4.1 Insurance companies

more likely is the possibility that a change in the savings products offered by other inter-

mediaries could cause an increase in the early terminations or ‘surrender’ of policies

as savers switch to the other products. Conceivably a company could underestimate

its future operating costs. The most serious risk faced by long-term insurance funds,

however, is that future economic and nancial conditions cause the future yield on

their portfolio to fall below expectations. The probability of such an event may be

low, but the consequences would be serious since investment income for long-term

funds is approximately half as large as their total premium income. We shall see in

a moment that the fall in stock market values in 2001 and 2002, and the persistence

of low ination and interest rates since the mid-90s has had a serious effect on the

solvency of life assurance companies, and has caused a great deal of concern to clients

holding ‘with prots’ products and to the UK’s Financial Services Authority.

In the circumstances, the composition of assets is not hard to explain. Their

liabilities are long term and the probabilities of both unforeseen shortfalls of income

and unanticipated paying out of benets are low. The need for short-term, highly

liquid assets is low. On the other hand, they are in competition with other forms

of long-term saving. For this purpose they need to maximise yield and in particular

their contracts need to produce ‘real’ returns, i.e. returns which exceed the rate of

ination. The emphasis upon company securities therefore is to be expected. However,

while a narrow range of assets may maximise yield, it also increases the exposure

to risk. This can be reduced by diversifying, in particular to achieve a mix of assets

whose values would not all be expected to move in the same direction at once.

Fixed-interest securities would be immune at least to some of the difculties that

might affect companies’ trading performance.

During 2004, long-term insurance companies bought about 15.4bn of UK govern-

ment securities and exchanged about £7bn of UK ordinary company shares for

preference and xed-interest securities. Within the category of overseas securities there

was a marked shift towards company shares (of all kinds) and away from govern-

ment bonds.

From 1 December 2001, the Financial Services Authority (FSA), which was set up

by the Financial Services and Markets Act of 2000, took over the prudential regulation

of all insurance companies and the conduct of business regulation of life insurance

companies in the UK. Before this, insurance rms had been regulated for prudential

purposes under the Insurance Companies Act of 1982, while the conduct of business

of life insurance rms had been covered by the Financial Services Act of 1986. The

1982 Act had made it an offence for anyone to conduct insurance business in the UK

without authorisation and resulted from concern following the collapse of several

(mainly general insurance) companies in the 1970s. Under the Financial Services and

Markets Act, the power of authorisation passed to the FSA. Authorisation is granted

to each company with respect to particular classes of insurance business. In addition

to providing authorisation, the FSA monitors the performance of companies, in

particular with respect to solvency margins, and has the power to intervene in various

ways: it may require a change in investment strategy, prevent the issuing or renewing

of policies and, of course, ultimately, withdraw authorisation. The ability to monitor

and to intervene stems from the requirement that companies provide specied annual

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Chapter 4 • Non-deposit-taking institutions

information relating to the conduct of their business. In the event that a company

should fail, in spite of this scrutiny, policyholders have some degree of protection

under the Financial Services and Markets Act, which also contains regulations on

the marketing of insurance products. For example, it laid down standards relating to

advertising, and specied a minimum ‘cooling-off’ period.

The fact that so many insurance products contain a substantial savings element

explains the inclusion of conduct of business regulation rstly in the Financial Services

Act 1986 and now in the Financial Services and Markets Act 2000. The various

changes to the regulatory regimes over the past twenty years have made little differ-

ence to the behaviour of the companies so far as the production of policies and

their conduct of business are concerned, but they have imposed constraints on the

marketing of what are now clearly seen as forms of saving.

Recent problems such as with the life insurance company Equitable Life and

with the possible insolvency of a number of large insurance companies have meant

that much of the FSA’s energies in its early life have been devoted to the insurance

sector. In addition, the creation of the FSA as a single regulator of nancial services

highlighted signicant differences between the regulation of insurance and other

sectors in respect of similar types of risk. Consequently, a project was initiated in

September 2001 to overhaul insurance regulation. In November 2001 a report was

submitted to the Economic Secretary to the Treasury outlining the agenda for

strengthening insurance regulation and listing actions the FSA already had in hand.

The main problem that came to light (and preoccupied the FSA’s insurance division

from 2001 to 2005) was the treatment of what were called ‘with prots’ investors.

We return to this and other problems of NDTI behaviour in Chapter 13, where we

discuss the regulation of nancial markets and institutions.