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COVID-19 has had and will continue to have impacts on virtually every corporation in Canada and globally.
The Conservative Party first set out its plans to reform the regulation of financial services in the UK in July 2009. The proposals published at that time included abolishing the tripartite system whereby the Bank of England, the Treasury and the Financial Services Authority (FSA) share responsibility for national financial stability. In its place, the Conservative Party proposed that both macro and micro-prudential oversight should be given to the Bank of England which, it was argued, was best placed to monitor systemic issues across the financial services sector.
In his first Mansion House speech delivered in June 2010, Chancellor of the Exchequer George Osborne announced that the Coalition Government would move to address what he considered the "spectacular regulatory failure of the City". He announced that the tripartite regime would be abolished and the FSA would cease to exist in its current form. A new prudential regulator would be created, operating under the supervision of the Bank of England, and an independent Financial Conduct Authority (FCA) would be established to regulate the conduct of firms providing services to consumers. The Government proposed that the process of dismantling the current regulatory system be completed by 2012.
Early in 2011, the Treasury Select Committee urged the Government to revisit the Financial Services and Markets Act 2000 (FSMA) in its entirety to ensure a coherent piece of reforming legislation. In February 2011, the Government published A new approach to financial regulation: building a stronger system, in which it confirmed that the reforms would be implemented by amending FSMA. According to the Government, the decision was taken so that the changes could be implemented with greater speed, whilst minimising the disruption to firms that would arise from repealing FSMA and starting with an entirely new Bill.
The legislative process began on 26 January 2012 when the draft Bill had its first reading in the House of Commons. Shortly after, the FSA announced that it would be moving to a “twin peaks” style regulatory model (designed to replicate that adopted by the Prudential Regulation Authority (PRA) and the FCA) from 2 April 2012. As expected, the Bill completed its passage through Parliament by the end of the year and received Royal Assent as the Financial Services Act 2012 (FS Act) on 19 December 2012. The new regulatory structure came into force on 1 April 2013. The FSA ceased to exist on this date, with the PRA and FCA assuming responsibility for financial services regulation.
Under the new regulatory structure, insurers, reinsurers and Lloyd’s will be subject to dual-regulation, whilst insurance intermediaries will be regulated by the FCA only. This article will consider the new regulatory landscape for insurance firms in the UK.
One of the main failures in regulatory oversight, identified following the financial crisis, was a lack of macro-prudential scrutiny. To address this perceived failure to spot systemic risks in financial markets, the July 2010 consultation paper entitled A new approach to financial regulation: judgement, focus and stability, proposed the establishment of a body within the Bank of England with primary responsibility for the oversight of financial stability.
The Financial Policy Committee (FPC) has a number of macro-prudential tools available to address systemic risk, including capital and liquidity tools. In response to the Government's proposals, the Treasury Select Committee stressed the need for clarity about what such 'stability' means and cautioned that ensuring the overall stability of the financial system should not mean that no firm will ever fail. Given that the white paper A new approach to financial regulation: the blueprint for reform accepts that firm failure is always a possibility, these comments appear to have been noted.
During the legislative process, both the Treasury Select Committee and industry commentators expressed concern that the membership of the interim FPC was too heavily weighted towards banking. In response, the Government stressed that, together with the Bank, it was committed to ensuring an appropriate balance and breadth of experience for the FPC. Stakeholders welcomed the Government's views on the importance of ensuring that external members of the FPC have recent and relevant financial services experience in non-banking areas like insurance.
On 26 March 2013, the Government announced the appointment of four external members of the FPC. In a statement, the Treasury noted that “all four external members bring a wealth of outside experience to the FPC with their expertise in equity markets, commercial and investment banking and insurance”. Despite the Government’s claims to the contrary the appointments do seem to indicate a focus on banking, with only one external member demonstrating experience in the industry sector.
The PRA is responsible for the micro-prudential regulation of all deposit taking institutions, insurers and banks. It was set up as a subsidiary of the Bank of England in order to bring both the macro and micro-prudential oversight of financial institutions within one body. Where the FPC identifies wider market issues which need addressing, it will request that the PRA take regulatory action to address any concerns with individual firms. For insurers, the PRA has a remit for the oversight of firms with permission for effecting and/or carrying out contracts of insurance.
