Sam Woods: Embarking on a new voyage? Solvency II in context
Text of The Insurance Institute of London Lecture by Mr Sam Woods, Executive Director of
Insurance Supervision of the Bank of England, at Lloyd's of London, London, 27 January
2016.
* * *
I am grateful to Kayleigh Guinan and Mark Cornelius for their assistance in preparing this speech. I am also
grateful to Norma Cohen (Bank of England), Dr Adrian Leonard (Cambridge), Professor Philip Rawlings (Queen
Mary) and Robert Thoyts (FCA) for their views and input.
Good afternoon.
The good ship Solvency II is now afloat. It has taken a long time to make it seaworthy. Some
might question whether we need this newly improved vessel. Indeed, some might challenge
whether we should have a ship at all. But that is largely academic, given we are now under
way and in light of the gargantuan efforts insurance firms and regulators have put into getting
us to this point.
In my speech today, I would like to look at this development in the wider context of insurance
history. First, I would like to offer a brief view on why, looked at through the lens of today, we
regulate insurance companies at all.
Second, we will take a very whirlwind tour of 5,000 years of insurance activity, for the single
purpose of pointing out that for at least four-and-a-half of those five millennia there was very
little regulation of insurance, if any.
Third, I will examine how the British state has involved itself in the affairs of insurance
companies over the past 500 years.
Finally, I will ask what - if anything - we can learn from this as we enter the Solvency II era.
My main conclusion, which may make me unpopular with many colleagues and members of
the insurance industry, is a simple one: Solvency II is a big and important change, but -
when viewed in the context of history - we are still sailing the same ship, in broadly the same
direction.
Why do we regulate insurers?
Individuals and institutions give money to insurance companies to transfer the cost of risks
they could not otherwise bear. In doing so, they trust that the insurer will make good on its
promise in the event that the insured risk crystallises. Indeed, the word policy comes from the
Italian "polizza", which meant a promise or an undertaking. Like banks, insurers invest
policyholder funds directly onto their balance sheet thereby exposing customers directly to
the risk inherent in those balance sheets. Our job at the PRA is to make sure that insurance
companies keep their promises to pay policyholders and do not let them down, often when
they need that money the most.
Insurance companies undertake an activity that matters, often critically - for the corporates
that rely on protection of insurance for the day-to-day running of their businesses, and for
individuals who invest a significant portion of their wealth in insurers over their lifetime, or
who rely on insurers to protect them against financial disasters. It is for these very basic
reasons that we are interested in insurance as a matter of public policy.
However, we cannot justify regulation of an industry just because its activity is important. The
aim of regulation is always to correct some sort of market failure. The insurance industry has
many characteristics that could lead to the market producing a sub-optimal outcome, if left
alone. First, the insurance business model is unusual in that it has an inverse production
cycle - insurers typically receive premia upfront for a service that may or may not have to be
rendered in future (claims), the cost of which is difficult to calculate. Policyholders rely on the
insurance company to set aside appropriate provisions to satisfy future claims, but the
market may not always be a reliable mechanism for ensuring that insurance companies do
not grow excessively by taking on too much risk.
Insurance obligations are often long-term and so policyholders trust insurance companies
with their money for considerable periods of time. It is possible that the behaviour and
incentives of an insurance company evolve in a way that does not take account of the
interests of policyholders, not least because the best interests of the shareholder and the
policyholder are not perfectly aligned.
The receipt of premia before claims have to be paid can introduce perverse incentives for
struggling insurers in particular. For instance, faced with the prospect of failure, there is a risk
that insurers begin to invest in high-return but riskier assets, or rely on unsustainably priced
new business to ride the tide, without being called to account by the market1. This looks
dangerously like a "gamble for resurrection", which might in some circumstances be a
rational strategy for shareholders but is unlikely to serve policyholders well.
Moreover, the inability of policyholders to transfer their policy or amend the terms of what is
essentially an infungibile contract limits the extent to which they can maintain the best deal.
Furthermore, it is difficult for policyholders to assess the true soundness of any one firm. The
absence of a tough claimholder therefore necessitates the existence of some objective
standard by which insurers can be assessed - in today's environment, this most often takes
the form of being authorised by a supervisory authority that subjects firms to legal regulatory
standards. Of course, this standard will always be imperfect - but I think it is far better than
nothing.
