that the insurance business
model is very different from the business model of the banks.
It is a pre-funded business model: we take in premiums. We're
not leveraged in the same way. We're not involved in maturity
transformation. You can't get a run on a general insurer; an insurer
only has liability to the extent that a claim is payable. And
it's clear that you can see the failure of an insurance company
long before it happens. You don't get a shock loss to an insurer.
Also, there is no interconnectedness. There are very tried and
tested mechanisms by which an insurance company's activities can
be wound down—either on a solvent or an insolvent basis—without
causing wider systemic implications into other parts of financial
services or, indeed, into the real economy.
Q451 <Chair:
What about the treatment of long-tail risks?
Mr McGovern: Long-tail
risks. There are certainly some questions over life insurance,
particularly the impact of financial stability on the balance
sheet of life insurers. Lloyd's does a very, very modest amount
of life business; we are a general insurer. So I think you're
quite right, there are some issues around the impact of changes
in volatility in financial markets, as far as life insurers are
concerned, and whether or not the actions of the life insurer
can amplify a systemic risk that arises through that volatility.
As I say, Lloyd's is a general insurer so that is probably straying
into areas beyond my experience.
Q452 <Chair:
What have you changed in response to this crisis and to what happened
to AIG?
Mr McGovern: Core
insurance does not create systemic risk. Lloyd's is only in the
business of insurance and reinsurance. There is no part of what
Lloyd's does that is involved in anything that could be remotely
described as being exotic. The system of regulation on insurance
here in the UK has been very robust and has been world-leading.
The Turner review acknowledged that the prudential regulation
of insurance in the UK has been stricter than in many other member
states. I think the regulatory regime in the UK has helped the
insurers navigate their way through this crisis. Speaking for
Lloyd's, we have navigated our way through the crisis very well.
We've been profitable throughout, our balance sheet has grown
throughout, and we have not been negatively impacted by what we've
seen. So, a very different experience to our banking sector colleagues.
Q453 <Chair:
Just to be clear, what is the obstacle to some type of AIG event
happening here? Is it self-regulatory, is it formal regulatory?
What is our protection?
Mr McGovern: The
protection is the debate about how financial conglomerates that
contain a mixture of regulated banks, regulated insurers and non-banking
activities that are in the shadows of the regulated sector are
dealt with. Obviously, that is where there is a very strong focus
of attention on how those non-banks can be brought within an integrated
regulatory framework.
Q454 <Chair:
And you are welcoming the regulators' engagement on that issue?
Mr McGovern: Yes.
Our concern is to make sure that when regulators are looking at
systemic risk more broadly—and obviously it is quite right
to look at it across financial services—we don't want simply
to be winning the last war. It is crucial that they recognise
there are different business models here, and measures that might
be necessary to address systemic risk that has arisen within the
banking sector are not automatically transferred into an insurance
regime where the business model and the risks created are very
different.
Chair: John?
Q455 <John
Thurso: Just following on from that, in your written
evidence you have said "There is nothing inevitable about
London's current financial success", referring, obviously,
to Lloyd's. Is there a real danger that you could be damaged by
the collateral effect of a fallout from regulation of banking
that would be inappropriate to Lloyd's?
Mr McGovern: I
have to say I think that is one of the biggest worries of the
insurance industry at present. All of the debate is around: how
can we fix the failures in regulation, the failures in the bank
business model? There is an assumption that if more capital is
required within banking or more regulation is required within
banking, that that should somehow be automatically read across
into the insurance sector. We're not only seeing it here in the
UK but we're also seeing it in Europe, with debates around crisis
management, debates around resolution funds. The question starts
with: so how do we bring financial services within this regime?
Our argument is that we don't need those solutions for insurance.
Our experience of the crisis demonstrates that the
insurance business model is very different. It's therefore a bit
disappointing that the consultation document—I think it
mentions the word "insurance" three or four times—doesn't
really recognise the importance of the insurance industry to the
UK economy. It is a major provider of employment. We think it
employs something in the order of 250,000 people. It contributes
about £8 billion-worth in tax revenue, and is obviously a
major exporter of services. The London insurance market is the
leading insurance market in the world and it is clear that regulation
has a big impact on how people perceive where to place their business.
Our business is highly capital-intensive. It's at the very specialist
end of the insurance and reinsurance market, and that capital
is highly mobile. What I would say at the moment is that the FSA
regulatory regime on insurance has been a real asset to the insurance
industry in the UK. What we would like to ensure is that when
we move to a new regime, housed in the PRA under the auspices
of the Bank of England, we don't lose the quality of insurance
regulation that has served so well.
