TUESDAY 27 NOVEMBER 2007

Mr Michael Folger, Ms Sarah Varney, Mr Peter Green and Mr Duncan MacKinnon

  Q80  Lord Renton of Mount Harry: You used the words "the cost of holding". How are you arriving at that? Are you saying that if you were not doing insurance with this money, you would be earning 6 or 7 per cent investing in gilts? Is that the approach?

  Ms Varney: Let me just be clear. It is very likely that Solvency II will, and QIS3 certainly did, specify the relevant cost that firms must assume in calculating the risk margin, and it specified a percentage above risk-free. Within QIS3, that percentage was 6 per cent.

  Mr Folger: As a mark-up over the risk-less rate, the gilts rate, and that essentially is a proxy for the time being for the kind of observations that can be made out in the marketplace, the cost of equity capital for firms essentially carrying certain kinds of risk.

  Ms Varney: That percentage is supposed to be the cost of capital to a roughly BBB-rated company to mirror the fact that the capital requirement is calibrated to a roughly BBB level.

  Q81  Lord Renton of Mount Harry: Perhaps we cannot pursue this more just at the moment. It is a very interesting subject. Could I carry on from the point that the Lord Chairman has already made with whether there is a political will in all the Member States for the sort of very substantial changes to the regulation of the insurance industry that this Directive will bring about as presently worded? Is everyone in the EU potentially with this or are there some who are much against because it runs against custom; they do not want to be part of an international insurance, as it were, compendium?

  Mr Green: If I might answer that, I think when we started this project that there were wide divisions within Europe between those who favoured moving towards the banking type model and making regulation much more risk-sensitive and aligning regulation with what firms do. Then there were some other countries I might characterise as having a more belt-and-braces approach towards the regulation of insurance, setting levels which on some arguments may be arbitrary but were clearly simple and at fairly high levels to give insurance regulators comfort that failures would be extremely rare. I think there has been a significant shift in the last few years. In particular, I do not think anybody now argues that there should be a zero failure regime. It is widely accepted now that we should have a system that does allow failures. Arguments that we had expected over the probability of those failures evaporated and we have alignment broadly between the banking sector and the insurance sector in terms of calibration. That was unexpected. I think a lot of countries started not believing in the market-consistent approach. Again, this goes back to belt and braces. I think that has moved on. A lot of the things at the beginning of this Directive, as I said earlier, that we thought would be difficult have not proved so. Some of those will re-emerge in Level 2. I am sure it will be the case that we will have further difficulties with some Member States, but in terms of the principles of this Directive, there is broad agreement across Member States as to how these principles should work.

  Q82  Lord Kerr of Kinlochard: Some of us detected, or thought we detected, in the excellent written evidence from the FSA and the Treasury a slight difference in tone, with the Treasury being rather more optimistic, an unusual phenomenon—I cannot remember seeing it before—than the FSA. Maybe this was because the dates were different. The FSA's is a more recent paper. The FSA, in telling us about the results of QIS3, said: "We have reservations about the possibility that Level 2 provisions could in some areas emerge as over-prescriptive and `maximum harmonising'. Superficially attractive from the (anti) gold-plating perspective, such an approach could be dangerous in practice, fettering supervisors' ability to deal with specific situations in an intelligent risk-based and timely way." That rings bells with me. I remember from negotiation how in the phase that I imagine you are still in the experts are discussing and nobody has yet given up on getting his way at expert level. In the last stages of the negotiation, there are some who feel they are losing and they appeal to the politicians to secure at a high level, at the last stage, things that they have failed to secure lower down. In an exercise like this, that might lead to piling on additional provisions to get back a little bit of the belt-and-braces approach which failed in the initial discussion. How high is that risk, and is that what the FSA are talking about in the bit of their paper that I read out?

  Mr Green: I am not an optimistic chap generally. Some of my optimism has been dented across the board in the last few months, but I remain optimistic as regards this Directive. That is because of where we have got to, given our starting point, given the difficulty we thought we would have in the agreement to the high level principles and our progress in getting agreement to that I think has left me—

  Q83  Lord Kerr of Kinlochard: It is not as bad as the Treasury thought.

  Mr Green: Absolutely. I think there are some very dangerous devils left in the detail, but with the principles well established, the battle is half-won. People cannot now go back and overturn those principles as regards, for example, market consistency, as regards the three pillar approach, as regards diversification benefits, which we are taking forward in our own groups' proposals. Although we will be pushed back on some of the details, and people I think will, and understandably, take different views about the calibration of particular parts of it, I do not see a large risk in people trying to overturn the fundamental principles, and I do not think they can through the Level 2 negotiations. That said, we are alive to the difficulties of Level 2 negotiations. I negotiated Level 2 of the Market in Financial Instruments Directive. We are putting in place everything we can now to try to influence the right outcome there, which is primarily around getting the right evidence and the right arguments articulated to make sure that where there are discussions about calibration, they are done very openly on the basis of evidence rather than on the basis of assertions.