The role of the PRA is to make sure that the risks for which insurance companies provide
protection do not revert to the customer when bad outcomes happen. It would be grossly
unfair if you had paid somebody to take your risks away, only to find that you had unwittingly
acquired a huge credit risk by giving your money to a financially unsound company. Our main
job at the PRA is to ensure that firms are safe and sound, and contribute to policyholder
protection. That way, the shareholder can reap the rewards if the risks pay off, but will bear
the cost if the firm loses money.
This public policy case is well established in many countries, such that the approach of
different regulators is often founded in commonly agreed principles. For instance, in the
1970s, the introduction of Solvency I codified these principles into a set of requirements
across the EU.
The birthplace of insurance
However, looked at across the sweep of insurance history, this public policy case is a
newfangled set of ideas. I have tried to find out what, if anything, public authorities have thought
about insurance through time. In my quest to find the answer to this question, I ended up
going back further than anticipated - to around 3000 B.C. - and came across the
curiouslynamed practice of "bottomry" in the era of Babylon. Bottomry, it turns out, was a type of
contract whereby a lender would, for a fee, put up money (either in the form of a loan or
sometimes a joint stake in the stock) for the purpose of advancing trade. This was on the
understanding that "the borrower should, in consideration of a high rate of interest, be freed
from liability in the event of certain accidents happening, e.g. failure of goods to arrive at their
intended destination"2. This looks to me rather like a Babylonian version of today's
catastrophe bond.
The practice of bottomry flourished due to the proximity of another group of great traders -
the Phoenicians, who adapted the basic concept to support trade expansion on the Greek
coastline during the 10th and 9th centuries B.C., and to the increasing domination in the
Aegean Sea after 800 B.C. of Greek traders who needed indemnity against their cargo.
Hop westward across the Mediterranean Sea to ancient Rome, and citizens were paying
subscriptions to so-called "burial societies" to cover the cost of expenses associated with
their death - a kind of latter-day funeral insurance. This activity evolved such that by the
second century A.D. it became common practice instead to pay the relatives of the deceased
person a lump sum (the funeraticium), provided their subscription was not in arrears and the
deceased had not committed suicide3. Despite not being labelled as such, this arrangement
seems in some way similar to a modern-day life insurance policy. And yet back then,
perhaps unsurprisingly, the subscriptions paid by members were not subject to any
protections or oversight - indeed, when a burial society did run out of money, it was
commonplace simply to issue a notice to convey the demise of the society and the fact that
funeral expenses would no longer be met. There is also evidence that soldiers in the Roman
army were paid a lump sum at retirement, despite the fact that contributions were not made
throughout the soldier's lifetime.
By medieval times, the Church had become one of the largest employers and had started
occasionally to issue pensions to clergymen. One such example involved Nicholas Thorne, a
former abbot of St Augustine's monastery, who was living in difficult circumstances. Thorne
had voluntarily retired, apparently stricken by a guilty conscience after he acquired some
documentation on behalf of the abbey through bribery at the Court of Rome. The scandal led
him to retire to an ordinary monastery in Yorkshire, but when his old comrades heard of his
infirmity and weakness, they awarded him an ex gratia pension of 10 marks a year4. It seems
unlikely that the Church extended such gestures on a regular basis, but from this point
onwards we can see evidence of pension provision via employers (the Church and King),
particularly for notable individuals in society where reliance on charity alone would not
suffice.
Such examples are not representative of the modern day insurance companies established
since the 19th century. But I include them to illustrate that the principles of insurance were
very much alive as far back as our earliest civilisations - and mostly without any controls or
regulation around them. So what changed?
Enter the state
This brings us to my main theme today: the interest of the British state in the affairs of
insurance companies. My aim is not to do full justice to this field of history given the rich body
of academic literature available, but - in order to see Solvency II in context - to give a flavour
of the sorts of philosophies and motivations that seem to me to have guided the British
state's involvement through time.
Most textbooks will reference marine risk as one of the earliest forms of insurance in the UK.
But evidence of one of the first genuine insurance policies suggests that whilst the first
marine contract may well have been written in nearby Lombard Street, the risk was not taken
on by British underwriters - instead, it was underwritten by Italian counterparts temporarily
resident in London5. Indeed, throughout this period, there are several mentions of insurance
interactions between London and the Italian regions of Lombardy and Tuscany6 - hence the
development of policy wordings according to the customs of what would become known as
Lombard Street.
The contracts written around this time - which de-coupled the insurance risk from the
financing of voyages such that there was a genuine insurance element - related to popular,
often expensive, commodities like woollens, iron and grain. So it is little surprise that disputes
arose when adverse events took hold, particularly when risks were written across borders. In
addition, it became easy to enter into dishonest practices, for example by finding multiple
brokers to write the same risk and then cashing in several policies for the same insured
event.
