Strategic Challenges Facing the UK Insurance Industry

On 10 February the Westminster Business Forum held a virtual Conference Next Steps for the UK Insurance Industry: regulation, reform, climate change, COVID 19 and priorities for a new relationship with the EU. The Conference was chaired by Lord Hunt of the Wirral and Craig Tracey MP, Co-chairs of the Insurance and Financial Services All Party Parliamentary Group. The Conference proved a timely opportunity to take stock of the challenges facing participants in the British insurance market.

Business Interruption Test Case

With the ink barely dry on the Supreme Court’s judgment, it was not surprising that a number of speakers touched on this. The test case did not deal with standard Business Interruption policies, which respond only to physical damage to the business premises. The case dealt with extensions to standard BI policies: “disease clauses”, and “prevention of access clauses”. Broadly, the Supreme Court found that disease clauses should respond to Covid-19, but that prevention of access clauses should not respond to lockdown. Fewer cases are involved than the reporting in the Press might suggest, but nonetheless insurers face a significant task in settling the claims.

The benefit of this test case, both to policyholders and to insurers, is that it happened so quickly. Normally, a complex case like this would take three years. But now we know the view of the courts in seven months, and the Courts deserve a great deal of credit for this. Personally, I doubt that this will be the end to litigation on this issue, as neither brokers nor reinsurers have had their day in court, but at least the main points of the law are now clear.

Insurers face the immediate, largely logistical, challenge of paying the valid claims. This will be no easy matter, involving legal analysis of each claim in the light of the Court’s judgment, and then directing loss adjusters with the relevant experience to the cases where their expertise is most needed. This is a challenge that insurers cannot afford to fail, as both the FCA and the FOS will be watching carefully.

However, successful handling of the aftermath of the test case will also mean addressing some longer-term challenges. In the medium term, many policyholders clearly did not understand their policies. This created an expectation gap which has taken the industry a step backwards in the constant struggle to maintain trust in the industry. Insurers have a part to play in this, by using simpler language in the policy itself, but also by producing some less technical explanatory material, which a small business owner has a chance of understanding. Brokers also have an important part to play at the point of sale. For complex policies such as these, it should be standard practice to confirm with the client that the cover they are buying is adequate to their needs.

Unfortunately, it is common for policyholders not to understand their insurance. In this case it is clear that the insurers did not know what they meant either, and this is less excusable. Insurers are on record as saying that these policies were not intended to respond to a pandemic. But in the event many of them did respond, leaving insurers unclear about their exposure. Some of the language in the policies had clearly not been reviewed for decades. A thorough legal review of policy construction and language are needed, so that insurers can be confident in their reserving. A similar exercise in other commercial policy lines would be wise, to avoid further unwanted appearances in court.

Clearer policy wordings will also highlight the large gap between the risks a business faces and the risks their insurer is prepared to cover. The traditional insurance model is not well suited to rare but expensive risks such as pandemics. Most small businesses would baulk at properly priced cover. Pandemic insurance was available before Covid-19, but very few people wanted to buy it. Even assuming that this hurdle is overcome, insurers would be left piling up huge reserves against something that might never happen, tying up capital that could arguably be put to better use. This issue cannot be solved by insurers alone, and wider stakeholders will need to be involved. Those who have done the maths usually reach for a Government-backed reinsurance solution, and a number of groups have tried to put together a credible proposals to Governments for a “Pan Re” along the lines of Pool Re and Flood Re. Governments may not quite see it this way. Clearly there are benefits both for insurers and for policyholders in such a solution, but Governments have just dug deep for Covid-19, and may be wary of taking on further explicit liabilities when it is not clear what the future competing claims on taxpayers’ funds may be.

Pricing in General Insurance

The FCA’s initiative to ban the loyalty penalty was the most popular item for debate. Robin Finer presented the FCA’s proposals and expectations:

• A ban on price walking;
• Reduce the barriers to switching found in some auto-renewal packages
• Ensure fair value for policyholders through improved product approval and governance
• Extensive reporting requirements and supervision of the industry response to the initiative, to avoid unforeseen consequences.

Robin also drew attention to the FCA’s findings that their proposals would lead to £4.2 billion of consumer savings over ten years. They believe that this will come from greater competition over the backbook, assuming that this does not affect current levels of competition on the front book.

Although industry representatives were broadly supportive of the FCA’s proposals, the regulator came in for criticism from academics and other neutral commentators. Reservations were expressed about the level of consumer savings. Other questions they raised may sound philosophical, but they merit reflection by the FCA:

• Once a regulator comes down in favour of one group of consumers (in this case, those who do not switch) against another group of consumers (in this case, those who do switch), how is this choice to be made?
• Does this mean that information remedies – such as the FCA’s previous requirement to show last year’s price are proven not to work? In which case, how does the regulator justify the cost of information requirements?
• Does the initiative put up further barriers to new market entrants?
• How would the proposals lead to consumers paying greater attention to the suitability of their products?

Why do we find both industry and regulator committed to proposals which come in for criticism from external commentators? Part of the answer may be that academics don’t see the postbag criticising the loyalty penalty. Market participants realistically have no option but to embrace the regulator’s approach. As with the Business Interruption Test Case, this had become an issue that was taking us backwards in the struggle to maintain trust in insurance.