  Chairman: Thank you and I am sure we wish you luck with that one. We have five minutes left and I would like to ask Lord Watson to ask a question.

  Q84  Lord Watson of Richmond: It is always encouraging to have an optimistic Treasury, particularly before midday. You have already answered a general question about winners and losers. I would like to focus on the standing of the City in all this and its international reputation. Do you see the reputation of the City as being a winner or a loser or do you see the Directive in that context as being neutral? We have just had a very interesting exchange about whether the devil still lurks in the detail, and obviously the City would be wary of anything which seemed to be over-regulation and the limitation therefore of its competitive position. You have been optimistic about that but I come back to that question: do you think the reputation of the City is a winner or a loser? If I may, could I attach a second question to this as well? There is a pattern beginning to emerge in many fields, not least environmental, that standards once set by the EU have a tendency to spread beyond the European Union geographically and begin to set a standard which is almost or actually global. I just wonder in that context what you see as the knock-on effect, assuming that Solvency II goes through, on regulation elsewhere in the world?

  Mr Green: I think the City will be a winner from the Solvency II Directive in the sense that this Directive will improve the Single Market for insurance. The City has shown itself to be very well able to exploit new openings and new opportunities. We have this regime essentially in its main parts in the UK and so the direct gains in the UK, in the City, will be around lowering of costs of UK regulation from the removal of the requirement to comply with two sets of requirements, the existing Directives and the new FSA regime.

  Q85  Lord Watson of Richmond: Just to be clear about that, you are saying then that the implication really is the creation of a market opportunity?

  Mr Green: That is right. I think there are some direct things that benefit firms in the City but they will benefit firms in the City in a sense more than firms in other countries.

  Q86  Lord Watson of Richmond: Because we are that much nearer?

  Mr Green: We are that much nearer and as a result we have an additional cost that firms have to bear which will be removed. But the main benefit comes from the Single Market. I think we see that across the Financial Services Action Plan. That was why the UK was such a strong supporter of that action plan, because we think it gives tremendous opportunities for the City to exploit its own natural vibrancy and natural innovation and spread that throughout the EU.

  Q87  Lord Watson of Richmond: So this is more of us exporting a model than having a model imposed on us?

  Mr Green: I think so, and we also gain advantages from having to respond to competition from outside. As to the question of how this might spread throughout the world, I am slightly less optimistic there than I was earlier. I think this is cutting edge; this is a kind of model of its kind, but it will be a long time before this Directive is actually in force. We do see some big differences between insurance regulation and banking regulation in other countries and it will take time for those to change. The main pressure for change will come from industry and from the competitive implications of this Directive and the demands on other regulators, other governments elsewhere, to allow firms in other countries to benefit from the same kind of regime that the EU is putting place. Until that is in place, I think those demands will be more muted.

  Mr Folger: To comment on that, perhaps the Treasury are a little more pessimistic here than the FSA. As Peter has said, the rate at which this kind of market-consistent and modernised approach would spread across the world remains to be seen, but a start has been made in the International Association of Insurance Supervisors (IAIS) which brings together European regulators, North American, Japanese and Australian regulators and so on. Some very good work has been done there, to which the FSA has contributed, that has led to some guidance papers for members which do place emphasis on the importance of a market-consistent approach, disciplined application of models, stress testing. And a paper is due to appear within a few weeks on a modernised approach to group supervision, which is one of the upsides we see in Solvency II. That kind of international dialogue is capable of running on for many years, but it seems to be moving in the right direction.

  Q88  Lord Watson of Richmond: To this point, is there any reaction in the States to this?

  Mr Folger: The US of course is a fractured system. There are 50 individual state regulators. The NAIC set out a prototype for what is by modern standards a fairly crude risk-based capital system of insurance, but the US are certainly signatories to these papers. For the moment, this is just guidance rather than fixed international standards.

  Chairman: In light of the time and the length of time we have kept you, may I ask that if there are any other questions that we wish to cover, we may write to you and ask them? If we have left you with anything unsaid, may the same be the case, that you would write to us when you had seen the transcript. Thank you very much for coming, particularly since this cannot be an easy time for those of you who also have responsibilities in the banking sector.