RETAIL CLIENT COMPENSATION FOR FINANCIAL SERVICES LICENSEES

Transcription

1 RETAIL CLIENT COMPENSATION FOR FINANCIAL SERVICES LICENSEES PROJECT SUMMARY July 2007 Melzan Pty Ltd ABN Telephone: Facsimile: (02) PO Box 732, Mona Vale NSW 1660

2 Project Summary The recent collapse of several financial entities has highlighted a significant risk to Australian consumers. Westpoint, Fincorp, Bridgecorp and Australian Capital Reserve have failed, leaving retail clients individuals who have often invested their life savings facing substantial losses with the prospects of recovery being at best highly uncertain. In many cases, retail clients have invested in these now-defunct companies on the advice of financial service licensees such as financial planners. As retail clients have sought compensation from those financial advisors, some have been confronted with an alarming reality. Many licensees simply do not have the insurance or the assets required to properly compensate people where they are legally liable. This leaves their former clients to join a long queue of creditors and stand in line for years in the hope that they will be repaid in winding up proceedings. The Federal Government has recently taken two important steps towards protecting retail clients. The first is making it mandatory for licensees to hold Professional Indemnity insurance (PI) insurance unless they are prudentially regulated by the Australian Prudential Regulatory Authority (APRA). The second is investigating, through the Council of Financial Regulators (CFR), a last resort compensation scheme for the retail clients of prudentiallyregulated licensees. However, the steps taken by the Federal Government to date are market-based and are not intended to be a comprehensive consumer safety net. PI is a competitive market in which insurers choose to cover certain risks at an affordable premium. PI leaves licensees to pay some parts of their liability themselves. The CFR proposal would assist deposit-holders and policyholders, but not the retail clients of nonprudentially regulated licensees, such as financial advisors, which make up 69% of licensees. This project The Financial Industry Complaints Service Limited (FICS) and other External Dispute Resolution (EDR) schemes that have the power to make awards for compensation have direct experience of the adverse impact that such gaps can have on retail clients. FICS has commissioned Melzan Pty Ltd (Melzan) to identify the gaps left by the mandatory PI, research the Australian and international models for compensating clients, explore options for client compensation beyond the mandatory PI, and suggest some next steps that should be taken to better protect consumers. Melzan has conducted research for FICS in three stages: stage one involved the identification of gaps (Gaps in the Professional Indemnity Market, Gaps Paper May 2007); stage two involved a detailed background investigation into Australian and international models (Research on Group Insurance and Compensation Schemes, Research Paper June 2007); and stage three involved the development of options and next steps for a compensation scheme

3 in Australia ( Options Paper, July 2007). Melzan s key findings at each of those stages is set out below. Gaps left by the Professional Indemnity market 1 PI leaves a gap in consumer protection because it does not cover losses sustained by retail clients where the principal of a licensee has been fraudulent or dishonest, or misappropriated the funds of client. 2 PI leaves a gap in consumer protection because run-off cover has limited availability. If a licensee is retired, they may not have sufficient assets themselves to compensate a former client. 3 PI leaves a gap in consumer protection because it may not assist where a licensee disappears, has their license withdrawn by Australian Securities and Investments Commission (ASIC), is wound up or is no longer a going concern. In such instances, the client may have an award made in their favour but the award is of little use to them because the defendant does not exist. 4 PI leaves a gap in consumer protection as even with PI, a licensee may become insolvent. Reasons include: Liability to clients exceeds indemnity provided by PI so the licensee becomes insolvent (for example, the quantum of the loss exceeds the limit of indemnity, sum of multiple losses exceeds the limit of indemnity including any reinstatements under the policy). Excesses are so high that the licensee becomes insolvent (for example, having to pay multiple excesses may make a licensee insolvent). Standard exclusions in PI cover requires such high levels of self-insurance that the licensee becomes insolvent (for example, authorized representatives acting outside the scope of their authority, conflicts of interest claims, and claims relating to products not on an approved product list ). The licensee is unprofitable for reasons which do not relate to claims made by clients (such as economic downturn, failure to properly manage business). 5 These gaps (points 1-4) may change when the mandatory PI requirement commences on 1 July 2008, depending on the content of the ASIC Regulatory Guide to be released in November Retail Client Compensation For Financial Services Licensees Project Summary 3

