Consultation Paper on Establishment of an Independent Insurance Authority
8 October 2010
Division 3, Financial Services Branch
Financial Services and the Treasury Bureau
18/F, Tower I
18, Harcourt Road
Dear Sir / Madam,
Consultation Paper on Establishment of an Independent Insurance Authority
We are writing with our response to the above consultation paper.
We welcome the Government's initiative to bring the insurance sector under independently-administered statutory regulation. Self-regulation by industry bodies is not appropriate in an international financial centre like Hong Kong. However, we are disappointed that the paper proposes to create another sector-specific regulator for the purpose, namely an independent Insurance Authority (IA), and appears to have given no consideration to other possible regulatory structures. In this regard, we draw attention to the Twin Peaks model, which has been adopted in Australia and is in the process of implementation in the UK. We believe that Twin Peaks is the superior model, and would address many of the problems to which Hong Kong's regulatory structure is prone. Establishment of the IIA would add one more financial regulator to the several in the sector and exacerbate existing problems of coordination, duplication and evasion of responsibility.
Merits of Twin Peaks model
Hong Kong currently follows the sector-specific regulator model, under which each segment of the financial industry has an autonomous regulator. There already exist the Securities and Futures Commission (SFC) for the securities sector, the Hong Kong Monetary Authority (HKMA) for the banking sector, and the Mandatory Provident Fund Authority for retirement schemes - not to mention other regulators such as the Companies Registry, the Stock Exchange, the Financial Reporting Council which have narrower but still significant roles. The IA will be Hong Kong's fourth full-scope financial regulator.
Under Twin Peaks, two regulatory missions are distinguished - prudential supervision, which seeks to ensure that financial firms have adequate capital and liquidity, and conduct of business or consumer protection supervision, which seeks to ensure that financial firms conduct their affairs and treat their customers in an appropriate manner. The prudential regulator oversees the prudential regulation of all financial firms, in banking, insurance, fund management, securities dealing, etc, while the conduct of business regulator has corresponding responsibility for supervising all financial firms' business conduct. The main merit is that each regulator has clarity of mission and can more easily attract and train personnel and establish systems and procedures to fulfil that mission. The two regulators will obviously have to coordinate with one another, particularly in more serious cases of misdemeanour, but in terms of their day to day operation, their culture, and above all their mission they remain distinct.
The key point is that the respective missions conflict with one another, and cannot easily be reconciled within a single organisation. Prudential supervisors are characteristically supportive of their regulatory charges, seeking where possible to allow them to make profits, even at customers' expense, in order to preserve their charges' safeness and soundness. Conduct of business supervisors, in contrast, are characteristically antagonistic to their charges, seeking to maintain a healthy record of prosecutions in order to deter inappropriate conduct. It is very difficult for an individual or even an organisation to adopt both of these characteristic traits. Therefore, regulators which are given both missions tend to emphasise one at the expense of the other.
This has been graphically illustrated by case of the UK Financial Services Authority. The FSA was charged with responsibility for both conduct of business and prudential supervision. However, born out of the (conduct of business) pensions mis-selling scandals of the 1990s, the FSA seems to have emphasised consumer protection at the expense of prudential supervision, with the catastrophic results that were seen in the recent financial crisis. Without massive intervention by the UK Government, substantial parts of the UK banking sector would have collapsed, and the UK would have suffered a depression.
The Hong Kong Monetary Authority (HKMA) exhibits the reverse trait. The HKMA has focused primarily on the capital adequacy of Hong Kong's banks, with considerable success, since the banks remained sound throughout the recent crisis, and have generally sustained capital ratios well in excess of Basel requirements. However, this success was achieved at the cost of what appears to have been almost complete neglect of conduct of business supervision. The Lehman mini-bonds scandal reveals that regulatory attention paid to the banks' selling of products to their customers had been completely inadequate.
A further problem of the sector-specific regulatory model is the duplication and turf battles that arise among the various regulators. A firm active in only one financial segment may need to seek the approval of several regulators - for example, an asset management company that wishes to promote a retirement fund product has to seek approvals from some three regulators in Hong Kong. And when there is a crisis, it is difficult to say which regulator has responsibility and authority to deal with it, witness the denials of both HKMA and SFC over responsibility for the Lehman scandal.
A third problem to which the segment-specific model is particularly prone is capture by its segment. Regulators, many of whom come from and expect to return to their segment, end up supporting their charges in lobbying the government for concessions or favourable policy change with the result that over time their regulatory grip slackens and risk factors build up. All regulators are vulnerable to capture, but the Twin Peaks regulators, being of broader scope and clearer mission, are arguably less vulnerable than others.
For our views on particular points in the paper, see our responses to the questions, attached.
