Financial Regulation: a preliminary consideration of the Government's proposals - Treasury Contents


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.



 
previous page contents next page

House of Commons home page Parliament home page House of Lords home page search page enquiries index

© Parliamentary copyright 2011
Prepared 3 February 2011