4 Australian and international client compensation schemes 6 Although there are schemes in place in all Australian States to protect the clients of lawyers (for example, LawCover and Fidelity Fund in NSW), doctors (Health Care Liability schemes in NSW and Federal levels), builders (Home Warranty Insurance), stockbrokers (National Guarantee Fund) and the members of Superannuation Funds (Federal Superannuation Protection Reserve), there is no scheme in place to protect the retail clients of financial services licensees. 7 There are compensation schemes in place to protect consumers who deal with financial planners, insurance brokers and other financial advisors in the United Kingdom, Canada and the United States. 8 Compensation schemes should be assessed on the basis of seven key criteria: A sufficient scope of cover for effective consumer protection Accessibility to consumers Adequate financial cover for consumers Affordability for whoever funds the scheme, whether that be industry, Government or consumers Efficiency Provides an incentive for industry, regulators and consumers to manage risk effectively Acceptability to stakeholders 9 On the basis of the criteria in point 8, we recommend that the Financial Services Compensation Scheme (FSCS) which is in place in the United Kingdom be used as a model for a compensation scheme in Australia. The core elements of that scheme are: A statutory requirement for licensees to hold PI A centralized fund established with legislative support and funded on an ongoing basis through levies on licensees Coverage of some gaps left by PI that arise when someone is unable, or likely to be unable to pay claims against them. Retail Client Compensation For Financial Services Licensees Project Summary 4

5 Options for client compensation schemes 10 There are a number of options available to stakeholders for developing a compensation scheme. They include: Option A: Compulsory PI combined with a Government-supported centralized fund Option B: Compulsory PI combined with an industry-run fund Option C: Government-run centralized fund with no requirement for PI Option D: Group insurance scheme 11 On the basis of the criteria (in point 8), we recommend Option A. The objective of this Option A is to minimise gaps that are currently left by PI alone, but it does not eliminate all gaps. The basic elements of Option A are: A statutory requirement for licensees to hold PI A centralized fund established with the assistance of Government funding and funded on an ongoing basis through levies on licensees Coverage of some gaps currently left by PI, namely fraud and misappropriated funds (fidelity component), and failure to pay in the event that a licensee ceases trading, loses license, disappears or becomes insolvent ( last resort component). Legislative support 12 We recommend the following design features of Government-supported centralized fund: Coverage of fidelity (fraud and misappropriation of funds) and last resort (insolvency, cease trading, disappearance and loss of license) Caps that are on par with EDR caps Operation by an independent body jointly governed by EDR schemes, consumer representatives, Government and industry representatives Multi-source funding by Government for establishment costs, ASIC for ongoing operating expenses, a borrowing facility combined with post-event levies on licensees Direct access by retail clients to the centralized fund Retail Client Compensation For Financial Services Licensees Project Summary 5

6 Supported by Federal legislation which ties the obligation on licensees to have adequate compensation arrangements to compliance with their funding obligations to the centralized fund Prospective application ideally commencing on the same date that the obligation on licensees to have PI commences, currently being 1 July 2008 Next Steps 13 We recommend that, given the proposed links between the EDR schemes and a centralized fund, FICS and other EDR schemes consider their jurisdiction with respect to former licensees. 14 We recommend that FICS commission the collection and analysis of data about the age and long tail of transactions and claims against licensees. Subject to agreement and appropriate arrangements concerning privacy and confidentiality, this data could be sourced from Court Reports, licensees, PI insurers, ASIC, FICS and other EDR schemes and/or the National Claims and Policy Database (held by APRA). 15 We recommend that an actuary and/or economist be engaged to: Quantify the extent of retail clients exposure to the risk of not being compensated by licensees. Although we can identify the gaps (points 1-4) left by mandatory PI, there is no data on the size and probability of this risk. Quantify the cost of establishing and maintaining basic operations of a centralized fund. These are the costs which would be borne by the Government and ASIC under the recommended model. Model different ways of levying licensees (for example, different annual caps, spread across licensees, structures for the fidelity and last resort components of the fund). This actuarial/economic modelling could be conducted privately (for example engaged by EDR schemes) or by the Treasury. 16 We recommend that stakeholder consultation commence. Key stakeholders include EDR schemes, consumer representatives, the Parliamentary Secretary to the Treasurer, Shadow Treasurer, Treasury, ASIC, industry associations representing licensees and large licensees. Additional stakeholders include PI insurers, the Insurance Council of Australia, Council of Financial Regulators and Australian Prudential Regulatory Authority. Retail Client Compensation For Financial Services Licensees Project Summary 6

