Corporate insurance
In-sight July 2014
Contents Hedge funds: all eyes Brokers’ conflicts of Spotlight on corporate Valuation risk for Futher information on the World Cup (and interest transparency and insurers Page 9 reinsurance) Page 3 accountability Page 7 Page 1 Page 5
Welcome to the latest update from Clyde & Co’s corporate insurance team. This update summarises recent developments with links to further reading. Hedge funds: all eyes on the World Cup (and reinsurance) The World Cup has been fantastic and has surpassed all expectations as it now reaches its climax. It is a shame that England could not also have surpassed expectations. Amidst all the coverage of the event, there was one interesting article in the press, which did not cover the usual ground of match reports, injury updates and post-mortems of England’s or Brazil’s performance – it was an article on how hedge funds are investing in the football sector and will continue to do so. The interest generated by the World Cup is only likely to whet the appetite of such investors even further. Alternative capital invested in accordance with the asset manager’s investment The same (investment by hedge funds and other strategy (subject, of course, to any relevant restrictions on, institutional investors) can also be said about the insurance for instance, what assets can be invested in for regulatory market. Indeed, hedge funds, pension funds, sovereign capital purposes). These asset managers will also have wealth funds, private equity firms and other institutional access to more permanent capital in that the reinsurer will investors have invested in the insurance market for a while, be a regulated entity with certain capital requirements. in particular the reinsurance market. This investment of In each of these cases, the institutional investors are so-called alternative capital has typically been channelled attracted by the ability to invest in risks which are into the market through the use of cat bonds, sidecars, uncorrelated to the financial markets, it allows them to collateralised reinsurance products and other insurance diversify their investment portfolios, to establish a more tax- linked securities (ILS). In some cases, the investors have efficient platform to manage assets, and to potentially earn invested directly into a (re)insurer. better returns than they would otherwise do if they were to There has been an emergence over the past few years, and invest in more traditional asset classes. a spike in the recent past, of hedge fund backed reinsurers. The amount of capital from these sources which has come These reinsurers tend to target low-volatility underwriting into the market is pretty staggering, and with the level business (which is different from the higher-volatility of returns some investors have seen and the continued business usually targeted by ILS products although in low interest rate environment, it is likely that the level of time and with the benefit of appropriate risk modelling, investment will increase yet further. According to a report ILS products may end up targeting non-cat perils). Such from Goldman Sachs published a year or so ago, assets reinsurers will typically be sponsored by an asset manager invested in reinsurance by non-industry investors have who will manage the investments and who will have access grown over the past few years by over 800% to around to a free “float” (i.e. the premium income) which can then be USD 45 billion. That is impressive growth by any standards. This alternative capital can be seen, and is seen by some, What is more, Goldman Sachs recently commented as a threat to the traditional reinsurance market. Indeed, that the influx of capital from the capital markets into some in the market have commented that there could be the reinsurance market could almost double to USD 87 a mismatch between the risk being underwritten and the billion within the next five years without the need for new capital backing it in that the focus of the new providers investment or proportionate allocations. is on returns and they may not necessarily be exercising sufficient underwriting discipline, and may not be ensuring Implications that risk is properly assessed, priced and supervised. A great deal of debate has centred around the impact of this alternative capital on, in particular, the traditional However, there is an opportunity to be grasped here. This reinsurance market. capital could be used to support new products covering emerging risks as well as to support the growth of emerging There is no doubt that the influx of this capital has resulted economies. The traditional market needs to make the case in a growing convergence of the insurance and capital for this. In the meantime, what the traditional players do markets. The alternative capital providers are making have is deep pools of underwriting expertise and this does available products which effectively package insurance risk set them