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BENEFITS OF EXTERNAL REGULATION SPELLED OUT IN REPORT

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LONDON-Sweeping reforms proposed for Lloyd's of London's regulatory system would shift the ultimate responsibility for overseeing the market to external agencies.

Lloyd's last year asked a panel of market executives and regulators from other parts of the U.K. financial services sector to review its current form of self-regulation and make recommendations for a new system of market governance.

After six months of deliberations, the panel issued its report earlier this month. The main recommendations in the 50-page report were accepted by the Council of Lloyd's, the organization's ruling body. However, "some detail, clearly, the Council needs to look at," said Sir David Rowland, chairman of Lloyd's, at the report's release.

In widespread but not unexpected changes to the current system, the panel recommended that the powers of the U.K. Department of Trade and Industry be extended "to give it a wider oversight role" of Lloyd's.

"We recommend. . .that while the Council of Lloyd's should retain the primary day-to-day responsibility for regulating the Lloyd's market, additional, formal, external accountability should be introduced in respect of the exercise of its regulatory responsibilities. This will demonstrate that policyholders' and members' interests are sufficiently and impartially safeguarded and that the Council's responsibility to ensure a properly regulated and solvent market is being discharged," the report said.

External regulation would have several benefits, the report contended, including:

Diminishing possible conflicts of interest between regulators and those they govern. Several of the people in senior regulatory positions are also market executives and the report cited a "perception that the current structure. . .can lack objectivity in dealing with conflict."

More consistency with regulation of other financial markets. In general, other markets in the financial services sector are subject to greater external regulation than Lloyd's.

Greater confidence from buyers in Lloyd's regulation, particularly following the market's near financial collapse in recent years. "There is a general willingness to make fundamental changes to restore that confidence," the report said.

Greater confidence from traditional unlimited liability members that their interests are being safeguarded.

Currently, the DTI is responsible for certifying that both Lloyd's and its individual members are solvent.

Following the successful completion of the market's reconstruction and renewal plan last year, the DTI reviewed its solvency testing procedures, and will implement another test at the end of this year designed to ensure that each member is not only solvent, but also has an acceptable solvency margin.

This should go even further, the panel report said, to make Lloyd's solvency standard comparable to that of U.K. insurance companies. It singled out two particular areas for reform, though implementing these would require changes to the Insurance Companies Act.

First, under the present regime, the Secretary of State for Trade and Industry becomes directly involved in regulating Lloyd's members should they fail the DTI's solvency tests.

Although this has never happened in practice-Lloyd's always has put up its own central assets to shore up members who did not reach the solvency levels required by the DTI-it gives the Secretary of State the power to demand that a potentially insolvent member of Lloyd's put sufficient assets into trust to meet all underwriting obligations, including future liabilities.

"We recommend that the Secretary of State should be empowered to act at an even earlier stage, should policyholders' interests be considered to be at risk, as is the case in respect of an insurance company," said the report.

Secondly, the report recommended giving the Secretary of State greater powers to seize the assets of Lloyd's members and agents "at the request of, or with the consent of, the Council of Lloyd's."

Currently, if a member defaults in paying losses, Lloyd's can only seize their "funds at Lloyd's," or assets backing their underwriting.

Members also may find themselves subject to external regulation, in the interest of better safeguarding their investment. The panel's report suggested the U.K. Securities and Investments Board would be best suited to oversee protection of members' investments in Lloyd's, though this would require a change in the Financial Services Act.

The SIB is responsible for protecting the interests of investors from malpractice in the securities industry. Although membership in Lloyd's does not constitute an investment under U.K. law, the panel still regarded the SIB as the most appropriate regulator.

Legally, members of Lloyd's are "sole traders" undertaking to write insurance. "But there are some similarities between members' interests and other investors," said Sir Alan Hardcastle, chairman of Lloyd's Regulatory Board and chairman of the panel that authored the report. Nevertheless, he said, "the detail remains to be discussed with the government and the SIB."

If the new Labour government implements the panel's recommended changes, both the DTI and SIB would have very different roles with regard to Lloyd's.

It would then be their responsibility to establish fundamental regulatory principles governing the institution, as well as approving the more detailed "rule book" that the panel suggested could remain the responsibility of the Council of Lloyd's. Also, both bodies most likely would be required periodically to review the Council's regulatory performance, including investigating any complaints about its regulatory procedures.

A spokesman for the DTI said, "This is very much a Lloyd's report. However, we welcome its intention."

