§ Motion made, and Question proposed, That this House do now adjourn.—[Mrs. McGuire.]
§ 12.4 am
§ Mr. Barry Gardiner (Brent, North)
I begin by reassuring my hon. Friend the Economic Secretary to the Treasury that I would quite understand if she began her response to our debate with the protest that we must stop meeting like this. During the past few weeks, I have detained the House, and my hon. Friend, in Adjournment debates with observations on the collapse of the Independent Insurance Company, the debacle of Equitable Life and now the collapse of Chester Street Insurance Holdings. Those are three bombshells that have hit the financial services industry particularly hard. They have prompted independent inquiries, appeals to the House of Lords, special industry compensation schemes and regulatory reviews. Above all, they have led to a severe undermining of confidence in the insurance industry, whose only tangible product, after all, is confidence itself.
Insurance gives us the confidence to engage in the commercial world without becoming paralysed by the potential liabilities that such engagement might bring—the confidence to employ staff whose work is intrinsically dangerous and the confidence to manufacture products, whose unforeseen failure would trigger crippling liabilities. In life assurance, it means the confidence to plan for a future that is financially secure beyond a lifetime of work.
The failure of these companies to furnish their policyholders with the benefits they undertook to provide has caused enormous distress and suffering. However, their failure goes further in so far as it has undermined confidence in the industry. By undermining that confidence, they have weakened the system of protection for everyone else.
I turn now to the failure of Chester Street Insurance Holdings. I have no intention of restating in detail the company's history. It is already known to the Minister and the House, and was the subject of an Adjournment debate in March. Stated simply, Chester Street Insurance Holdings Inc., after selling its interest in the subsidiary insurance company that was its main asset, concluded that it still was unlikely to be able to meet all its future liabilities. The company therefore proposed a scheme of arrangement under section 425 of the Companies Act 1985, and on 5 February this year creditors approved the scheme by the necessary 75 per cent. vote in favour. The declared percentage pay-out to creditors under the scheme was 5 per cent.
Chester Street's book of business was employers' liability which, since the Employers Liability (Compulsory Insurance) Act 1969 came into force in 1972, has been a compulsory insurance. Under the Policyholders Protection Act 1975, policyholders are protected by statute when an insurance company is unable to meet its liabilities. The Policyholders Protection Board pays 90 per cent. against valid claims for non-compulsory insurances through a fund raised by levy on the insurance industry. However, it pays compulsory insurances in full.
The combined effect of those two Acts of Parliament is to ensure that although virtually all Chester Street's valid claims arising after 1 January 1972 are met by the PPB in 150 full, claims arising before that date can only be paid out at the 5 per cent. rate under Chester Street's scheme of voluntary liquidation. Of course, the injured employee still has a valid claim against the employer concerned, and that caused enormous concern among those large engineering firms such as Corus, British Shipbuilders and Harland and Wolff that were some of Chester Street's major policyholders. It gave rise to even greater distress among individuals who had suffered industrial injury through such long tail liabilities as vibration white finger, noise-induced hearing loss or asbestosis.
Where the employees' former employer was still in business, there was a prospect of hugely delayed and compromised payments. Where the former employer had subsequently gone into liquidation, the chance of recovery was virtually nil.
I commend the Government and the Association of British Insurers for the way in which they worked to put together a compensation scheme to benefit those individuals who fell between the stools of the PPB and Chester Street because they had contracted their illness prior to 1972 and found that they had no one to claim from because not just their insurer but their former employer had gone into liquidation.
The financial services compensation scheme announced by the ABI on 8 August this year is funded by a levy on insurance companies and will ensure that victims receive 90 per cent. of the value of their award in such cases. It is not quite the 100 per cent. provided for under the PPB, but for those who, less than a year ago, thought that they faced a maximum of 5 per cent. of their rightful claim, it is a tremendous and welcome improvement.
Although I do not want to minimise what has been achieved, the House must express its concern that the collapse of Chester Street is yet another major insurance failure, and that our financial regulation system failed so manifestly not only to anticipate it but to provide for it. The Government and the Financial Services Authority must look again at the regime of solvency and capital requirements placed on insurance companies. Later in my remarks, I shall direct the Minister's attention to those aspects.
First, I want to examine the paradox that is the Policyholders Protection Board itself. The PPB penalises good insurers and rewards bad ones. The insurance market is one of extreme competition where consumers have increasingly made the mistake of regarding insurance cover as a product—a commodity that may as well be purchased from any provider—and where the sole consideration is to achieve the lowest price. There will always be companies, such as Independent Insurance and Chester Street, that are desperate to win market share by slashing premiums to unsustainable levels or by paying unsustainable commissions to intermediaries.
