Bischoff's Understated Record Speaks For Itself

The departure of Lloyds Banking Group chairman, Sir Win Bischoff, provides another reminder that nothing much has changed in UK banking. 

The so-called 'City grandee' has spent the past five years as chairman of a banking group that's been fined at least £40m so far, and owes customers £10bn in compensation for mis-sold PPI. The fines have included £28m for mis-selling individual savings accounts and income protection insurance products between 2010 and 2012. Yet Win still talks of banking with his 'stomach' (as did the Lehman's gang) and trots out the languid understatement that "all of us have to be very much more mindful of whether the product or service we provide actually meets the needs of the customer." 

Win doesn't need to say that he hates all this new-fangled regulation - we get that from the career stats - but he reminds us anyway, in typically understated fashion: "I still hark back to the days when I would have tea with the governor of the Bank of England and he wouldn't be sitting there with the rule book. He would say '"Win... is this the right way of going about it or should you be in this kind of business'." 

History doesn't record how often the governor actually said this to Win, or what Win said or did in response (if anything). But it's pretty clear that tea consumed in this manner was spectacularly harmful for the UK economy. Unless, of course, you count steadily declining bank competition, mortgage endowment mis-selling, consistent underinvestment in payment systems and a century of under-funding small businesses as wondrous achievements... (and, you know, I think Win just might!).

Anyhow, Win will have plenty of opportunities for cosy chats over a nice cup of tea in future, as he's off to head up the Financial Reporting Council, the accountancy 'watchdog'. They'll relish his capacity for understatement over there, too. You see the FRC has been having a little difficulty in defining the nature of scepticism in the audit context...  biscuit?

Optional Annuities Could Mean Working Pensions

Odd that Will Hutton should claim in The Observer, of all places, that making the purchase of pension annuities optional will end in long term social disaster. UK pensions are already a long term social disaster. Hutton himself points out that "400,000 people buy £11bn of annuities every year", yet "the annuity market [has become] overstretched, offering indifferent and often wildly different rates." 

This is because consumers have no choice. There's no competitive pressure at all on the insurance companies or their agents to remove unnecessary middlemen, reduce fees to customers or simplify products. In fact, the Financial Services Consumer Panel recently found that the annuities industry continued to focus on increasing its revenues through product complexity, even when consumers were given the option to shop around. No one in the industry seized the opportunity to make annuities more transparent and better value for the consumer. [Update on 26 March: Legal & General has suggested the market for individual annuities will shrink by 75% - rather endorsing the government decision to make them optional!].

Will Hutton argues that rather than make annuities optional "the response should have been to redesign [the market] and figure out ways it could have offered better rates with smarter investment vehicles". But that seems naive, given the FSCP findings. The industry had that opportunity and declined it. 

It's equally naive to suggest that less demand for annuities will mean losing a valuable opportunity for insurance companies to 'pool the risk' of funding pensions. The industry merely sees risk pooling as a chance to exploit asymmetries of information to line its own pockets. 

The only way for the government to shake up the cosy annuities cartel was to remove the implicit guarantee that everyone would have to buy an annuity. 

Mr Hutton then seeks to set up some kind of moral panic that the 'freedom to buy a Lamborghini' instead of an annuity will result in people simply frittering away their life savings. Not only does this suggest that he'd rather your life savings were placed in the grubby mitts of the annuities industry so they can buy the Lamborghinis, but it also insults the consumers who face the abyss of the annuities market. Their concern clearly arises from the lack of decent returns, not because they're eager to spend the cash on exotic cars.

Finally, Will suggests that the State is entitled to control how you invest your pension money because it allowed you to avoid paying income tax on your pension contributions in the first place. If you agree with that, then presumably you would say the State is entitled to control how you spend every penny of your income that it has allowed you to keep. This of course places a great deal of trust in the State's financial management capabilities that we know from bitter experience is ill-deserved. As a result, it's more likely that citizens will gain greater control over the allocation of 'their' tax contributions, not less (as I've joked about previously). But regardless of whether it's the State or the taxpayer who is in control, neither party wants the State to be saddled with the consequences of an uncompetitive and opaque annuities market. That would only suit the annuities spivs. Again, the only alternative is to expose the market to competition from all manner of transparent savings and investment opportunities. 

Importantly for economic growth, the freedom to avoid annuities opens up the potential for £11bn a year to be invested directly into the productive economy at better returns in much the same way that the new ISA rules will liberate 'dead money' from low yield bank deposits. Not only could we see some pension capital crowd-invested into long term business and infrastructure projects in a way that won't be interrupted by the need to purchase an annuity, but those in draw-down might also consider some 3 to 5 year loans to creditworthy borrowers as a way to generate some additional monthly income.