The PRA has two statutory objectives: a general objective to promote the safety and soundness of the firms it regulates and an objective specific to insurance. The FS Act inserted a new section 2C into FSMA specifying the PRA's insurance objective to contribute to the securing of an appropriate degree of protection for those who are, or may become policyholders.
The insurance objective is designed to recognise the correlation (especially in with-profits policies) between the management of risk and consumer outcomes. The application of the objective to those who may become policyholders has the potential to cause confusion, as noted by a number of respondents to the June 2011 paper, who questioned whether the reference to “future policyholders” could prove to be ambiguous. Despite further criticism, most notably in a report by the Joint Committee of both Houses of Parliament, the standalone insurance objective was chosen in favour of cross-sectoral objectives. In an October 2012 speech, CEO of the PRA, Andrew Bailey declared that “the public interest” justified a specific insurance objective reflecting the very long-term nature of some insurance policies and is a key feature of the amended FSMA.
A joint BoE/FSA paper, entitled The Bank of England, Prudential Regulation Authority - Our approach to insurance supervision, confirmed that the PRA would have a concurrent objective to seek to minimise the adverse impact that either the failure of an insurer, or the way it carries out its business, could have on the stability of the system. Prior to legal cutover, the FSA frequently stated that the new legislation was not aiming for a zero-failure regime. Instead, the regulatory focus is on ensuring that where firm failure does occur, it is managed in an orderly way thereby minimising adverse affects on policyholders and disruption to the financial system.
The PRA has adopted a "judgement-based" supervisory approach. Practically, this means that the nature and intensity of the PRA's supervision will be commensurate with the level of risk a firm poses to policyholders and to the stability of the system. Whilst there is an acceptance that insurers are not systemic in the same way as banks, when judging the risk posed by a firm the PRA will consider various factors, for example, the combination of insurance and banking in a single group that may give rise to system-wide risk if the failure of the insurer threatens the financial condition of the bank. Furthermore, the investment decisions of insurers can accentuate movements in asset prices and groups containing an insurer may undertake non-insurance activities that bring risk to the system.
In an effort to move away from the much criticised “box-ticking” style of FSA regulation, the PRA will take a forward-looking approach to supervision. As such it assesses insurers not just against current risks, but also against those that could plausibly arise in the future. The level of supervisory interaction will depend on an insurer’s categorisation. All firms are divided into five categories of impact. Category 1 firms are the most significant insurers whose size, interconnectedness, complexity and business type give them the capacity to cause very significant disruption to the UK financial system and to the interests of policyholders, whilst category 5 firms are those that have no capacity to individually cause disruption to the financial system or to the interests of policyholders.
Dual-regulation means that not only are insurers supervised by the PRA and FCA, but also that policyholders are protected by both regulators. Whilst the PRA looks to ensure that an insurer is likely to have sufficient financial resources to meet its obligations to policyholders as they fall due, the FCA's role as conduct regulator is to ensure that consumers are treated fairly in all their engagements with insurance firms.
The FCA was originally given a single strategic objective of protecting and enhancing confidence in the financial system. The FS Act was amended, however, to entrust the FCA with “ensuring that the relevant markets work well”. Relevant markets include financial markets, markets for regulated financial services, and markets for services provided by unauthorised persons carrying on regulated activities without contravening the general prohibition (this also covers appointed representatives and exempt professions).
In the build-up to the FCA assuming responsibility for conduct regulation, questions were asked as to how its supervisory approach would differ to its predecessor. The FCA has assessed its remit as “very clear” and “uncomplicated”. The plethora of material produced in anticipation of the new regulatory structure suggested that the FCA would focus its efforts on ensuring the markets work well for all participants; allowing good firms to make profits, and ensuring product innovation and choice for consumers As the new regulator sought to distinguish itself from its predecessor, firms were warned that a tougher, more intrusive style of supervision would replace the “primarily reactive” culture of the FSA.