Q456 <John
Thurso: It is quite a complicated model, Lloyd's.
You have the society; you have members; you have agents; you have
corporate members, and all the rest of it. Do you think the Government
understands you and your importance to the British economy?
Mr McGovern: I
hope they do, but we never cease to remind them at every opportunity
and, as you say, the market structure is unique, so it is hardly
surprising that the consultation document has a reference to Lloyd's,
which is basically, "There is more work to be done."
We do look forward to further engagement with Government on exactly
how—
Q457 <John
Thurso: Do you think you are getting to the authorities
and putting your points across, or do you feel there is a barrier?
Mr McGovern: I
think we are. We have had meetings with the Bank of England and
with the Treasury at ministerial level. We have good engagement
at the working level, and I do think we are getting our points
across, albeit, clearly, that the action is all about the banks,
and we have to keep reminding people of the importance of the
UK insurance industry.
Q458 <John
Thurso: How should Lloyd's itself be regulated?
Should it simply be the same regulation as other insurance companies,
or are there differences that Lloyd's should have because of its
unique structure?
Mr McGovern: The
structure is unique and our relationship with the FSA is unique,
for many different reasons. We believe that our regulation should
be focused within the Prudential Regulatory Authority and not
dispersed across different agencies, because the unique structure
of Lloyd's, and the knowledge that it takes to regulate it effectively,
is currently housed within a dedicated team within the FSA. There
is something like 14 people within the FSA whom we work with very
closely.
Q459 <John
Thurso: You feel they know what you are about?
Mr McGovern: Yes,
absolutely, and we have invested a lot of time in helping them
understand us. We co-operate and co-ordinate with them extremely
closely. So we think the PRA is the right place for Lloyd's but
we do think that it is important for the PRA to be the lead supervisor.
I think one of the things that we will be continuing to push for
is this concept of lead supervisors, because the most important
thing, from a regulatory perspective, in relation to Lloyd's—given
the type of business we do, which is predominantly specialist
business written for corporate buyers—is prudential solvency,
making sure that there is enough capital within the Lloyd's system.
So conduct of business regulation is second order, in my view,
to the importance of prudential oversight. There are clearly some
aspects of the market where we will be required to demonstrate
conduct of business priorities, but prudential regulation is the
lead.
Q460 <John
Thurso: Last question, slightly different angle.
You operate in more than 200 countries; you are spread right across
the world. Has the FSA been effective in working with overseas
counterparts on your behalf?
Mr McGovern: The
answer is yes. I think the business model of Lloyd's is very important
for London. We do write business from 200 countries and territories
around the world. The US is our largest market; 40% of Lloyd's
business comes from the US, but all of that business is written
and all of the economic activity that supports the business is
in London. So we don't have lots of subsidiaries around the world
with hundreds of people underwriting business. It is all done
out of London. So the importance for us—
Q461 <John
Thurso: So you do not really have a problem with
regulators in other countries, because all your activity is here?
Mr McGovern: But
crucially, because we have managed to convince the other regulators
around the world to rely on the effective regulation that we have
here at home. So for an international business like us, it is
absolutely critical that we have a credible, robust regulatory
regime to avoid duplicative regulation across the globe.
Chair: I think Mark Garnier
has a few follow-up questions on regulation.
Q462 <Mark
Garnier: I was going to say I am very grateful
to Mr Thurso for asking all those questions I was going to ask,
but it does give me an opportunity to drill down a bit more deeply
into these points.
Carrying on from what John was asking, Lloyd's is
a marketplace, and obviously there are a lot of different organisations
within it: you have underwriters; you have brokers; you have names,
agents and all the rest of it. When I look at the proposed regulatory
regime that is coming up, there are certain bits that are clearly
specific to the retail investor. I am probably using the wrong
word, because "investor" is not necessarily the right
thing, in terms of looking for buyers of insurance products. But
you also have parts of the regulatory regime that are looking
at the system, and the PRA is looking at the marketplace as a
whole. You have already said that there is a problem with the
fact that this consultation document only mentions insurance two
or three times, but I suspect that that is looking at insurance
companies. This is a very complex organisation that you run. How
do you see it mapping out here? Who is going to be regulated by
which part of the spider's web that is the proposals?