apart from the alternative capital providers. In (in the same way as other risks such as credit and foreign- whatever form the alternative capital providers structure exchange risk have been packaged) and allow it to be sold their investments, they will require underwriting expertise to capital market investors. Indeed, as noted above, in some and this can be and is being provided in a number of cases cases these providers are adopting a familiar reinsurer by the traditional players. model (albeit with a more aggressive investment strategy). There is also some convergence on the part of the traditional Final thought reinsurers and a sense amongst some of them that “if you If this alternative capital is in for the long term, and if can’t beat ‘em, then join ‘em”. A number of traditional products backed by such capital increasingly have the same reinsurers have, as a result, developed new investment structural features and terms as more traditional products, structures to attract and manage third-party capital. This is there any mileage left in still labelling this capital as has generated a new income stream for them, as well as alternative? It is probably fair to say that the new capital possible access to risks which they did not have the capacity providers have owners with different return expectations to underwrite on their own and the ability to potentially which could, in turn, drive a different (possibly shorter-term) cherry-pick the best risks for themselves. strategy in some cases, although this remains to be seen. We are probably not there yet, but it would appear that we This new capital is putting downwards pressure on pricing are heading in a direction of travel where the actual source as the providers of this capital can benefit from having a of the capital may become less of a differentiating factor cheaper cost of capital (not least because in many cases they over time. are not rated). This has the consequence of taking the edge off the insurance cycle and smoothing some of the peaks of the pricing cycles. It would be premature to announce the death of the insurance cycle (no doubt to the relief of some players in the market) but it may be that, in certain business lines at least, the cycle may become less pronounced over time.
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2 Brokers’ conflicts of interest The Financial Conduct Authority (FCA) recently published a report which sets out its findings into how general insurance intermediaries are identifying and managing potential conflicts of interest where they receive revenue from both their customers and insurers.
Specifically, the FCA is looking to understand whether, Practical steps to manage conflicts when acting as agent for an insurer (or other third party), There is a concern that a number of firms simply pay lip- this might unduly influence a broker to recommend an service to the requirement to manage conflicts of interest insurer against the customer’s best interest and to cause fairly. A number of practical steps can be taken to ensure it to improperly perform its duties to its customer. In other such management which include the following: words, the concern is that certain brokers may be acting more in their own interests rather than their customers’ –– Having a management and control framework in place, interests and, as a result, the customers are not getting the with specific senior persons responsible for ensuring best deal or the deal which they thought they were getting. compliance with agreed policies and procedures –– Clarifying the capacity in which a broker is acting (i.e. This report should not really have come as a surprise to the whether the broker is acting for the client or for the broking community. We have after all been here before. The insurer (e.g. as a MGA) or, in some cases, for both and to FCA is picking up an issue which its predecessor had looked whom fiduciary duties are owed) into a number of years ago, but which was somewhat put on the backburner when the fallout from the financial –– Describing clearly what service is being provided (e.g. crisis began to otherwise occupy it. is advice being given or not, is the broker conducting activities exclusively with one or more insurers or is the The segment of the market which the FCA has focussed on broker conducting activities on the basis of a fair analysis is small and medium-sized enterprises (SME). About 10 years of the market, will the broker be involving another ago, the FSA (as it was then) commissioned a report into this intermediary in the process?) issue, and that report highlighted that the SME market was –– Confirming what the broker is being paid and by whom the area probably most at risk from any poor management for providing the relevant service (including the extent of conflicts – unlike with retail customers, products sold to which revenue is derived from, for example, arranging to SME customers are less commoditised, and, unlike