The FCA’s overarching strategic objective is supported by three operational objectives, namely: securing an appropriate degree of protection for consumers; protecting and enhancing the integrity of the financial system; and promoting effective competition in the markets for regulated financial services in the interests of consumers. The FCA also has a free-standing duty to have regard to the importance of taking action to minimise the extent to which regulated business may be used for a purpose connected with financial crime. These objectives and the principles to which the FCA should have regard to in discharging them reflect the Government's new approach to regulation in the wake of the financial crisis. Notably, the requirements that the regulator considers the desirability of facilitating innovation and maintaining the competitive position of the UK are no longer included in FSMA. The financial services industry makes a major contribution to UK GDP and employment. Recognising that an effective regulatory system can attract business, the Treasury Committee, in its report entitled House of Commons Treasury Committee: Financial Conduct Authority, stated that it is important that the new regulatory bodies do not ignore the impact of their actions on the competitiveness of the UK.
In addition to having responsibility for conduct issues, the FCA is responsible for the prudential regulation of around 23,000 firms that are not regulated by the PRA. Insurance intermediaries, for example, are solely regulated by the FCA. The British Insurance Brokers’ Association and the Institute of Insurance Brokers have been openly critical of the previous regulatory regime stating that the style and intensity of regulation is inappropriate for insurance brokers. They have argued that fundamental reform is essential to allow the FCA to deliver discernable value to regulated firms and their customers. The Confederation of British Industry was particularly vocal in its concern about the role of the FCA and cautioned that the differing objectives of the two regulators could give rise to the potential for differences in their approach to prudential regulation. One issue that was raised was the possibility of creating a two tier regulatory regime for firms within the same industry that could damage competition between firms that are close to the dividing line between being supervised by the FCA or PRA.
The FCA was originally to have been named the Consumer Protection and Markets Authority and was branded a “strong consumer champion”. This label was heavily criticised by the Treasury Select Committee who considered it to be inappropriate, confusing and dangerous. The crux of their argument was that the promotion of a regulator as a consumer champion would lead consumers to falsely believe that all financial products are risk free, potentially creating moral hazard. The Government dropped this name in favour of the FCA but stressed that the term "consumer champion" should be viewed in the context of the FCA's role as a focused and proactive conduct regulator that is entirely independent and impartial.
The FCA’s regulatory approach is set out in a document entitled Journey to the FCA which was published in October 2012. The FCA will focus more closely on wholesale conduct and will take a more assertive and interventionist approach to risks caused by wholesale activities. The FCA does not believe there is a clear divide between retail and wholesale markets and consequently, its approach will recognise that activities in these markets are connected and that risks caused by poor conduct can be transmitted between them. Poor behaviour has a wider impact on trust in the integrity of markets and, following a number of high-profile scandals in recent years, will not be tolerated by the regulator. Further thematic work on key risks and priorities in the wholesale market will be carried out in due course.
Consumer protection lies at the heart of the FCA’s approach and the regulator has far-reaching powers at its disposal to achieve its objectives. Perhaps the most controversial new power is the FCA’s ability to temporarily ban flawed products. The FCA will make a temporary product intervention rule where it identifies a threat to its statutory objectives which requires prompt action. The FCA has “no plans to introduce pre-approval of all products as a matter of course” but has not ruled the possibility altogether. The FCA’s approach looks to build on changes that its predecessor had begun to implement in light of the Payment Protection Insurance (PPI) mis-selling scandal and the FSA’s regulatory failures. Although the FSA intervened robustly to secure redress of consumer detriment, in the future the FCA will look to ensure that fewer such problems develop in the first place. To this end firms can expect far greater scrutiny of the product lifespan, from design to point of sale. Recent enforcement action indicates those areas the FCA will be focussing on and the level of intervention firms will need to get used to.
We have produced a briefing looking at how the FCA will supervise product development and issues firms need to consider when designing insurance products. For further information: Insurance product development in the new regulatory landscape.
Effective coordination between the FCA and the PRA is a vital part of the new regulatory framework. To this end, the Government has legislated for a variety of general coordination mechanisms including a statutory duty to coordinate the exercise of the authorities' functions (contained in a Memorandum of Understanding), cross-membership of boards and a veto mechanism for the PRA to reduce the risk of regulatory actions by the FCA threatening financial stability or the disorderly failure of a firm.
The general principle underpinning the Government's model of dual regulation applies to insurance regulation. The FCA is responsible for supervising the day-to-day conduct of insurance firms in dealing with their customers and clients, whilst the PRA will look to promote their long-term soundness and stability. There are, however, certain areas which require further consideration.
