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Report

Prepared For:

British Insurance Brokers' Association

8th Floor, John Stow House

18 Bevis Marks

London, EC3A 7JB

Future regulation for insurance brokers

Prepared by:

Kyla Malcolm and Charles Xie

Charles River Associates

99 Bishopsgate

London EC2M 3XD

Date: March 2011


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TABLE OF CONTENTS

EXECUTIVE SUMMARY ....................................................................................................... 1

1. ............................................................................................................. 4 INTRODUCTION

1.1. .................................................................................................... 4 MOTIVATION FOR REPORT

1.2. ................................................................................................................... 5 METHODOLOGY

1.3. ................................................................................................ 6 STRUCTURE OF THE REPORT

2. ............................................................ 7 POTENTIAL RISKS IN INSURANCE BROKING

2.1. ................................................................................................. 7 ASYMMETRIC INFORMATION

2.2. ............................................................................ 11 NEGATIVE EXTERNALITIES - REPUTATION

2.3. ........................................................................ 12 NEGATIVE EXTERNALITIES - SYSTEMIC RISK

2.4. ........................................................................................ 15 SUMMARY OF MARKET FAILURES

3. ............................................................................................... 16 LOW QUALITY ADVICE

3.1. ........................................................................................................ 16 CURRENT APPROACH

3.2. .................................................................................................... 17 INFORMATION PROVIDED

3.3. ...................................................................................................... 17 PRODUCT REGULATION

3.4. ........................................................................................................ 18 FUTURE REGULATION

4. ........................................................................................................... 20 CLIENT MONEY


4.2. .......................................................................................... 25 COMPLEXITY AND COMPLIANCE


5. ........................................................................................... 32 ADEQUATE RESOURCES


5.2. ..................................................................................................... 34 POTENTIAL CONTAGION

5.3. ......................................................................................................... 37 EFFECTS OF FAILURE


6. ................................................................................................ 42 POST SALE REDRESS

6.1. ............................................................................... 42 PROFESSIONAL INDEMNITY INSURANCE

6.2. ...............................................................................................................................46 FSCS

7. .............................................................................................. 52 COST OF REGULATION


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7.1. ......................................................................................... 52 REGULATORY COSTS IN THE UK

7.2. .............................................................. 55 COMPARING REGULATORY COSTS WITHIN EUROPE

7.3. ..................................................................................... 58 SUMMARY OF REGULATORY COSTS


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LIST OF FIGURES

Figure 1: Regulatory costs of large firms across European countries.................................3

Figure 2: Number of general insurance intermediaries .....................................................21

Figure 3: Percentage of firms by proportion of business covered under RTAs ................22

Figure 4: Regulatory costs in the UK.................................................................................54

Figure 5: Regulatory costs across European countries ....................................................56


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EXECUTIVE SUMMARY

Charles River Associates (CRA) was commissioned by the British Insurance Brokers’ Association (BIBA) to conduct research into what appropriate and proportionate regulation might look like under the UK’s new Financial Conduct Authority (FCA). In particular, CRA has been asked to assess whether the regulatory costs faced by general insurance intermediaries in the UK are proportionate to the risks imposed by the sector and to set out an overview of the desirable direction of future regulation.

Following the financial crisis, the Financial Services Authority (FSA) has changed its style of regulation and supervision to take a more intrusive approach. Not only has this been applied to firms directly involved in the credit crisis, but this increased intrusion has also applied to general insurance brokers resulting in significant increases in costs.

It is necessary to ensure that general insurance broking is well regulated but regulatory actions and the costs they impose need to be proportionate to the risks that they address. The industry has voiced substantial concerns that the burden of regulation is disproportionate to the risks within the sector and out of line with regulatory costs in other European countries, with recent changes to the regime exacerbating this concern.

Potential risks in insurance broking

When considering the risks posed by general insurance brokers it is crucial to understand the difference between brokers and other parts of the financial services sector. Unlike banks, it is not the essence of a broker to take on credit risk or liquidity risk and interconnections between brokers are such that systemic risk does not arise. Brokers are also distinct from insurance companies since they do not hold insurance risk.

Instead of concerns relating to the level of capital that should be required, the more pertinent areas of risk within broking are that of providing low quality advice (because clients can not always assess the advice given by their broker) and the loss of client money (where the potential detriment could be substantial).

Low quality advice

Regulatory requirements aimed at limiting low quality advice are already in place through the Insurance Mediation Directive (IMD). With the exception of advice related to payment protection insurance (PPI), there have been few problems associated with poor advice as demonstrated by low claims against professional indemnity insurance (PII).

Nonetheless, PPI related claims have been high indicating that mis-selling has occurred despite current regulatory requirements. The FSA has proposed that additional product regulation could combat this, placing greater responsibility on the manufacturer of the product to ensure that the product is appropriately designed and sold.

In addition, changing the focus of the supervision of the new FCA towards conducting file reviews rather than assessing whether organisational processes are in place should be considered. Such reviews are not required where firms advise large commercial clients who are able to impose their own discipline on brokers, but rather should focus where


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firms advise individual customers, particularly in respect of products that the FSA has identified as high-risk. This is not to suggest that greater resources will be required by the FCA but rather that resources should be deployed in a different way.

Client money protection

Insurance brokers are entrusted with money which covers the premium for the client’s insurance as well as paying for the broker’s services and it is right that client money should be treated with care. Overall, only around 27% of general insurance intermediaries are regulated to hold client money and we find that around 66% of business is conducted under risk transfer arrangements (RTAs) in which money paid to intermediaries is treated as if it has been paid to insurers thereby transferring client money risks onto the insurer. RTAs are less likely to apply where business is conducted through chains of brokers.

Many large and medium firms have expressed concern regarding the complexity of client money rules which makes them impractical to implement and generates considerable cost. Further, the complexity of the rules creates risk as mistakes can be made by individuals administering them. Similarly, insurers apply differing standards to RTAs adding yet further complexity to the approach that brokers must follow.

There is therefore merit in the FCA moving to a more simplified approach to client money along with insurers and brokers developing industry-wide standards to be followed, thereby reducing the complexity of arrangements and simultaneously reducing risk.

Adequate resources

As already noted, brokers do not take on credit, liquidity or insurance risk and therefore holding resources to protect against contagion is disproportionate. Bankruptcy is rare and no interviewee was able to name a large broker that had gone bankrupt. Where brokers have failed, there is no evidence of detriment spreading to other firms.

Even rapid collapse would not cause difficulties since clients can be quickly transferred to other firms. Not even large brokers have unique binding authorities for which there are no alternatives available and insurers have every incentive to move such arrangements to competitors as quickly as possible in the event of broker failure.

Despite this, large brokers have been required by the FSA to hold substantial amounts of capital in excess of that specified in prudential rules. Interviewees state that this was done with little notice and opaque methodologies used without public consultation.

Instead it would be preferable for the FCA to consult on whether changes to current capital requirements are needed (the evidence for which seems lacking) and to subject this to the standard consultation process and cost benefit analysis.

Post-sale redress

The Financial Services Compensation Scheme (FSCS) is a scheme of last resort, helping to protect consumers by providing redress should other sources of compensation such as direct from the firm or through PII fail to do so. The costs of the FSCS for general insurance brokers have increased dramatically in the last few years due to the large number of PPI claims.


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Many BIBA members are concerned that they are paying costs of claims generated by firms with whom they share few characteristics save that they are all considered within the one general insurance intermediary sub-class of the FSCS. The current approach also means that firms pay the same levies irrespective of the quality of their business.

It should be considered whether to split the general insurance intermediary sub-group by different characteristics of firms such as whether general insurance broking is their main business activity. Alternatively, or alongside changing the sub-groups, introducing a more risk reflective levy (on an “ex ante” approach) would help to differentiate between firms that impose different risks, encourage better risk management and align more closely with the principle that the polluter should pay. This could be done by basing the levy on risk indicators such as income from different product types, the presence of appointed representatives, the use of binding authorities and any regulatory indicators of risk.

Cost of regulation

Finally, we have gathered information on the cost of regulation in the UK and within Europe both in terms of the direct costs (fees and levies charged) and indirect costs incurred (such as through time spent dealing with FSA requirements or reports by independent experts to show compliance).

We find that regulatory costs are particularly high for small firms (revenues less than £1 million) and large firms (revenues above £150 million). In addition, as shown in Figure 1 below, costs in the UK are substantially above those in other European countries.

Figure 1: Regulatory costs of large firms across European countries

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Source: CRA calculation based on BIBA and LIIBA survey data.

Given the lack of apparent detriment arising in the broking sector in other European countries Figure 1 lends support to the view that the costs of regulation in the UK are disproportionate to the risks imposed by the sector.


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1. INTRODUCTION

Charles River Associates (CRA) was commissioned by the British Insurance Brokers’ Association (BIBA) to conduct research into what appropriate and proportionate regulation might look like under the UK’s new Financial Conduct Authority (FCA). In particular, CRA has been asked to assess whether the regulatory costs faced by general insurance intermediaries in the UK are proportionate to the risks imposed by the sector

and to set out an overview of the desirable direction of future regulation.1

Following the financial crisis, the Financial Services Authority (FSA) has changed its style of regulation and supervision to take a more intrusive approach. Not only has this been applied to firms directly involved in the credit crisis, but this increased intrusion has also applied to general insurance brokers resulting in significant increases in costs.

It is necessary to ensure that general insurance broking is well regulated but regulatory actions and the costs they impose need to be proportionate to the risks that they address. The industry has voiced substantial concerns that the burden of regulation is disproportionate to the risks within the sector and out of line with regulatory costs in other European countries with recent changes to the regime exacerbating this concern.

1.1. Motivation for report

Following the financial crisis, the Financial Services Authority (FSA) has changed its style

of regulation and supervision to take a more intrusive approach.2 Not only has this been applied to firms directly involved in the credit crisis, but this increased intrusion has also applied to general insurance brokers resulting in significant increases in costs.

It is necessary to ensure that general insurance broking is well regulated but regulatory actions and the costs they impose need to be proportionate to the risks that they address. The industry has voiced substantial concerns that the burden of regulation is disproportionate to the risks within the sector and out of line with regulatory costs in other European countries with recent changes to the regime exacerbating this concern.

These frustrations have been intensified by the sharp increase in the Financial Services Compensation Scheme (FSCS) levy which has resulted from the large number of claims related to payment protection insurance (PPI). BIBA members are concerned that they have to share in the very substantial costs of these claims despite many of them never selling these products and believing that they are operating in a high quality manner or remedying any problems themselves.

1 In this report we focus on intermediaries active in the general insurance market. We use the terms brokers and

intermediaries interchangeably to refer to these firms and individuals. Other types of intermediaries that are

specified will be explicitly referred to with further descriptive information.

2 FSA, The Turner Review: A regulatory response to the global banking crisis, March 2009.


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1.2. Methodology

In approaching this research we have sought to set out the risks associated with general insurance brokers and to consider whether the regulations in place to address the risks are broadly proportionate. This approach is therefore considered to be in line with the

Government’s principles of good regulation.3 Using these principles helps to identify where intervention is required, the type of intervention that is needed and ensures that regulation is appropriate to the problems that need to be addressed.

It should be noted that this research does not attempt to apply the FSA’s detailed approach to cost-benefit analysis (CBA) to each of the areas of future regulation suggested. That is, we do not examine the impact of any proposed changes on quantity; quality; variety of services; efficiency of competition; the FSA’s direct costs; and the compliance costs for firms. Instead we provide an overview of areas where the current approach appears out of line with the risks of the sector. In many cases these issues relate more to the nature of the supervisory approach (where a CBA would not typically be conducted) than to the underlying rules (where a CBA would be required).

Further, when considering the future approach to regulation it is also important to recognise that the Insurance Mediation Directive (IMD) is in place and therefore that there are certain constraints which apply in the UK irrespective of the decisions by the FCA in

the future.4 However, there are a number of areas where regulation and supervision goes beyond the requirements of the IMD.

During the course of the project we have undertaken a variety of different tasks including:

Desk research: background research has been conducted to understand current regulation and make sure that existing evidence is considered;

Interviews: we conducted 26 interviews in total with firms of different sizes, trade associations, and other stakeholders including the regulator. Qualitative as well as quantitative evidence has been collected from interviews. Details of the interviews are set out in Table 1 below;

Surveys: three surveys were carried out to enable quantitative analysis of regulatory costs faced by firms of different sizes in the UK and within Europe; and

Case studies: we conducted case studies to assess whether detriment to consumers arose in the cases where brokers failed.

3 These are that regulation should be: proportionate; accountable; consistent; transparent: and targeted. These

were published by the Better Regulation Task Force in 2003.

4 Directive 2002/92/EC of the European Parliament and of the Council of 9 December 2002 on insurance

mediation.


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Table 1: Number of interviews

Interviewee Number of interviews

Brokers and representatives 20

Brokers specialising in professional indemnity insurance 3

Insurer representative (Association of British Insurers) 1

Regulatory bodies (FSA and FSCS) 2

Source: CRA

In addition to the interviews the ABI gathered views from a range of its members in response to our information requests. Finally, the research has also been assisted by the London and International Insurance Brokers’ Association (LIIBA).

1.3. Structure of the report

In the rest of the report we examine:

Potential risks in insurance broking in Chapter 2;

Quality of advice in Chapter 3:

Client money in Chapter 4;

Adequate resources in Chapter 5;

Post-sale redress including Professional Indemnity Insurance and the FSCS in Chapter 6; and

Cost of regulation in the UK and within Europe in Chapter 7.


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2. POTENTIAL RISKS IN INSURANCE BROKING

It is important to start the examination of how the general insurance intermediary sector should be regulated by considering the nature of any problems that could arise in the absence of regulation. These are commonly referred to as market failures.

Setting out the extent to which market failures arise in the general insurance intermediary sector is important in framing the discussion surrounding the type and extent of regulation that is appropriate for the sector. If potential market failures are serious and have the capacity to bring considerable detriment, then regulation needs to be robust in these areas. By contrast, if market failures are unlikely and low impact, a less interventionist approach is appropriate.

