regulatory Landmines in Financial Institution Insurance

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1 FINANCIAL INSTITUTIONS RISK BULLETIN JUNE 2014 Welcome to the June edition of the Arthur J. Gallagher Financial Institutions Risk Bulletin. In this edition we review the implications to buyers of financial institutions insurance of: The FCA 2014/2015 Business Plan The Draft Finance Bill and proposals to increase HMRC s powers Changes to Eurozone bank supervision In addition there is a chance to get to know a member of the Arthur J. Gallagher financial institutions team a bit better and an update on recent underwriter appointments. THE FINANCIAL CONDUCT AUTHORITY BUSINESS PLAN 2014/2015 WHAT ARE THE RAMIFICATIONS FOR BUYERS OF FINANCIAL INSTITUTION INSURANCE? The FCA issued their 2014/2015 business plan in combination with their 2014 FCA Risk outlook on the 31st March. Both documents make for insightful reading into what financial institutions can expect from the FCA. In this article we will summarise the key points and comment on any likely ramifications for buyers of financial institution insurance. The FCA s key objectives are to: Secure an appropriate degree of protection for consumers. Protect and enhance the integrity of the UK financial system. Promote effective competition in the interests of consumers. In the business plan the FCA details a number of new activities which it is undertaking, including: Assuming responsibility for consumer credit from the office of fair trading. Implementing the Financial Services (Banking Reform) Act 2013 including recommendations regarding senior managers and certified persons regimes. Preparing the launch of a new regulator to oversee UK payment systems. In addition, the following other key activities are detailed: Working to build orderly and competitive financial services wholesale and retail markets using market studies to assist. Continuing to embed a risk based supervision model through structured assessment of firms, event driven work and thematic reviews. From April 15th the FCA will become a concurrent regulator with the Competition and Markets Authority. In conjunction with the Prudential Regulatory Authority (PRA), reviewing the requirements for firms entering or expanding into the banking sector with a view to lowering barriers to entry. Consulting on prudential requirements for personal investment firms. Embedding the Alternative Investment Fund Managers and Markets in Financial Institutions Directives. Increasingly focus on how firms manage payment protection insurance complaints and proactively contact those who may have been mis-sold. A post implementation review of the Retail Distribution Review. Implement a Mortgage Market Review. Enhancing the effectiveness of the listing regime with emphasis on appropriate protection for minor shareholders. Establishing a robust framework of supervision for LIBOR. Continuing to assess anti-money laundering processes and controls in major banks and the staff responsible for them. Source: Executive Summary FCA Business Plan 2014/2015

2 REVIEWING THIS DOCUMENT FROM THE PERSPECTIVE OF ANYONE INVOLVED IN THE PURCHASE OF PROFESSIONAL LINES INSURANCE WE WOULD HIGHLIGHT THE FOLLOWING: 1. The following areas in particular can expect specific scrutiny should firms not be able to demonstrate appropriate culture, controls and processes: Financial crime and market abuse Governance and risk management processes Conflicts of interest Sales Practices Protecting client money and custody assets (CASS) Treating customers fairly Competition Culture and incentives It follows that financial institution underwriters may also be seeking additional disclosure from their assureds in this regard. 2. It is evident from the business plan that the breadth and extent of work that the FCA is undertaking is increasing so it is realistic to assume that the number of firms involved in dialogue with the FCA will also rise. In addition, the FCA will continue to use and increase the number of thematic reviews and market studies it undertakes. The FCA is undergoing some 58 current and planned thematic works ranging from PPI redress to financial crime controls in C3 and C4 firms, to resilience against cyber attacks, and another 39 European Union Initiatives. We have summarised some of the planned reviews in the appendix Financial Institution underwriters will view these developments with caution, and expect an increase in claims against their policies as a result. We would not however expect this to change to have a material effect on the current favourable market conditions in the short and medium term.