7 RETAIL CLIENT COMPENSATION FOR FINANCIAL SERVICES LICENSEES GAPS IN THE PROFESSIONAL INDEMNITY MARKET Paper 1 May 2007 Melzan Pty Ltd ABN Telephone: Facsimile: (02) amason@melzan.com.au PO Box 732, Mona Vale NSW 1660 Retail Client Compensation For Financial Services Licensees Gaps Paper 1

8 Executive summary Melzan Pty Ltd (Melzan) has been commissioned to conduct research for the Financial Industry Complaints Service (FICS) into retail client compensation for financial services licensees. This paper, Gaps in the Professional Indemnity Market ( Gaps Paper May 2007) forms the first stage in the research and involves the identification of gaps in the protection of retail clients of financial services licensees ( licensees ) left by Professional Indemnity insurance ( PI ). Stage two involves a detailed background Research on Group Insurance and Compensation Schemes ( Research Paper to be provided in June 2007). Stage three involves the development of options and next steps for a compensation scheme in Australia ( Options Paper to be provided in July 2007). Melzan s key findings at this stage are that there are four key reasons why market-based PI leaves a gap in consumer protection. Firstly, PI does not cover losses sustained by retail clients where the principal of a licensee has been fraudulent or dishonest, or misappropriated the funds of client. Secondly, PI leaves a gap in consumer protection because run-off cover has limited availability. If a licensee is retired, they may not have sufficient assets themselves to compensate a former client. Thirdly, PI leaves a gap in consumer protection because it may not assist where a licensee disappears, has their license withdrawn by ASIC, is wound up or is no longer a going concern. In such instances, the client may have an award made in their favour but the award is of little use to them because the defendant does not exist. Finally, PI leaves a gap in consumer protection as even with PI, a licensee may become insolvent. Reasons include: Liability to clients exceeds indemnity provided by PI so the licensee becomes insolvent (for example, the quantum of the loss exceeds the limit of indemnity, sum of multiple losses exceeds the limit of indemnity including any reinstatements under the policy). Excesses are so high that the licensee becomes insolvent (for example, having to pay multiple excesses may make a licensee insolvent). Standard exclusions in PI cover requires such high levels of self-insurance that the licensee becomes insolvent (for example, authorised representatives acting outside the scope of their authority, conflicts of interest claims, and claims relating to products not on an approved product list ). The licensee is unprofitable for reasons which do not relate to claims made by clients (such as economic downturn, failure to properly manage business). Retail Client Compensation For Financial Services Licensees Gaps Paper 2

9 TABLE OF CONTENTS Executive summary Introduction Adequacy of P.I. Insurance for Monetary Compensation FICS s Limits of Jurisdiction Multiple Claims Priority and Apportionment Defence Costs Statistical Evidence Cover Issues Non Disclosure Corporations law breaches Standard policy exclusions Fidelity and Fraud Run-off Cover Recommendation...7 Retail Client Compensation For Financial Services Licensees Gaps Paper 3

10 1 Introduction The scope of the project outline by FICS has nominated key areas for consideration including: Run-off cover Fraud Policy exclusions such as approved product lists Acting outside scope of authority The purpose of this first brief report is to review the report Compensation Arrangements for Financial Services Licensees which was commissioned by ASIC in December 2006 and provided to FICS and other stakeholders, to see if there were other specific matters that should be taken into account. In response it is hoped that FICS will be able to examine its recent case history to see if there are other matters that should be taken into consideration. 2 Adequacy of P.I. Insurance for Monetary Compensation This was discussed in Section 6 of the ASIC report in some detail. Whether or not a policy is adequate to meet a loss is only able to be determined on a case by case basis. This discussion presumes that there is a civil liability which will be met by the policy. Potential gaps therefore arise if: a) The quantum of the loss exceeds the limit of indemnity. b) The sum of multiple losses exceeds the limit of indemnity including any reinstatements under the policy. c) The amount of the excess under the policy is an amount not insured and therefore the licensee has to have the capacity to pay. d) In the event of multiple claims the licensee may need to have the capacity to meet multiple excesses. 2.1 FICS s Limits of Jurisdiction An interesting added permutation is whether or not the issue of adequate compensation should be considered in the context of the FICS jurisdictional limit or the licensee s overall exposure. The question therefore is, is it in any way relevant from the consumer perspective, as to whether or not the insurer s policy will meet a FICS determination up to a specified Retail Client Compensation For Financial Services Licensees Gaps Paper 4