2.1. Asymmetric information

One of the most common forms of market failures identified across multiple financial services markets is that of asymmetric information. Not all insurance customers have full information about their own insurance needs, the products which are available to them to

fill these needs and the providers which would offer appropriate insurance.5 For this reason, customers often rely on intermediaries to advise them about the appropriate choices, but then customers suffer from asymmetric information with respect to the intermediary who has more information than the customer. Indeed, the greater information which the intermediary has is one of the key characteristics which leads customers to use intermediaries. It is these issues of asymmetric information with respect to the intermediary (rather than with respect to the insurance) which are the more pertinent when considering the potential market failures in the intermediary market.

2.1.1. Asymmetric information regarding the quality of the advice process

There are certain aspects of the sales process which may cause conflicts of interest between the customer and their intermediary which, due to asymmetric information, may not be fully understood by customers.

Basis of advice

Concerns about these incentive problems underlie some of the existing regulation of the sales process through both the IMD and the Insurance Conduct of Business Sourcebook (ICOBS). The IMD requires that intermediaries disclose the basis of their advice (such as whether they search the whole market or only recommend the products of one or a small number of providers) in order to help customers to understand the services that they can expect from intermediaries.

Interviews have not identified any concern relating to a lack of information about the basis on which the advice is given and we do not consider this issue further.

5 It is also the case that insurance companies suffer asymmetric information with respect to their customers, but

we do not consider this issue.


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Remuneration

There have been extensive discussions on incentive problems caused by asymmetric information in respect of remuneration structures including; the potential for bias to sell, product bias and provider bias; as well as a concern that these may be exacerbated by particular types of remuneration such as contingent commissions.

Previous work has been conducted by CRA for the FSA on the impact of commission arrangements in commercial general insurance markets in December 2007. The research concluded that there was limited market failure in respect of remuneration arrangements and that mandatory commission disclosure did not pass a cost benefit analysis test. CRA has also undertaken recent work for the ABI on the impact of commission disclosure in general insurance personal lines. This research found that there was no evidence of

market failure associated with a lack of disclosure about the costs of intermediation.6

In the UK, both retail and commercial clients have the right to ask intermediaries to disclose information on commission arrangements. In addition, following our research for the FSA, BIBA led the development of industry guidance aimed at reminding commercial clients that they have the right to ask intermediaries to disclose information on

commission arrangements.7

Since our work for the FSA was conducted three years ago, during the course of interviews we have explored with interviewees whether there have been any significant changes to commission arrangements and their disclosure for commercial clients which would have the effect of worsening the situation compared to 2007. There was no evidence of this and therefore we do not consider issues to do with the transparency of remuneration further in this report since the conclusions of our previous work are still valid.

Quality of advice

The final element of the advice process where clients suffer from asymmetric information is in respect of the advice itself. Clients seek the services of intermediaries because they do not all know their own insurance needs, the products which are available to them and the providers which would offer appropriate insurance. Instead they are frequently dependent on the advice from their broker regarding these issues and may be unable to assess the advice when it is given.

There is therefore a risk that clients suffer from mis-selling of a particular product or that errors or omissions by the adviser mean that the product does not cover the needs of the client. Compared to advice related to long-term savings products, we would expect fewer problems to arise in connection with general insurance which represents a repeat purchase enabling clients to assess the performance of their broker over time

6 CRA, Commercial insurance commission disclosure: Market Failure Analysis and high level Cost Benefit

Analysis, December 2007; and CRA, Impact of Commission Disclosure in general insurance personal lines, ABI

Research Paper No 25, December 2010.

7 BIBA, Transparency, disclosure and conflicts of interest in the commercial insurance market.


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In order to assess the extent to which these potential market failures actually arise in practice we have considered information related to claims made against PII and through the FSCS. With respect to the FSCS, few claims are made in relation to general insurance intermediaries (excluding PPI) with claims of around £0.1 million per year typical – further details are found in section 6.2, but there are few claims made against general insurance intermediaries (taking into account the recent number of PPI claims). Where claims are made we understand that the overwhelming majority of claims relate to mis-selling issues rather than to any other topic. This indicates that the quality of advice is an important potential market failure from a regulatory perspective (although one for which the requirement to hold PII is aimed, at least in part, to address).

In respect of PII, discussions with those brokers who focus on arranging PII cover for insurance brokers have also revealed that there are few issues of concern in relation to claims against insurance brokers. Again these appear to be focused on “low level” errors and omissions which are relatively rare (compared to other professions). It is precisely these sorts of claims which PII policies are well placed to deal with. We consider additional issues related to PII along with the FSCS in Chapter 6 since evidence related to PII claims provides a useful source of information in respect to approaches to be considered for the FSCS.

Differences between customers and products

As with many markets, the extent to which clients are likely to suffer from asymmetric information will vary. Our previous work for the FSA identified that in general, large sophisticated commercial clients will often have dedicated staff responsible for insurance issues, many of whom may have worked in the insurance sector, and who conduct regular reviews of the appointment of their insurance brokers. The very largest clients may also use alternatives to insurance such as self-insurance, captive insurance companies and alternative risk transfer products. These various characteristics lead large commercial clients to be less likely to suffer from asymmetric information.

Smaller commercial clients and retail clients face greater asymmetry of information but because of their more standardised requirements often have the ability to purchase insurance on a non-advised basis through remote channels such as the internet and over the telephone.

It is also interesting to note that we are not aware of widespread situations of mis-selling for any customers other than retail clients. Further, examples of mis-selling of financial products have more commonly been associated with life insurance products such as pensions and endowments. PPI, which is classified as a general insurance product, shares some of the characteristics of these policies and many interviewees therefore saw this as a different type of product compared to most general insurance products. We consider issues to do with PPI in Chapter 3.

2.1.2. Asymmetric information regarding the quality of the broker business

Another aspect of asymmetric information, which has typically been less discussed when considering the regulation of intermediaries, is that clients may not know as much information about their broker’s business as the broking firm itself. Areas where clients suffer from asymmetric information include their understanding of:


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The likelihood of failure;

The quality of record keeping on issues such as client money; and

Where client money falls in the hierarchy of creditors in the event of failure.

Likelihood of failure

Clients may suffer from asymmetric information because they do not know whether their broker is likely to go bankrupt. We therefore consider the frequency with which insurance intermediaries go bankrupt (potential consequences of bankruptcy are examined below). Information is not easily available on the number of bankruptcies that have arisen and we understand that the FSA does not collect information on the number of bankruptcies. The available evidence is as follows:

No interviewee was able to name a medium or large general insurance broker that

had gone bankrupt;8 and

Evidence from BIBA finds that of around 1,700 members, over the last 3 years, on average only 14 members per year have left BIBA membership because of ceasing

trading (not all of whom would have gone bankrupt). It is worth noting that these figures relate only to 2008-2010 which coincides with the credit crisis and subsequent recession and therefore these figures would be expected to be higher than would be

typical in more benign economic circumstances.9

It is clear from this that there are only a very small number of bankruptcies that arise within the broking community. This is consistent with information from interviews where interviewees regularly struggled to identify any insurance broking firms that they had gone bankrupt over the last five years other than those associated to selling PPI. Beyond the cases referred to the FSCS, there is no evidence of any detriment to clients arising from the small number of insurance brokers that have failed (and cases referred to the FSCS where detriment does arise would have this remedied through the scheme).

Indeed, many interviewees indicated that the competitive market led firms to more commonly be purchased by other businesses if they were in decline or simply for small brokers to close down their firm over a period of time if they did not or could not sell the firm. The growth in the role of the “consolidators” is consistent with a market-based solution in which firms in decline are taken over, with no evidence that we are aware of that this has resulted in any market failures.

8 One firm, Whiteleys was mentioned by some interviewees as an example of a firm that had failed. However, we

understand that Whiteleys was acting as an insurance provider rather than an insurance broker. Indeed, it was

allocated to the insurance provider group for the purpose of the FSCS and therefore does not represent an

example of broker bankruptcy for our purposes.

9 Only 3 firms left BIBA membership because of ceasing trading in 2007. Reliable data is not available from

before 2007. Source: Data provided by BIBA to CRA.


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We consider the potential causes of bankruptcy and other issues to do with this further in Chapter 5 below where we examine whether there are any potential risks of contagion in the insurance broking sector.

Client money

In the current market, it is common for clients to pay intermediaries the money which not only covers the broker’s remuneration but also covers the premium for the underlying insurance product. There is therefore a risk that intermediaries do not treat premiums appropriately. For example, brokers could commit fraud by not passing on the money for the underlying product. Alternatively, they could place the customer at risk if the intermediary firm fails and the money is treated as part of the firm’s general assets and is therefore available to any creditors.

A misuse of client money could put the entire sum of money for premiums at risk which could lead to substantial detriment to clients. All interviewees agreed that the handling of client money was one of the most significant risks in the broking sector.

There are alternative approaches that can be used under the current regulatory framework to ensure the safety of client money. Risk transfer arrangements (RTAs) can be used through which insurance companies effectively take on the risk of any mis-use of client money. Evidence collected for the purpose of this research has found that a considerable proportion of money is already handled on a risk transfer basis.

Although the handling of client money is seen as a significant risk in broking, it nonetheless needs to be assessed in the context of the relatively few numbers of bankruptcies identified above since it is in the case of bankruptcy that the identification of client money is most needed.

We also understand from discussions with representatives of insurers that, in practice, a relatively small value of premiums is affected by problems related to client money and that insurers would typically include any risks associated to this within their bad debt estimates. In turn this is understood to mainly relate to bad debt from clients rather than from brokers.

We consider issues to do with client money in more detail in Chapter 4.

2.2. Negative externalities - reputation

A further potential market failure which could arise is that of negative externalities where the actions of one firm has negative consequences for other firms. We consider the issue of reputation in this section, and examine the potential for contagion, which is another example of a negative externality, in section 2.3 below.

Customers of intermediaries are seeking expertise from their adviser but it is possible that low quality actions by one broker, or a subset of brokers, could damage the reputation of the whole sector. At the extreme this could cause some customers to withdraw from seeking services from the intermediary market (and potentially not purchasing insurance either). The main issue to do with reputational risk that was identified from interviews was that of low quality advice which was considered in section 2.1.1 above.


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The potential for reputational risk to the whole sector is one of the reasons why compensation arrangements are commonly sector wide with all members of the sector required to make some form of contribution to them. In addition, insurance is not available for an individual’s own fraud hence any fraud committed by brokers who work on their own would never be covered through PII which also necessitates a compensation scheme to be in place for consumer protection reasons. We consider issues to do with the FSCS in section 6.2.

Alternative approaches to the potential risks to the reputation of the industry involve the development of brands or firms taking action to identify themselves as high quality firms such as through holding some form of qualification. Indeed the development of chartered status could work in this way through representing a screening characteristic that clients use to select their broker. (This would be in addition to any benefits to the firm from improving their processes in line with the requirements of chartered status such as increased retention rates or fewer disputes with clients.)

2.3. Negative externalities - systemic risk

One type of negative externality that can arise in some financial services markets is that of contagion or systemic risk where the failure, or near failure, of one financial institution threatens the stability of other institutions and potentially of the system as a whole.

This was clearly seen during the credit crisis of 2007-2008 where concerns about the credit worthiness of some banks caused withdrawals of customer money and restrictions in credit to other banks thereby impacting the whole banking market.

In order to prevent contagion arising in banking markets, various regulatory interventions are currently in use or are proposed including the regulation of capital and liquidity, resolution regimes and living wills.

However, it is important to consider whether or not a similar sort of effect would apply in the insurance broking market since the conditions through which contagion arises may not be present for intermediaries. In particular, an assessment is needed as to what happens next when a firm fails or is seen to be in danger of failing and whether this has detrimental impacts on the overall market such that other market participants are damaged or substantial market disruption could arise. This is considered in section 5.2

The main issue to consider with respect to contagion is the potential risk of bankruptcy itself – since it is the fear that one firm going bankrupt will cause others to go bankrupt that causes difficulties to arise. As noted in section 2.1.2, there is limited evidence on the failure of brokers but the evidence that is available shows very low failure rates.

Here it is important to understand the role of general insurance intermediaries and how they differ from both banks and insurance companies. In particular:

One of the essential roles of a bank is to provide lending to its customers and

therefore banks face credit risk as such lending made may not be repaid;


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A second essential role of the bank is the transformation of the term of lending such that short-term borrowing by the bank (from deposit holders or wholesale markets) is

used to fund longer-term borrowing by the bank’s customers (such as for medium-term loans or mortgages); and

An essential role of insurance companies is that they take on insurance risk and have

to pay out money in the event of claims. (It is unclear that insurance risk could be described as systemic risk.)

It is important to recognise that none of these risks are an essential feature of insurance broking where instead the essential role of the broker is to advise clients on their

insurance needs.10

Credit risk

Lending money to clients is not the essential role of insurance brokers. Brokers may face some short term credit risk if some clients do not pay for services that the broker has provided, but it is not the essence of a broker to extend credit for other purposes in a way that a bank would offer a loan to a customer.

Furthermore, in respect of allowing customers time to pay for the services provided, insurance brokers are no different to any other professional service company such as accountants, lawyers or surveyors or the wide range of businesses which allow their customers to pay for services after the “point of sale”.

Some brokers may also offer their customers “premium credit” facilities which act as a short term loan facility. We understand that in the great majority of cases the premium credit will be offered by a separate company with brokers simply enabling access to this for their customers (for which the broker would typically receive some form of commission payment). In these circumstances the credit risk would be faced by the external provider of the facility. Based on our interviews it is rare for brokers to offer premium credit facilities themselves rather than for these to be outsourced.