There can be no hint of collusion on a pricing issue – the FCA has already investigated the banks for collusion in their response to the FCA remedy on overdrafts, finding no case to answer. So market participants are obliged to develop a commercial strategy in response to the new pricing environment on their own, blind to the direction other market participants will take. This is such a huge change in the market place that it would be easy for market participants to base their response almost entirely on commercial considerations. This is the kind of thinking that got the industry into the loyalty penalty bind in the first place, many years ago when a Director of Distribution had the bright idea of using the PCW mechanism to offer an introductory discount, without thinking what might happen next.

The complex challenge of GI Pricing of course requires a commercial plan, but also some careful strategic thinking. In particular, market participants should be aware of the dynamic evolution of the FCA’s expectations. It is implicit in the regulator’s actions that insurers broke no rules in price walking – otherwise the industry would be facing much more serious penalties. Nonetheless they concluded that the practice was unfair, and have upended the market to eradicate it. Note carefully that the information requirements go much wider than supervision of the remedy. And the governance requirements, building on the FCA’s far-reaching interpretation of the Insurance Distribution Directive, are equally broad. The regulator has left itself the tools to pick up a wide range of changes – and to say that they don’t like them. Market participants would be well advised to think what the medium term consequences will be of their pricing strategy, and to discuss these carefully with the regulator.

Solvency II Review

Anna Sweeney presented the views of the PRA on the Treasury’s Review of Solvency II, starting with a heretical re-interpretation of the tale of Goldilocks and the Three Bears.

The PRA has a duty to uphold prudential standards, and has no appetite for any change to the fundamental principles of Solvency II, but within that framework they see a significant opportunity to tailor some of the mechanisms in Solvency II to the needs of the British market. Anna gave the Risk Margin as an example, and nobody will disagree with her there.

Some CFOs might have furrowed their brows when she maintained, following in the footsteps of Goldilocks, that the current level of capital requirements are just right; the PRA has seen no evidence that capital levels are either too high or too low. This sounds reasonable enough, until you reflect that by definition the PRA can have no evidence that they are just right either. There has never actually been a debate about what the right levels of capital are.

Insurers have a choice here. If they want a capital release, they will need to mount a well evidenced case, supported by figures. If not, the PRA will be right by default.

Climate Change

One panellist devoted his remarks to this, pointing out that this is not a regulatory issue, but one that is fundamental to the business of insurance. Insurers’ liabilities will be fundamentally affected by climate change, and also their assets. But overall, this issue did not receive the attention I believe it deserves.

Some insurers have grasped the nettle of climate change, but many have not. I detect in some quarters a sense that climate change is a long term issue, whereas Covid is an immediate crisis that has to be managed before any thought can be given to climate change. This is short-sighted, and Boards would be well advised to give the question a strategic airing as soon as possible.

The regulatory deadlines are close. The PRA set out in 2019 their expectation that climate change will be fully embedded into firms’ governance and risk management systems by the end of this year. The Biennial Exploratory Scenario stress test also takes place this year. We know that the PRA were not satisfied with insurers’ response to the 2019 Climate Stress scenario, and believe that insurers lack the capacity to deal satisfactorily with the exercise. There is not much time left if this is to be rectified.

But putting the regulators to one side, there are overwhelming business reasons why an insurer should urgently wish to know how climate change will impact their assets and their underwriting. The alternative is that a competitor finds out sooner, leaving you with bad underwriting risks and impaired assets.

Future relationship with the EU

This was covered only lightly. Very likely all parties are exhausted by the preparations for Brexit. Billions have been spent just trying to stand still, and maybe the hope is that, now the negotiations are over, a solid platform has been erected, on which both sides can now build to ensure close regulatory co-operation and encourage healthy business relations between the UK and the EU.

I have been dealing with the EU for decades, and sadly I think this view is naïve. It fails to take into account how the EU, and in particular the Commission works. The EU is not a sovereign body; it is a creature of law. As such its prime concern is to protect and preserve the set of rules built up over the years. If the EU had wanted close co-operation, they would have negotiated Brexit differently. Look at the adversarial way the Commission runs commercial relations with the US or even Switzerland. The UK must expect the same treatment. The Treaty leaves room for innumerable detailed disputes. Insurers with interests in the EU would be well advised to consider what action EIOPA and the Commission can take to make their life difficult, and take what mitigating action they can.

Conclusions

Is there anything missing?

One panellist made a spirited effort to introduce the issue of insurers’ use of data. He was right to do so. Insurers are completely dependent on data. Meanwhile, in another part of the universe, data majors are fighting a losing battle against public and political suspicion of their use of data. As with the GDPR, this is where the battle will be fought, and the rules will then be applied to insurance. The industry will need a compelling story to explain in public why its use of data benefits its policyholders. We have yet to see this story.

Reflecting on this excellent Conference over a nameless glass of wine, it occurred to me that none of these challenges can be met by the traditional compliance approach. All these issues have to be addressed in a cross-disciplinary manner. They can only properly be addressed, and the decisions embedded in the firm’s forward thinking, by strategic thinking at Board level.