Delivering a wide ranging speech covering topics from ‘Big Data’ to the FCA’s Future Mission review, he said risk sharing across the industry needed to be applied fairly. Big Data, allowing individual setting of premiums based on claims history, would potentially transform the sector but needed to be implemented carefully, he said.

Here are extracts from his speech today covering the PI and FSCS review and his thoughts on the way forward.

He said: “I do not subscribe to the view that we no longer need the theory of aggregated rationality that underpins our models of people’s behaviour because we have access to a lot more data.
“But it does mean that insurers can move the boundary between risk assessment based on aggregate modelled behaviour and risk assessment based on the observed behaviour of the individual. It therefore takes us somewhat away from pooling. This point about pooling – just to warn you – is one that I will come back to several times in this speech.

“…Let’s now turn to the world of the FCA only firms. Here, the FSCS is called upon where the firm has acted to the detriment of its customers in an agent or advisory capacity and it has become insolvent so that it cannot make good that detriment.

“Two points stand out for me here: first, while losses as principal dominated the financial crisis – in other words, the failure of banks – and the interest costs of these failures remain even now the biggest costs being covered by the FSCS, failure of firms acting as agent are more common, if on average smaller.

“But size has to be related to the resources of the FSCS. For agency firms, capital is not where we should start - as holding capital is an inefficient way of mitigating the risks posed by firms who are not typically a threat to the system. The front stop should be commercial insurance in the form of Professional Indemnity (PI) Cover, much as it is for lawyers and other professions. But PI cover is not by experience always reliably performing the role, particularly in the IFA and investments world, – the contracts are framed often in ways that rule out loss absorption in the context we are dealing with here when the firm fails. What is the consequence of this? It is that the protection of client assets and ultimately the FSCS become the primary lines of defence, and this is what has happened.

“You can see from this that in the principal world, the pooling of risk and thus the insurance occurs in the backstop, whereas in the agent world it occurs in the frontstop. The latter in my view requires further thought. On the face of it this is a public policy issue in terms of the availability of insurance and where the pooling should occur. Pooling can here take one of two forms. It can be pooling through private insurance (PI cover) or pooling through mutualised industry risk cover via the FSCS. It is important to note however that there is a very important difference between private insurance with pooling for which a risk-based premium is charged – assuming that insurers can obtain sufficient data to charge a risk-based premium - and the FSCS, in which a risk-based premium is not currently charged. The frontstop problem in the agency model is really caused because there is no risk-based cost. This creates a very marked incentive problem.

“Why is this relevant today? It is because we are currently conducting the review of FSCS pooling on the agent side of its activities. This is not primarily a review about whether there should be insurance for consumers but rather about the sharing of the burden of the pooled risk across the agent world. Here, there are two tensions and no easy answer. The first tension is how to divide the provision of risk cover among the various sub-sectors of the finance industry. The tension is between spreading the cost enough to avoid damaging other firms seriously versus spreading it so much that firms are paying price for failures that are a long way from their area of activity. The second tension is how to spread the cost in the agency world between the creator of the product and those who sell and/or advise on it.

“But these tensions would be at least less pointed if they were not trying to cover a world where there is no risk-based pricing of insurance in the front-line.

“This is rightly a public policy issue, but it is also a private issue too because many advisory firms are meeting substantial bills for FSCS pay-outs. With all this in mind, my request today to the insurance industry is to help us to think through how we might solve this problem.

“At the moment I would say that the insurance scheme we have to limit the cost of financial conduct risk is highly limited outside the FSCS provision. If there is a desire to solve this problem and I hope there is, we need to work together to determine what is possible on professional indemnity or related insurance.”