The Government originally intended to insert a section into FSMA giving the PRA sole responsibility for securing an appropriate degree of protection for the reasonable expectations of policyholders in regard to their returns under with-profit policies. This necessarily covers conduct as well as prudential issues. The Joint Committee were openly critical of the Government’s proposals for the regulation of with-profits business suggesting that there is legal uncertainty regarding the definition of “reasonable expectations” and much of the Equitable Life litigation revolved around the problems of defining the term. The Joint Committee contended that the phrase would make it difficult for the PRA to be clear on the meaning of its duties, and near to impossible for consumers and Parliament to hold the PRA to account for its actions. Given the importance of facilitating effective communication, the Joint Committee also suggested that the PRA should be subject to an explicit duty to consult with the FCA on matters affecting with-profits customers.
FSMA, as amended by the FS Act, includes a new section 3F covering with-profits insurance policies. A with-profits policy is defined as a contract of insurance under which the policyholder is eligible to receive a financial benefit at the discretion of the insurer. Additionally, a with-profits insurer is defined as “a PRA-authorised person who has a Part 4A permission…relating to the effecting or carrying out of with-profits policies”. FSMA does not set out how the regulation of with-profits business is split between the PRA and FCA and instead requires the regulators to enter into and maintain a memorandum describing in general terms the role of each regulator in relation to with-profits insurers.
The memorandum of understanding (MoU) between the PRA and FCA was published on 2 April 2013. It states that the exercise of discretion in policyholder returns gives rise to questions of fairness which is a matter for the FCA. The PRA will be concerned about the impact on the safety and soundness of with-profits insurers, in particular their solvency, of any action taken or proposed by the firm. It is the FCA’s responsibility to ensure that any proposed changes that might affect benefits or payments are consistent with previous policyholder communications, the FCA’s conduct rules and the overriding obligation to treat customers fairly.
The PRA meanwhile will consider whether actions proposed by the insurer are affordable. Insurers are expected to establish and maintain adequate financial resources in respect of both guaranteed and discretionary payments to with-profits policyholders. The PRA is granted a significant power, under section 3J, which allows it to direct the FCA not to exercise its regulatory powers (or not to exercise them in a specified manner) if the regulators cannot reconcile their concerns.
The MoU also details how with-profits regulation will operate in practice. Both regulators have rule-making powers in their respective areas of competence. In cases where the PRA has no affordability concerns (or other concerns in line with its objectives), firms can expect to deal with the FCA. For conduct of business matters that do not trigger affordability issues, the PRA will have no role and the FCA will determine the outcome on the basis of fairness. The Conduct of Business Sourcebook (COBS) 20 has been divided between the regulators accordingly.
In the Government's original consultation paper, the Society of Lloyd's was hardly mentioned and Lord Myners described the consideration given to the regulation of Lloyd's as an "afterthought". This lack of thought was heavily criticised by the Treasury Select Committee in Financial Regulation: a preliminary consideration of the Government's proposals, in which it was argued that Lloyd's merited greater focus than the consultation provided.
During the legislative process, however, specific provisions were made for the regulation of Lloyd’s. The PRA is the lead regulator for Lloyd's as a whole, with the FCA taking the role of regulating member's agents and brokers. The Society of Lloyd's and Lloyd's managing agents are dual-regulated firms with the PRA responsible for prudential regulation and the FCA responsible for conduct. The FCA is tasked with the oversight of market conduct and consumer protection.
The division of responsibility largely follows the division of interests in relation to insurance business or activities but also has regard to the unique nature of Lloyd's, including the way it operates as a specialist financial market and the distinctive roles played by certain participants in the market.
Firms must apply to the PRA for authorisation if they wish to effect or carry out contracts of insurance. The PRA will administer the application and be responsible for granting authorisation. Authorisation to carry out regulated activities will not be granted unless both the PRA and the FCA are satisfied that it should be. Before granting authorisation, the PRA will assess whether the firm satisfies the relevant statutory threshold conditions.