Regulators need to address the fact that responsible insurance companies suffer a double jeopardy: not only do they lose business when those companies are trading, because they are not prepared to pursue business at any price, but they have to bail out the self-same companies by contributing to the PPB levy when they go under. The cost of that for major insurance companies runs into millions of pounds.
151 It has even been suggested that some brokers cited the PPB as a reason for not advising their clients to switch from Chester Street long ago. They said that even if the company failed, the PPB would still provide full cover, so it did not matter.
I grant that the current PPB framework makes the insurance industry self-funding and thus accountable, in aggregate, for its financial soundness. However, the operation of the PPB is ad hoc and inconsistent. Levies are raised only on an as-needs basis. Indeed, between 1993 and 2000 there were no levies. That means that levies are entirely unrelated to the risk that each insurance company is running. They are entirely unrelated to the expected economic cost that each company imposes on the rest of the industry by its own risk of failure.
The first result of that is freeloading: bad companies make a short-term profit, go bankrupt and contribute nothing to the industry levies that are required from the good companies to bail out the victims of bad companies. Secondly, there is a lack of regulatory incentives to improve risk management. As long as the industry is prepared to bail out the victims, the regulator fails to address the fundamental problems that produce the victims in the first place.
The Minister must focus on two aspects of regulatory failure. There is a lack of clear accountability for the funding of insurance failures. The ad hoc nature of the PPB levies combined with the potential for catastrophic losses that could result from several insurance company failures suggest that there is no clear accountability as to how such catastrophic losses might be funded. This year, the Government negotiated with the ABI. The FSA should be given that clear responsibility.
There is a lack of any analytical framework for assessing the aggregate financial condition of the insurance industry. At present, it is not possible to assess the likelihood of the failure of an individual insurance company in the UK. It is certainly not possible to assess the likelihood of multiple failures, hence it is not possible to assess the adequacy of the PPB fund, or to link its capitalisation to an explicitly defined level of confidence in the market. The FSA should be given that clear responsibility.
In order to fulfil that role the FSA will have to focus on key issues relating to the solvency regime and capital requirements. On 1 December, we will have a new single regulator with more extensive powers of intervention, a single ombudsman and compensation scheme, group solvency monitoring, earlier deadlines for the completion of annual returns and an approved persons regime. The recent consultation has indicated the FSA's intention to move towards a risk-based approach to regulation and to introduce an integrated prudential source plan. Those are formidable advances in the regulatory armoury, but they must be brought to bear on the following problems.
First, reserving is inconsistent. The FSA's failure to require any benchmarking of reserve levels to industry standards or loss ratios is a major problem. It is compounded by the freedom given to the actuaries and underwriters to manipulate their own reserve levels. In particular, external actuaries have only one very crude weapon in their armoury when they validate the reserves—to refuse to sign off. As with most nuclear weapons, it is practically useless and hardly ever used.
152 Secondly, reinsurance standards are inadequate. The Minister is well aware of the ineffectiveness of regulation on such issues, and we have discussed before the way in which the Independent Insurance Company was legally able to reinsure its portfolio in an ultimately circular deal that ended up with a wholly owned subsidiary company of Independent itself. Indeed, 70 per cent. of Independent's outstandings were reinsured, for all the good that it did that company or its victims.
Thirdly, minimum regulatory solvency levels are inadequate. There are few better examples of gross regulatory failure than the fact that an insurer that held the minimum solvency margin would have approximately a one in 40 chance of insolvency every year. The failure to set formal target and intervention trigger levels for insurers means that the regulatory solvency margins do not have any material impact on the way that the insurance industry manages risk. I have had occasion before to disparage the European solvency margins in front of the Minister. It is clear to me from my discussions with the German insurance regulator that even the author of the infamous Muller report has difficulty in maintaining any longer that those solvency requirements are sound in principle and in practice.
Fourthly, there is a lack of differentiation. Solvency margins do not significantly differentiate the different risks run by different insurance companies. Required margins should vary according to premium income, by line of business.
Fifthly, there is a one-size-fits-all framework. At present, the regulator takes no account of any sophisticated internal risk measurement framework implemented by various market-leading companies.
I have presented the Minister with several detailed complaints and observations about how I consider that the insurance industry is failing the public and how the FSA, as regulator, is failing the industry. It is perhaps not incumbent on me to offer solutions to those problems, but, equally, it is only fair to those about whom my remarks are critical that I at least present a marker that can be shot at.
I believe that the FSA should establish ratings for individual insurance companies. Those ratings should be published and should take account of an insurer's risk profile and financial strength. Private sector rating agencies, such as Standard and Poor's, already measure each insurer's financial strength, but the main problem with most of those commercial rating agencies is that they are based on primarily public information and do not reflect internal information about the controls and processes to which a regulator should have access. Moreover, rating agencies do not have the same resources as regulators. S and P has only a handful of people covering the entire United Kingdom insurance sector. There is no reason why regulatory financial strength ratings would not be possible, and I believe that they would represent a significant improvement on the current regulatory minima and private sector ratings.