Mr McGovern: As
I say, I think the prudential regulatory authority should be the
lead. It is critical that there is proper co-ordination, not only
between any CPMA regulation of Lloyd's and the PRA, but also with
Lloyd's itself. The organisation I work for is the Society of
Lloyd's. It is a not-for-profit statutory corporation, which is
charged with running the market and regulating the market. So
we have front-line responsibility for making sure that everybody
in the market—whether they are members, whether they are
the managing agents, whether they are the members' agents—conducts
themselves in an appropriate fashion, and that there is adequate
capital within the system. We do that under the watchful eye of
the FSA. We have an explicit co-operation agreement that was put
in place with the FSA when the FSA took over regulation of Lloyd's
in 2001. It was recognised that with the FSA, which regulates
the Society of Lloyd's—the organisation I work for—managing
agents, and members' agents, there was a real risk of regulatory
duplication between what we do in overseeing the market and what
they do. We have worked very hard with the FSA to make sure that
we are clear who does what and how we do it, and we work very
effectively. We have this formal co-operation agreement in place;
we share information, and we have a very strong understanding
about how we perceive risk in the market. Going into the new regime,
it is going to be crucially important that those co-operation
arrangements continue to exist. There is going to be a challenge
with that.
Q463 <Mark
Garnier: That is with the PRA?
Mr McGovern: Predominantly
with the PRA. I will come on to the conduct aspect in a moment.
So what we are looking for is the arrangements we have with the
FSA in terms of the co-operation that exists—that has worked
very effectively for Lloyd's over the last nine or so years of
FSA regulation—being carried through into the PRA. Crucially,
what that allows the FSA to do is take account of the systems
and controls that we have over the market in judging how much
regulation they need to conduct of the managing agents and other
parts of the market. They don't like to use the word "rely",
because they ultimately have regulatory responsibility, but it
is true that, in framing the regulation of Lloyd's, they look
at the work that we do, and we have a 150 people whose job it
is to oversee the management of risk in the market. They take
account of that in then determining how much resource and effort
they apply to regulating the market. So that co-operation and
that reliance, for want of a better word, needs to be carried
through into the PRA.
On the conduct side, conduct of business regulation
is very important for the limited amount of personal lines business
that is written in the market. We do write some personal lines
business. Again, it tends to be at the specialist end, so it is
the 25-year-olds driving the Ferraris, rather than standard motor
policies. So the way in which we work with brokers to sell those
products has to be compliant with good conduct of business regulatory
principles, as it does now. However, what I think the CPMA's regulation
of Lloyd's needs to recognise is that it is a business-to-business
market. We don't deal directly with clients. Everything that we
do goes through insurance intermediaries.
Q464 <Mark
Garnier: Although your names can be private individuals,
can't they?
Mr McGovern: Yes.
The profile of names has changed pretty dramatically. In the late
'80s there was something like 34,000 names at Lloyd's. They constituted
the entirety of the Lloyd's capital base. They all underwrote
on an unlimited liability basis. We now have fewer than 4,000
individuals who are actively underwriting on that basis. They
represent 4% of the market. They aren't consumers, in the traditional
sense of the word. We have a system of protections in place for
names, because they obviously have interactions with various elements
of the Lloyd's structure. There is an ombudsman's scheme and there
is a compensation scheme. Those are all part of the FSA regulation
of Lloyd's, so we conduct that under the very watchful eye of
the FSA. It is adequate; the representative groups that represent
names believe they are adequate. So again, it is a case of carrying
those sensibly into the new structure.
In terms of what we would like to see, when it comes
to dividing issues between PRA and CPMA, with regard to Lloyd's,
I do think that there is going to need to be some pragmatic decisions
taken. As I said, understanding Lloyd's as a cohesive whole is
going to lead to much more effective and efficient regulation
of Lloyd's than compartmentalising things, because they appear
to fit better into the CPMA. That is what we're encouraging Treasury
and the Bank of England to consider. We understand the principles
of the division between the PRA and the CPMA, but we may need
a sprinkling of pragmatism to make sure that we come out with
a regime that achieves the right regulatory outcomes.
Q465 <Mark
Garnier: I think you mentioned that you have 14
people at the FSA who are specifically dedicated to looking after
Lloyd's. Since the Government announced its plan to split up the
FSA, have you experienced any difficulties engaging with them?
Clearly, you like these people, so are they all staying there?
Do you anticipate they will all move across to the new regulatory
regime? Indeed, when they do move across—if they do—do
you think they are going to go to the right organisation?