11 amount (currently $100,000)? It is understood that FICS is partially attempting to address this by proposing that its jurisdiction will be restricted in quantum only in terms of the award made, not in terms of the total amount subject to dispute. A complicating factor is the basis of the determination. FICS has a conciliation type role and has the power to determine disputes on what is fair and reasonable. This could,and most probably does, mean that insurance policies which only pay for a civil or legal liability are more restricted in scope. 2.2 Multiple Claims Priority and Apportionment If there are multiple claims and/or determinations made against a licensee which in total exceed the available limits under the policy, there is a theoretically interesting scenario in determining which claimant should receive the insurance proceeds or the first awards and how do subsequent claimants proceed? This issue of course becomes simpler in insolvency. 2.3 Defence Costs Licensees are entitled to seek indemnity for defence costs either as part of the limit of indemnity or in addition to the limit of indemnity under professional indemnity insurance policies. Where costs are expressed as inclusive the amount of the limit of indemnity available to meet the compensation claims to the consumer is by virtue of the extent of costs reduced, on the other hand if costs are in addition there is no impact on the amount available to meet consumer claims. Similarly, as noted in the report excesses can apply to costs,or not, depending on the policy. These are detailed issues that will need to be thought through if a compensation fund is designed that has consistency of application. However, this issue only applies to claims made against licensees during a period when a valid professional indemnity insurance policy is in place. 2.4 Statistical Evidence The statistical evidence that was able to be included in the report plus the anecdotal views of insurers and brokers seem to indicate that relatively low limits such as $2 million are sufficient to meet in excess of 90% of all claims. It will be helpful if, from FICS s, APRA ASIC or insurers records, a statistical analysis could be prepared identifying where claims have exceeded the available amounts under insurance policies. 2.5 Cover Issues Claims Made. Policies are all written on a claims made and notified basis. If a claim is not made during the period of insurance but there is a delay in notification then there may be no policy to respond to the loss. This issue should be considered jointly with consideration of run-off cover. Here again, however, it would be helpful to ascertain to what degree claims against licensees and disputes received by FICS are late notified. It is to be expected that as Retail Client Compensation For Financial Services Licensees Gaps Paper 5

12 a matter of course most claims will arise long after the initial investment has been made or the transaction which is in dispute took place. A more specific problem is where a claim is made against a licensee but not notified by the licensee to the insurer and therefore the policy will not indemnify the licensee. 2.6 Non Disclosure Selling products not on the approved products list and compliance generally with policy terms and conditions are examples of a myriad of circumstances in which a licensee could jeopardise the cover available under its professional indemnity insurance policy. This raises an interesting question in the design of any proposed compensation fund as to whether it is appropriate that the fund responds in such circumstances. Here again any case studies would be helpful. 2.7 Corporations law breaches Consumers could suffer loss as a result of the licensee breaching obligations under the Corporations Law including as extreme matters as not paying the required fee and therefore being unlicensed, breaching requirements of the Act in regard to Statements of Advice (SOAs), Financial Services Guides (FSGs) or Product Disclosure Statements (PDSs), not complying with training obligations and so forth. As the report to ASIC has identified, insurance policies generally do not respond to breaches of Chapter 7 of the Corporations Act. Nevertheless such incidents are thought to be extremely low in probability and actual occurrence. Nevertheless it is a design feature that will need to be taken into account. 2.8 Standard policy exclusions There are a range of policy exclusions which are found in most insurance policies, including for example, exclusion of terrorism, war, and nuclear risks. Whilst there is no evidence that any of these risks has arisen or given to rise to losses, nevertheless, the exclusion of sovereign risk needs to be kept in mind. 2.9 Fidelity and Fraud Most policies will cover the actions of employees and indemnify innocent Directors, Partners etc. Fraud of principals however, is uninsurable. Evidence is that these other matters are low in frequency but in the absence of a mutual or statutory fund it is unlikely that the insurance market will ever cover it Run-off Cover This is the most significant gap between what the insurance market can and does provide and the exposure to consumers. Retail Client Compensation For Financial Services Licensees Gaps Paper 6