The SIB will be "carefully considering the panel's ideas," a spokesman said. The spokesman added that the need for legislative changes to implement the main recommendations would be a government, rather than an SIB, decision.

The Assn. of Lloyd's Members, a body representing the market's traditional members, praised the report. ALM Chairman Sir David Berriman said he personally welcomed the recommendations, saying they would "move Lloyd's regulation closer to the position of other high risk markets, and I hope any necessary legislation can be passed quickly. The burden of responsibility now is for the market to minimize the scope for conflicts of interest and to ensure the equal treatment of all its capital providers."

More immediately, the panel called for a senior member of the SIB to sit on both Lloyd's Council and its Regulatory Board, said David Gittings, director of regulation at Lloyd's and a member of the panel. He said that there may be an appropriate appointment later this year, adding that input to the panel from former SIB chief executive John Young had been "quite invaluable."

The report recommended maintaining Lloyd's Regulatory Board but reducing its members to 12 from 18, with equal numbers drawn from the market, the external Council members and independent representatives. It also suggested setting up a series of subcommittees reporting to the Regulatory Board and focusing on specific areas of regulation.

Any moves to regulating Lloyd's externally most likely won't be swift.

This is mainly due to the time it would take for reform to be introduced and approved-a period the panel estimates at up to three years.

It does seem, however, that the government is willing to go full steam ahead with any changes it sees as strengthening the regulatory regime. Last week, Chancellor Gordon Brown announced major changes to the regulation of various sectors of the financial services industry. In a surprise parliamentary statement, Mr. Brown said he intended to extend the powers of the SIB, making the Bank of England accountable to it. Other self-regulating organizations governed by the Financial Services Act would also come under its watchful umbrella, said Mr. Brown. Lloyd's, however, is exempted from such regulation by the Financial Services Act.

Mr. Brown's proposals are expected to become law early next year.

The chancellor's statement contained no information on changes to the supervision of non-life insurers, which currently are accountable to the DTI. A DTI spokesman refused to comment but a spokeswoman for the Assn. of British Insurers said the proposals may indicate the eventual move of all financial services regulation to the SIB.

In his statement, Mr. Brown commented on the "plethora of different supervisors" currently responsible for regulation, which he said "increases the cost and reduces the effectiveness of supervision." Welcoming Mr. Brown's proposals, the ABI spokeswoman said that streamlining regulation and reducing bureaucracy would lower costs for U.K. insurers.

Whether Mr. Brown's proposals on the SIB will delay Lloyd's external regulation proposals remains to be seen.

"Clearly we have a major task ahead of us," said an SIB spokesman, referring to a regulatory review Mr. Brown has asked to be ready by the end of July. Both Lloyd's and the ABI say they hope to be included in the review's consultation process.

Until primary legislation can be changed to accommodate changes to the Lloyd's regulatory regime, the panel report suggested that Lloyd's not only appoint an SIB representative, but also discuss with the SIB how it can "shadow the arrangements that would be formalized when the legislation was amended."

The panel also reaffirmed Lloyd's commitment to continuing the Central Fund, a guaranty fund that steps in if members cannot cover underwriting losses. The panel stressed, though, that using the Central Fund to pay losses is at the discretion of the Council of Lloyd's.

Other recommendations called for:

An assessment of Lloyd's total exposure to aggregated risks.

"We recommend that Lloyd's should follow the example of other regulators and establish a specialist financial risk assessment unit staffed by suitably qualified individuals," the report said.

A review of the education and training requirements of senior agency staff.

A review of the staffing levels, training and salary structure of the Corporation of Lloyd's regulatory division.

A review of the Lloyd's Compensation Scheme, currently available to compensate members for losses resulting from fraud, dishonesty or accounting failures.

A return to compulsory errors and omissions cover for Lloyd's agents and advisers, insured outside the Lloyd's market.

Implementing a "user pays" system into the charging of regulatory services.

Broker regulation is expected to be addressed in a soon-to-be-released consultative document on distribution channels for Lloyd's products, so the panel did not tackle the issue.

Meanwhile, during the panel's investigation, a gray area emerged about the role of members' agents. It may be determined that they are providing investment advice to unlimited liability members, which would fall under the Financial Services Act rather than being subject to Lloyd's general exemption under the act, the panel said. "Uncertainty as to the scope of the exemption needs to be resolved as a matter of urgency," the report said. "We recommend that the (Lloyd's Regulatory Board) should take the appropriate legal advice and subsequent steps to ensure that the interest of members are properly safeguarded."