We hope that our views are helpful.
Alan Lung Ka-lun
Specific Responses to Consultation Questions
Do you agree that an independent IA should be established along the principles set out in paragraph 2.6?
An independent IA is certainly preferable to the existing regulatory arrangements; however, as argued in the main body of our letter we believe that the Twin Peaks model is superior to an independent IA, and urge that Twin Peaks be given consideration.
Do you think that there are other important principles in addition to those set out in paragraph 2.6 that the Administration should adopt in working out the detailed legislative proposals for the establishment of the independent IA? If so, what are they?
See above regarding Twin Peaks model. If an independent IA is required, the principles appear acceptable.
Do you agree that the independent IA should have an expanded role beyond the existing functions of the IA as set out in paragraph 3.1? If so, do you agree that the independent IA should assume the additional functions as proposed in paragraphs 3.3 and 3.4?
See above for our preference for Twin Peaks. If an independent IA is established, we agree that it should have expanded functions, especially to directly supervise the conduct of insurance intermediaries. However, as stated in our letter, we doubt that a single regulatory institution can effectively, ‘...maintain the stability of the insurance sector...' and ‘...protect interests of existing and potential policy holders...'.
Do you agree the independent IA should also have a duty to enhance the competitiveness of the insurance industry, which will help to reinforce Hong Kong's status as an international financial centre?
We doubt that such a regulator can or should seek to, ‘strike a reasonable balance between regulation and market development'. A regulator should pursue its regulatory mission wholeheartedly, and justify itself to higher bodies such as the government or the legislature, through which process the desired ‘balance' would presumably arise. We doubt even more that the regulator should have to, ‘enhance the competitiveness of the insurance industry.' Responsibility for industrial development should be the given to some other government body, such as the Trade and Industry Department.
Do you agree that the independent IA should be vested with additional powers as proposed in paragraph 4.7 to enable it to regulate insurers more effectively?
See above remarks on the Twin Peaks model. If an independent IA is established, we support it having such additional powers. However, we find it sad that the paper envisages setting up a duplicate of the model in the Securities and Futures Ordinance. If that model is satisfactory, and we tend to agree that it is, why cannot the existing SFC resources be expanded to cover the insurance sector as well? This would surely be more effective as well as less costly.
Do you consider that the existing self-regulatory arrangements for insurance intermediaries should be changed, and if so, do you support that Option 2 (i.e. direct supervision of insurance intermediaries by the independent IA) should be pursued? If not, why?
Whether under Twin Peaks (which we prefer) or the independent IA model, we strongly support option 2, direct supervision by the regulator. Self -regulation is a discredited model and is not appropriate in a developed international financial centre like Hong Kong.
Do you consider that in relation to the sale of insurance products in banks, the HKMA should be vested with powers similar to those for the independent IA to allow HKMA to regulate bank employees selling insurance products given the different client profile and sale environment in banks?
This highlights exactly our point about the merits of Twin Peaks and the demerits of the existing segment-specific model which the paper proposes to entrench. It is startling that after the HKMA's manifest failure to properly supervise the banks selling Lehman mini-bonds the paper can advocate that responsibility for supervising the banks' sale of insurance products be delegated to the HKMA. How can this be an acceptable solution when victims of the Lehman scandal are still demonstrating outside the banks' offices? We urge reconsideration of this point, at the very least. Additionally, the paper's reference to ‘detailed arrangements to ensure seamless interface between HKMA and the independent IA in the supervision of insurance intermediaries will have to be worked out,' is surely unrealistic - the interface will inevitably be full of friction, costly to the industry, and ultimately ineffective.
Do you agree that the recommendations as set out in paragraphs 6.5 to 6.8 should be pursued for the independent IA to operate as an independent entity? Any other views?
As stated, we prefer the Twin Peaks model.
Do you agree with the proposed checks and balances and governance arrangements for the independent IA as set out in this Chapter?
As stated we prefer the Twin Peaks model. The hope expressed in para 7.7 that the IA and the other regulators would , ‘strengthen their communication and collaboration arrangements to minimize duplication of efforts...' and establish ‘... a formal inter-regulator communication platform...' seem to us unrealistic. Duplication, turf battles and mutual recriminations in the event of crisis are much more likely.
Do you agree that the Government should provide a lump sum to support the independent IA in its initial years of operation and the independent IA should seek to reach full cost recovery in six years?
As stated, we prefer Twin Peaks. However, we agree that the regulator should be properly funded.
Do you agree with the proposed fee structure as set out in paragraphs 8.2 and 8.6?
See answer to 10 above.
Reproduction of this paper is permitted with proper attribution to the Hong Kong Democratic Foundation