13 When a licensee retires, dies or becomes insolvent the professional indemnity policy normally runs to its next expiry date. If the licensee has the requisite assets and capacity then 1 years worth of run off cover can usually be purchased. Longer periods are rare for the reasons set out in the report to ASIC. If the licensee sells its business to another licensee then ongoing cover can be provided under the umbrella of the purchasing firm s insurances, subject to the underwriting decisions of the insurer. This is an area of great consumer potential exposure as investments and superannuation investments in particular are by their very nature long term issues. Losses and therefore claims may only materialise after the initial investment has been made or the advice was received. It is also interesting to consider that the relevant licensee may no longer be in existence. A further issue is whether FICS has jurisdiction where a claim is brought against a person or entity that no longer has a license and/or is no longer a member of FICS. 3 Recommendation We recommend that FICS commission the collection and analysis of data about the age and long tail of transactions and claims against licensees. Subject to agreement and appropriate arrangements concerning privacy and confidentiality, this data could be sourced from FICS and other EDR schemes, Court Reports, licensees, PI insurers, ASIC and/or the National Claims and Policy Database (held by APRA). Retail Client Compensation For Financial Services Licensees Gaps Paper 7

14 RETAIL CLIENT COMPENSATION FOR FINANCIAL SERVICES LICENSEES RESEARCH PAPER ON GROUP INSURANCE AND COMPENSATION SCHEMES Paper 2 JUNE 2007 Melzan Pty Ltd ABN Telephone: Facsimile: (02) amason@melzan.com.au PO Box 732, Mona Vale NSW 1660

15 Executive Summary As identified in the Gaps in the Professional Indemnity Market Paper ( Gaps Paper, May 2007), the requirement that financial services licensees ( licensees ) hold Professional Indemnity (PI) insurance is an important step towards consumer protection, but is a marketbased solution which is not intended to provide a comprehensive consumer safety net. This Research Paper examines various ways in which Australia and other countries have attempted to bridge gaps in the protection of financial services consumers. Although there are group insurance and centralized funds in place in all Australian States to protect the clients of lawyers (LawCover and Fidelity Fund in NSW), doctors (Health Care Liability schemes in NSW and Federal levels), builders (Home Warranty Insurance), stockbrokers (National Guarantee Fund) and the members of Superannuation Funds (Federal Superannuation Protection Reserve), there is currently no scheme in place to protect the retail clients of financial services licensees. There are also compensation schemes in place to protect consumers who deal with financial planners, insurance brokers and other financial advisors in other countries, for example the United Kingdom (Financial Services Compensation Scheme (FSCS)), Canada (Canadian Investor Protection Fund) and the United States (Securities Investor Protection Corporation). However, there is currently no scheme in place to protect the retail clients of financial services licensees in Australia. An adequate compensation scheme meets seven key criteria: sufficient scope of cover for effective consumer protection; accessibility to consumers; adequate financial cover for consumers; affordability for whoever funds the scheme, whether that be industry, Government or consumers; efficiency; provision of an incentive for industry, regulators and consumers to manage risk effectively; and, acceptability to stakeholders. On the basis of these criteria, we recommend that the FSCS which is in place in the United Kingdom be used as a model for a compensation scheme in Australia. The core elements of the FSCS scheme are: A statutory requirement for licensees to hold PI A centralized fund established with legislative support and funded on an ongoing basis through levies on licensees Coverage of some gaps left by PI that arise when someone is unable, or likely to be unable to pay claims against them. The design features of the FSCS are assessed in detail in the third paper developed for FICS by Melzan, Options Paper, July 2007.

16 TABLE OF CONTENTS Executive Summary Introduction Scope of Research Research Methodology Scheme options Group Insurance Schemes HIH Claims Support Ltd Medical Indemnity Lawyers Schemes Builders Warranty Compensation Funds National Guarantee Fund ASX Supplemental Compensation Fund Sydney Futures Exchange Fidelity Fund Superannuation Government proposals for a compensation facility Financial Services Compensation Scheme, United Kingdom Canadian Investor Protection Fund Securities Investor Protection Corporation, United States Analysis of compensation schemes and funds Discretionary mutual funds Captive arrangements APRA licensed insurers Analysis against criteria Summary of key features...41 Appendix 1 Support Schemes for Medical Indemnity Insurance...44 Appendix 2- Summary of group insurance schemes...45 Appendix 3 - Summary of Australian compensation schemes...50 Appendix 4 - Summary of international compensation schemes...53 Appendix 5 - Reference websites...54 Appendix 6 - Abbreviations used in this report...55