Mr McGovern: There
has been a lot of staff leaving the FSA at all levels. Some very
senior staff have left, which is very unfortunate. We have been
very fortunate, in that the dedicated team at Lloyd's has been
very stable over quite a long period of time and we haven't seen
the rotation of staff that some other organisations have seen.
I think that is in part because FSA senior management recognise
that continuity of knowledge and understanding of Lloyd's is very
important. We are concerned that there is a risk that we will
lose that experience and knowledge. We expect that the vast majority
of that team—all of them, we hope—will transfer into
the PRA.
Q466 <Mark
Garnier: That is where you want them to go?
Mr McGovern: That
is where we want them to go. But what I think is absolutely critical
is that the Bank of England do need to recognise that regulating
insurance is different from regulating banks. So the structure
of the PRA does need to recognise that. At the moment, if you
read the consultation document, it's all about how they're going
to regulate banks more effectively. Insurance is terribly important.
It takes different skills, and they do need to carve out the expertise
to be able to do that effectively as well.
Q467 <Mark
Garnier: One of the things that the LMA—Lloyd's
Market Association—has warned about is this triple regulation,
which is obviously the PRA, CPMA and Lloyd's itself; that has
been talked about. The other element of this proposed regulatory
change is the Financial Policy Committee, which is looking at
systemic risk. It is, of course, broadly speaking, designed to
focus much more on the banking system, the monetary system. But
with something like AIG—referring back to the Chairman's
earlier questions—clearly there was a systemic risk there.
Do you think that not only do you have the existing triple level
of regulation but then, on top of that, you might have that further
fourth element focusing in on what you are doing? How do you see
that causing problems and do you think the LMA are right to be
very concerned about this?
Mr McGovern: On
the Financial Policy Committee, it is clear that that policy committee
is going to have influence, both on macroprudential regulation
and microprudential regulation. It is a bit unclear as to exactly
what that influence is going to be. As the FPC is going to have
that influence, we are concerned that they do need to be properly
informed about insurance business so we don't get a complete focus
on banking. So we would certainly be encouraging the FPC to have
insurance skill as part of that committee structure. We feel the
same way about the PRA. Some of the non-execs on the PRA do need
to be drawn from an insurance background so that knowledge is
in-built, so we don't get gaps in the system and we don't get
inappropriate read-across. On the triple regulation, that really
does go back to the importance of having a lead supervisor where
the skill and regulatory focus is concentrated in the PRA, and
also the transfer across into the new structure of the co-operation
agreements that currently protect the market from duplication
of regulation, which we have, and should help to guard against
triple regulation in the new structure.
Q468 <Mark
Garnier: The cost of having to deal with all those
regulators could be a problem.
Mr McGovern: Yes.
There is obviously a cost to the market of supporting the infrastructure
of the society that is responsible for the oversight of Lloyd's,
and what we have to do is make sure that the benefits that the
market get from being at Lloyd's, and the other things that come
from being a participant in the Lloyd's market, are balanced by
the costs of our oversight. But we have significantly invested
in our own oversight of the market over the last nine years. There
has been significant investment at the FSA and in insurance regulation
in general, but also in Lloyd's oversight. That is a cost. I don't
think we are so concerned about the cost. We're more concerned
about the efficiency of the regulatory framework. I think it's
difficult to see how this new regulatory framework can be delivered
without an incremental cost and I think there will be a tolerance
for a marginal increase in the cost. But what we can't do is end
up with a system that is more inefficient from a management perspective,
a compliance perspective and a capital perspective.
Q469 <Chair:
I am asking a lot of witnesses this question: do you know what
the full compliance cost really is? You don't have to tell me
now.
Mr McGovern: Currently?
Not of the new regime. We know what the cost of the FSA currently
is.
Chair:> Why
don't you send us a note with what you think the real cost is,
and therefore the average cost per customer? Stewart Hosie.
Q470 <Stewart
Hosie: In your recent "Insurance Day"
editorial, when you were talking about the internal restructuring
to establish the shadow PRA and the CPMA, you spoke about constructive
engagement and then said, "We should seek to manage the potential
damage such a move would cause to the UK's ability to compete
for financial services both in the short-term, through a difficult
transition, but also in the longer term". So I'm keen to
find out what you think these risks and dangers are, and whether
it's your view those risks are partly to do with the fact that
you believe the insurer supervision has been treated as an afterthought,
which was what was put in your response to the Treasury?
