Examination of Witnesses (Questions 80
TUESDAY 27 NOVEMBER 2007
Mr Michael Folger, Ms Sarah Varney, Mr Peter Green
and Mr Duncan MacKinnon
Q80 Lord Renton of Mount Harry:
You used the words "the cost of holding". How are you
arriving at that? Are you saying that if you were not doing insurance
with this money, you would be earning 6 or 7 per cent investing
in gilts? Is that the approach?
Ms Varney: Let me just be clear. It is very
likely that Solvency II will, and QIS3 certainly did, specify
the relevant cost that firms must assume in calculating the risk
margin, and it specified a percentage above risk-free. Within
QIS3, that percentage was 6 per cent.
Mr Folger: As a mark-up over the risk-less rate,
the gilts rate, and that essentially is a proxy for the time being
for the kind of observations that can be made out in the marketplace,
the cost of equity capital for firms essentially carrying certain
kinds of risk.
Ms Varney: That percentage is supposed to be
the cost of capital to a roughly BBB-rated company to mirror the
fact that the capital requirement is calibrated to a roughly BBB
Q81 Lord Renton of Mount Harry:
Perhaps we cannot pursue this more just at the moment. It is a
very interesting subject. Could I carry on from the point that
the Lord Chairman has already made with whether there is a political
will in all the Member States for the sort of very substantial
changes to the regulation of the insurance industry that this
Directive will bring about as presently worded? Is everyone in
the EU potentially with this or are there some who are much against
because it runs against custom; they do not want to be part of
an international insurance, as it were, compendium?
Mr Green: If I might answer that, I think when
we started this project that there were wide divisions within
Europe between those who favoured moving towards the banking type
model and making regulation much more risk-sensitive and aligning
regulation with what firms do. Then there were some other countries
I might characterise as having a more belt-and-braces approach
towards the regulation of insurance, setting levels which on some
arguments may be arbitrary but were clearly simple and at fairly
high levels to give insurance regulators comfort that failures
would be extremely rare. I think there has been a significant
shift in the last few years. In particular, I do not think anybody
now argues that there should be a zero failure regime. It is widely
accepted now that we should have a system that does allow failures.
Arguments that we had expected over the probability of those failures
evaporated and we have alignment broadly between the banking sector
and the insurance sector in terms of calibration. That was unexpected.
I think a lot of countries started not believing in the market-consistent
approach. Again, this goes back to belt and braces. I think that
has moved on. A lot of the things at the beginning of this Directive,
as I said earlier, that we thought would be difficult have not
proved so. Some of those will re-emerge in Level 2. I am sure
it will be the case that we will have further difficulties with
some Member States, but in terms of the principles of this Directive,
there is broad agreement across Member States as to how these
principles should work.
Q82 Lord Kerr of Kinlochard:
Some of us detected, or thought we detected, in the excellent
written evidence from the FSA and the Treasury a slight difference
in tone, with the Treasury being rather more optimistic, an unusual
phenomenonI cannot remember seeing it beforethan
the FSA. Maybe this was because the dates were different. The
FSA's is a more recent paper. The FSA, in telling us about the
results of QIS3, said: "We have reservations about the possibility
that Level 2 provisions could in some areas emerge as over-prescriptive
and `maximum harmonising'. Superficially attractive from the (anti)
gold-plating perspective, such an approach could be dangerous
in practice, fettering supervisors' ability to deal with specific
situations in an intelligent risk-based and timely way."
That rings bells with me. I remember from negotiation how in the
phase that I imagine you are still in the experts are discussing
and nobody has yet given up on getting his way at expert level.
In the last stages of the negotiation, there are some who feel
they are losing and they appeal to the politicians to secure at
a high level, at the last stage, things that they have failed
to secure lower down. In an exercise like this, that might lead
to piling on additional provisions to get back a little bit of
the belt-and-braces approach which failed in the initial discussion.
How high is that risk, and is that what the FSA are talking about
in the bit of their paper that I read out?
Mr Green: I am not an optimistic chap generally.
Some of my optimism has been dented across the board in the last
few months, but I remain optimistic as regards this Directive.
That is because of where we have got to, given our starting point,
given the difficulty we thought we would have in the agreement
to the high level principles and our progress in getting agreement
to that I think has left me
Q83 Lord Kerr of Kinlochard:
It is not as bad as the Treasury thought.
Mr Green: Absolutely. I think there are some
very dangerous devils left in the detail, but with the principles
well established, the battle is half-won. People cannot now go
back and overturn those principles as regards, for example, market
consistency, as regards the three pillar approach, as regards
diversification benefits, which we are taking forward in our own
groups' proposals. Although we will be pushed back on some of
the details, and people I think will, and understandably, take
different views about the calibration of particular parts of it,
I do not see a large risk in people trying to overturn the fundamental
principles, and I do not think they can through the Level 2 negotiations.