17 1 Introduction Professional indemnity insurance (PII) is commonly used by professionals to manage their risk exposures and indemnify them for their liabilities to clients. Claims against financial services licensees are most typically for inappropriate advice, although they can also be for misappropriation of funds and breaches of trade practices provisions. Commonwealth Treasury has inquired into the adequacy of compensation arrangements for loss in the financial services sector 1. In the Government s Position Paper, a preference for arrangements based on professional indemnity insurance was expressed and it was proposed that regulations should specify professional indemnity insurance as the primary type of arrangement acceptable for the purposes of section 912B of the Corporations Act The draft regulation was designed to: prescribe adequate professional indemnity insurance as the required compensation arrangement under section 912B prescribe the factors to take into consideration when determining what type of insurance cover is adequate require licensees to note their professional indemnity cover in their Financial Services Guide prescribe factors that ASIC must take into account before approving alternative arrangements to professional indemnity cover and exempt certain licensees (prudentially supervised institutions and certain related entities) from the requirements. The draft regulation has now been amended in response to public comments and The Hon Chris Pearce, MP, Parliamentary Secretary to the Treasurer, announced that the regulation is expected to be made by 1 July Melzan Pty Ltd was engaged by ASIC to research the professional indemnity insurance market in relation to the compensation arrangements for financial services licensees. Research highlighted many gaps between available and proposed professional indemnity insurance and potential client compensation needs were identified. Financial Industry Complaints Service Ltd (FICS), in its response to the draft legislation 3, raised a number of concerns including conditions and exclusions on professional indemnity 1 Compensation for Loss in the Financial Services Sector, Position Paper, December 2003, Commonwealth Treasury and Compensation arrangements if financial services are provided to retail clients under section 912b of the Corporations Act 2001, Commentary on draft regulations. 2 Financial Services Compensation Arrangements Announced, Press Release No. 020 by The Hon Chris Pearce, MP, Parliamentary Secretary to the Treasurer, 18 May 2007 Retail Client Compensation For Financial Services Licensees 4

18 insurance policies and the ease at which a financial services licensee can avoid their responsibilities to consumers by ceasing to trade. FICS highlighted potential pitfalls in the proposed reliance on PII to protect retail clients and showed preference for a centralised fund. FICS engaged Melzan Pty Ltd to conduct research into the options for providing compensation to clients of Financial Services Licensees in addition to, or separate from, the professional indemnity insurance requirements set out, or proposed to be set out, in Section 912B of the Corporations Act The research is presented in this report. 1.1 Scope of Research The research undertaken has been divided into three parts Identified deficiencies in PI cover Deficiencies in the current professional indemnity insurance model were identified, based on the research undertaken by Melzan Pty Ltd for ASIC in regard to professional indemnity insurance. A report, Gaps in the Professional Indemnity Market ( Gaps Paper ) was provided to FICS in May It highlighted issues in relation to: multiple claims priority and apportionment, defence costs, cover issues, non disclosure, Corporations law breaches, standard policy exclusions, fidelity and fraud, and runoff cover Research into group insurance schemes and compensation funds This paper forms stage two in the research Melzan has been commissioned to conduct. It involves a detailed background investigation into Australian and international models of compensation schemes. Group Insurance Schemes Research has been conducted into the structure, design, operating requirements and costs for HIH Claims Support Limited Medical malpractice insurance, in particular government support arrangements Consumer protection and professional indemnity insurance for Solicitors, focussing on arrangements in NSW and Victoria Home Builders Warranty Insurance (HBWI) in NSW, Victoria and Queensland and recent State Government reports Compensation Funds Australian compensation fund models have also been investigated. They include: 3 Submission in relation to draft regulation entitled Compensation arrangements for financial services licensees, Financial Industry Complaints Scheme, December 2006 Retail Client Compensation For Financial Services Licensees 5