with premium finance, administration charges, commissions larger customers, SME buyers tend to have less sophisticated on add-on insurances, profit shares, over-riders, in-house risk management expertise (if any). contingent commissions and fees for work transfer) As a result of its findings, the FCA is taking a number –– Regularly reviewing management information and of follow-up actions including, amongst other matters, systems and controls, including tracking revenue flows supervisory engagement with the firms involved in the and their sources, monitoring the impact (if any) of review to address specific issues, providing feedback to the any differential commission and other remuneration wider industry, and engaging proactively with the industry arrangements on placement activities, reviewing insurer to enhance understanding of the findings. facilities, insurer panels and binding authorities to ensure that these arrangements still represent the right choice for customers, and ensuring that there is an audit trail to support broking decisions made
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3 Disclosure along the lines described above may in many Occasionally, though, none of these measures will be a cases be an adequate way of managing a conflict or panacea and the broker may have to decline a particular potential conflict. For example, the disclosure could set out engagement. An example of this could be where a broker the basis and sources of remuneration which the broker is handling a claim for a client in circumstances where the is entitled to. This should enable the customer to make an broker has also been delegated authority by the insurer informed judgement as to the relationship between the to handle that claim. The broker’s position would become broker and relevant third parties, and the extent to which particularly untenable if, for example, the broker were the broker is incentivised to promote certain products. If, aware that, in settlement discussions, the insurer would be however, any disclosure is only generic or not very clear, willing to settle for a higher amount than had initially been then the disclosure may not, in fact, be adequate. Such offered to the insured. disclosures (however detailed or otherwise) will often be made in a terms of business agreement (TOBA). Brokers Time for brokers to act would be well advised to keep such TOBAs under regular The regulators understand that conflicts arise regularly review to check whether any amendments or tweaks are in the insurance market. They always have done so. required to the wording from time to time. Indeed, one judge noted when giving judgment in a case concerning brokers that they hunt with the hounds and Sometimes, additional measures may be required. For run with the hares. example, firms and groups operating integrated models including a mixture of open-market broking activities and However, it is probably fair to say that conflicts are insurer agent activities (including MGAs and coverholder increasingly more likely to arise now as many brokers or delegated authority arrangements) are more likely adopt new business models and these models continue to to have more inherent conflicts of interest. In such an evolve. As noted above, some of these models are likely to integrated model, the broker will frequently be acting in have more inherent conflicts of interest, many of which can a dual capacity (i.e. as agent for both the customer and be managed. the insurer) on the same transaction. In this situation, to What is clear though is that a number of brokers are not manage the conflict, it is critical to have in place measures implementing even basic conflict management systems, to protect the customer. such as making clear and full disclosures to customers, These measures could include setting up information monitoring the impact of arrangements with third parties, barriers or “Chinese walls” or having staff who carry on and ensuring there is segregation of activities where there open-market broking activities located in one place and is a clear potential for conflict. Brokers have now been put staff carrying on insurer agent activities located elsewhere on notice that they will need to put their house in order on each with different reporting lines and knowledge of this, or else the regulator will have to step in and do so. remuneration arrangements. In some cases, these activities will be carried on by different legal entities within the same group in order to ring-fence and separate them. The risk of conflict will be increased where there is no such clear segregation of roles, revenues, and information between the relevant operations.
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4 Spotlight on corporate transparency and accountability Insurers and their directors should be aware of Government proposals to enhance corporate transparency and accountability and to clamp down on director misconduct.