Unless brokers are running large scale premium credit facilities through their own balance sheet they therefore would not be expected to run credit risks which are different to those run by a wide range of businesses. Where premium credit is offered internally, we would expect that regulatory oversight would be required of such a facility to ensure that the credit risk was taken into account given the pattern of repayments which are typical for lending to the customers of insurance brokers.

Liquidity risk

In respect of liquidity risk, the Chairman of the FSA has recognised that even insurers do not typically take on maturity transformation risks which are those that give rise to

10 Given the essence of insurance broking, this also suggests that the most significant risk is likely to relate to

giving poor quality advice to clients rather than any other issue.


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potential liquidity issues.11 Instead problems within insurers tend to build up over-time with resolution through gradual wind-downs.

Similarly, maturity transformation is not part of an insurance broker’s business. It is possible that firms face the risk that their cashflow is not sufficiently well managed (and so face some degree of liquidity risk). However, all businesses need to manage their cashflow and well-run firms would take into account the potential for unexpected events to have a negative impact on their cashflow position. In addition, as with insurers, it is likely that difficulties would arise over time and also that resolution would occur over time rather than risks suddenly arising. Again it is therefore important to distinguish insurance brokers from other financial services providers whose business involves maturity transformation.

Insurance risk

In respect of insurance risk, this risk is borne by insurance companies whose products are distributed by insurance brokers and not by the brokers themselves.

It is the case that some brokers will receive profit commission related to the performance of a binding or underwriting authority where they act as agent of the insurer. In such cases, brokers may receive contingent commission which align the interests of the insurer and broker. Indeed on average, brokers state that they receive profit commission on

around 12% of their business.12 However, profit commission typically represents a much smaller proportion of premiums (1-2%) than does standard commission. Furthermore, no interviewee was aware of a situation where insurers would be able to recoup any commission from brokers in the event of poor performance of a book of business i.e. profit commission is not negative. Hence even brokers in receipt of profit commission would not face any downside insurance risk.

Similarly, where firms have binding authorities (around 38% of brokers and around 18% of business), and can therefore “bind” the insurer, it is nonetheless the insurer who holds the risk. Hence even in this situation the broker does not hold any insurance risk.

Summary of risks in broking

With respect to contagion, distinguishing the risks that insurance brokers face from those which are faced by other types of firms operating in the financial services sector is important in assessing the relative degree of regulation that is proportionate to the risks that the different sectors pose.

In particular, given that insurance brokers do not face credit risk or liquidity risk to any degree that is different to other professional services companies, and neither do they face insurance risk it would not seem proportionate to require these firms to hold capital or resources because of concerns about systemic risk.

We consider these issues further in section 5.2.

11 FSA, Address to the IAIS Annual Conference, Speech by Adair Turner, Chairman FSA, 27 October 2010.

12 CRA calculation based on “Broking Now – BIBA regulation questions January 2011”.


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2.4. Summary of market failures

In the light of the research conducted, the two potentially significant market failures in the insurance broking market are:

The potential for low quality advice resulting in the mis-selling of products either due to deliberate acts or due to errors and omissions - we consider this further in Chapter

3; and

The potential for loss of client money due to fraud or negligence in record keeping – we consider this further in Chapter 4.

In both of these cases we consider the existing regulatory requirements which are in place and where changes could be made in order to both limit the extent to which detriment can occur as well as ensuring that such regulation is proportionate to the risks imposed.

The potential for systemic risk and contagion to arise through the broking sector seems limited and it is important to distinguish brokers from banking. Unlike the latter, it is not the essence of a broker to take on credit risk or liquidity risk and unlike insurers they do not hold insurance risk. We consider the issue of the appropriate level of adequate resources for brokers to hold in Chapter 5.

Finally, in respect of the potential for negative externalities to damage the reputation of the insurance broking sector we note that this is one of the reasons which means that compensation schemes should apply across the sector, with the inability to insure own

fraud a further reason that leads compensation schemes to be required.13 We consider the FSCS along with PII in Chapter 6.

13 This is not necessarily to imply that all firms currently regulated as general insurance intermediaries would share

the reputational impact to the same degree or should all be in the same pool of the compensation scheme – this

is considered further in section 6.2


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3. LOW QUALITY ADVICE

As discussed in the preceding chapter, low quality advice is one of the main risks within the broking sector due to the asymmetry of information between the broker and their client. In this section we consider the regulatory requirements that are in place both through the IMD and the FSA’s own additional regulation and supervision.

3.1. Current approach

There are a number of requirements within the IMD which are aimed at reducing the extent to which mis-selling arising. For example, the IMD requires that firms:

Specify whether they have a holding of more than 10% of an insurer or vice versa

(Article 12 (1c and 1d));

Explain the basis of their advice as to whether it has been given on a fair analysis, whether the firm is under obligation to conduct business with one or more insurers, or

whether the firm does not have a contractual obligation to conduct business with one or more insurers but does not provide advice on a fair analysis (Article 12 (1e));

Provide a “demands and needs” statement including the underlying reasons for any

advice given (Article 12 (2)); and

Provide information in a durable medium (Article 13).

The IMD requirements have been transposed in a fairly direct manner by the FSA into ICOBS such that the FSA rules mirror the IMD requirements. In addition to transposing the IMD, the FSA provides guidance indicating that the format of the statement of demands and needs is flexible and provides examples of approaches that may be

appropriate where a personal recommendation has not been given.14

3.1.1. Supervisory approach

As well as the provision of information related to the advice given, however, there is also a significant question as to whether the advice provided is in fact deemed to be good advice. The demand and needs statement should help the client to assess whether this is the case, although the asymmetric information that they suffer from does limit the extent to which they can do this in practice.

Interviews with brokers of a variety of sizes have suggested that the FSA tends to focus its supervisory attention on whether systems are in place to ensure that information is delivered to clients, but does not focus as much time on whether the firms have delivered good advice. It would seem as though the only feasible way for the FSA to do this would be through file reviews of advice given by the firm and most interviewees indicated that such an approach was not typically pursued by the FSA.

14 ICOBS 5.2.4 (G)


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3.2. Information provided

During the course of the research, a number of interviewees expressed their concerns that there is considerable waste associated with providing a large amount of paperwork to clients. Many firms believe that clients do not read this information and therefore that this simply involves incurring costs while not bringing any benefits.

Further, some interviewees suggested that clients (especially individual consumers) might feel overwhelmed by the amount of information received and therefore would not read any of the documents, even those parts of the information that the broker would consider to be key to the terms of the policy.

It should be noted that in general the concern regarding the level of information provided to clients was raised by small brokers rather than by medium or large brokers.

Although there are concerns regarding the level of information provided to clients, brokers did not suggest that the information requirements had increased in recent years in the light of the financial crisis.

Furthermore, the information requirements that these brokers were most concerned about flowed directly from the IMD rather than representing issues on which the FSA had applied additional rules or, therefore, areas in which the FCA would be at liberty to reduce the burden of compliance in the absence of changes at European level. We also note that recent discussions regarding the development of the successor to the IMD (“IMD2”) appear more likely to require additional information to be provided rather than less. It is unclear whether this will be done on the basis of evidence related to the impact of the information already provided.

3.3. Product regulation

Despite the fact that regulation and information requirements are in place, it is clear that mis-selling has nonetheless continued to arise. Evidence presented in Chapter 6 shows that there have been a large number of claims against the FSCS related to the PPI and we also understand from the FSCS that non-PPI related claims are mainly to do with mis-selling issues as well.

There is therefore a concern that the current regulatory and supervisory approach is not picking up mis-selling issues early enough in the process and the evidence of continued mis-selling raises the question of whether it is necessary to impose further rules. As shown in section 6.2 it is important to recognise that the number of non-PPI related claims against the FSCS is actually very small and has remained at a very low level suggesting that issues may well be highly specific to PPI. That is, there is not evidence of widespread mis-selling across the whole range of general insurance products suggesting that any potential changes in regulation may need to be targeted rather than to apply everywhere.

In this regard it is interesting to note that the FSA has recently published a discussion paper on the potential use of additional product regulation stating that,

“[the FSA] will now intervene earlier in the product value chain, proactively, to anticipate consumer detriment where possible and stop it before it occurs. We are


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looking in more detail at how firms design products and their ongoing governance procedures to ensure that products function as intended and reach the right

customers.”15

Under the new approach, the FSA states that it could conduct examination of a range of products which might be most in danger of underperforming or increasing the risks of detriment to consumers. Amongst other factors, they state that this could include bundled products or those with opaque structures; products designed to be sold as secondary or tertiary products; products with complex charging or return structures; a target market of

consumers facing financial hardship; and product features outside the core range.16

In addition to the existing regulatory framework and potentially more prescriptive rules, the FSA is also seeking discussion on a range of product intervention options that could be followed including banning or mandating certain product features; and additional

competence requirements for advisers.17

One potential advantage of this approach is that it places greater responsibility on the manufacturer of the product to ensure that the product is appropriately designed and that the manufacturer may need to take steps to prevent the extent to which distributors of products would be expected to mis-sell them. Given the product-specific nature of cases of mis-selling that have arisen in the past it is appropriate to consider whether this sort of product regulation would be beneficial although, as with all regulation, it will be important to consider whether any interventions are proportionate to the problems they address. In addition, subject to the cost of intervention, this could prevent problems from arising in the first place rather than costs of mis-selling being paid across the industry through the FSCS.

3.4. Future regulation

In addition to the greater product regulation that is already under consideration and which could limit the extent to which problems arise in the first place, the other area of potential change which could be considered is a change in the focus of the supervisory process.

As highlighted above regulatory requirements related to preventing mis-selling are already in place, yet mis-selling has occurred in breach of these rules. This suggests that it would be appropriate for the regulatory focus to be placed on greater assessment of whether rules are being enforced (rather than requiring additional rules to be applied). Interviewees have stated that the FSA does not currently spend much of its supervisory time conducting file reviews and a refocusing towards such an approach would seem appropriate. Such reviews are not required where firms advise large commercial clients who are able to impose their own discipline on brokers, but rather should focus where

15 FSA, Discussion Paper: Product Intervention, DP11/1, January 2011, p9.

16 Speech by Sheila Nicoll, Director of Conduct Policy, the FSA, “Product intervention and European Union

engagement: two key strands of our consumer protection strategy”, 25 January 2011.

17 FSA, Discussion Paper: Product Intervention, DP11/1, January 2011, p48.


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firms advise individual customers, particularly in respect of products which the FSA has already identified as high-risk.

Although this would be an appropriate course of action, it is important to set this additional enforcement in the context of a sector which generally poses relatively low risks and therefore this greater enforcement does not imply greater resources being required for enforcement but rather would involve a different focus with respect to existing resources.

Were such an approach to be taken in the future, it would be important to ensure that FCA staff reviewing cases are those who had a good understanding and experience of general insurance intermediation such that they would be in a position to make judgements on whether or not the advice appeared appropriate.


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4. CLIENT MONEY

As noted in section 2.1.2, the need for client money requirements is based on potential market failures related to asymmetric information regarding the quality of the broker business. This includes the inability of most clients to assess the approach which a firm has to handling client money, lack of detailed information about the financial viability of the firm and lack of information about where, in the event of failure, client money would fall in the hierarchy of creditors.

In theory, the potential detriment to clients from issues surrounding client money is quite considerable. If the firm does not hold client money separate from that for running the business there is a danger that, in the event of failure, clients lose the money that has been paid to brokers, but do not receive insurance cover because the money has not been passed on to insurers.

The potential risks related to client money were also reflected in interview evidence as firms indicated that assessment of the treatment of client money was one of the key areas of due diligence when considering taking over another broking firm.


Under the IMD, in respect of client money, competent authorities need to take,

“all necessary measures to protect customers against the inability of the insurance intermediary to transfer the premium to the insurance undertaking or to

transfer the amount of claim or return premium to the insured.” 18

The IMD continues, that such measures shall take “any one or more” of the following forms which are broadly characterised as:

Risk transfer agreements;

Capital requirements of 4% of annual premiums subject to a minimum of €15,000;

Use of client accounts; and

A guarantee fund.

It is notable that in the UK, all of these types of requirements have been put in place. It is therefore at least arguable that the sector is subject to overlapping regulation with multiple regulatory interventions all of which deal with potential market failures to do with client money, but not necessarily all of which are necessary in order to protect clients.

The FSA specifies client money as the money of any currency that a firm receives and holds for its client (or clients of appointed representatives, field representatives or other agents) when carrying on insurance mediation. It can include premiums, claims money

18 IMD, Article 4.


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and premium refunds as well as professional fees due from clients, for example, for

onward payment to a loss adjuster.19

Detailed rules regarding the handling of client money by general insurance intermediaries are found in the Client Assets Sourcebook (CASS) chapter 5. The rules set out various provisions to ensure that firms keep client money separate from firm money and to keep records to enable it to distinguish assets for different clients. In the event of failure, these records would be used by an insolvency practitioner to ensure that the money is appropriately dealt with.

A firm can take one of two main approaches to ensure adequate protection of client money or a mix of both:

transferring the risk from the firm to the insurer(s) through RTAs; and

segregating client money into trust accounts.

Alongside these regulations, additional capital requirements are in place for firms holding client money as well as audit reports being required for some firms.

Figure 2 below sets out the number of general insurance intermediaries by whether they are directly authorised or an appointed representative. Firms required FSA permission to hold client money and the number of firms authorised to do this is also shown.

Figure 2: Number of general insurance intermediaries

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Source: FSA, FSA sector statistics for retail intermediary firms, as of December 2010. http://www.fsa.gov.uk/Pages/About/Who/Management/Teams_1/Retail/statistics/index.shtml

19 FSA, Guide to Client Money for General Insurance Intermediaries, March 2007, p4.

http://www.fsa.gov.uk/Pages/About/Who/Management/Teams_1/Retail/statistics/index.shtml


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As Figure 2 shows, the total number of intermediaries (both directly authorised and appointed representatives) has fluctuated around 30-35,000 over the last five years. However, there has been a clear trend of a reduction in the number of directly authorised firms with a corresponding increase in the number of appointed representatives.