At Last: ISAs Go To Work

Finally, the last lines of resistance have fallen and the Chancellor has announced that ISAs will go to work: 

"To further increase the choice that ISA savers have about how they invest, ISA eligibility will be extended to peer-to-peer loans, and all restrictions around the maturity dates of securities held within ISAs will be removed. The government will also explore extending the ISA regime to include debt securities offered by crowdfunding platforms."

In addition, from 1 July 2014 ISAs will be reformed into a simpler product, the ‘New ISA’ (NISA), with an overall limit of £15,000 per year. You will be able to hold cash tax-free within your Stocks and Shares NISA (if your provider allows it). And you'll be able to ask NISA providers to switch your money between cash-NISAs and Stocks and Shares NISAs.

As has been pointed out repeatedly, these changes offer a huge boost to the real economy, because savers will be able to lend their 'dead' savings directly to each other and to small firms to help fill the funding gap left by the banks. At the same time, savers will improve the value of their investments, not only by diversifying into a new asset class, but also one that provides a decent return.

In 2012, the Treasury estimated that about 45% of UK adults have an ISA, with a total of £400bn split equally between cash and stocks/shares.  But others had found that cash-ISAs were only earning an average of 0.41% interest (after initial ‘teaser’ rates expire), and 60% of savers never withdraw money from their account. That amounts to £120bn worth of 'dead money', because only £1 in every £10 of bank loans goes to small firms, and we rely on those firms for 60% of new jobs.

Hats off to the government and the Treasury for putting in the work to turn this situation around.

Wolf Attacks On Local Authorities

It's a vicious coincidence that 'lobo' means wolf in Spanish and a 'Lender Option Borrower Option' in derivatives sales jargon (not to mention parallels with the infamous Timberwolf deal and even The Wolf of Wall Street).   

As explained to me by a researcher from MoveYourMoney in December, LOBOs were sold to UK local authorities to provide (very little) additional funding and to replace the authorities' long term, fixed rate loan contracts with terms that give the lender the option to increase interest rates every 5 years, while the borrower's only 'option' is to repay the loan. This introduces huge uncertainty over local authority funding costs that did not exist before.

How big a problem is this? 

Well, this post suggests that in 2009 at least 30 housing associations may have mistakenly replaced stable long term loans with high cost LOBO facilities in return for only small increases in net funding. But responses to recent Freedom of Information requests suggest that the problem goes further back in time. A response from Brent Council, for instance, shows that in the eight years to April 2010, the council agreed nearly £100m worth of LOBOs, with £21m of funding at risk of being 'called' this year, another £20m in 2015 and £35m in 2016.

Brent's last LOBO was agreed in 2010 and the lender has the option to raise rates in 2015. That was a deal for £10m at an interest rate of 6.75%, even though 'Liebor' rates were at rock bottom. The previous LOBO, agreed in 2008, had a rate of 3.95%. There's no telling what the lender might charge next year...

Now why would local authorities agree to LOBOs? Did they understand the value of the long term deals they were giving up? 

There should be yet another inquiry, but I suspect it will reveal the same old problems amongst the usual suspects that were highlighted by the Banking Standards Commission. Banks are only in the market to make money for themselves.

Thoughts On The Potential For P2P Insurance

Some interesting discussions these past few weeks about the potential for innovation and 'disruption' in the insurance markets. As ever, there are stark differences between areas that industry players see as ripe for innovation/disruption and the opportunities outsiders see...

A signficant source of this disconnect - and a great source of opportunity for outsiders - is the tendency for established institutions to view the market through the narrow lens of their own existing products and activities, rather than from the customer's standpoint. To really solve a customer's problem, a supplier has to understand the end-to-end activity in which that customer is engaged; and has to consider that it might need to collaborate with other suppliers in the process.

For instance, as a consumer of car insurance, it's important to understand that you don't simply drive you car. You drive it from A to B in the course of some other activity. Is it a one-off journey, or a commute? Does it involve both city streets, motorways and/or rural roads? What time of day is it? Are the road conditions always the same, often wet or sometimes extreme? Why couldn't I switch insurers, policies and/or premiums as these variables change? Could my car be covered by household insurance while parked at home? The answer hardly requires advanced telematics.

Another problem for insurers is their preoccupation with managing short term financial performance within regulatory capital requirements. This favours cost-reduction at the expense of more strategic, long term business development. In fact some insurers may be better off admitting they are simply running-off their existing book. [Update on 26 March: FT coverage of RSA's rights issue underlines this point - it's all about cost-cutting and disposals, to which CEOs have tied some nice incentives].