On 25 June 2014, the Small Business, Enterprise and In addition, the Government has also proposed to increase Employment Bill 2014-2015 (the Bill) received its first the accountability of registered directors whose conduct reading in Parliament. The Bill contains, amongst other falls below the expected standard by: things, a number of proposed measures designed to –– Increasing the scope of the director disqualification promote transparency and accountability in UK companies. regime Corporate transparency and accountability –– Making it easier for creditors who have suffered loss to Transparency and accountability are essential elements of claim compensation from directors good corporate governance and play an important role in promoting public trust and confidence in business. A lack Increasing the scope of director disqualification of transparency and accountability erodes trust and may Directors who fail to meet their legal responsibilities can be facilitate the misuse of companies for criminal activities disqualified under the Company Directors Disqualification such as money laundering, tax evasion and terrorist Act 1986 (CDDA). The matters which a court must take into financing. account when determining whether to disqualify a director are set out in Schedule 1 of the CDDA; however, this The Bill follows a 2013 consultation by the Department for schedule is viewed as outdated and there is currently a gap Business, Innovation and Skills (BIS) entitled “Transparency & between what the law says and the factors that the courts Trust: Enhancing the Transparency of UK Company Ownership and actually take into consideration in practice. Increasing Trust in UK Businesses”, to which the Government published its response in April this year. The proposed Part 9 of the Bill proposes amendments to the CDDA to measures, set out in Part 7 of the Bill, include: incorporate a wider and more generic set of factors that the court must take into account including: –– Creating a public central register of beneficial ownership information (although companies already covered by –– The materiality of the director’s conduct; the Financial Conduct Authority’s (FCA) Disclosure and –– Culpability of the director; and Transparency Rules or listed on a regulated market –– The nature and extent of any loss or harm (or potential subject to equivalent disclosure requirements will be loss or harm) caused by the director’s behaviour. exempt) –– Reducing the potential for opaque control of company The new factors will also specifically include: directors by: –– Breaches of sector regulation: regulators such as the FCA –– Prohibiting the appointment of corporate directors and the Prudential Regulation Authority (PRA) will have (commonly used for occupational pension schemes) greater power to share information with the Insolvency subject to certain specific exemptions Service for the purpose of director disqualification –– Extending the duties and liability of ‘shadow directors’ proceedings (unregistered individuals who control registered –– Overseas misconduct: The Secretary of State will have directors) the power to disqualify a UK director upon conviction –– Abolishing bearer shares for UK companies of a criminal offence in connection with the promotion, formation or management of a company overseas. Such action could be taken prospectively against individuals who are not yet directors in the UK but who might pose a risk in the future
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5 Compensating creditors Conclusion In its response to the BIS consultation, the Government The Government hopes that the proposed changes emphasised its concern that the current disqualification will benefit UK companies and the wider economy regime does not adequately protect and benefit those by improving trust and confidence in business and who have suffered loss as a result of director misconduct. making it harder for companies to be used to facilitate Although liquidators and administrators are currently criminal activity. The Bill still faces a long passage permitted under the Insolvency Act 1986 (IA) to bring through Parliament and it remains to be seen whether actions on behalf of creditors (for wrongful and fraudulent Parliamentary time will allow for the changes to be pushed trading, preferences and transactions at undervalue), such through before the general election next year. Nevertheless, actions are not commonly used and cannot be brought insurers and their directors should be aware of the planned directly by creditors. changes to the law concerning corporate governance and the greater risk to directors who get it wrong. Consequently, the Bill also provides that: –– Liquidators and administrators will be able to assign their permitted actions to the creditors themselves so that creditors will be able to pursue the directors directly –– Administrators will be afforded the same rights as liquidators to commence actions for fraudulent and wrongful trading, removing the need for (and the cost of) placing the company into insolvent liquidation prior to commencing such actions –– Any director who is disqualified may be ordered by the court to pay compensation to specific creditors (or to creditors generally) where his or her actions have caused loss
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6 Valuation risk for insurers The Prudential Regulation Authority (PRA) has published a draft supervisory statement setting out its expectations of insurers in relation to existing rules on the valuation of financial assets.