One notable trend is that the number of firms holding client money has been steadily declining from more than 5,800 firms to less than 3,500 firms in the last five years.

4.1.1. Risk transfer agreements

RTAs are written agreements between an intermediary and an insurer which allow an intermediary to act as an agent for an insurer. This can include receiving and handling premiums, claims money and refunds. Where RTAs are in place:

money which customers pay to intermediaries for insurers is considered as being paid to insurers as soon as it is paid; but

money which insurers pay to intermediaries for customers is not considered as being

received by customers until it actually is received by them.

In this way, RTAs have the effect of transferring risks associated to client money from the intermediary to the insurer.

Proportion of business covered by RTAs

During the course of the research we have gathered information on the proportion of business written which is covered by RTAs.

Figure 3: Percentage of firms by proportion of business covered under RTAs

16%

4%

13%

42%

25%

Less than 85% 85-90% 90-95% 95-100% 100%

Source: CRA calculation based on BIBA survey of its members.


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As Figure 3 above shows, around:

25% of firms in the survey have all their business covered by RTAs; and

84% of firms have more than 85% of their business covered by RTAs

Overall, among relatively small firms, around 66% of Gross Written Premium (GWP) is covered by RTAs.

Interview evidence with larger firms suggests that they would be more likely than smaller firms to have business conducted on an RTA basis. Medium to large firms indicated that 85-100% of their business (by GWP brokered) is done with RTAs in place. Indeed, interviews have identified that a number of medium and large intermediary firms have sought, and continue to seek, to move towards having 100% RTAs in place.

Evidence from smaller firms suggests that they have relatively weak bargaining positions with the insurers and therefore have not sought to increase the proportion of their business on an RTA basis although most insurers appear to offer this as a matter of course where the client-facing broker is also the insurer facing broker.

Where RTAs are in place, insurers will typically require certain standards to be met with respect to handling client money (this is considered in section 4.2).

Business not covered by RTAs

Discussions with brokers regarding the business for which RTAs are not in place have been consistent in identifying the situation where insurers are willing to provide RTAs for the broker when they are client-facing, but are less willing to do so where the broker is acting as a wholesale broker (i.e. a broker who deals with another broker rather than with the end client). This was also supported by evidence from insurers. There are various arrangements that might be in place including:

Refusal to give RTAs where the broker is not both the client-facing broker and the

insurer facing broker;

Willingness to provide RTAs where the firm was acting as a wholesale broker so long as the insurer could identify the client-facing broker; or

Willingness to provide RTAs where the firm was acting as a wholesale broker for all business except that coming from specifically named client-facing brokers.

Nonetheless, what is striking about the results is that with a high proportion of business conducted with RTAs in place, there is a relatively low proportion of client funds for which protection would be lacking even absent all of the other forms of regulation that are in place to protect these assets. Further, there was little evidence from insurers of substantial concern about the operation of existing arrangements.


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4.1.2. Statutory and non-statutory trust accounts

Any client money which a firm receives and holds which is not held as an agent for an insurer must be held in either a statutory trust client bank account or a non-statutory trust client bank account.

A non-statutory trust account can be used to make advances of credit.20 This enables a client's premium to be met from the pool of client money held before the client pays the premium to the intermediary. A statutory trust account does not permit this use of credit.

One of the dynamics that has been arising in recent years is a reduction in the number of intermediaries that are authorised to hold client money. Indeed, as set out in Figure 2 this has fallen from more than 5,800 in January 2006 to less than 3,500 in September 2010. While some of this fall is due to wider changes to the intermediary sector such as a reduction in the number of directly authorised firms through consolidation as well as exit from the profession, there has nonetheless been a reduction in the proportion of directly authorised firms who hold client money. It seems likely that it reflects some increases in the use of RTAs, as well as some firms choosing to no longer hold client money due to the complexity of the rules. It is also possible that some firms are not authorised to hold client money where in fact they do hold this.

It is important to note that even where RTAs are in place, many firms will nonetheless continue to use segregated accounts for the money received from clients. There are two main reasons for this:

Paying all money into a single client money account is easier for firms compared to

paying some money into a client money account and other money into a different account depending on the arrangements with insurers. Brokers have indicated that FSA rules regarding time constraints within which money must be allocated into client

money accounts makes a more flexible approach difficult to follow. Attempts to separate money according to the presence or absence of RTAs at the point at which it is given to the broking firm may itself give rise to risks of money being handled in a

way which is not in compliance with current rules; and

Insurers will typically require that the money is held in trust accounts in order to meet the conditions of the RTA (see section 4.2).

4.1.3. Capital requirements

A further important issue related to client money is that the manner in which client money is held affects the capital requirements that firms must hold. These are set out in Table 2 below.

20 FSA, Applying for a variation of permission, Frequently Asked Questions, as at 13 December 2010.


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Table 2: Capital requirements

How do you handle client money? Capital requirements

Holding money as agent of an insurer only. £5,000 or, if higher, 2.5% of the firm’s annual income from regulated activity.

Holding money in a statutory trust for retail or commercial customers or holding money in a non-statutory trust for commercial customers.

£10,000 or, if higher, 5% of the firm’s annual income from regulated activity.

Holding money in a non-statutory trust for retail customers.

£50,000 or, if higher, 5% of the firm’s annual income from regulated activity.

Source: FSA, Guide to Client Money for General Insurance Intermediaries, March 2007, p11.

The trade–off between capital requirements and approach to client money is a good example of avoiding unnecessary regulatory overlap. Where less risky approaches are taken to handling client money, less capital can be held as firms are less likely to need to use this capital because of problems related to client money.

4.1.4. Audit report

A client money audit is required of all general insurance intermediaries who:

hold client money in a non-statutory trust client bank account; or

have held more than £30,000 in a statutory trust client bank account at any time (even if only for one day) in the client money audit reporting period.21

The FSA estimates that there are around 1,800 firms that hold more than £30,000 of client money and are required to provide information to the FSA about their client money

including through the provision of an auditors report.22 This represents around half of all firms that are authorised to hold client money.

4.2. Complexity and compliance

Although client money rules are in place, concern has been identified from interviews regarding the complexity of the current rules and the level of compliance with them. Many interviewees highlight that these two issues interact.

4.2.1. Complexity of current FSA rules

A large number of interviewees have expressed concern regarding the complexity of client money rules. In particular, many brokers perceive the rules as being very detailed but not necessarily practical to implement. Some of the areas that were specifically described as driving costs for brokers included:

21 FSA, Guide to Client Money for General Insurance Intermediaries, March 2007, p34.

22 FSA, Improving the auditor’s report on client assets, CP10/20, September 2010, Annex 1.


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Assessment of client money on the basis of cleared funds rather than money received;

Inability to move client money funds between regulated entities in the case of takeovers;

Ambiguity on acceptable forms of written agreement between insurers and brokers;

Whether the standard audit report can be considered as evidence of adequate systems and controls or whether a separate report is required for this;

Conflicting requirements between client money clauses regarding not withdrawing

money from the client money account for prudent reasons on an item that has not been reconciled compared to whether having such an unreconciled item on the client money account at the time the reconciliation arises should be cateogorised as a

breach;

Impracticality of the client money accruals requirements where clients pay money before the renewal date and with the client money reconciliation falling in between the

payment date and the renewal date where commission would need to be transferred for client money purposes but where financial accounting would not accrue this until the date of renewal;

A lack of clarity regarding whether both reconciliation and bank transfers have to arise or only reconciliation for firms to have met their requirements;

The requirement to continue checking whether a wholesale broker has passed money

on to the insurer more than twelve months after the insurance has been provided; and

The overall structure of the client money rules with multiple clauses and sub-clauses

giving rise to interpretation issues and a lack of clarity as to the appropriate approach.

One of the concerns regarding the level of complexity in the rules is that this complexity itself gives rise to additional risks as mistakes can be made by those administering highly detailed client money rules where mistakes would not be made were those rules to be more practical to implement. Interviewees describe the impact of the rules as leading to considerable frantic activity on the day on which client money is reconciled because non-standard transactions need to be assessed on the day rather than being examined within a more normal 10 day period.

It is also important to consider the benefits associated to aspects of the client money rules. For example, in the case of takeovers, while new money can be processed in line with the requirements of the purchasing firm, existing client money must remain in the previous entity. This imposes unnecessary costs on the combined entity (especially where there is a lack of reconciliation of money in the client account) but does not bring any obvious benefits. It appears surprising that the regulator is unable to routinely permit money to be transferred in the circumstances where it is able to assess the client money processes of the purchasing firm.


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In the example of the need to assess client money on the basis of cleared funds rather than on a cashflow basis, the justification for the use of cleared funds is that if money has been withdrawn from the client money account against a cheque which subsequently bounces, and at the same time the broker goes bankrupt, then the client money account would be short of funds that have been withdrawn:

The cheque could be from a sub-broker on behalf of their client – if this money was being paid out of the sub-broker’s client account then it would only bounce where the

sub-broker’s client account is already being mis-used and it is understood from interviews that it would be exceptional for cheques from sub-brokers to bounce. Client detriment would require that the wholesale broker took their brokerage from the

client account against uncleared funds and went bankrupt and that the sub-broker went bankrupt at the same time (since otherwise funds would be available from the sub-broker); or

The cheque could be from a client for a new policy – if the broker draws down their brokerage fee before the cheque bounces, and at the same time goes bankrupt, this could mean that the client would lose funds equivalent to the brokerage fee. It is not

clear that the detriment associated with this, relatively rare event, outweighs the costs associated to administering the rules. Further, the client who suffers would be the one whose cheque bounced and potentially it is not unreasonable that they should

bear some risk from their own lax approach (and they would still have a claim against the broker).

It seems likely, however, that the costs of these issues is likely to be reduced overtime as society moves further away from the use of cheques and towards increased use of electronic transfers where funds clear on the same day.

4.2.2. Complexity of insurer requirements

It should also be noted that not all of the complexity of client money arrangements are in fact due to FSA regulation, but they are also a function of the requirements placed on brokers by insurers through RTAs. Some of the issues that have been raised in respect of requirements under RTAs include:

Variation in the timing at which broker remuneration can be recognised and then withdrawn;

Whether or not funds can be co-mingled with the money due to other insurers;

The frequency with which money needs to be passed to the insurer(s) following payment of premiums from the client;

Whether or not risk transfer cascades to other brokers in a chain; and

Whether risk transfer for credit applies or not.

The extent to which insurers require different rules to be in place in order to meet the terms of the RTA is understood to vary between brokers. For example, large brokers indicate that they are in a strong bargaining position to negotiate with insurers and obtain


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arrangements which are acceptable to the broker while small brokers are clearly not able to exert this sort of influence over the insurers.

On the issue of money being co-mingled between different insurers it is very unclear that this is necessary given that, in practice, there are few actual concerns arising due to client money arrangements. Further, this would impose practical difficulties where multiple insurers are being used for the same risk.

The Lloyd’s market has its own standards which apply across the whole market in which premiums and claims between brokers and syndicates are netted off on a daily basis before payments being transferred as relevant. Further, we understand that the Lloyd’s and London company market have model agreements in place for both RTAs and non-RTAs business. A similar approach could be considered outside the Lloyd’s market.

4.2.3. Compliance with existing rules

As noted above, one of the concerns with having complex rules in place is that this may make it less likely that firms comply with them.

Evidence from interviews indicates that a large number of firms may have made what they describe as “technical breaches” of client money rules in the past. In general, larger firms claim to have invested in better systems and controls to ensure compliance with regulatory requirements. Many firms acknowledge that some of this investment has happened relatively recently in the light of weaknesses in this area across the market being revealed through FSA visits. A number of these large firms now consider that they have systems in place to handle the complexity of the arrangements.

What is of some surprise is that few small firms appear to consider client money requirements as particularly burdensome. This may be because they are relatively uncomplicated businesses. However, there is concern, supported by evidence from consolidators, that the relatively low burden perceived by small firms is because they are in breach of client money rules. In the vast majority of cases most of these are considered to be “technical” breaches of rules rather than ones that actually give rise to client losses in practice. This is further supported by evidence of larger brokers in the context of their checks regarding whether or not money has been transferred to the insurer where they use a wholesale broker for specialist risks. It is clear that these brokers have made far more requests of other brokers in comparison to the number of requests for similar checks that they receive from small brokers.

FSA’s client money review

The relatively poor compliance with client money rules was also identified through the FSA’s recent thematic review in this area in which the FSA reported that compliance with

CASS across the industry was poor.23 It is interesting to note that some of the areas of concern which were highlighted interact with some of the areas that firms have stated are unnecessarily complex. For example:

23 FSA, Client Money & Asset report, January 2010.


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Inconsistencies between Terms of Business Arrangements (TOBAs) and client money calculations; and

Failure to perform sufficient due diligence to assess client money risks arising from an acquisition.

Given the unfavourable results of the FSA’s visits it is particularly striking that there have actually been relatively few cases in which client money concerns have given rise to detriment to clients.

For example, over the 2009-10 period, only 2 out of the 179 cases of enforcement

specified in the FSA’s Annual Report were categorised as to do with client money.24 In fact this related to the same issue with the individual concerned prohibited from any significant influence function in relation to any regulated activity and the firm having its permissions cancelled. The total loss of client money was approximately £85,000 with 700 clients exposed to an “unacceptably high risk of finding themselves without insurance

cover”.25 The firm concerned was a mortgage and general insurance broker and mainly arranged insurance in connection with mortgages; additional failures of the firm related to failure to pay premiums to insurance companies when these were due and failures to monitor and control remittance of premiums.

Other cases that have arisen in 2010-11 include cases where directors failed to ensure insurance premiums were passed on to insurers, and cases where directors knowingly

transferred client money to the firm’s business account to fund business expenses. 26

Although the immediate clients of firms abusing client money regulations are clearly at risk, press searches provide no evidence of any knock-on effects of this to the rest of the broking sector.