19 The National Guarantee Fund ASX scheme providing compensation for loss due to noncompletion of sales and purchases, transfer of securities without authorisation and Dealer insolvency ASX Supplemental Compensation Fund providing compensation for retail clients of a stockbroker with trading permission to deal in futures who have suffered a loss due to misappropriation or fraudulent misuse The Futures Exchange Fidelity Fund compensation scheme for clients of Dealers of the SFE in connection with futures contracts Arrangements under Part 23 of the Superannuation Industry Supervision Act Commonwealth Government proposals for a compensation fund in the event of a financial failure of a licensed insurer or approved deposit taking institution International approaches to compensation funds were also investigated and examples are taken from United Kingdom, Canada and the United States. Detailed research was conducted on the Financial Services Compensation Scheme in the United Kingdom. Publicly available information was supplemented with intelligence gained through face to face interviews with representatives of the Financial Services Compensation Scheme, the Financial Service Ombudsman and the Association of British Insurers. 1.2 Research Methodology Publicly available information combined with information gained by interviewing key personnel was used to provide an overview of key compensation schemes. Included is an analysis of the relative advantages and disadvantages of: APRA licensed insurers Mutual funds Captive arrangements. A set of key criteria or parameters was developed against which the models were assessed and compared. Retail Client Compensation For Financial Services Licensees 6

20 The key criteria are defined as: Criteria Definition Sufficient scope of cover Covers common law and statutory (Corporations Act) obligations, Covers fraud and misappropriation of funds Covers products and services where risks lie (eg licensees that do not have proper risk management strategies in place, authorised representatives who act outside the scope of authority Accessibility Directly accessible by retail clients Clear eligibility criteria and definition of claims coverage Compatible with EDR schemes Retail clients who may have low levels of financial literacy are aware it exists and know how to access it Access costs are kept within reasonable limits Adequate financial cover Covers clients if licensee loses license or stops trading Meets retail clients reasonable expectations of what level of compensation they might receive, even in cases of insolvency Aggregate losses sufficient funds to meet all losses Affordable for licensees Level of impost on licensees and financial services providers reasonable Ideally, those who cause loss to retail clients pay the compensation (ie no cross subsidisation) Does not put excessive upward pressure on prices Efficiency Provides compensation to eligible claimants within an acceptable timeframe (ie not excessive and in line with market practice) Administration and management costs are controlled Reasonable level of set up costs Administrative requirements on licensees kept to a minimum Provides incentive for risk management Provides an incentive for licensees to manage their risks of breaching duty or statutory non-compliance Does not create a moral hazard for regulators Acceptability to stakeholders Consumers indicated by number of claims accepted to declined Licensees level of financial or administrative cost Regulators level of regulation required, EDR mechanisms Government level of government support required, legislation required Professional indemnity insurers compulsory, regulated product 1.3 Scheme options Options for a scheme to compensate retail clients of financial services licensees have been developed and are provided in a separate report. The options detail inter alia alternative administration and structures, coverage, benefits and funding arrangements. Retail Client Compensation For Financial Services Licensees 7

21 2 Group Insurance Schemes A number of group insurance schemes have been investigated. They include HIH Claims Support which was established by the Commonwealth Government and the Insurance Council of Australia to respond to the collapse of HIH, professional indemnity insurance schemes for medical and legal practitioners and insurance for home buildings and renovations. A summary table is included in Appendix HIH Claims Support Ltd The HIH Group of companies was placed into provisional liquidation on 15 March 2001.The Commonwealth Government stepped in to provide assistance to individual and small business policyholders who suffered financial hardship as a result of the collapse. HIH Claims Support Limited (HCSL) was set up as a non profit company as a subsidiary of the Insurance Council of Australia. HCSL had its own Board of Directors (with the majority being independent non-executive directors) and was charged with the overall administration of the assistance scheme. Four insurance companies were appointed to provide claims services while the eligibility assessments, call centre functions and other activities were outsourced by HCSL to another service provider. An important part of the process was the need to reconcile assistance payments with the records of the HIH Liquidator and so the Liquidator was an important part of the process. The Australian Government funded the scheme through the Appropriation (HIH Assistance) Act 2001 which provided for funding up to $640m. Funding and scheme payments were made through a trust of which HCSL was Trustee. Eligibility criteria applied to all claims and can be summarised as: Must be Australian citizen or permanent resident Small business must be Australian owned with 50 or less FTE employees and not a related entity of a larger organisation Not-for-profits must be Australian based private individuals were subject to an income test based on taxable income base of $77234 no such test for applications by small business owners corporations (strata/body corporates) and trusts were also subject to specific eligibility criteria. Policyholders who were deemed eligible for assistance were entitled to receive 90 or 100% of their claim, dependant on the type of policy, income and other criteria. For salary Retail Client Compensation For Financial Services Licensees 8