Mr McGovern: I
think that, unfortunately, insurance supervision has been treated
as an afterthought, and we're engaged in a lot of activity to
try and get the Treasury and the Bank of England focused on looking
at how insurance supervision can be effective in the new regime.
In terms of worrying about the implications in the short to long
term, I think the implications for us as insurers in the short
term are twofold. The first is that there is an awful lot of activity
going on in Europe at the moment, and not only in the insurance
field. We have major debates going on about insurance guarantee
schemes, we have big debates going on about crisis management,
and we have big debates going on about resolution funds and resolution
authority.
Specifically on insurance, there is a very big change
to regulation going on at the moment, which is called Solvency
II, which is fundamentally changing the way in which insurance
is regulated throughout Europe. We welcome that because it will
harmonise regulation. We think the UK is well positioned, and
we think it will harmonise and bring the standard of insurance
regulation up in the EU as a consequence. But it is the biggest
project that we, as Lloyd's, are dealing with, and I suspect that
for all insurers in the UK, it is going to be the biggest project
that they are dealing with. Between now and the end of 2012, we
will have spent something like £200 million on implementing
Solvency II. It's the biggest project the FSA is having to deal
with. Again, it is interesting that it doesn't get the attention
that everything to do with banks seems to get, but the insurance
regulatory regime and the implementation of Solvency II is the
biggest project the FSA is currently dealing with. There are two
consequences to that: one is that we have a situation where the
FSA and the industry are somewhat distracted by this debate about
the regulatory structure, at a point at which we are all trying
to implement the biggest change to insurance regulation that there
has been for a generation. That is not good for us.
The second reason why it's not good is that these
debates around Solvency II, but also wider debates about the new
supervisory architecture and what that ultimately is going to
mean, and all of these other issues that are currently on the
table in Europe, are very actively being discussed, and the UK
needs to be strongly represented in those debates. So it was very
alarming to read, in the FSA response to this Committee's request,
that one of the transition risks for the FSA was that they were
not going to have senior management time to engage as much as
they used to in Europe. From our perspective—not having
caused the financial crisis, and being rather swept up in the
change to the regulatory regime that is a consequence—we
are worried that the UK is potentially going to miss some tricks
in the EU because the FSA is not as engaged as they ought to be
in those debates. So there is a real concern that, in the short
term, the transition could damage the insurance sector because
the UK agenda in those negotiations may not be being pushed as
hard as it could be.
Q471 <Stewart
Hosie: That is very similar use of language to
the stock exchange, where they said, within ESMA, when they got
down to the granular regulation negotiation and formulation level,
they were concerned to have absolutely the right people with the
right skills set, so that nothing was done that caused unnecessary
burdens while maintaining protection. Is that fundamentally the
same concern you have with FSA people, knowing that there isn't
the scrutiny, in what is going on with Solvency II, within the
European architecture and regulation generally? Is that the same
sort of concern, then?
Mr McGovern: Yes,
it is the focus and attention. Clearly, the banking crisis has
somewhat distracted senior management's attention at the FSA away
from insurance. That is a good thing, in a way, because it demonstrates
that we're not a sector that is keeping them awake at night, but
there are moves in Europe to change the basis on which insurance
is regulated. There are ways in which the insurance sector could
be damaged through the implementation of directives within the
EU, and we're concerned that there is a lack of focus on the EU
aspect of financial regulation. I also think that the consultation
document to some extent underestimates the influence that Europe
now has over financial services regulation. I think some of the
things that are being talked about—a more judgement-led
approach to regulation and wanting to reduce the FSA handbook—are
all very laudable goals, but I think you have to recognise that
we now operate in an EU context, where the UK is required to demonstrate
that it has implemented its EU obligations in an effective manner.
We also have the new EU supervisory architecture. We were comfortable
with where those negotiations ultimately landed, in terms of respecting
home state regulation. We think there are certain benefits to
be gained from the new architecture. But clearly there are going
to be new regulatory authorities in Europe and, once those are
established, there are going to be debates around whether EU regulation
should go further, and the role of home state supervisors versus
these authorities. We need to make sure that there is adequate
focus on those debates at senior levels.
Q472 <Stewart
Hosie: You have the UK structure and the EU structure,
with the potential, perhaps, for conflicting policy direction;
overlaid on top of that, of course, is the new macroprudential
levers and powers that the FPC will have. What is the combination
of all of these things, in terms of risks for Lloyd's?
Mr McGovern: I
think the combination can best be summarised by the uncertainty.
