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Life after N2

A flurry of FSA fines in December showed the financial services industry more clearly than ever that the FSA is serious about clamping down on instances of misselling, ineffective management and poor corporate governance. A year on from the introduction of the N2 regime, the FSA has not shied away from some high-profile naming and shaming. How does the insurance industry shape up in all this?

Back in November 2001, the FSA observed that “the insurance industry has not moved ahead as far as other sectors of the financial services industry in terms of corporate governance, risk management, and systems and controls.”

The changes introduced by the Financial Services and Markets Act in December 2001 were expected by many to have a greater impact on insurance firms than other parts of the financial sector and yet their potential effect was assessed very differently across the insurance industry.

Some N2 preparation projects were highly engineered while others were scarcely adequate. What has been the impact of changes in the regulatory environment since N2? Have firms which put significant effort into N2 preparations have reaped rewards?

A principal shift in the regulatory environment has been the emphasis which the FSA places on senior management responsibilities in virtually every area of its policy. This focus may only become evident, however, when something has gone wrong.

Almost the first concrete evidence of the adequacy or otherwise of firms&#39 preparation has been the risk mitigation programmes emerging from the FSA&#39s first round of risk assessment visits carried out in 2002 at 100 or so of the bigger, more complex, insurance groups.

These have taken the form of a letter to the CEO, with the expectation that this will be considered by the board, outlining actions which the FSA expects the firm to take and a timetable for doing so.

A common theme emerging is the need for senior management in many insurers to address weaknesses in a number of areas, including:

•Outsourcing – inadequate agreements and management controls.

•Risk management – firms&#39 processes to identify, assess, mitigate and report risks.

•Documentation – of procedures and controls, of computer systems, and reporting the operation of key controls;

Responsibilities -documentation and control of limits and authorities delegated to subsidiary companies, management and staff.

•Business continuity plans.

•Stress and scenario testing.

Many firms clearly still have much to do, particularly since the FSA has signalled an intention to adopt a tough stance where compliance breaches have resulted from poor corporate governance, inadequate risk management systems or ineffective systems and controls. The FSA&#39s willingness to use powers of intervention and fines to clamp down on failings is clear.

What has emerged from publicised cases is the importance of firms engaging with the FSA and being proactive in dealing with issues. Where senior management does not fully accept its responsibilities to customers and to implementing changes required by the regulator, it has been clear that the penalties imposed are significantly greater.

The insurance industry still faces the prospect of extensive change beyond that brought about at N2. The FSA is keen to meet its regulatory objective to secure protection for consumers across the industry and insurers can expect further requirements and detailed scrutiny in this area, including provision of information after the point of sale and radical reporting changes.

Additionally, the FSA is consulting on proposals for regulating the sale of general insurance, which will set out the standards that insurers and intermediaries should meet when selling insurance and handling claims.

The regulatory framework for the insurance industry is also being overhauled (the Tiner review) – the FSA intends to introduce its “risk-based” approach to supervision and implement a pro-active and challenging relationship with firms, expecting:

•More openness with regulators and consumers.

•Increased responsibility and accountability for senior management.

•Greater awareness of the impact of their actions on consumers.

Uncertainties in the broader financial sector – including falling equity markets, pressure on costs, the need to show stronger capital backing, and consolidation within the industry – mean that strong governance and risk management have become crucial, particularly for insurers.

The FSA has made it plain that a desired outcome of the Tiner review is that insurance firms themselves should implement a more rigorous approach to managing risk.

The proposed requirements of the Integrated Prudential Sourcebook amplify the need to strengthen risk management systems, and to use stress and scenario testing and other modelling techniques to deter- mine capital requirements which better reflect the risk profile of companies.

More sophisticated risk management systems and economic capital models will take many years to build. However, significant benefits for managing and controlling the business, enhancing shareholder returns, and improving transparency and corporate governance can be achieved.

What has become clear for the insurance industry over the past 12 months is that the stronger the controls and the compliance culture, the less need there should be for regular regulatory intervention.

The FSA&#39s new standards will be attained with the least difficulty if the senior management of insurers is prepared to engage with the regulator.

Given the individual responsibilities placed on them under the regulatory regime, CEOs, in particular, need to initiate and lead the drive for change. The pace of regulatory change has not diminished and insurers need to be much more forward looking.

As with preparing for N2, some firms are already some way down the path but those that are not need, as a matter of urgency, to review their position and start making improvements.

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