This brings us to the first, to my knowledge, serious participation of the British state in the
affairs of insurers: disputes. These disputes led to the involvement of the judicial system, with
high volumes of cases referred to the Privy Council. When this situation became untenable,
the Privy Council established a tribunal (later known as the Court of Assurances) to which
seven merchants (along with a Judge of the Admiralty and one civil and one common lawyer)
would report twice a week (Monday and Thursday) to resolve disputes. This group had
authority from Parliament to commit underwriters to prison if they failed to meet their
obligations7. In 1575, the Privy Council ordered the Lord Mayor to compile some rules since
no body of law existed to determine the resolution of insurance disputes. Around the same
time, Queen Elizabeth granted a monopoly on the writing of assurance policies to Richard
Candeler, who led the newly-created Office of Assurances. The Office introduced a system
of fees - with the Office receiving a fixed percentage per £100 insured8 - for the production
of physical written policies.
Both through the creation of the Office and Court of Assurances, and the receipt of customs
duties from insurers, the Privy Council in the 16th century - as approved by the monarch -
cemented the role of the state in exercising a judicial function and creating an environment of
policy registration and anti-fraud conducive to commerce. So, as I see it, this first phase of
engagement between the British state and the insurance sector was effectively a trade:
dispute resolution services were provided by the state, and insurers contributed some
revenue to it in return. Indeed, in the early stages this revenue went directly to Candeler
himself.
Despite the tight state controls around who could write insurance, the nature of risks being
underwritten was granted little oversight - so much so that, for many, the practice of
insurance became synonymous with gambling in the 18th century. Perhaps - and I say this
with some trepidation here at Lloyd's - some of the most egregious examples of such
behaviour were evident in the marine market. By this point, London had emerged as a centre
of excellence in marine risks, due partly to its strategic location on famous shipping routes.
Marine insurance had become a necessity for trade - without protection, a bad storm could
overturn the entire fortunes of merchants. But a lack of safeguards paved the way for abuse.
One particularly spectacular example involved John McDougall, a Glaswegian merchant,
who arranged to have a ship called Friends (whose cargo was valued at £1000) deliberately
shipwrecked off the coast of Denmark - but not before insuring his own stake in the voyage
in five separate policies for £3,475 and insuring the ship and other goods for £1,660 in a
further three policies. In total, he obtained eight policies on the same risk - spreading the
deceit between unsuspecting underwriters across Glasgow, Dundee, Hull and London. In
doing so, McDougall (and others like him), introduced a speculative spirit that threatened the
more sober motives crucial to indemnification contracts9.
Practices such as those described above ultimately led Parliament to take action. This first
took the form of the Marine Insurance Act 1745, which rendered void marine policies made
without an insurable interest. A similar provision was subsequently applied in relation to life
insurance under the Life Assurance Act 1774. These Acts did leave a gap - namely,
nonmarine indemnity policies. However this was filled when gambling contracts were rendered
void by the Gambling Act 1845, as the existence of an insurable interest served to distinguish
insurance contracts from gambling contracts.
This was not the first time that Parliament had concerned itself with the affairs of insurance
companies, however. In 1739, Britain entered into a war with Spain. As a consequence,
trade with Spain ceased but - perhaps surprisingly - the underwriting of Spanish ships by
British underwriters continued unabated. This led to a somewhat perverse situation in which
British insurers compensated enemy merchants for shipping losses suffered at the hands of
British privateers and squadrons of the Royal Navy. The value of insurance trade was, it
seems, considered by many to be too valuable to forfeit voluntarily10 as Britain entered a
period of sustained warfare with Spain and then France.
By 1748, attitudes had changed and Parliament passed an Act which banned the insurance
of enemy ships by British insurers. Yet the Act was expired just a few months later (after the
Seven Years War ended) such that insurers did, in fact, enjoy considerable discretion over
which risks to underwrite, including foreign enemy ships. I think that what this example
ultimately demonstrates is the importance of trade and competitiveness in shaping the British
state's involvement in the affairs of insurers. The protection of enemy ships was at direct
odds with Britain's foreign policy - but trade was ultimately considered strategically more
important. In common with the environment in which our eighteenth-century forebears
worked, trade and competitiveness remain important contextual factors in the debate about
how we should regulate insurers today. Indeed, it is useful to remind ourselves that these
debates about competitiveness have been a feature of the state-business nexus around
insurance for several hundred years.