At the moment it is very difficult to understand what exactly
the implications of all of these different measures are going
to be. Of course, you have named just a few; there is a significant
range of things that could also be done to financial services
generally and insurers specifically. So there is a great uncertainty
and, as I said, the concern we have is that the debate generally
starts from, "We need to do this to financial services."
What we need in the debate are informed voices sitting around
the table—whether it is here in London or whether it is
in Brussels—who can point out the differences between different
aspects of financial services, so the right outcomes are reached.
Q473 <Stewart
Hosie: Given that it is those people whom you need,
are you having any difficulty recruiting or retaining people with
specific skills, with Solvency II knowledge, with a deep understanding
of the potential European framework? Do you have the right people?
Mr McGovern: We
do at Lloyd's. Unquestionably, there is a significant strain on
talent at the moment in insurance. Solvency II is causing a real
problem. There are limited actuaries in the world. There are limited
people who understand risk management and how to implement risk
management. There is a lot of competition for a very limited amount
of resource. Like many organisations, I think the FSA are finding
themselves in a position where it's difficult to compete in monetary
terms for that talent. But we do need talent within our regulators,
not only to regulate firms effectively, but also to influence
the debates that are taking place outside the UK.
Chair: Michael Fallon.
Q474 <Michael
Fallon: Which of the new macroprudential tools
that the Financial Policy Committee might deploy would most impact
on your market or your members?
Mr McGovern: I
think there are some macroprudential tools that could influence
us on the balance sheet side, in terms of what happens with interest
rates. Having said that, the impact on Lloyd's should be manageable.
It should be limited, for this reason: the Lloyd's market doesn't
write long-tail business generally; we're much more about covering
catastrophic property casualty risk. So our profile, in terms
of our investment philosophy, is very conservative. We hold a
third in cash, a third in Government bonds, and a third in corporate
bonds. So what happens with interest rates, what happens with
corporate bond spreads, will impact us just like they impact everybody
else, but we believe that we are in a position to be a little
bit more nimble on our balance sheet side because we're able to
dip in and out of assets much more quickly. We have almost no
equities in our portfolio. So I think that side is manageable.
The other macroprudential tools that we would want
to guard against is, again, the inappropriate application to the
insurance sector generally of pro-cyclical capital buffers. I
think we have demonstrated that the general insurance industry
has navigated the most significant upheaval in financial markets
that there has been in living memory. We have sustained some very
significant catastrophic losses, going back to 9/11, through to
the hurricanes of Katrina, Rita and Wilma. We have withstood all
of those and remained profitable, and our financial strength has
grown. So I think there are two aspects. One is the activities
that are taken to shape financial markets, which I think we can
manage. The other is just inappropriate application of capital
levers, for example, which is why we need knowledgeable people
at the FPC level and the PRA board level, to understand the implications
of trying to use those levers on the insurance sector.
Q475 <Michael
Fallon: Why should you be exempted from pro-cyclical
buffers?
Mr McGovern: Because,
firstly, we're not in the business of providing credit, so the
credit cycle is not something that impacts our business. But the
insurance sector has its own cycle, the insurance cycle, which
is driven by what is happening in the rating environment. If insurance
rates are good, that attracts capital, and that, generally speaking,
ultimately leads to a down phase in the cycle, where there is
too much capital in the system, which leads to underpricing, and
then we go up again in the cycle. But we are not implicated in
or affected by the credit cycle, as the recent two or three years
have demonstrated.
Q476 <Michael
Fallon: The Financial Policy Committee is going
to have only four external members. How realistic is it for you
to lobby that there should be one with a background in the insurance
sector?
Mr McGovern: I
would hope that we should get at least one person with an insurance
background. I believe the consultation document does mention the
possibility of somebody being drawn from the insurance sector.
It is true that there is representation on the European Systemic
Risk Board, so the European systemic infrastructure has seen fit
to have an insurance voice around that table.
Q477 <Michael
Fallon: But the committee is not a representative
committee; that is not its purpose.
Mr McGovern: It's
not, but again, I think it goes back to the fact that the PRA
has been designed with only banking in mind. Clearly, there are
going to be implications from what the FPC does, not only for
insurance but for other parts of the financial services industry.
So we believe that, given the size, depth and importance of the
UK insurance industry to the economy, there should be at least
one person at that level.
Q478 <Michael
Fallon: You are effectively arguing for an insurance
seat on the Financial Policy Committee.