Nonetheless, given the relatively small number of cases in which enforcement actions are taken, the evidence from insurers and interviews with consolidators, this suggests that many of the breaches are those relating to the technicalities of the rules rather than more flagrant examples of abuse such as taking money from the client money account.


There are a small number of issues where changes to the approach related to client money may need to be considered

24 FSA Annual Report 2009/10, Appendix 5. It is possible that other cases also involved client money but do not

specify this in the issues raised.

25 FSA, Final notice to Matthew Sixsmith, 1 February 2010 and FSA, Final notice to Bridgewater House UK Ltd, 1

February 2010.

26 FSA press release, FSA takes action against two insurance brokers for failing to protect client money and

assets, 08 June 2010. FSA press release, FSA bans insurance broker David Marriott for persistent misuse of

client money, 2 September 2010. The latter case involved a client money deficit of £570,841 and false

information being provided to the FSA including that a client money audit had been conducted when it had not.


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4.3.1. Assessment of whether firms hold client money

As noted earlier, only around 27% of directly authorised firms hold client money. Given the potential risks for clients associated with client money, it is important that firms that are not authorised to hold client money do not in fact hold it. Although there is no evidence of widespread abuse of this, it is unclear whether greater perimeter checking may be required on this issue especially given the fall in the number of firms who have permission to hold client money.

4.3.2. Expansion of RTAs

The evidence from interviews is clear that insurers are typically willing to offer RTAs to those firms with whom they deal directly, but are not always willing to offer RTAs for situations where there is a chain of brokers. One of the risks that this creates is that it is not always clear whether or when money becomes risk-transferred.

One possible alternative to the current approach would be for all business to be conducted on an RTA basis, while retaining the ability for insurers to withdraw RTAs from firms that they considered to be unduly risky (since it is appropriate for insurers to retain the ability to control the sale of their products). Given the high prevalence of RTAs at present, such a change would affect a relatively small proportion of business. Evidence from interviews indicates that insurers are able to identify firms which are unduly risky in their approach to client money issues.

This approach would have the advantage that it would provide sharper incentives for a small number of risky brokers to raise their quality such that they could continue to access insurers who would otherwise be unwilling to work with them. Failing this, the withdrawal of a willingness to work with brokers could lead to a small number of brokers being forced to withdraw from the market or to consolidate with other firms who do have RTAs in place. It is expected that this would affect small brokers more than large brokers. Evidence from interviews suggests that since insurers are dependent on brokers to distribute their products, insurers would be unlikely to be unduly conservative in the firms they were willing to deal with. However, it may be the case that such a requirement would need to be combined with money being held in a trust account in order to ensure money retained a high level of protection.

It is also unclear whether such an approach would be appropriate for international business conducted in London where risk transfer may both be less necessary (since clients are likely to be well informed) and implementation less enforceable in any chain.

4.3.3. Industry-wide standards for client, and risk-transferred, money

As highlighted above, there are a number of areas of the current client money requirements, both those directly from FSA regulation and also those prompted by insurer action that lead to requirements that are unduly complex without regard to practicalities. One of the concerns about this is that complexity generates risks as mistakes are made against complex rules. In addition, with respect to requirements from insurers, different insurers require slightly different requirements to be in place which also generates additional complexity.


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There has been some suggestion from interviews that these additional requirements from insurers are likely to grow due to Solvency II potentially leading both to additional costs but also to additional risks arising from added complexity in arrangements.

While large brokers can bargain with insurers regarding the treatment of money under RTAs and can also invest in systems to deal with complex and differing arrangements between insurers, smaller firms are in a much weaker position. Given the current lack of concern about this issue emanating from smaller brokers this may be evidence of a lack of compliance with complex arrangements.

There is therefore merit in considering whether movements to a more simplified and standardised approach would be preferable to the current situation. This proposal would be relevant both in combination with a movement to 100% RTAs but also as a stand-alone proposition.

It is worth noting that it is most unlikely that insurers or brokers gain competitive advantage with end clients through having particular requirements in place regarding client money. Hence encouraging high standards in this area is to the advantage of clients particularly if regulatory costs for both insurers and brokers can be limited from this. This would therefore appear to be an area where the most appropriate course of action would be for representatives of insurers and brokers to seek to develop industry wide standards in combination with the FCA.


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5. ADEQUATE RESOURCES

As noted in section 2.1, clients do not always know the quality of the broker business with whom they are dealing and this may bring risks to client money as examined in Chapter 4. In terms of the IMD, the only mention of holding capital is in the context of client money where this is one of a number of alternatives that could be followed to protect clients. No mention is made of any need to hold capital for any other reason.


5.1.1. FSA rules

The FSA sets out its prudential requirements in its prudential sourcebook for mortgage and insurance intermediaries (MIPRU) which prescribes a general solvency requirement

and a capital resources requirement.27 As already set out in Table 2 in the previous chapter, these resources depend on whether, and how, client money is held.

More generally, the FSA requires that the firm must have “adequate” resources as set out in Threshold Condition 4 (TC4) which states that,

"The resources of the person concerned must, in the opinion of the Authority, be adequate in relation to the regulated activities that he seeks to carry on, or carries

on."28

The FSA interprets the term “adequate” as meaning sufficient in terms of quantity, quality and availability, and “resources” as including all financial resources, non-financial resources and means of managing its resources; for example, capital, provisions against liabilities, holdings of or access to cash and other liquid assets, human resources and

effective means by which to manage risks. 29

5.1.2. Current supervisory approach

Following the recent financial crisis, the FSA has taken a more interventionist approach to supervising firms. In addition, the FSA has warned that the economic downturn could lead firms to come under financial pressure in the event of a reduction in business activity and argued that firms needed to ensure that they had the resources to withstand downturns in the the financial climate. They noted that 32% of general insurance intermediary firms

have regulatory capital of less than £50,000.30

27 FSA, MIPRU 4.2 Capital resources requirements.

28 FSA, COND 2.4 Adequate resources

29 FSA, COND 2.4.2.

30 FSA, Financial Risk Outlook 2008, p46, 62.


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While there has been greater focus on the banking sector with respect to increased intervention when supervising firms, this approach has also been applied across insurance broking. The change in supervisory approach in the insurance broking sector has had very different implications for different types of firms.

Small brokers

Small brokers stated that from their perspective issues to do with adequate resources did not appear to have altered over the course of the last few years. Many of these brokers indicated that when FSA regulation first started and when firms were required to hold a particular level of capital, building up this level of capital was burdensome at the time. However, having built up this level of capital, they now do not appear to see holding this money as a particularly large cost although some consider it to be wasteful to have the money “just sitting there”. Many of these brokers have aimed to meet the minimum requirements set by MIPRU and refer to simply having a “pot” of money which is put aside and which they know they can not touch.

Larger brokers

By contrast, larger brokers have a radically different view of changes in the approach to adequate resources over the last few years. The larger brokers that we interviewed stated that they have faced a more interventionist approach to do with adequate resources generally and, in particular, that they have been requested by the FSA to hold additional levels of capital which are well above those prescribed under MIPRU. This issue was seen as one of the most significant issues out of all of the regulatory landscape with brokers highlighting that the regulatory burden had increased substantially despite the risks in the broking sector remaining at a low level.

As set out under TC4, firms must hold resources which the FSA considers to be adequate. While MIPRU sets out the capital that is required, TC4 is currently being interpreted as allowing the FSA to require firms to hold a buffer above this minimum. It is clear that the FSA exercising their ability to do this has raised substantial concerns among large firms including:

Level of capital – some firms have been asked to hold 2-4 times the level of capital

required by prescribed rules (or even a greater multiple than this). Many firms consider this to be unreasonable in comparison to the risks that they impose;

Time for increasing capital – some firms were asked to make these substantial

increases to capital within very short periods of time (a few days) which was considered to be unreasonable. While additional discussions arose over a longer period of time, these occurred after firms had already been required to hold additional

capital; and

Methodology for additional capital – some interviewees have expressed considerable concern that the methodology for arriving at the level of additional capital was not

clearly set out by the FSA through a rules-based approach and was therefore not subject to consultation and the usual cost-benefit analysis test required for new regulations. Firms were of the view that their subsequent challenges to the

methodology were rejected without giving a clear view on why, or which part of, a


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proposed methodology was not acceptable. In general the methodology was considered to be based on circumstances that were exceptionally unlikely to arise

such as multiple simultaneous failures (we consider this further in section 5.2 below); and

A number of firms indicated that they were unable to challenge the FSA’s approach to too great an extent because they were feared some form of alternative regulatory intervention arising instead. Many firms were also clearly concerned that an issue of this magnitude also took up large amounts of time from senior management and (reluctantly) reaching agreement with the FSA at least had the advantage that interaction over the detail would be brought to an end.

5.2. Potential contagion

The main reason that capital requirements are in place is that this represents a buffer against which any losses made can be paid out in the event of the firm getting into financial difficulty. As already set out in section 2.1.2, few brokers go bankrupt in practice and it is important to ensure that capital requirements are appropriate to the overall level of risk imposed.

Section 2.3 highlighted that, in theory, systemic risk could arise within the broking sector and it may therefore be important for some, or all, firms to hold capital requirements to take into account this issue. However, in practice it is not part of the essential function of insurance brokers to hold credit risk, liquidity risk or insurance risk and as such the bankruptcy risks in the broker sector are fundamentally different to those in either banking or insurance indicating that contagion risks are limited.

Nonetheless we consider in section 5.2.1 the specific issue of contagion and whether the broking sector has the characteristics that make it a high risk. Section 5.3 then considers the impacts that appear to arise in practice when firms do go bankrupt.

5.2.1. Criteria for the assessment of contagion

The Financial Stability Board (FSB) has set out its definition of systemic risk as a disruption to the flow of financial services that is caused by an impairment of all or parts of the financial system and has the potential to have serious negative consequences for the

real economy.31 The FSB has put forward three criteria to assess the risk presented by an institution which we consider below namely: size; interconnectedness; and substitutability. In addition we also examine the speed with which failure could arise.

Size

Large firms are likely to pose more systemic risk than small firms and it is therefore important to assess whether there are firms that would be considered large in proportion to the overall market i.e. whether there are firms that would be seen as “too big to fail”.

31 Financial Stability Board, Guidance to Assess the Systemic Importance of Financial Institutions, Markets and

Instruments: Initial Considerations, October 2009.


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Insurance broking does not appear to be an especially concentrated market (in contrast to banking which has higher levels of concentration). There are around 13,000 firms directly authorised to undertake general insurance intermediation activities most of which are relatively small firms that compete mainly for personal and SME customers.

There are a small number of very large brokers although it is common for the largest of brokers to be competing against smaller, but specialised, brokers for different types of products. In addition it is important to note that the very largest brokers are often competing internationally against brokers located in other countries and where risks could be placed outside the UK as an alternative to within the UK indicating that the definition of the “market” within which size is being measured would need to encompass more than simply the business being placed in the UK. No interviewee suggested that any broker active in the UK was too big to fail.

It should be noted that the FSB states that clusters of institutions could be exposed to common risk factors, but within the broking sector there are many different brokers that specialise in different areas indicating that even this clustering effect would be limited.

Interconnectedness

Only if risk is transmitted from one institution to another can this present a risk for the system as a whole. The Chairman of the FSA has acknowledged that failures of insurance companies do not tend to produce knock-on failures since their liabilities are

mainly policy-holder rights not investments held by other financial institutions.32 A similar characterisation applies to insurance brokers in respect of the rights of their clients. Liabilities from one insurance broker would not typically have knock-on effects for others.

In theory, one area where knock-on effects could arise is where there are chains of brokers being used. However, evidence from the survey of BIBA members has suggested that less than 10% of all transactions (in terms of GWP) involve chains of

brokers in which client-facing brokers use wholesale brokers.33 While the figure varies considerably between brokers and between insurers, this suggests that risks arising from interconnectedness would be unlikely.

Risks could be transferred to the insurance sector due to the use of RTAs. This has been discussed in more detail in chapter 4 on client money, but it was clear from that chapter that the extent to which client money concerns arose in practice was small. In addition, insurance companies already factor this in to their calculations of bad debt anyway and would therefore not expect to face significant risks from this route. Furthermore, problems with client money tend to represent isolated cases of fraud rather than an issue which goes across the entire broking sector and to which insurers would anticipate seeing correlation of risks across multiple brokers. (In contrast to, for example, credit risk where multiple banks see credit defaults increasing across many of their portfolios at the same time.)

32 FSA, Address to the IAIS Annual Conference, Speech by Adair Turner, Chairman FSA, 27 October 2010.

33 Insurers were unable to provide a precise figure although this result is within the range of their responses.


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Substitutability

Systemic risk can be exacerbated if an institution has some form of technical specificity or plays such a unique role in a market that it would be difficult to substitute an equivalent firm in the short term. Interviews with market participants have indicated that in the insurance broking market no firm has any significant unique position for which other firms can not provide viable substitutes.

One potential area where firms could have specialist positions is in respect of binding authorities where a broker could have a binding authority for a particular type of insurance business. As noted in section 2.3, around 18% of business is conducted through binding authorities although this will vary by insurer and broker.

Discussions with brokers and representatives of insurers have indicated that while a broker could have the only binding authority for a particular insurer, the availability of alternative insurers means that a single broker would be highly unlikely to hold the only facility across the market even in very specialised markets. (In addition, as noted in section 5.3.2 below, transfer of binding authorities would be expected to happen rapidly in the event of the failure of a firm holding such positions.)

Even among the largest of brokers there was acknowledgement that bindings authorities were usually available to their competitors including both the other large brokers and also specialists in certain areas.

Speed of failure

Unlike in other parts of financial services where liquidity risk is a bigger concern it was thought unlikely that brokers would suddenly go bankrupt without any warning of this being expected. As such, planning could arise to wind up the business gradually with clients unlikely to suffer in such a scenario.