At any rate, this tells me that insurers will end up reacting to changing demand, rather than reinventing insurance in any substantial way.

The same goes for the insurance industry's attitude to Big Data. While large insurers are quite sophisticated exponents of Big Data, the industry is merely dedicating itself to persuading customers to disclose more and more personal data about themselves for use in marketing extra products, reducing fraud or improving claims-handling.

This ignores the evolution of personal information management services that go in search of products that are right for you personally. Insurers argue that's what happens on price comparison sites already, and the Cheap Energy Club takes that a step further. But we have not yet seen the truly personal 'open data spider' that some of us have been dreaming about. In that machine-readable future, the challenge for insurers won't be to find customers, but to be able to instantly formulate policies in response to customer devices directly peppering their systems with requests for tailored cover.

To be fair, there are also plenty of mistaken assumptions by outsiders about how insurance actually works (or doesn't) today, and which elements of the value/supply chain that are ripe for improvement or disintermediation. For instance, people forget the key role of reinsurers and reinsurance brokers in diffusing the risk of loss across many sources of capital.

So before disrupting today's insurance markets, it's worth pausing briefly to understand the nature of insurance and how the markets operate.

In layman's terms, insurance is a way for you (the 'insured') to transfer to someone else (an 'insurer') the risk of loss, in return for payment (a 'premium'). 

But it's not quite that simple. In legal terms, that 'risk of loss' translates into 'a defined event, the occurrence of which is uncertain and adverse to the interests of the recipient'. The practice of pooling risks also lies at the heart of modern insurance, such that premiums paid for insuring lower risks are used to fund payouts on higher risks. This of course presents a significant moral hazard, and the scandals involving payment protection insurance and so-called 'identity theft' insurance illustrate how the industry has tended to seek out customers who don't actually face a genuine risk that is adverse to their interests and/or would never be able to make a claim (even if they were aware they'd bought the insurance).

Which brings us to the main problem with insurance markets today - they are highly complex and heavily intermediated, often by players who have little or no interest in seeing a genuine risk is insured appropriately.

Modern insurance can be traced to the need to insure property against the risk of fire after the Great Fire of London (and some might say little has changed since then in the way non-retail insurance business is transacted!). The need to spread the exposure to other risks of loss has created markets around certain types of other events, businesses and property. Reinsurance markets have developed to enable insurers to insure themselves against the risks they underwrite. In each of these markets, the distribution, marketing and sale of insurance is heavily intermediated by brokers and others who take their own cut from the gross premium that you pay (the net premium being what the insurer receives in return for underwriting the risk). Insurers also must invest their premiums in order to help fund payouts and ensure they have enough capital to cover their exposures. So there are strong links between global markets for insurance and other financial products, which brings with it hidden costs and fees, the risk of re-concentrating risk in suprising places and exposure to global financial crises...

Rolling all of these issues together, it seems to me that the real purpose of an insurance business is to find people who genuinely face adverse consequences from specific events, the occurrence of which are uncertain, and then to diffuse that risk across as many different sources of capital as possible, as efficiently as possible. 

Some would say that this amounts to concentrating the risk of loss, since those who don't genuinely need insurance would be excluded (but allowed to buy it if they genuinely do just want it for 'peace of mind').  But that only means we should cease pooling risk and find another way to spread it, such as the peer-to-peer marketplace model that is at work in many other industries.

Peer-to-peer insurance would involve the operator of an electronic platform enabling direct insurance contracts between each insured and many investors (whether traditional insurers or not), each of whom would receive a small portion of the overall premium yet only have to pay out small sums in the event of loss. In this way, the risk of loss could be diffused amongst many investors who would only provide insurance as part of a widely diversified portfolio.  In common with the impact of the P2P model in other industries, removing all the middlemen would cut the margin between net and gross premium to a transparent fee for running the platform, leaving the lion's share of the difference with the market participants.

There are some interesting examples that are headed in this direction. Friendsurance, for example, goes part of the way by enabling a crowd of people to fund the excess on each of their insurance policies. I'm also aware of jFloat (yet to launch), which some have suggested is an application of the P2P model. But I understand that it will still involve pooling risk on a kind of mutual basis, whereas I'm talking more about a 'pure' P2P model.

Presumably, this is not what today's insurers, brokers, reinsurers, reinsurance brokers and other established industry participants want to hear. But they too could benefit in the longer term (if they can afford to think that far ahead) by setting up their own platforms or contributing their own capital and expertise.

It's okay, everyone, I'm not holding my breath...