Mr McGovern: I
think we're arguing for having one of the seats that are available
appointed or given to somebody who isn't necessarily actively
engaged in the insurance industry now but who has had a big chunk
of their career in the insurance sector and understands how it
relates to the banking industry. I think that can only make the
FPC's considerations more meaningful.
Q479 <David
Rutley: The Chairman expressed a concern around
compliance. Clearly, you have expressed a concern about the cost
of compliance as well throughout the conversation this morning.
In your evidence, you have suggested that the cost of regulation
for you has gone up from £1.3 million in 2008 to £2.2
million in 2010-11. Are these direct costs? Are there further
indirect costs related to that, and could you explain why they
have gone up?
Mr McGovern: The
£2.2 million is the cost of the FSA to the whole market.
So the cost of the current FSA regulation of the market is £2.2
million. It has gone up significantly recently. That has largely
been driven by Solvency II implementation. In effect, the FSA
has had to resource up for Solvency II, and naturally they're
levying the industry for that cost. So we—like others in
the industry—have had to pay our share of the cost of the
resources devoted to Solvency II. So it is not so much related
to funding the more intrusive regulation; it is more explicitly
on Solvency II.
Q480 <David
Rutley: The other point was that while there are
direct costs, are there additional, indirect costs?
Mr McGovern: That
is simply the direct cost. It does not take account of the indirect
costs of having compliance people at all the different levels
in the organisation. The Chairman has asked if we will estimate
those costs, and what they might be under the new structure, as
best we can.
Chair:> What
they are now.
Mr McGovern: Now,
yes.
Q481 <David
Rutley: As you look at the challenges of restructuring,
with the new regime coming forward, and also the overlays of EU
regulation, how much do you think that cost of regulation is going
to increase by?
Mr McGovern: I
think the ongoing cost of regulation is bound to increase for
the insurance sector. As I said, as a market, we are spending
£200 million on implementing Solvency II between now and
the end of 2012. How much of that cost is going to be an ongoing
cost is unclear at the moment, but we are certainly adding significantly
to our own resources, and there are new people being brought in
at all levels within the market. The FSA is having to increase
its level of staff, so I think it is inevitable that that cost
will increase. Again, we can try and estimate that as part of
an estimate of the current costs and what we think they might
be under the new structure.
Chair:> We have
to find some way of reversing this ratchet, and the first step
is to find out the scale of the ratchet, and very few industries
really know, so it is important work. Andrew Love.
Q482 <Mr
Love: Earlier, you touched on changes in EU regulation.
One of the things that have come to the fore in our discussions
about this whole subject is the misalignment between the new structure
in the UK and the EU structure, and you sort of touched on that.
How serious is that misalignment?
Mr McGovern: I
think it just needs more thought. I'm sure it's capable of being
resolved. We are going to have to deal with the new EIOPA, the
new regulatory authority that is responsible for insurance and
pensions. The consultation document talks about how the primary
interface with EIOPA will be the PRA, and it will have the UK
representative seat on that authority. But it is true to say that
EIOPA will be dealing with conduct of business issues, just as
much as it is dealing with prudential issues. So somehow we need
to make sure that the two authorities can work out how they're
going to ensure those issues are best covered by the people with
the right skills at the right level. I'm sure it is capable of
being resolved, but I think it just needs a lot more thought.
Q483 <Mr
Love: Perhaps you could give us your thoughts on
how that could happen, from a Lloyd's perspective.
Mr McGovern: From
a Lloyd's perspective, it is not so critical an issue for us,
for the reasons I explained. The influence on our business in
Europe is predominantly on the prudential regulatory side. The
adequacy of our UK influence on the conduct of business side is
much more of an issue for some of the composite insurers in the
UK, who are very focused on conduct of business issues. How can
it be resolved? I think it's going to have to come down to practical
arrangements between the CPMA and the PRA. There are other systems
of twin peak regulation within the EU. We're not the first to
have tried to do this. So I think trying to understand how other
countries are proposing to tackle it would be a good place to
start, too.
Q484 <Mr
Love: You mentioned earlier on that you would like
to keep together the FSA team that deals with Lloyd's, but the
implication of the twin peaks system will be that there will be
a split. You have obviously expressed a preference for PRA, and
I think that will probably occur. But if there is a split, how
will you ensure that that part of the CPMA that deals with Lloyd's
can feed into the European structure adequately?
Mr McGovern: About
90% of the regulation of Lloyd's is prudential, so the conduct
side is very marginal in comparison with the prudential side.