I believe that the FSA should ensure that there is accountability in the industry for solvency. In particular, the industry as a whole should finance all the costs associated with insurance failures with no subsidy, explicit or implicit, from the taxpayer. The fund for that should be reviewed annually on the basis of the FSA's assessment of the aggregate financial conditions of the industry. 153 Cross-subsidisation between industry participants should be minimised so far as possible, so that those insurers that are most at risk of failure should pay proportionately more for the additional benefits that they derive from schemes such as the PPB.
To enable it to do that, the FSA needs to have its performance measured in a way that is aligned with its accountability for the stability and soundness of the insurance industry. That will give it an incentive to take a more robust and sophisticated approach. An effective regulatory framework should not just incorporate a rules-based system, as is currently the case, but should balance that against a bottom-up supervision of reserving and internal risk models and controls.
The current regulatory framework allows cases such as Chester Street to go unanticipated and poorly provided for. Companies such as Chester Street and the Independent Insurance Company are able consistently to under-capitalise themselves and get away with poor or minimal risk management techniques. When they realise their losses and collapse, they leave the better companies in the industry, the Government and the public to pick up the bill. The current situation is bad for the public, bad for the industry and does not provide the country with the systemic stability and financial security that it needs.
At the beginning of my remarks, I suggested that it would be understandable if, in my hon. Friend's response, she were to express the hope that we might stop meeting like this. I would certainly share that hope, not because I do not enjoy spending time with her but because we all want an end to the spate of disasters that has struck the insurance industry and resulted in our recent debates. I hope that she will also indicate that she considers that the remedies I have proposed may be of some help in preventing future failures. What is far more important, though, is that she should suggest that she shares my analysis of the problem and that she should commit our Government to tackling it.
§ The Economic Secretary to the Treasury (Ruth Kelly)
I congratulate my hon. Friend the Member for Brent, North (Mr. Gardiner) on securing this important debate. He is clearly an expert on these matters, and I am sure that we shall continue to meet from time to time, whether in this forum or outside.
First, I wish to restate the Government's great sympathy for victims of asbestos-related diseases, which are particularly unpleasant and distressing for both sufferers and their families. This suffering is made even worse when compounded by financial uncertainty. That was the case for a group of people whose no longer existent, or now insolvent, employers insured with Chester Street. That group faced the possibility of being ineligible for the compensation due to them following Chester Street's insolvency on 9 January.
The consequences of Chester Street's insolvency were particularly worrying for victims of asbestosis and their families whose former private sector employers had insured with Chester Street, but no longer existed or were insolvent. In particular, there were fears that those whose injuries had been sustained during employment in the private sector before 1972—or 1975 in Northern Ireland—would not receive the compensation for which their employers would have been liable.
154 As my hon. Friend is aware, the Government worked extremely hard in partnership with the insurance industry in the spring of this year to end the uncertainty. The arrangements were set out on 10 May by my right hon. Friend the Chief Secretary to the Treasury. Under these arrangements, the Government are meeting their liabilities to former public sector employees, and the insurance industry is covering claims from former private sector employees.
The insurance industry will fund claims as follows. First, the PPB is making payments in accordance with its statutory powers if the compensation award or settlement was made prior to Chester Street's insolvency. Secondly, if the award or settlement was made on the day of, or after, Chester Street's insolvency, the insurance industry is funding equivalent payments pending the implementation of the new financial services compensation scheme—FSCS—at midnight on 30 November. The FSCS will supersede the PPB. Thirdly, the rules of the FSCS will ensure continuity of cover in respect of awards and settlements made after 30 November. I welcome my hon. Friend's remarks that this is a tremendously welcome improvement on the situation that existed before the spring of this year when the deal was negotiated.
My hon. Friend raised several points relating to the PPB and, in particular, to the way in which it is funded. Of course, the PPB will be superseded by the new financial services compensation scheme at midnight on 30 November. As I explained earlier, the particular problem that Chester Street raised in relation to compensation arrangements under the PPB has already been addressed by the Association of British Insurers and will be resolved by the new rules. I understand my hon. Friend's concern that sound insurers pick up the bill for those that become insolvent—companies which, as he points out, may have been in fierce competition with each other prior to the insolvency.
The FSA has long been familiar with the arguments that contributions to compensation schemes should be risk based. I understand that it considered a range of alternatives for the new compensation scheme, including a system of individually risk-weighted premiums, but concluded that at the present time funding arrangements similar to current arrangements were the most suitable and cost effective, relative to the available alternatives. Individually risk-weighted premiums were particularly expensive due to the prohibitive cost to the FSA and the FSCS of implementing an appropriate and objective risk assessment system on the basis of current information.