That said, we are alive to the difficulties of Level 2 negotiations.
I negotiated Level 2 of the Market in Financial Instruments Directive.
We are putting in place everything we can now to try to influence
the right outcome there, which is primarily around getting the
right evidence and the right arguments articulated to make sure
that where there are discussions about calibration, they are done
very openly on the basis of evidence rather than on the basis
Chairman: Thank you and I am sure we
wish you luck with that one. We have five minutes left and I would
like to ask Lord Watson to ask a question.
Q84 Lord Watson of Richmond:
It is always encouraging to have an optimistic Treasury, particularly
before midday. You have already answered a general question about
winners and losers. I would like to focus on the standing of the
City in all this and its international reputation. Do you see
the reputation of the City as being a winner or a loser or do
you see the Directive in that context as being neutral? We have
just had a very interesting exchange about whether the devil still
lurks in the detail, and obviously the City would be wary of anything
which seemed to be over-regulation and the limitation therefore
of its competitive position. You have been optimistic about that
but I come back to that question: do you think the reputation
of the City is a winner or a loser? If I may, could I attach a
second question to this as well? There is a pattern beginning
to emerge in many fields, not least environmental, that standards
once set by the EU have a tendency to spread beyond the European
Union geographically and begin to set a standard which is almost
or actually global. I just wonder in that context what you see
as the knock-on effect, assuming that Solvency II goes through,
on regulation elsewhere in the world?
Mr Green: I think the City will be a winner
from the Solvency II Directive in the sense that this Directive
will improve the Single Market for insurance. The City has shown
itself to be very well able to exploit new openings and new opportunities.
We have this regime essentially in its main parts in the UK and
so the direct gains in the UK, in the City, will be around lowering
of costs of UK regulation from the removal of the requirement
to comply with two sets of requirements, the existing Directives
and the new FSA regime.
Q85 Lord Watson of Richmond:
Just to be clear about that, you are saying then that the implication
really is the creation of a market opportunity?
Mr Green: That is right. I think there are some
direct things that benefit firms in the City but they will benefit
firms in the City in a sense more than firms in other countries.
Q86 Lord Watson of Richmond:
Because we are that much nearer?
Mr Green: We are that much nearer and as a result
we have an additional cost that firms have to bear which will
be removed. But the main benefit comes from the Single Market.
I think we see that across the Financial Services Action Plan.
That was why the UK was such a strong supporter of that action
plan, because we think it gives tremendous opportunities for the
City to exploit its own natural vibrancy and natural innovation
and spread that throughout the EU.
Q87 Lord Watson of Richmond:
So this is more of us exporting a model than having a model imposed
Mr Green: I think so, and we also gain advantages
from having to respond to competition from outside. As to the
question of how this might spread throughout the world, I am slightly
less optimistic there than I was earlier. I think this is cutting
edge; this is a kind of model of its kind, but it will be a long
time before this Directive is actually in force. We do see some
big differences between insurance regulation and banking regulation
in other countries and it will take time for those to change.
The main pressure for change will come from industry and from
the competitive implications of this Directive and the demands
on other regulators, other governments elsewhere, to allow firms
in other countries to benefit from the same kind of regime that
the EU is putting place. Until that is in place, I think those
demands will be more muted.
Mr Folger: To comment on that, perhaps the Treasury
are a little more pessimistic here than the FSA. As Peter has
said, the rate at which this kind of market-consistent and modernised
approach would spread across the world remains to be seen, but
a start has been made in the International Association of Insurance
Supervisors (IAIS) which brings together European regulators,
North American, Japanese and Australian regulators and so on.
Some very good work has been done there, to which the FSA has
contributed, that has led to some guidance papers for members
which do place emphasis on the importance of a market-consistent
approach, disciplined application of models, stress testing. And
a paper is due to appear within a few weeks on a modernised approach
to group supervision, which is one of the upsides we see in Solvency
II. That kind of international dialogue is capable of running
on for many years, but it seems to be moving in the right direction.
Q88 Lord Watson of Richmond:
To this point, is there any reaction in the States to this?
Mr Folger: The US of course is a fractured system.
There are 50 individual state regulators. The NAIC set out a prototype
for what is by modern standards a fairly crude risk-based capital
system of insurance, but the US are certainly signatories to these
papers. For the moment, this is just guidance rather than fixed
Chairman: In light of the time and the
length of time we have kept you, may I ask that if there are any
other questions that we wish to cover, we may write to you and
ask them? If we have left you with anything unsaid, may the same
be the case, that you would write to us when you had seen the
transcript. Thank you very much for coming, particularly since
this cannot be an easy time for those of you who also have responsibilities
in the banking sector.