As I say, we hope that we will end up with a system where the
PRA is where our team—the FSA team that looks after Lloyd's—is
housed. On the conduct of business regulation aspect, I think
one of the very positive things that we have here in the UK is
a very active dialogue with the Treasury and the FSA currently
about how the debates are shaping up in Europe. What we need to
make sure is that the Bank of England, the PRA and the CPMA recognise
the importance of engagement with the industry here so that when
they go into those negotiations and debates, whether it is on
prudential issues or conduct issues, that they can understand
the potential implications and the viewpoint of the industry.
Q485 <Mr
Love: We are never going to have a perfect fit,
because we have different structures. Is there a danger that,
in order to try and paper over the differences—and you mentioned
this in your submission to us, about gold-plating—we will
throw additional resources and try and set a higher standard as
a result of the misalignment?
Mr McGovern: This
issue of gold-plating is quite commonly cited, and it is a very
real concern for financial services in the UK. From the insurance
side, and from Lloyd's perspective, we haven't felt that we have
been the victim of gold-plating. As I said, we feel that back
in 2005 the UK FSA led the way on insurance regulation. They implemented
a new system of regulation; they weren't required by EU directive
to do so. The industry welcomed it. It has served the industry
extremely well, not only in terms of our experience since 2005,
but in preparing for this new regulatory framework that will come
in in 2013, Solvency II. We're ahead of the game as a UK industry.
So, where appropriate, I think the FSA has taken some very good
steps to improve regulation, which have benefitted the industry.
In terms of gold-plating, I guess one area that has concerned
the industry overall—but again, not Lloyd's so much—is
that we have had a very significant amount of time and effort
spent by the FSA on its Treating Customers Fairly regime, which
has been very burdensome for the industry to cope with, from a
compliance perspective. So I think it is more areas around some
of the conduct of business regulation where gold-plating has been
a problem.
On the banking side, I know there is significant
concern that the UK is getting ahead of some of the debates around
how banks should be regulated, whether it's looking at liquidity
requirements or capital buffers. Those debates are not settled.
I think there has been progress in Basel on those recently, but
they are certainly not settled in the EU. There is concern that
the UK is going to drive an agenda that may not be followed quite
so diligently by some of our European colleagues, and certainly
won't be followed by all countries around the world, and that
could damage the UK sector.
Q486 <Mr
Love: We have had some discussions in previous
sessions about whether or not CPMA should become a consumer champion.
I know you don't deal in consumers, but in terms of treating customers
fairly, do you think there is a danger that they will be even
more prescriptive than the FSA has been?
Mr McGovern: Like
others in the industry, we were somewhat alarmed by the expression
"consumer champion". I don't think it is appropriate
for a regulator to come out and advocate on one side of a financial
contract. It is the place of the regulator to set clear expectations
for how customers are to be dealt with, but you don't start by
being the customer's advocate. There are other mechanisms in place,
whether it is the ombudsman's scheme, and so on, that can fulfil
that role.
Q487 <Mr
Love: Let me ask you finally—and you touched
on this—about taking our eye off the ball, in European terms,
because of the changes that are going on here. How serious a danger
do you think that is? What would be the worst thing that could
happen as a result of taking our eye off the ball?
Mr McGovern: I
do think it is serious. I am a member of a body that has recently
been established in the City, called the International Regulatory
Strategy Group, which is a cross-sector group of people drawn
from financial services, who are looking at all of the things
that can affect us from a regulatory perspective. I have to say
the agenda is absolutely crammed full of competing priorities,
whether that is in the UK or whether it is in the EU. So we have
corporate governance reviews here in the UK; we have corporate
governance reviews in the EU. We have crisis management proposals
here in the UK; we have separate crisis management proposals in
the EU. So there is a significant risk of misalignment, which
may mean we don't get the regulatory outcome we want but could
also put the UK at a disadvantage, versus other jurisdictions.
Q488 <Chair:
Thank you very much for giving evidence. Before you go, it would
be handy if you felt able to supply us, in writing, with something
on the "Know your client" initiative, as far as it affected
your industry; a cost-benefit analysis of it, for example.
Mr McGovern: I
would be very happy to.
Chair:> It would
also be interesting to have anything on paper that you can provide
that lies behind your concern that other countries in the EU might
not be as vigorous in applying new rules as we would be in the
UK. Thank you very much for your contribution. It has been extremely
informative, and we have appreciated it.
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