So, I think that we can see in this phase the emergence of a more complex set of interests
and motivations for the British state in dealing with the insurance sector - heightened
concern about reckless or dishonest practices by policyholders, and debates about
competitiveness and the importance of the industry to London and the Exchequer. But back
in the 18th century, the aversion of Governments to getting involved in the affairs of insurers
led to the development of a "freedom with publicity" approach. In practice, this meant
selfregulation with some element of disclosure in order to encourage market discipline. A
burgeoning insurance press emerged in the 1840s; initially funded by the revenue from
insurance advertisements, these newspapers quickly emerged as guides to help the
consumer and, indeed, many became increasingly critical as new companies began to go
bust11.
It wasn't until the Bubble Act was repealed in 1825 that insurers were able to organise freely
as regular joint stock companies, outside the auspices of the Office of Assurances. As a
consequence, the number of insurance companies skyrocketed; following a flurry of
formations in the 1820s, more than four hundred insurers were established over the next four
decades12, ranging from small (often fraudulent) companies to some names still around
today. Somewhat startlingly, of the 219 insurers established between 1843-1870, 170 were
discontinued by 187013 - so over three out of every four new companies failed.
In 1869, the Albert Life Assurance Company failed, in part due to an over-ambitious takeover
strategy14 but also to having racked up excessive expenses, inadequate premia and an
unexpectedly high surrender rate. Despite a suspicion that the Albert had been insolvent for
several years, the company only failed when it ran out of liquid assets to pay current claims -
thus revealing the limited oversight of insurers more generally and, in this case, the lack of
legal means available to prevent the company from trading any earlier.
The Albert is therefore often cited as the catalyst15 for a piece of legislation passed the
following year - the Life Assurance Companies Act 1870 - which attempted to address such
problems and establish a scheme of regulation specifically tailored to insurers. This in part
reflected the view of the insurance industry by Parliament - described by the Select
Committee of 1853 as "those useful institutions" - as playing an important role in the
economy. It is noteworthy that even back in the 19th century, many were outraged by the
introduction of the Act which to them represented 'the mephitic influence of red-tape
regulations'16 - a sentiment that has surely been uttered in more recent times too. But
ultimately, it was considered too costly for the state to rely on the effectiveness of market
discipline at a time when the reputation of the industry was so sour it was being satirised in
novels by Dickens. Indeed, for these reasons the 1870 Act was widely welcomed by
professional bodies like the Institute and Faculty of Actuaries17.
The 1870 Act introduced a number of elements aimed at regaining the confidence of
policyholders in the insurance sector. First, insurers now had to stump up £20,000 (roughly
£2m in today's money) as security before they reached a certain size, which curbed the influx
of new companies that, up to this point, had been entering the market at very rapid rates. In
addition, accounts and balance sheets had to be published in a prescribed form, thereby
introducing a degree of consistency and comparability between different firms. Importantly,
firms now had to publish an actuarial report on their financial condition every five years and
insurers had to take into account prospective liabilities under existing policies; in other words,
they had to look forward.
The 1870 Act was clearly a major evolution of the state's approach to insurance and
established many of the building blocks that still underpin the regulation of insurers today -
the importance of solvency, the role of the actuary, the interests of current and future
policyholders, and a role for financial disclosure. Despite contemporary opinion at the time
suggesting that a delicate balance needed to be struck between the role of the state and the
activity of the market, the willingness of the state to legislate on these matters was a
significant step in that it acknowledged more explicitly than before a legitimate public interest
in insurance18. Despite this, many thought that the Act was not robustly implemented, nor did
it deliver results overnight. Indeed, the 1870 Act was relatively non-interventionist compared
to how insurance regulation would evolve throughout the 20th century.
But before we come to developments in the nearer term, it is worth noting that it wasn't just
the private sector that was mobilising itself in the insurance industry at this time. In 1865,
Parliament passed the Government Annuities Act, which empowered the
PostmasterGeneral to conduct life assurance business on behalf of the state. A year earlier, Gladstone
(then Chancellor) delivered a speech to the House of Commons in which he was particularly
scathing of the high lapse rates and expense ratios which it was felt were giving
policyholders a raw deal. His remedy was for the state to compete directly with these
companies in the mass market in a bid to raise standards or drive them out of business19.
The insurance sector today is no doubt relieved that such a strategy is not being adopted by
the PRA. And, in fact, the scheme was not very successful in the end, largely because it
abandoned the collection of weekly premia by doorstop agents which ultimately increased
lapse risk.