Risk-based premiums may turn out to be inappropriately weighted, cause competitive distortions and increase financial pressures on already weaker firms, particularly in a pay-as-you-go funded scheme in which contributions are collected only following an insolvency. Conversely, a scheme in which a fund is built up in advance may see a loss of capital from the industry, representing a deadweight cost, especially, as we would hope, if failures are low. I should also point out that the existence of a compensation scheme benefits the whole industry by boosting policyholders' confidence that, come what may, most if not all of their claims will be met.
None the less, the FSA has committed itself to reviewing that matter again as part of a wider review of compensation arrangements. It will consider their effectiveness three years after the scheme comes into effect. At that point, it will consider further international 155 and domestic experience, the activity of the FSCS and levies in practice and ongoing academic analysis in this area.
My hon. Friend also set out a number of concerns about the regulatory framework and the FSA. I note his observations on the issues on which he believes the FSA's integrated prudential sourcebook should be brought to bear. I shall cover as many of those as I can in the time available.
First, my hon. Friend is concerned about the FSA's requirements for reserving. I understand that it recognises the importance of benchmarking and already takes it into account in its supervision of individual firms. It will, however, be further enhancing its expertise in that area and will be considering the role played by the actuaries and auditors of insurance firms.
Secondly, on reinsurance requirements, my hon. Friend made an interesting point on independence insurance. The FSA plans to review the use of financial reinsurance within the insurance market and the extent of the industry's reliance on it. That issue has also arisen in the context of other parts of the insurance market and I am sure that the FSA will comment on its prevalent use. Particular attention will be paid to arrangements that do not result in a material transfer of risk to the reinsurer and those that are, in effect, regulatory arbitrage.
Thirdly, my hon. Friend mentioned solvency standards. The FSA agrees that the current European solvency margin requirements for insurance firms are inadequate. It expects almost all firms to hold buffers in excess of the European minimum levels to meet its adequate financial resources requirement. The European solvency margins are also under review and there may be further improvements on that score. However, change at an international level will clearly take time. In the meantime, the FSA is making a number of enhancements to its capital adequacy requirements for insurance firms.
As my hon. Friend noted, the FSA issued a consultation paper on an integrated prudential sourcebook in June 2001. It sets out proposals for integrated prudential standards that will apply to all types of firm. It is proposed that, for insurance firms, these proposals will take effect from early 2004.
My hon. Friend expressed concern that solvency margins do not significantly differentiate between the different risks run by different insurance companies. The FSA's view is that determining required margins according to premium income by line of business would perpetuate inappropriate rigidity in the determination of solvency requirements. A better approach is to take account of all the risks in the business, including, for example, the adequacy of systems and controls and firms' own measurement of risk.
The FSA's risk-based approach to regulation is designed to take account of the full range of risks within each firm, and it is strengthening its expertise to carry 156 out such assessments. It is also working to develop and consolidate the current approaches used in different sectors for setting individual capital requirements for firms, with the intention of extending that to insurance firms.
On the "one size fits all" framework, which my hon. Friend mentioned, it is not correct to say that the FSA currently takes no account of any sophisticated internal risk measurement frameworks implemented by insurance companies. It frequently discusses with the larger companies the outputs of their internal risk models, and the new regulatory regime for Lloyd's, for example, explicitly recognises the value of its risk-based capital model.
The FSA plans to take more account in future of firms' internal measurement of risk. As I have already explained, the draft integrated prudential sourcebook proposes placing a requirement on all firms to take a view of the overall level of financial resources required to enable them to meet their liabilities. The FSA also plans to add insurance risk expertise to its risk review department, thus further equipping it critically to assess risk models used by the industry.
My hon. Friend made a number of suggestions that he believes would address his concerns. The FSA accepts that insurance firms' risk profiles and financial positions should be more transparent and easier to interpret, especially for life business. However, it believes that this would be best achieved by improving information in the public domain, for example in the regulatory returns and in the accounting treatment of insurance business in accounts under the Companies Acts. Some improvements in the regulatory returns have already been made or are being consulted on; others will be proposed as part of a fundamental review of regulatory reporting, starting next year.
It would be inappropriate for the FSA to publish confidential regulatory information. However, it is considering the need to improve its environmental analysis of the insurance sector, and it will also consider whether to publish that type of analysis for the benefit of consumers and the market.
It is not possible in the time available to address all my hon. Friend's points. However, these are important issues and I undertake to pass on his comments to the chairman of the FSA, who I am sure will be delighted to respond more fully than I can. I thank my hon. Friend for securing this debate. I am sure that he agrees that there are great strides to be made in the regulation of insurance companies and the move to a more risk-based regime. I recognise the points that he made about the regulatory and compensation regimes that affected Chester Street, and I hope that I have addressed the most important of them.
Question put and agreed to.
Adjourned accordingly at twenty-seven minutes to One o'clock.