While the gradual decline of a small broker would not necessarily be identified by others in the market, many such brokers would be expected to seek alternative means of addressing decline including through seeking the sale of the business. Indeed, the considerable amount of consolidation in the industry that has occurred over the last five years indicates that this would be a plausible solution for brokers to pursue since there are firms willing to make such purchases.

In terms of a sudden failure, examples of the cause of this included the illness or sudden death of the sole trader or key partner in a small partner firm. Alternatively, the loss of a firm’s biggest client if such a firm represented a very substantial proportion of the firm’s business could lead to rapid decline.

However, for the larger firms, brokers and insurers believed that sudden failure would be highly unlikely and they struggled to identify examples of such rapid decline. Reference was made to potential mis-selling scandals with claims against the broker holding the potential to bring the firm down. Large scale mis-selling has occurred within the retail sector and has led to failures of small firms although even this has occurred over time. However, the larger firms are understood to have less retail business and, given the size of the firms, were mis-selling to arise it is thought unlikely to threaten the viability of the


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firm. Furthermore for any very large claims which might be made against the firm, this would be expected to take time to emerge and considerable time to be resolved reducing the likelihood of sudden failure and enabling steps to be taken to limit the impact on the firm.

Alternatively, the withdrawal of financing arrangements was thought to be one potential risk which could lead to the sudden decline of a large broker. Yet, even this would usually be known about in advance and it would commonly be a more profitable strategy for both equity holders and the financers of a firm to sell parts of the firm before financing was withdrawn. Furthermore, insurers highlighted that brokers had successfully dealt with the recent, very significant, recession and that financing arrangements including from private equity sources had been readily available for large brokers.

Other criteria

It is also worth noting that other factors highlighted by the FSB as exacerbating financial vulnerabilities such as leverage, liquidity risks, maturity mismatches and complexities of group structures also appear not to be especially relevant to most insurance brokers.

Summary regarding contagion

Given the criteria set out above, the insurance broking sector does not share the characteristic that give rise to contagion being of concern. Brokers and insurers were of the view that failure of one firm would not lead to knock-on consequences elsewhere in the market as firms were insufficiently interconnected to have this effect and alternative brokers could be found to take on binding authorities thereby limiting any market disruption.

Furthermore, sudden failure of the largest brokers was considered highly unlikely by participants in the research including insurers. Indeed, the experience of the last few years is considered by insurers to be evidence of the strength of the broking sector rather than cause for alarm.

Finally, brokers and insurers were also highly sceptical that simultaneous failure of multiple large brokers was at all probable, viewing this as far too remote to seriously consider. Since insurers would face the need to distribute their products through other means in these circumstances it is particularly strong evidence that they view this scenario as exceptionally unlikely. In any event, insurers stressed that in this example, clients would not face detriment since they would continue to be insured and, assuming there were no concerns about the client money account, any payments for premiums would be safeguarded.

5.3. Effects of failure

The section above highlights that insurance broking does not share the characteristics of banking with respect to the risks of contagion. In this section we consider the evidence


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regarding the effects of failure examining both the frequency of failure and the impacts

when it arises.34

5.3.1. Frequency of failure

It is useful to consider the frequency with which firms fail due to a lack of adequate resources being in place.

Enforcement cases

According to FSA data for 2009-10, only 2 enforcement cases in which decision notices were published related to inadequate resources – both of these cases appear to relate to firms engaged in mortgage broking (although with general insurance intermediation potentially included within their regulated permissions as well).

Other cases have arisen where firms had to take action to increase the adequacy of their resources including where a firm failed to make adequate provision for its obligations to fund additional pension contributions as well as a firm relying on intercompany debts to

demonstrate compliance with FSA rules.35

Actual broker failures

During the course of interviews, interviewees were asked to name the largest broker that they were aware of that had failed. The majority of interviewees were unable to name a firm.

The largest firm that was named was Ward Evans and it should be noted that this firm went into administration in 2002, some years before the FSA became responsible for general insurance brokers. Ward Evans had debts of more than £3.5 million and had previously been one of the UK's top 50 brokers with more than 130 staff in Leeds, London and Glasgow at its peak. We have conducted press searches to ascertain the impact of the failure at the time. There is no evidence of any widespread detriment to customers resulting and interviewees who mentioned Ward Evans did not believe that there had

been knock-on consequences to the rest of the market.36 Similar press searches have been conducted for a small number of other brokers that are known to have failed over the last decade and these also provided no evidence of knock-on effects to the market.

No large firm failure has been identified subsequent to FSA regulation even before regulation increased in intrusiveness.

34 It is possible that a firm where financial viability is at risk may begin to take other actions which are not in line

with regulatory requirements such as mis-selling products in order to obtain additional revenue in order to keep

the company afloat. In as far as this occurs, it would seem likely that this cause of action would be of greater risk

in the context of small firms than large firms where those giving advice may not understand the direct impact on

the financial situation of their own employer.

35 FSA, Dear CEO letter, 23 February 2010, p2.

36 Yorkshire Post, “Bans for bosses at jet-set company”, 11 March 2006.


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Overall, it is important to note that the credit crisis does not appear to have precipitated large scale broker failure and the largest brokers have not had their financial viability threatened in an equivalent manner to that of the banking sector. The noticeable increase in the level of intrusiveness by the FSA does not therefore appear to reflect evidence of an increase in the risks of the sector.

5.3.2. Impacts of failure

In practice failures among brokers are rare, and given the lack of risk which is actually born in the broking sector (i.e. no credit risk, no liquidity risk, no insurance risk) the impact of any such failure would be expected to be modest. As described below, evidence from both insurers and brokers shows why impacts would be expected to be limited.

Transfer of clients

Insurers and brokers stressed that clients can be rapidly transferred from a failing firm either to another broking firm or to dealing direct with the insurer if the client prefers this. Interviewees indicated that this could be done in a matter of days. While some delays could result in identifying whether clients had paid premiums or whether this was still due, and potentially in confirming documentation, these were seen as reasonably easy to resolve.

Brokers were consistent in agreeing that any clients that were in the process of making claims would receive assistance from the new broker despite the fact that they would not typically be paid for this action (assuming that remuneration was on a commission basis). This was because brokers would see it as an investment in the client relationship and would subsequently expect to retain the client.

It was also noted that if one of the large firms failed gradually, other firms would be expected to rapidly poach staff with teams of brokers likely to move from the failing firm to its competitors and clients thought likely to move with those brokers. In the event of sudden and total failure the time necessary for many individuals to move to new firms was thought to be relatively short as multiple competitors seek to seize the opportunities to attract staff.

Furthermore, far from being concerned about the implications of a major broker failing, brokers universally stated that this would be welcomed by competitors as it would provide the competitors with the opportunity to pick up additional clients. (This is in contrast to what might be expected in the banking sector where the failure of a major bank would not usually be welcomed by other banks.)

Contract extensions

Where brokers go bankrupt just as renewal terms for insurance were being arranged, a number of interviewees suggested that insurers would be willing to extend the existing insurance arrangements in order to ensure that the client did not suffer due to a lack of insurance. This view was also supported by evidence from insurers. It is clear that insurers would have the incentive to act in the interests of clients both from a treating customers fairly perspective but also since this would increase the likelihood that clients would remain with their existing insurer for a longer period of time. It seems likely that


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insurers would be even more willing to take this approach in the (unlikely) scenario of a very sudden collapse of a very large broker.

Transfer of binding authorities

As noted earlier, brokers are not in the position where they are the only broker that has access to a particular type of insurance but rather competing brokers with competing binding authorities was the much more common scenario. However, interviewees were clear that the failure of one broker with a specialised binding authority would lead the insurer providing this facility to simply look for another broker to take it up. This position was supported by evidence from insurers and it was anticipated that such a transfer could happen with considerable speed (within days) limiting any market disruption.


Overall there is considerable evidence that the characteristics associated with contagion are not present in the broking sector. Interviewees were consistent in indicating that the failure of one firm would not have knock-on consequences and that the drivers of failure were unlikely to be highly correlated in ways that would cause multiple failures to arise simultaneously. Failures of any but the smallest firms are rare and market based resolution arises and would be expected to be rapid thereby limiting any potential client detriment from arising in practice.

Sudden failure of brokers is unlikely and insurers were highly sceptical that simultaneous failure of multiple large brokers was at all probable, viewing this as far too remote to consider. Indeed, the experience of the last few years is considered by insurers to be evidence of the strength of the broking sector rather than cause for alarm.

However, despite the evidence that the risk of failure in the broking sector is remained low and despite the fact that it has remained low during the economic crisis, the regulatory approach has become increasingly intrusive for the largest of firms. This does not appear to be proportionate to the risks that are involved.

Large firms have been required to hold additional resources based on scenarios which are considered so remote as to be implausible (multiple simultaneous bankruptcies over a 48 hour period) and despite harm to clients not being established. The level of capital required to be held has been above even what is predicted from these implausible scenarios. That these requirements were applied suddenly through supervisory approaches that did not involve consultation or cost benefit analysis has substantially exacerbated the concerns.

Instead, it would be more appropriate for the regulator to engage with representatives of the industry to consult on whether changes to capital rules are required. Any methodology used to consider this should not be on the basis of assumptions that are so remote as to be implausible.

While it is within the remit of the FSA to demand additional resources, consultation is preferable compared to sudden changes with little warning. Numbers of interviewees have stressed that the approach taken has had damaging consequences regarding the


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perceived attractiveness of investing in UK based brokers compared to brokers active in other international markets.

Smaller brokers are currently unaffected by the FSA’s more intrusive approach to regulation reflecting the limited impact that their failure would have on the market. However, a number of interviewees highlighted that with small brokers the potential to fail relatively quickly because of the loss of a major client was not a negligible risk. It does not appear to be the case that the FSA collects information on the proportion of business generated by the largest client (or the sum of the top 5 clients) to assess for which firms this may be a risk. Given the relatively low levels of failure among brokers collecting this information is not a particular priority but some consideration of it may be worthwhile if data collection is reviewed in the future.


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6. POST SALE REDRESS

Although other regulatory interventions seek to limit the extent to which problems arise, it is also necessary to have mechanisms in place in order to remedy those issues that do arise. There are two main areas through which post-sale redress can arise: professional indemnity insurance (considered in section 6.1) and the Financial Services Compensation Scheme (examined in section 6.2). These interact with each other in two main ways:

The presence of PII reduces the extent to which payments would be expected to

arise in the FSCS since mis-selling claims can be paid out through PII instead of falling back on the FSCS; and

Evidence from the claims made through PII policies can reveal information on the

areas which give risk to risks in the broking sector which can therefore help in understanding the likely impacts of the sector on the FSCS.

We consider PII in section 6.1 and the FSCS in section 6.2.

In addition to these forms of redress, firms also have complaints procedures in place although no concerns were revealed during interviews regarding this area and therefore we do not consider it further.

6.1. Professional indemnity insurance

6.1.1. PII requirements

Under the IMD, firms are required to hold PII with the level of cover at least €1.12 million

for a single claim and €1.68 million in aggregate.37 Under MIPRU, firms are required to hold 10% of annual income up to £30 million in aggregate if this is higher than the IMD

requirements.38 The level of cover is the only element of PII which is specified in the IMD and there are relatively few other constraints on the terms and conditions which are applied by the FSA.

One area of constraint from the FSA is in respect of the level of excess which can be held. Limits are put in place regarding the excess that is allowed depending on the level of income of the firm and whether client money is held. If a firm seeks to have an excess which is higher than the relevant limit, it must hold additional capital the level of which

depends on the firm’s annual income and the excess obtained.39

37 If a policy is denominated in a currency other than euros, firms are required to ensure that they meet this level of

cover at the start of the policy but not necessarily throughout the duration of the policy if this varies due to

exchange rate fluctuations.

38 Source: FSA, MIPRU 3.2 Professional indemnity insurance requirements, http://fsahandbook.infoFSA/ html/

handbook/MIPRU/3/2

39 Source: FSA, MIPRU 3.2 Professional indemnity insurance requirements, http://fsahandbook.infoFSA/ html/

handbook/MIPRU/3/2.


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The requirements to hold PII cover only exist while the firm is in business and there is no requirement to hold “run-off” cover. Since PII operates on a “claims made” basis, this means that a firm which closes may no longer have PII cover in place if a claim is made after closure. While the lack of requirements for run-off cover is unusual among the professions, there is no evidence that this has caused substantial problems. This is because most general insurance policies have annual renewals and therefore any problems which do arise will typically do so within a year of the advice being given. This is very different to the situation for firms such as surveyors or solicitors where problems with the advice may be identified many years after the advice is given and where professional bodies and regulators have therefore typically required firms to obtain run-off cover for up to around six years.

6.1.2. PII coverage

We held a small number of discussions with individuals within the broking community who specialise in advising on PII policies both for brokers and also other professions. Based on these discussions, there is little evidence of any problems with the existing requirements for PII.

In particular, there was no evidence that the level of cover itself was typically insufficient for brokers and it was highlighted that firms whose business is to advise clients on taking out an appropriate level of insurance were likely to have clear views on the benefits of insurance themselves.

A small number of the very large brokers are understood to use captive insurance companies for their PII insurance. It is understood that the FSA has raised some concerns about whether firms should be able to use such captives because, ultimately, claims against the company would remain within their overall group structure.

Interviewees consider that if such captives meet the appropriate regulations required by the regulator of the captives then this ought to be an acceptable form of arranging PII cover. In this way they see this as no different to other large firms which arrange captive insurance companies to deal with compulsory forms of insurance such as employers liability or motor insurance.

6.1.3. Claims through PII policies

Number of claims

PII brokers indicated that in general there were relatively few claims made against brokers. They described the insurance broker PII market as a “soft” market and the low risk of the sector is reflected in the reasonably low premiums that brokers have to pay for

their PII cover compared to other professions.40

Overall, most claims against PII were mainly errors and omissions with human error or mistakes usually to blame. Interviewees stated that issues to do with client money did not

40 Premiums of around £500-2,000 were seen as typical for small brokers obtaining cover of £1.5 million.


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usually result in PII claims. This is consistent with the evidence from the FSCS identifying that most claims against the FSCS are also for mis-selling (including non-PPI claims).