The state would later dabble in annuities once more but motivated by a different set of
reasons this time - the funding of war. During the early part of the 20th century, I am told the
Government extended annuity provision as a way to access funding for World War. Indeed,
there is evidence that states have used the provision of insurance as a way to self-fund going
as far back as the 15th Century; in 1425, the city-state of Florence introduced a specialised
social insurance system, the so-called 'Dowry Fund', which enabled fathers to make regular
deposits on behalf of their daughters to accumulate a dowry that would be payable upon their
marriage20 - all for the purpose of financing the state purse.
Over the course of the 20th century, regulation evolved further but the concept of supervision
had not yet surfaced, at least not in the UK; the UK Board of Investment appointed its first
actuary in 1917, but by this point the New York State Insurance Department was already
employing 179 (supervision) staff. By the 1970s, an era of supervision - as distinct from
regulation - had begun in the UK. The more recent history of insurance regulation over the
last century is a major topic in its own right, so I only propose to outline a few points.
In 1923, the Industrial Assurance Act introduced a Commissioner to discharge statutory
powers on behalf of the Board of Trade, with the idea of specific regulatory bodies
introduced21. By 1946, the regulatory framework had expanded to include motor, aviation and
transit insurance and, significantly, the deposit system was replaced by a more sophisticated
solvency margin which specified that a particular margin of assets over liabilities should be
maintained.22.
A string of high-profile failures in the 1960s and 1970s - including the failure of Fire, Auto
and Marine which left 400,000 (mostly motor) policyholders uninsured, and an even bigger
failure in 1971 when Vehicle & General, with 1.2 million policyholders, collapsed - led to
demands for further reform23 at a time when a wave of consumer protection laws beyond the
insurance sector had put regulation firmly on the agenda in any event.
Relatively speaking, up until the 1970s, individuals running insurance companies attracted
scarce regulatory attention. This all changed in the 1970s when conditions around the fitness
and propriety of senior individuals were introduced. In practice, however, the professional
conduct of individuals - as well as the organisation and culture of insurance firms - has
always mattered, particularly in earlier periods when reputation was the only means by which
policyholders could assess the safety and soundness of insurers.
The failure of Equitable Life in 2000 - driven by an over-extension on the part of the
company in offering guaranteed annuity rates on their products with insufficient reserves to
pay out - reinforced the importance of a sound regulatory and supervisory framework and,
once again, the case was reform was alive.
But perhaps the single largest factor in determining the nature of state involvement in the
insurance sector towards the end of the 20th century was the UK's membership of the
European Economic Community. Not only did it require the UK to enact a package of
European directives (colloquially known as Solvency I), but it has had a significant impact on
the British state's involvement in the affairs of insurance companies ever since. Whilst
Solvency I allowed the state to introduce further UK-specific initiatives for the insurance
sector - such as the Individual Capital Adequacy Standards (ICAS) regime - insurers and
regulators alike are now bound by European-wide maximum-harmonising requirements,
most notably of course through the recent implementation of Solvency II.
Conclusion
What can we learn from this? As with all history, one can take different views on what
happened in the past, why it happened and whether it has any significance for us today.
Personally, I take three things from it:
• First, there is a sound public policy case for the regulation of insurance. But looked
at in the very long context of insurance history, the state's involvement in the direct
regulation of insurance activity is a relatively recent phenomenon.
• Second, coming to the UK, a tidy-minded historian could easily identify some
common themes which appear present in different phases of the British state's
involvement in insurance, and perhaps weave them into a coherent narrative. I am
less convinced. With the exception of a consistent interest in being able to raise
revenue from insurance activity, the motivations and philosophies which have
guided the British state's involvement in insurance matters seem to me to have
varied very widely through time. The earliest phase of dispute resolution, the later
phase of freedom with publicity, and our current phase of quite intensive prudential
and conduct supervision seem to me to be very different.
• Third, although there are important technical differences between ICAS and
Solvency II, the basic philosophy remains similar: market-consistent capital
regulation coupled with supervision. I do not wish to underplay the huge efforts
made by many people across the insurance sector in bringing in Solvency II, but
compared to previous shifts in philosophy, the change appears quite modest. To
return to my marine analogy, the good ship Solvency II has more up-to-date and
useful features than the old one. But it is an evolution, not a revolution, in ship
design. It still has cabins, a bow, and propellers. More importantly, we may have
tuned up the engine a bit and altered course by a few degrees, but we have clearly
not changed our course or our destination.
Thank you.
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