The draft statement, published for consultation on 30 May –– Wherever possible, insurers must use “mark-to-market” 2014, reminds insurers to review their compliance with valuation (i.e. current market prices obtained from the valuation rules set out in Chapter 1 of the General independent sources). Where mark-to-market is not Prudential sourcebook (GENPRU) and makes it clear that possible, insurers must use valuation models that have insurers are expected to have robust procedures in place to been independently assessed and tested. Insurers must manage valuation risk. ensure that their senior management are aware of positions valued in this way and understand how the What is valuation risk? uncertainty and risk inherent in such valuations might Valuation risk is the financial risk that an asset is affect reporting of business performance overvalued and is worth less than its reported value when –– Insurers must always perform independent price it matures or is sold. This risk is most often associated with verification regardless of the valuation method used portfolios of structured products and illiquid securities, but it can also apply to large portfolios of conventional What’s new? investments where a firm holds concentrated positions The draft statement does not represent a change in policy that it may not be able to unwind at reported fair value. by the PRA but rather reinforces the existing rules set out in Managing valuation risk requires an assessment of GENPRU. In particular, the draft statement emphasises that valuation uncertainty of each asset or portfolio of assets an insurer’s assessment and quantification of valuation (i.e. the range of plausible values of the asset or portfolio uncertainty and associated risk must be underpinned by at the valuation date). adequate standards of financial asset valuation governance and control. This includes: What are the current rules? –– Sufficient independence in valuing assets The existing rules require insurers to comply with applicable national and international accounting rules and –– Adequate documentation of policies and procedures set out certain additional accounting requirements. They –– Adequate understanding of and control over valuation also impose various further regulatory requirements in models relation to control and governance of valuation procedures: –– Adequate management information –– Insurers are required to establish and maintain systems –– Consistent governance between internally and externally and controls sufficient to provide prudent and reliable managed funds valuation estimates; including: Client-supplied pricing –– Documented policies and procedures for the process of One particular concern around governance and control valuation singled out by the PRA in the draft statement is the use of –– Reporting lines that are clear, independent of the front client-supplied pricing. This is where an insurer receives office, and ultimately lead to a main board executive valuations from an external valuation provider but the director valuations are based on prices or pricing inputs provided by the insurer itself or the insurer’s investment managers and are therefore not truly independent.
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7 The PRA observes that this lack of independence might allow landscape is putting pressure on insurers to look towards performance to be manipulated by investment managers less traditional investment types and he asserted that the and makes it clear that the PRA expects insurers to: PRA would be vigilant to the risks in any such move. The less traditional investment types referred to by Mr Carney –– Monitor and limit their use of client-supplied pricing are likely to include complex structured products that –– Have clear visibility of the price sources used and to carry a higher degree of valuation risk. identify where client-supplied prices are used in their valuations Furthermore, it is apparent from the wording of the draft statement that the PRA has identified that insurers have –– Where the use of client-supplied pricing is unavoidable, not been complying with all of their current obligations have robust controls, including independent price under GENPRU. In particular, the emphasis placed in the verification and reporting to senior management draft statement on independent price verification and Comment reporting to senior management suggests that there is The publication of the draft statement follows recent need for improvement in these areas. With the approaching comments by the Governor of the Bank of England, Mark implementation of Solvency II in January 2016, it appears Carney, on the PRA’s approach to insurance regulation that the PRA is now stepping up its efforts to improve risk (reported in last month’s edition of this newsletter). valuation governance: the draft statement serves as a In his article in The Times on 22 May 2014, Mr Carney notice to insurers that they can expect greater scrutiny of acknowledged that the current economic and regulatory their governance procedures in the future.
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8 Further information If you have any comments or queries on anything in the newsletter, please can you contact Martin Mankabady or Chris Hill, editors of this update, or your usual contact. Further details of the team are set out below.
Ivor Edwards Andrew Holderness Partner Partner T: +44 (0)20 7876 4162 T: +44 (0)20 7876 5586 E: [email protected] E: [email protected]
Chris Hill Martin Mankabady Partner Partner T: +44 (0)20 7876 4557 T: +44 (0)20 7876 4016 E: [email protected] E: [email protected]
Stephen Browning Gary Thorpe Partner Partner T: +44 (0)20 7876 6119 T: +44 (0)20 7876 4172 E: [email protected] E: [email protected]
Geraldine Quirk Andy Tromans Partner Partner T: +44 (0)20 7876 4258 T: +44 (0)20 7876 4173 E: [email protected] E: [email protected]
Mark Williamson Partner T: +44 (0)20 7876 5341 E: [email protected]
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