There is also evidence that the number of claims against PII policies fell substantially following FSA regulation in 2005 and has continued to decline, albeit more slowly in more recent years. Interviewees estimated that claims fell by 20-30% in the first few years following FSA regulation. This is evidence that FSA regulation had a positive effect on the conduct of brokers when it took over regulatory responsibility and PII specialists did indeed credit FSA regulation with the reduction in claims. Part of this effect was thought to have occurred through the FSA removing a tail of low quality brokers who did not obtain regulated status, but part was also the improvement of standards of those that remained in the industry. In particular, the need to have systems and standards in place was thought to have reduced the number of relatively minor claims from simple mistakes and failure to send information to insurers or clients.

Interviewees suggested that the credit crisis itself had not prompted additional PII claims to arise which is consistent with evidence in other chapters that the credit crisis has not revealed any latent risks within the broking sector and that the broking sector maintains a low level of risk.

However, there have been slight increases in the number of claims made against brokers because of the subsequent recession – we understand that it is common for PII claims in many sectors to increase in a recession as both insurers and clients face greater financial pressure prompting insurers to refuse more insurance claims from clients and clients to seek to pursue the broker instead. In addition there was some suggestion that the increased use of conditional fee arrangements by lawyers was also prompting an increase in claims associated to an increasingly litigious society. Interviewees did not suggest that there had been a sudden decline in claims in the light of the FSA’s more intrusive approach to regulation.

Risk factors within PII

Discussions with PII specialists also revealed that there were a number of issues which were likely to lead to higher risks and higher premiums being paid through PII policies. These include:

The type of insurance business brokered - Interviewees indicated that business which falls into “financial services”, especially that related to credit insurance, would be

considered more risky than general commercial policies. One of the reasons for this was that these policies bring the additional risk that poor advice could run across all such policies. This is in contrast to other product lines (property, general commercial

etc) where poor quality advice would more commonly arise for specific customers rather than across a whole book of business.

The number of appointed representatives - These were seen to be more risky than

other intermediaries. Indeed most proposal forms for PII require additional information to be provided if the firm has appointed representatives;

The use of binding authorities – Some interviewees indicated that binding authorities

could give rise to additional risks and again proposal forms require additional


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information to be provided about these arrangements. This is mainly due to the risk that brokers going beyond the terms of the authority they are required to operate

under such as by giving cover to a client that did not meet the requirements set down by the insurer who was providing the binding authority. It was also noted that there was variation in whether PII would cover such a position; and

The level of experience in a particular product line or whether firms “dipped in and out” of different product areas for which they may not have sufficient competency.

Some brokers have obtained qualifications such as chartered status from the Chartered Insurance Institute (CII). Obtaining this requires meeting certain standards that helps to improve the compliance and general quality of the firm and therefore holding chartered status could therefore serve as an indicator of the quality of the firm. In theory this should therefore lead to lower PII premiums. In practice, however, at the current time, given the softness of the market and that the premiums are already very low, chartered status is not thought to bring substantial reductions in premiums. PII brokers did suggest that having chartered status would be expected to make more of a difference in a hard market.

In terms of paying out claims, PII brokers noted that some brokers were weak in clerical and administrative areas which meant that they were not always able to document the advice given and therefore claims may go against them because they were not able to prove that their advice had met regulatory requirements.

6.1.4. BIBA standardisation

As noted in section 6.1.1, FSA requirements related to PII are quite minimal. One concern that arose in the past regarding this was that insurers may therefore use a variety of different policy terms and conditions which could bring confusion in the market.

In the light of this concern BIBA has taken two main steps in order to raise the standards of PII coverage.

First, the development of the BIBA PI Policy Wording Guide assists members in understanding these complexities by providing typical examples of policy wording and points for members to consider regarding the various different components of PII policies. This includes issues such as insuring clauses, exclusions, general conditions, claim

conditions, excess and related clauses, endorsements and extensions, etc.41

Second, the appointment of three accredited PII insurance brokers who agree to make their best effort to offer certain terms and conditions in the PI insurance policy. Areas where standards have been raised because of this include:

41 For example, in respect to insuring clauses the guide provides three examples of typical policy wording on

“claims made” basis, fraud/dishonesty, professional liability and civil liability. For each of the three examples, the

guide analyses the wording and suggests points to consider. Similarly in respect of exclusions, the guide

provides a list of typical exclusions and examples on misdeeds, bodily injury/property damage, claims by

associated companies, USA/Canada Exclusion and assumed duty or obligation.


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In the case of fraud and dishonesty, the accredited brokers do not typically arrange cover for the fraudulent act itself but would usually arrange cover for aspects of

dishonesty.

Cover with respect to advice on binding authorities being whereas in other policies it had not always been clear whether these would be covered if the broker is taking on

some of the functions of the underwriter;

Cover for any civil liability rather than limits to negligence and contract law

Removal of “condition precedent” aspects of the notification of claims; and

Cover on an “each and every claim” basis.

In some of these cases the actions of BIBA has also led to standards being raised across the market more generally rather than this being limited to the policies arranged by the accredited PII brokers.

6.1.5. Future regulation

The number of PII claims is relatively small and PII specialists have indicated that there are no major concerns in respect of PII policies. BIBA has taken action to ensure that there is more consistency in policy wordings (or at least that there are a number of insurers who will offer particular policy wordings). Furthermore, the number of claims against the FSCS is also modest with the exception of PPI related claims (as described in section 6.2 below). As such there seem to be limited problems with the existing arrangements related to PII and limited need to make changes.

6.2. FSCS

As noted in section 2.2, the potential for reputational risk affecting the whole sector and the inability to insure an individual’s own fraud both provide reasons for the FSCS along with a regulatory desire to protect consumers should other regulatory requirements fail to do so or be breached. Indeed, previous reviews of the FSCS by the FSA identified that the FSCS supported two of its statutory objectives – maintaining confidence in the

financial system and securing an appropriate degree of protection for consumers.42

The FSCS applies across the financial services sector and is split into five funding classes: deposits; general insurance; life and pensions; investments; and home finance. Most of these classes are then divided into provider and intermediary sub-groups. The scheme is run on a “pay as you go” basis with levies paid to support the costs of the relevant sub-group for which firms are authorised along with supporting the base costs of the scheme as a whole. If the costs of one sub-group exceed pre-defined limits, the costs can be shared across the wider group and then across the whole scheme.

42 FSA, FSCS Funding Review, PS07/19, November 2007, p3.


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As is seen in Table 3 below, the value of FSCS levies has increased dramatically over the last three years. This is overwhelmingly due to claims related to payment protection insurance (PPI).

Table 3: FSCS levies for general insurance intermediaries

Levies (£ million)

2006/07 £0.48

2007/08 £1.93

2008/09 £2.01

2009/10 £7.98

2010/11 £61.4

2011/12 £93.5 (indicative)

Source: FSCS, Plan and Budget 2011/12 p10; Annual report 2009/10, p29; Annual report 2008/09, p33, 44; Annual report 2007/08, p33, 44; Annual report 2006/07, p21, 23, 34. Note that comparable information is not available for 2006/06 which was the first full year in which general insurance intermediaries were covered by the FSCS.

All interviewees expressed very considerable concern regarding the rapid increase in the FSCS levies. In particular, interviewees were concerned that they were being held responsible for the actions of firms that they did not consider to be “like them” and for a product which many of them had never actually sold themselves.

6.2.1. FSCS claims

In respect of clients of general insurance intermediaries, the FSCS would provide

compensation to clients if the firm was unable to pay claims against it.43 The most likely scenario is where a firm has gone bankrupt and placed into liquidation or administration although it could also be that the firm has closed and can not be traced.

Recent years have seen a dramatic increase in the number of FSCS claims due to the large number of PPI claims which we consider in section 6.2.2 below. In respect of non-PPI claims, we understand from the FSCS that the majority of cases are nonetheless linked to mis-selling. Some of the common examples which arise include:

Where the firm had not yet placed cover with an insurer before its date of default;

If the firm uses the services of a secondary intermediary to arrange cover for its

customers, and the secondary intermediary becomes insolvent before passing premiums to an insurer;

43 Compensation from the FSCS in respect of general insurance intermediation is limited to 90% of the claim with

no upper limit. Claims relating to compulsory insurances (such as third party motor insurance) are covered in

full. Source: FSCS, A guide to the work of the Financial Services Compensation Scheme.


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Where the firm places insufficient cover for its customer, or fails to tell the customer about a relevant exclusion in the contract, which causes the insurer to reject the

claim; and

Where fraud arises, for example if premiums are inflated for the intermediary's own gain or even fraudulent selling, where the customer is told they have cover but no

insurer actually exists.

It is important to note that of these, the first and second examples would not give rise to claims on the FSCS where there are RTAs in place. Even in the absence of RTAs the value of premiums or any claims paid should be available in the client money account. In the case of fraudulent selling where the firm claims that the customer has insurance without seeking to put any in place, these cases may be allocated to the insurer sub-group rather than the insurance intermediary sub-group since the firm is acting as an insurer rather than as an intermediary.

Table 4 below sets out the details of the FSCS claims in respect to general insurance intermediaries.

Table 4: FSCS compensation claims for general insurance intermediaries

PPI claims Non-PPI claims

Total number of claims

made in the year

Compensation paid (£ million)

2006/07 35 £0.10

2007/08 110 £0.07

2008/09 535 205 740 £0.13

2009/10 2,411 102 2,513 £12.31

Source: FSCS, Plan and Budget 2011/12 p10; Annual report 2009/10, p29; Annual report 2008/09, p33, 44; Annual report 2007/08, p33, 44; Annual report 2006/07, p21, 23, 34. Note that comparable information is not available for 2006/06 which was the first full year in which general insurance intermediaries were covered by the FSCS.

No breakdown was available between the PPI and non-PPI claims before 2008 but since PPI was not mentioned in the 2007/08 annual report, it is reasonable to assume that the majority of claims made in 2006/07 and 2007/08 were non-PPI claims.

The very modest number of claims and level of compensation paid for non-PPI claims reflects the modest risks imposed by the GI broking sector generally. In addition, we understand that there were relatively few claims per individual firm indicating that claims were typically specific to mistakes made for a particular client rather than representing large scale mis-selling across a whole book of business.

6.2.2. PPI claims

As is clear from Table 4 above, there has been a very strong increase in the number of claims made against the FSCS in the general insurance intermediary sector. It is


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noteworthy that 96% of claims in 2009/10 related to PPI and of those 2,411 claims some 908 relate to one firm – Picture Financial Services Plc. The proportion of claims which were paid is higher for PPI than for other claims (89% compared to 60%) and the average compensation paid was also higher for PPI claims than for other claims ((£8,540 compared to £1,152). This implies that more than 96% of the value of compensation was

due to PPI claims.44

The main conduct issues associated with the sale of PPI related to inadequate consumer

eligibility checks; and inadequate disclosure of key information, such as price.45

It is worth noting that it is clearly in the interest of most general insurance intermediaries to have appropriate levels of regulation in respect of the sales process. Had regulation prevented the extent of these claims from arising then all other general insurance intermediaries would have gained from this.

6.2.3. Future regulation

Interviewees were extremely concerned that the very high value of PPI claims is being passed on to a wide set of brokers who did not share the same characteristics of the majority of firms responsible for the PPI claims. This raises issues regarding whether both the sub-classes within the FSCS and the levies within those sub-classes have been appropriately determined.

Sub-groups

At present the FSCS is divided into a small number of sub-groups one of which is for all general insurance intermediaries.

One of the reasons in favour of maintaining a relatively large sub-group is that when claims arise these can be spread over a large number of firms thereby reducing the potential for the claims to cause substantial detriment to any individual firms within that group. For any given size of claims that need to be paid out, a smaller sub-group will lead to a greater burden on each firm.

However, against this argument is the principle behind the FSCS that firms are categorised into groups with whom they share characteristics and between whom risks would be expected to be similar. Hence insurance intermediaries who do not hold deposits are not placed in the same group as banks that do hold deposits.

Interviewees have raised substantial concerns that, in fact, there are a large variety of different types of firms captured within general insurance intermediation. It may therefore be appropriate to split the intermediary sub-group according to different characteristics of firms such as whether FSA regulated activities form the core business of the firm and whether general insurance intermediation is their main business activity.

44 FSCS, Annual Report and Accounts 2009/10, p29.

45 FSA, Financial Risk Outlook 2010, p66-68.


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We have not had access to data to enable us to assess whether it would be possible to differentiate between firms in a way that would have more accurately predicted the firms that subsequently faced claims against them related to PPI.

At the same time we also note that some of the concerns related to PPI potentially relate to some of the underlying product characteristics as well as to how they were sold. For example, the FSA quotes evidence from the Competition Commission which found that the overall claims ratio for PPI products for the first half of 2008 was 18.1%, and notes

that this is low relative to the claims ratios of other general insurance products.46

In as far as product characteristics are partly responsible for any mis-selling of PPI, this would suggest that the insurers who designed these products should also be responsible for contributing to the costs of PPI related claims. This argument would suggest that far from reducing the size of the sub-group, it could be more appropriate to either widen the sub-group to include insurers, or, for particular examples where there are large numbers of claims, would be appropriate to apportion some of the value of claims to those responsible for selling the product and some to those responsible for the design of those products and the conditions through which the policies were sold.

Risk-reflective levy

An additional way to alter the FSCS levy, which could be used as an alternative or in addition to changing the sub-groups would be to make the levy more reflective of the risks of different firms.