3 3. The FCA reiterates its stance of taking tough and meaningful action against firms and individuals who fail to follow our rules and committing to using our enforcement tools effectively to help us use our aims and objectives. The accountability of senior management for compliance and conduct issues will continue to be a focus. There is additional evidence of this available in the data the FCA and predecessor regulator provides regarding historic fines levied against both firms and individuals (which can be viewed on the FCA website here). ANALYSIS OF THE FREQUENCY AND SEVERITY OF THESE CLAIMS PRESENTS A NUMBER OF CLEAR CONCLUSIONS: 1. The total monetary amounts of fines levied have increased every year since 2007: Monetary amount of fine m Year 2. The number of fines against individuals has risen consistently per year, particularly when compared to fines against entities. Between 2002 and 2007 the number of fines issued against firms consistently outnumbered those against individuals. Since 2008 the frequency of fines against both individuals and firms is now approximately equal: Number of fines Total Entities Individuals Year

4 3. The average fine levied against individuals has also increased: Average fine Year Fines issued by the FCA are not insurable, however covered insurance claims very frequently accompany an FCA fine, for example the costs of securing legal advice throughout the process or aggrieved third parties seeking traditional compensation. In particular the identified trend of increased FCA action against individuals emphasises the need for the broadest possible investigation costs coverage to ensure that the D&O coverage begins to pay at the outset of the regulatory investigation. As the start date for cover is so important the policy language should trigger coverage at the earliest possible juncture. Outside the scope of fines and penalties, financial lines policies can provide broad protection for claims triggered by regulatory action. Given the increases in exposure we consider this a key area for consideration. DRAFT FINANCE BILL IMPLICATIONS TO INSURANCE BUYERS FOR FINANCIAL INSTITUTIONS The draft Finance Bill is currently making its way through parliament. It contains provisions to increase HMRC s powers with regard to tax avoidance and in particular the point in time at which disputed tax becomes due. At present, if a tax avoidance scheme is challenged in court the tax only becomes due upon the case being resolved. The Finance Bill proposes a change whereby schemes covered by Disclosure of Tax Avoidance Schemes (DOTAS) or counteracted under the General Anti-Abuse Rule (GAAR) will be subject to an accelerated payment. This means the tax in dispute is required to be paid upfront before a formal decision has been made as to whether it is actually due. Moreover should HMRC issue a follower notice then other taxpayers that have used a similar scheme are required to accept the judgment and return the taxes. The bill is still in draft, progressing through parliament and both the Law Society and Institute of Chartered Accountants in England and Wales have expressed concern regarding the extension of HMRC s powers. Nonetheless the Treasury expects that if enacted, it could speed up the collection of approximately 4bn of taxation. We highlight this issue as a potential emerging risk to any financial institutions involved in either the manufacture or selling of what are considered to be tax avoidance products given the possibility of a concurrent acceleration in damages claims brought by third parties alleging mis-selling or improper advice. We envisage that consideration may also need to be given to insurance policy triggers to take into account the ability of the insured to show that they are liable despite no admission of liability or legal due process.

5 EURO-ZONE BANK SUPERVISION The European Central Bank (ECB) will assume responsibility for supervision of a number of commercial banks in the 18 nation euro zone from 4th November The Single Supervisory Mechanism (SRM) rules, which are still in draft, will give the ECB authority over approving mergers and acquisitions, approval and withdrawing bank licenses and capital buffers. In addition, should the ECB s supervisory board find that a bank is no longer viable the SRM rules will apply the Bank Recovery and Resolution Directive (BRRD). One aspect of the BRRD is that it passes on the costs of restructure and resolving non-viable financial institutions from taxpayers to the institutions, shareholders and creditors. Only certain euro zone banks will fall under direct regulation with the balance being subject to national supervision, however, the ECB will be able to intervene if necessary. It is expected that around 130 banks will be subject to ECM regulation having fallen within the following criteria: Total asset value. Its relative importance to the national economy in which it operates and the EU as a whole. Cross-border activities. Whether it has received financial assistance from the European Financial Stability Facility European Stability Mechanism. Whether it is a top three significant bank in its country of domicile. MARKET MOVERS AND SHAKERS Mark Fellows is now Financial Institutions Manager at AIG Calum McPherson is now London FI Manager at AXIS Capital Gary Lill is now D&O line Underwriter at HISCOX Elke Vengenende is now Head of Financial Institutions at Allianz Global Corporate and Speciality