Under the new regulatory structure, each regulator will be responsible for different sets of threshold conditions. The Financial Services and Markets Act 2000 (Threshold Conditions) Order was amended so that four sets of threshold conditions were inserted into Schedule 6 of FSMA: Part 1B, 1C, 1D an 1E. The result is that dual-regulated firms will have to comply with two sets of threshold conditions: Part 1C that deals with FCA-specific conditions for firms authorised by the PRA and subject to dual-regulation, and Part 1D which covers PRA-specific conditions for insurance firms. Part 1B covers threshold conditions for firms authorised and regulated by the FCA only (i.e. insurance intermediaries).
The most significant change to the threshold conditions is the inclusion of a completely new “business model” condition. This is an FCA condition and is therefore applicable to all firms. For firms that are regulated by the FCA only, the condition requires that the business model is suitable and considers the interests of consumers and the integrity of the system. For dual-regulated firms, the business model condition means that the firm’s strategy for doing business must be suitable for its regulated activities, having regard to the FCA’s operational objectives. To meet this requirement, insurers should be prepared to explain their business model to the FCA and justify the rationale behind it.
The Bank of England and FSA joint paper explained that the importance of scrutinising firms' business models is one of the key lessons learnt from previous episodes of insurer distress. The requirement was designed to prevent insurers attracting business through aggressive pricing, without setting aside sufficient claim reserves (as occurred in the case of HIH Group and Independent Insurance) and to ensure that a firm's business model does not run ahead of its capital potential (as was the case in Equitable Life).
In terms of authorisation, the PRA will lead the process for dual-regulated firms. The PRA and the FCA will seek to minimise the administrative burden on firms of the new authorisation procedures. As such there will be a single administrative process with a single application form and timetable for decisions by each authority.
Prior to legal cutover, one issue that sparked debate was the possibility of overly burdensome administrative processes and the risk of duplication as a result of dual-regulation. Initial proposals amending the approved persons regime were criticised by firms for being inefficient and confusing. Consequently, the FSA scrapped plans to divide the significant influence functions between the PRA and FCA and instead a much simpler regime was implemented. There is very little change for FCA-authorised firms. For dual-regulated firms, the PRA will designate those functions deemed to be materially connected to the prudential soundness of a firm. Meanwhile, the FCA will lead on all functions concerned with a firm’s interface with customers including client assets, anti-money laundering and compliance. The FCA has a statutory obligation to minimise the likelihood of duplication of approvals, but not eliminate the possibility entirely.
Finally, the FCA can withdraw approval, granted by either regulator, from a person carrying on a controlled function if it considers that the person is not a fit and proper person to perform the function. Both the PRA and FCA may withdraw approval from a person who is carrying on a significant influence function in connection with a dual-regulated firm, regardless of which regulator gave approval. If withdrawing an approval given by the other regulator, it must consult that other regulator first.
Part VII of FSMA sets out a framework to enable the transfer of insurance business from firm to firm. The FS Act did not alter the substance of the current framework. The courts are ultimately responsible for sanctioning or rejecting an application for a business transfer. The PRA will be primarily responsible for the process but the FCA also has an interest and will need to satisfy itself that, as a minimum, the transfer will not adversely affect the customers of the firms involved in the transfer.
Both regulators will be able to make representations to the court during the transfer process. Significantly, the PRA is required to consult the FCA at the outset and throughout the process. The involvement of two regulatory bodies in the transfer process may lead to more complex negotiations between the transferring parties and the regulators in relation to issues such as notification, particularly in light of the different objectives of the PRA and FCA.
For firms passporting out of the UK, the PRA will be responsible for issuing all relevant notices in relation to insurers. It is clear that the PRA needs to oversee the entire financial system in the UK, including parts made up of branches passporting in from other countries. Nevertheless, prudential supervision under European single market directives remains within the remit of the home state regulator, with only conduct issues regulated by a host state under the "general good" provisions. Accordingly, the PRA will need to build close working relationships with overseas regulators and supervisory colleges supervising large firms passporting into the UK.
Notifications from overseas regulators in relation to the Reinsurance Directive, the Consolidated Life Assurances Directive and the First, Second and Third Non-Life Insurance Directives will go to the PRA, in order to mirror its responsibilities on a domestic basis. Notifications in relation to all other directives will go to the FCA. As conduct is regulated under the "general good" provisions, the amended FSMA requires the PRA to give a copy of any notice received to the FCA without delay.