Currently, the FSCS levy is based on the value of “eligible claimant income” – this ensures that firms that have clients who could claim against the FSCS have to pay more

than those who could not make claims.47 However, it does not differentiate between brokers with different risk profiles and therefore does not encourage risk management improvement. For example, two firms with the same level of turnover, may impose very different levels of risk to the economy if one firm sold only motor insurance while the other sold only PPI.

It would therefore seem appropriate to consider whether there are indicators that could be used to identify the risk of different firms. This could include:

Additional detail on how the eligible income splits between different product types

with some products being designated as higher risk products and therefore having higher levies attached to them and noteworthy that credit based products were at the heart of the financial crisis. That PPI was also linked to the extension of credit may

therefore give pause for thought as to whether products involved in, or linked to, the extension of credit are ones which bring additional risk with a need for this to be taken

46 FSA, Financial Risk Outlook 2010, p68.

47 Eligible claimant income has three component parts: commissions and fees earned in respect of individuals;

commissions and fees earned in respect of businesses with a turnover of under £1m; and commissions and

fees earned in respect of the two compulsory classes (third party motor and employers’ liability). Firms without

eligible claimant income still have to contribute to some of the running costs of the FSCS.


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into account in both supervisory approach and the range of fees that need to be paid for regulation. As explained in section 3.3, the FSA has set out a number of

indicators that they may use to determine where more intensive product regulation is required suggesting that these would be useful characteristics to use for the purpose of the calculation of the FSCS levy;

Information related to whether firms have appointed representatives – this is seen as one of the risk indicators from the perspective of the cost of PII and would therefore be a plausible indicator to use for the purpose of the FSCS levy. (As highlighted in

Figure 2 there has been a trend away from directly authorised firms towards appointed representatives in recent years);

Whether products are sold through a binding authority – again this is used as one of

the risk indicators from the perspective of PII; and

FSA related indicators as to whether a firm is considered to be a high risk firm based on information gathered through the Retail Mediation Activities Return (RMAR).

Basing the levy on more risk related indicators such as more detailed information on products and how these products are sold in addition to turnover would be expected to bring benefits if this was used in advance of claims being made against the FSCS (an “ex ante” approach). This would encourage firms to be more cautious when selling high risk products as well as giving good firms an incentive to have high standards of advice to be provided alongside these products in order to avoid the risk of paying for the mistakes of other firms.

Using an indicator based on the FSA’s own methods of identifying risky firms (or indicators which feed into this) would also bring about direct incentives for firms to improve risk management in order to reduce their levy. This would be to the benefit of the individual firm, the sector as a whole, the regulator and clients as the risks of the sector would be reduced overall.


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7. COST OF REGULATION

We have assessed the risk of the general insurance intermediaries sector in the preceding chapters and found that the overall risk of the sector is low. Given the low level of risks of the sector, we now consider whether the regulatory costs the sector incurs are proportionate to these risks.

The regulatory costs faced by intermediaries in the general insurance sector have been considered in two parts: direct costs and indirect costs. We assess these costs in this section with information that has been gathered through three different surveys:

A survey of 86 members of BIBA and LIIBA considering the current costs of

regulation in the UK;

A survey of a small number of the largest UK brokers gathering information on the costs of regulation in their various European offices; and

A survey of the direct costs of regulation in Europe for three sample firms gathered with the help of BIPAR members from various European countries.

7.1. Regulatory costs in the UK

We first assess regulatory costs in the UK by setting out the components of regulatory costs before analysing the data collected from the survey of BIBA and LIIBA members.

7.1.1. Components of regulatory costs

Within the UK, the direct regulatory costs consist of four main fees and levies:

Financial Services Authority Periodic Fee – firms are required to pay a minimum fee of £1,000 plus 0.243% of their eligible income above a threshold of £100,000 for year 2010-2011;

Financial Capability / Consumer Financial Education Body Periodic Fee – firms are required to pay a minimum fee of £10 plus 0.02% of their eligible income above £100,000 for year 2010-2011;

Financial Ombudsman Service Levy – firms are required to pay a minimum fee of £85 plus 0.031% of all their eligible income; and


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Financial Services Compensation Scheme Levy – firms are required to pay £0.31 per

£1,000 of eligible income. 48

The calculation of fees and levies due is based on information provided through RMAR.

As well as the direct costs faced by firms, most insurance intermediaries face additional costs because of supervision by the regulator. For example, this could include the time spent on completing information requests from the FSA, the time spent preparing for a supervisor to visit the firm or the cost of a report by an independent expert to prove that the firm is meeting the regulatory requirements. The costs could include those incurred by internal staff and by external staff when compliance work is outsourced.

The cost of completing RMAR has been raised as a concern by some small firms as they have to spend time collating and submitting this data. Many of these firms are sceptical to whether or not all of the data gathered is actually used in practice. However it is clear from the research that the main driver of cost is when RMAR changes or when the method of providing the information changes (such as the move to the FSA’s “Gabriel” system) rather than the ongoing costs associated to providing the same information each year. Since the system is now already in place and firms have adapted to it, this suggests that changes in the approach even to reduce the amount of information would not necessarily be to the advantage of the sector.

7.1.2. Regulatory costs faced by firms in the UK

Figure 4 below sets out the direct and indirect costs of regulation in the UK for firms of different sizes.

48 Firms who become directly authorised during the course of the financial year, are entitled to a new joiner

discount of 25% on fees and levies. Further, they are only required to pay the base cost element of the FSCS

levy in their first fee period of authorisation. FSCS levy based on information from FSA, Policy Statement 10/7,

Consolidated Policy Statement on our fee-raising arrangements and regulatory fees and levies 2010/11

Including feedback on CP10/5 and ‘made rules’ , Annex 7. Information on other fees based on the FSA online

fee calculator. http://www.fsa.gov.uk/pages/Doing/Regulated/Fees/ calculator/index.shtml.


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Figure 4: Regulatory costs in the UK

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

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Source: CRA calculation based on BIBA and LIIBA survey data.

As Figure 4 shows, regulatory costs as a percentage of revenue from general insurance intermediation are highest for intermediaries with revenue from general insurance intermediation less than £1 million. However, it is also interesting to note that the regulatory costs for large brokers increase substantially compared to brokers that are somewhat smaller than them.

The effect of direct costs decreases as revenue increases, which shows that there exists some degree of economies of scale with respect to direct costs as the result of the fixed fee introduced by the FSA and the business models run by firms of different sizes. It is also likely to reflect the different mix of business that firms have and whether or not all of the income is counted as “eligible” income for the purpose of the calculations of the different fees. As already set out in section 6.2 firms were particularly concerned about the level of direct costs associated to the FSCS which has increased substantially in recent years.

As for indirect costs, certain regulatory activities may have broadly fixed costs that apply irrespective of the size of the business. Hence, again small firms have relatively high levels of indirect costs as a proportion of their revenue, but there is some degree of economies of scale in certain compliance related functions.

However, it is also clear that there comes a point where indirect costs increase substantially. Based on the evidence from the cost survey this occurs for firms that have direct supervision by the FSA as opposed to having their main contact with the FSA through the client contact centre.

This is consistent with the evidence from interviews that the largest firms have to incur substantial indirect regulatory costs as they have to have a much larger compliance team internally and meet the intensive supervision requirements from the FSA. These firms


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have also highlighted the very substantial costs in terms of senior management time required to deal with the sudden increase in intrusiveness of regulation that they have faced. In addition, many of these firms have expressed frustration regarding the high turnover of FSA supervisory staff which itself imposes costs on firms. For example, firms state that they were required to spend time educating new supervisors about their business (rather than this arising through internal handover discussions within the FSA) as well as often needing to educate supervisors about broking more generally.

The main areas of indirect costs arising are those relating to the cost of maintaining an internal compliance team accounts which typically accounts for around 75% of total indirect costs followed by outsourcing compliance work and internal audit fees which account for 7% and 6% respectively. Larger firms were also the firms that were more likely to state that their indirect costs had increased slightly or substantially over the last few years.

In summary, the survey shows that the smallest and largest firms face the highest regulatory costs measured as the proportion of revenue from general insurance intermediation. It is high for the smallest firms because of the impact of fixed costs in their own compliance as well as the minimum fees and levies that have to be paid. At the same time the largest firms have been faced with substantial indirect costs due to the intensive supervision approach by the FSA.

7.2. Comparing regulatory costs within Europe

It is useful to compare regulatory costs across European countries as well as considering the UK regulatory costs across different types of firms.

7.2.1. Regulatory costs of for UK firms across Europe

The first exercise we conducted was to collect the data from the local European offices of a small number of the very largest firms in the UK who had European offices in addition to the UK. It should be noted therefore that the size of offices will vary both between respondents and between countries, but this method of information collection had the advantages of enabling “real” information to be captured on indirect as well as direct costs. Information has been aggregated across different firms for each European country and is presented in Figure 5 below.


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Figure 5: Regulatory costs across European countries

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1.5%

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3.5%

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Direct cost Indirect cost

Source: CRA calculations based on BIBA and LIIBA survey data.

As Figure 5 shows, UK has by far the highest regulatory costs among the 13 European countries in the survey in terms of both direct and indirect costs measured as the proportion of revenue. Direct costs are broadly in line with some of the other European countries (although remain the highest in the survey). However, it is in the indirect cost category where the UK costs are substantially higher than the other countries. This is at least partly due to the intensive supervision these firms receive.

It is notable that the costs in Figure 4 for all other countries are lower than the costs previously presented in Figure 3 for all different sizes of firms.

The survey also finds that regulatory costs in most of the countries in the survey have either remained unchanged or only increased slightly in the past five years while the costs in the UK are described as having increased significantly.

It is clear from the evidence gathered from European offices that regulators in some countries take a broadly passive approach to regulation and do not proactively supervise firms unless an alert is raised against a firm. This type of approach naturally imposes less cost than the costs associated to a more active regulator. This is particularly likely to affect the indirect cost which is where the UK is especially out of line compared to other countries.

One caveat in interpreting the data is that it only reflects the cost side of regulation and does not contain information about the outcome of that regulation. While some regulators could be more efficient than others, some regulators may also be wiling to tolerate more client detriment than others. However, the evidence collected during the course of the research has not revealed that there have been significant detriment arising in the general insurance broking sector in other countries. Hence there is little evidence to suggest that client detriment is widespread in other countries while these other countries maintain


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much lower burdens of cost than the UK.49 Conversely, given the evidence regarding the low level of risks within UK brokers, this does not suggest that greater costs are required to contain these risks in the UK.

7.2.2. Regulatory costs of sample firms across European countries

Another way to benchmark regulatory costs across Europe is to gather information on the costs of a standardised set of firms. By doing so, we can remove the effects of the differences between individual firms in the survey results above. We use the following standardised firms:

Firm 1: A small firm with 3 general insurance intermediaries and revenues from insurance intermediation of €300,000;

Firm 2: A medium firm with 30 general insurance intermediaries and revenues from insurance intermediation of €5 million; and

Firm 3: A large firm with 1000 general insurance intermediaries and revenues from insurance intermediation of €100 million.

Although it would have been useful to compare both direct and indirect costs for these three sample firms across European countries, it was not straightforward to quantify what the indirect costs would be for these standardised firms. Therefore, our analysis is focused on the direct costs which could be calculated based on the requirements in each of the countries in the survey. Information on indirect costs is then considered more qualitatively.

Table 5: Direct regulatory costs of three sample firms across European countries (€000s)

Firm 1 Firm 2 Firm 3

Austria 0 0 0

France 0.2 0.2 0.2

Germany 0.7 0.7 0.7

Spain 0.0 0.2 1.0

Ireland 0.9 15.0 23.4

Netherlands 2.1 8.7 47.9

Belgium 0.3 1.8 53.0

Italy 0.8 4.5 80.5

49 Not all other regulators may have an equivalent of the FSCS to provide additional protection to consumers. This

could be one of the reasons for differences in the direct cost of regulation, although it is clear that the indirect

costs of regulation are the more substantial cause of differences between countries.


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Finland 1.4 5.9 168.0

Luxembourg 0.9 9.0 300.0

Romania 0.9 15.0 300.0

Estonia 2.3 35.2 700.2

UK 3.6 46.7 918.1

Source: CRA calculation based on BIPAR survey data.

It should be noted that not all countries will have firms which are as large as the example of Firm 3. Hence some of the calculations presented for the direct costs of regulating Firm 3 are hypothetical calculations rather than costs that actual firms currently pay. For example, in Finland, the largest insurance broker intermediates only €84 million of insurance and therefore would be expected to have intermediation revenue of around 10-20% of this figure. Luxembourg, Romania and Estonia are also not thought to have firms with €100 million insurance intermediation revenue hence caution needs to be applied

when interpreting these results.50

Nonetheless, as Table 5 shows, and consistent with the results presented in Figure 5 above, the UK has the highest direct regulatory costs for all the three sample firms across the countries in the survey. (The caveat in the previous section regarding the outcomes of regulation also applies here.) It should also be recalled from Figure 5 that the indirect cost of regulation in the UK far exceeds that of direct costs and indirect costs are less significant in other countries. Hence even the comparison in Table 5 will understate the extent to which costs in the UK are higher than those elsewhere.

Information gathered in this survey also highlighted that regulators in other countries have not responded to the credit crisis by altering their approach to regulating general insurance intermediaries in the way that has occurred within the UK.

7.3. Summary of regulatory costs

The evidence on the level of regulatory costs is clear in identifying that costs in the UK are greater than those in other European countries. This conclusion holds for a range of different types of firms (as the standardised comparison shows) as well as within European locations for the same firms (as shown by Figure 5). It is notable that the cost of regulation as a percentage of revenue for all sizes of firm (shown in Figure 3) is greater than the costs for all other countries (as shown in Figure 4).

Given the lack of apparent detriment arising in the broking sector in other European countries this supports the conclusion that the costs of regulation in the UK are disproportionate to the risks imposed by the sector.

50 For example, it could be the case that if firms such as Firm 3 existed in these countries, the method of

calculating the direct fees would be different to the current calculation in order to prevent high fees from being

paid.

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