6 MEET THE TEAM Kevin began his insurance career in 1983 with Minet focussing on professional indemnity insurance for the Big 8 / 6 accountants, leaving as a Divisional Executive Director in He then spent several years with international broking firms, including 4 years broking in the Bermuda market, during which time he specialised more in the D&O and Financial Institution sectors, predominantly for large multinational clients. In 2002 Kevin joined Arthur J. Gallagher before being approached by specialist Financial Institutions broker FirstCity in 2005 FirstCity s subsequent integration in to Arthur J. Gallagher gives him a unique perspective on the strengths of the fastest growing broker in our market. Kevin holds a black belt from the Japan Karate Association and has run multiple ultramarathons, including the landmark 100 mile distance. He is also the race director of the Stour Valley Marathon. Relaxation time is spent with his wife, two daughters and menagerie near Colchester. Kevin Payne Executive Director Tel: +44 (0) kevin_payne@ajg.com If you would like more information about anything discussed within this bulletin, please contact your Account Executive or uk.financial.institutions@ajg.com About Arthur J. Gallagher Founded in 1927, Arthur J. Gallagher & Co. has become one of the largest, most successful insurance brokerage and risk management companies in the world. With extraordinary reach internationally, our parent group employs over 17,000 people and provides service in more than 140 countries. Outside the US we are known as Arthur J. Gallagher, and wherever and whenever there is an issue of risk we re there for our clients. We are a business without barriers working together to create solutions that drive value and competitive advantage. Whether you are an individual, small business or international conglomerate, our people, their depth of technical knowledge and our global reach will deliver unrivalled advice and coverage expertise. Financial and Professional Risks Arthur J. Gallagher (Specialty) The Walbrook Building, 25 Walbrook, London, EC4N 8AW Arthur J. Gallagher (Specialty) is a trading name of Arthur J. Gallagher (UK) Limited which is authorised and regulated by the Financial Conduct Authority. Registered Office: The Walbrook Building, 25 Walbrook, London, EC4N 8AW. Registered in England and Wales. Company Number: CONDITIONS AND LIMITATIONS This information is not intended to constitute any form of opinion and recipients should not infer any opinion from its content. Recipients should not rely exclusively on the information contained in the bulletin and should make decisions based on a full consideration of all available information. We make no warranties, express or implied, as to the accuracy, reliability or correctness of the information provided. We and our officers, employees or agents shall not be responsible for any loss whatsoever arising from the recipient s reliance upon any information we provide and exclude liability for the statistical content to fullest extent permitted by law.