In their joint paper, the Bank and the FSA stated that the PRA's policies and supervisory actions will take place within an international context and that much of the PRA's proposed approach in relation to insurers will be achieved through the application of Solvency II. The joint paper states that the PRA will play an active and constructive role in shaping the development of the common framework for regulation and supervision at a global level and in the EU. Ongoing delays to Solvency II, and the absence of a definite timetable has forced the PRA to adopt its own “sensible planning period” for Solvency II. The PRA will reconsider its approach should a realistic timetable emerge but, in the meantime, firms have until 31 December 2015 to submit their internal models to the regulator. In February 2013, the FSA announced that firms would be able to make use of their IMAP preparations if they opted for the ’ICAS+’ approach. The approach has been taken on by the PRA and allows firms that have already undertaken a significant amount of IMAP work to use this for ICAS purposes.
As noted above, many international insurers operate in the UK and the PRA will collaborate with other organisations including the European Insurance and Occupational Pensions Authority (EIOPA) and the International Association of Insurance Supervisors to ensure that it is able to address risks that non-UK insurers may pose to its statutory objectives. The PRA will represent the UK in EIOPA. The PRA and the FCA will work together to ensure that the other regulator and any other relevant authorities are kept fully informed of any matters due to be discussed which fall within their sphere of responsibility. When another body has an interest, the PRA may bring along a non-voting representative of that national body. This is particularly important as conduct issues (such as the proposed IMD2) fall within the scope of EIOPA.
During the legislative process, the Joint Committee explained that it is vital that the MoU establishes a committee responsible for ensuring that the UK authorities agree consistent objectives and exercise their functions in a way that is effective. The MoU on international organisations, published in January 2012, sets out a framework for consultation and cooperation amongst the relevant authorities in order to ensure that the UK takes a coherent position internationally and a consistent line in discussions with its international partners. Amongst other things, the MoU confirms that where not all the UK authorities are represented in international organisations and bodies, the UK authorities that are represented shall, in a timely manner, consult with, and keep the other UK authorities informed, in relation to any matter of common interest. It also provides for the establishment of an International Coordination Committee, which will be responsible for ensuring that the UK authorities act in accordance with the principles set out in the MoU.
Aside from the need for effective regulatory coordination between the two organisations, there are other issues that are worthy of note. For example, the power of the regulators to publish warning notices at an early stage of any enforcement action has been widely publicised. FSMA originally imposed a general prohibition preventing a regulator from publishing or giving details of any notice. The Financial Services Act 2010 lifted the prohibition in relation to decision notices and the FSA utilised this power for the first time in May 2011.
The FS Act amends FSMA in order to relax the general prohibition against the publication of warning notices and the FCA and the PRA may publish information following consultation with persons to whom the notice is given or copied. According to FSMA, the FCA may not publish a decision or warning notice if, in its opinion, publication of the information would be: unfair to the person against whom the action was taken (or was proposed to be taken); prejudicial to the interests of consumers; or detrimental to the stability of the financial system. The PRA will apply different criteria in considering whether to publish a notice. Again, it will not publish a notice if this would be unfair to the person against whom the action was taken but it will also consider whether publication will be prejudicial to the safety and soundness of PRA authorised persons or to securing the appropriate degree of protection for policyholders.
Firms have objected to the proposal citing the potential reputational impact of an early warning notice and worries about consistency with natural justice. In the past, there have been examples of FSA enforcement actions that have not been taken forward or that have been challenged and it is unlikely that the publication of a notice of discontinuance will repair the damage that has been caused. The FCA’s proposals in relation to its power to publish information about the matters to which warning notices relate were published in a March 2013 consultation paper. The key proposals relate to the type of case this power will apply to (i.e. disciplinary outcomes only), the kind of information that will be published and restrictions based on unfairness. In deciding whether publication would be unfair, the FCA will consult with the recipient of the warning notice. To establish unfairness, the firm or individual must provide “clear and convincing evidence of how that unfairness may arise and how they could suffer a disproportionate level of damage”. The circumstances in which the recipient of a warning notice will be able to establish that publication would be unfair are likely to be limited. In addition, it seems clear that the bar will be set high in terms of what may constitute sufficient evidence to prevent publication.
The Financial Services Act
Government consultation papers
House of Commons Treasury Committee reports
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