7 APPENDIX PLANNED FCA REVIEWS RETAIL BANKING Unauthorised transactions The FCA will look at whether consumers who suffer unauthorised transactions are getting fair outcomes. Packaged bank accounts Review how banks have implemented the packaged bank account rules that were introduced in March 2013 and how they are dealing with past complaints. The impact of cost-cutting initiatives on different consumer groups Review cost-cutting initiatives that affect a significant number of customers. LONG-TERM SAVINGS AND PENSIONS Effective due diligence for retail investment advice Look at whether investment advisers are carrying out appropriate due diligence to ensure that consumers are sold suitable products and services. Sales practices at retirement Look at sales practices that consumers experience at retirement, the results of which will feed into wider work on retirement income products. Fair treatment of long-standing customers in life insurance Assess whether firms are operating historic (often termed legacy or heritage ) products in a fair way and whether they have adopted strategies that exploit existing customers. Governance of with-profit funds Review whether firms have effectively implemented the changes the FCA made to with-profits rules in 2012 and assess how adequate with-profits governance arrangements are for a particular aspect of their business. Use of in-house funds in wealth management firms Assess how wealth managers and private banks effectively control the conflicts of interest that arise when client assets are invested in in-house investments. Risk at client take-on in contract for difference providers Assess the risks arising from the client take-on procedures in firms offering contract for difference products. MORTGAGE AND CONSUMER LENDING Forbearance practices and the treatment of customers in arrears in the high-cost short-term lending market Review the arrears management processes of high-cost short-term credit firms and how customers are treated when they are in financial difficulty. Suitability of advice in debt management firms Look at the suitability of advice given by debt management firms, including how incentive structures and the use of lead generators may affect consumers. Mortgage Market Review (MMR) post-implementation testing Review areas such as how firms are implementing new affordability rules and how they give advice to customers. The FCA will also look at how firms may be finding ways to avoid the rules. Hybrid equity release products Look at the development of hybrid equity release products as a potential solution to the interest-only maturity issue. Maturity of interest-only mortgages Look at a sample of smaller firms to determine if customers are being treated fairly in line with the guidance published in August Governance over mortgage lending strategies Review governance, risk management and strategies of the firms with recent risk appetite changes across a sample of the lender population. Look at the development of hybrid equity release products as a potential solution to the interest-only maturity issue

8 GENERAL INSURANCE AND PROTECTION Commercial claims Building on findings from current retail claims work, consider whether commercial customers expectations are met in the claims process, where poor behaviour could have a wider impact on trust in the market, as well as leading to poor customer outcomes. Cover holders Look at distribution chains in firms that operate in wholesale markets, but also looking through to the impact on retail and small commercial customers. Propose to look into the key risks in complex distribution chains and the mixed responsibilities in them, including the cultural risks relating to product design, sales and post-sales handling. The FCA will also aim to improve the way intermediaries identify and manage conflicts of interest. Premium finance Review insurers and intermediaries sales practices and disclosures when selling premium finance to consumers alongside general insurance products. This follows on from previous work on commercial premium finance and aligns to the FCA s new responsibility for the regulation of consumer credit from April Motor legal expenses insurance Ensure that firms have embedded the recommendations the FCA made in 2013 in this market. WHOLESALE BANKING AND INVESTMENT MANAGEMENT Conflicts of interest in investment banks Look at how firms effectively control the conflicts of interest that can exist between their obligations to clients and sales and the trading positions they take. Controls over flows of information in investment banks Look at how firms effectively ensure that the confidential information they receive in one part of the business is not used by another business area in an abusive way. Market abuse controls in asset managers Look at how firms ensure trading activity is consistent with the FCA s expectations of market conduct. Trader controls around benchmarks Look at how firms effectively reduce the risk of traders manipulating benchmarks. Agency responsibilities of asset managers The FCA will ensure that asset managers are acting as good agents and taking proper account of investor interests. CROSS-SECTOR Managing the performance of staff Following the FCA s work on financial incentives, look at how firms manage the performance of their sales staff and whether pressure put on staff (through, for example, sales targets) increases the risk of mis-selling. Resilience against cyber attack In response to the Financial Policy Committee recommendation, the FCA will work with the Treasury, the Prudential Regulation Authority (PRA) and the Bank of England to assess and test the Financial Services Critical National Infrastructure s resilience to cyber-attacks. Visibility of IT resilience and risks at board level Assess how far individual firms have progressed against the feedback they were given after the 2012 dear chairman exercise. The FCA will will do this jointly with the PRA and the Bank of England. The aim is to assess how well firms manage their own exposure to risks, to what extent IT risks are discussed at board level, and whether boards have the skills and expertise to challenge executive decisions.