22 continuance type claims - personal injury and total loss of primary place of residence, 100% of the claim was paid. The 90% limit on most claims was intended to reduce moral hazard to have consumers liable for some of the risk in the choices or decisions they make. Small business was defined as having fewer than 50 FTE employees. Applicants would assign their rights to HCS in applying for assistance. Approaching applications were received between 2001 and Feb 2004 when access to the scheme formally closed. Eligibility criteria aimed at balancing fairness and simplicity as a complex system would add to the administration burden. Most of the claims dollars went to long-tail classes such as public liability and professional indemnity. 2.2 Medical Indemnity Medical indemnity cover provides compensation to claimants in the event of medical error or negligence. Medical defence organisations have historically provided indemnity cover for doctors. The medical defence organisations (MDO) that offered medical indemnity cover were not-for-profit mutuals. Indemnity was offered on a discretionary basis and the MDO had no contractual obligation to indemnify a medical practitioner. The discretionary nature of these funds meant that MDOs were not subject to regulation by APRA. As members of the MDO, medical practitioners paid an annual fee, however, if the MDO considered its financial position to be weak the MDO could call on further funding from members. Medical indemnity insurance is not mandatory in all states and territories and health care professionals can choose how they will manage their business risks. Options range from doing nothing (that is, no form of insurance), through to purchasing commercially available medical indemnity insurance as individuals. For some, their employer may purchase insurance for the organisation that also covers its employees, such as medical practitioners and nurses. In NSW, professional indemnity insurance for medical practitioners was made compulsory under the Health Care Liability Act 2001 (HCL Act) 4. In the years leading up to 2002 significant upward pressure on prices had resulted from risk rating of high risk specialities and high risk procedures whilst the numbers of claims and claims costs were on the rise. The collapse of HIH added further pressure as it was a reinsurer of various MDOs. The appointment of a provisional liquidator to the largest provider in the market, United Medical Protection (UMP), in 2002 signified the turmoil in the market and there were increasing demands to bring the industry under the same regulatory regime as the providers of other insurance products. A number of Government initiatives were introduced in the following years to bring more stability and certainty to the market. The Medical Indemnity Act 2002 enabled participating 4 Section 19 Retail Client Compensation For Financial Services Licensees 9

23 medical defence organisations and medical indemnity insurers to make claims under four medical indemnity schemes which are administered by Medicare Australia. Medical Indemnity Legislation Amendment Act 2005 refined and improved the operational and administrative aspects of some of medical indemnity schemes. The Consolidated Revenue Fund is appropriated for the purposes of making payments under the schemes. Appropriations are based upon an actuarial assessment to arrive at a reasonable estimate of the liability under each of the schemes. The initiatives are: Premium Support Scheme - to assist eligible doctors whose medical indemnity costs exceed 7.5% of their gross private medical income 5. High Cost Claims Scheme - which reimburses insurers on a per claims basis by funding 50% of the cost of medical indemnity insurance payouts between $300,000 and up to the limit of the practitioner's cover. Exceptional Claims Scheme - to provide protection for doctors against personal liability for claims that exceed their insurance of $20 million. Claims can be either a single very large claim or an aggregate of claims that together exceed the contract limit. Run-off Cover Scheme 6 - to provide run-off cover for eligible doctors aged 65 years or more and permanently retired, on maternity leave, retired for more than three years, retired due to disablement, or the estate of those who have died or leave the private medical workforce permanently. Under the run-off cover scheme, insurers are obliged to give eligible doctors medical indemnity cover on the same terms and conditions, and for the same range of incidents, as the last cover that they had prior to becoming eligible for the scheme. This must cover the period when the doctor was a registered medical practitioner and had medical indemnity cover with an insurer. IBNR Scheme - where the Government will cover the costs of claims from UMP's unfunded incurred but not reported liabilities (IBNRs), with UMP members contributing to these costs through the UMP Support Payment 7 (the UMP Support Payment replaces the IBNR contribution 8 ). The Government s initial intention was to fund only the unfunded IBNR liability but later extended the scheme. 5 The PSS is a broader based scheme that has now replaced the Medical Indemnity Subsidy Scheme 6 Medical Indemnity (Run-off Cover Support Payment) Act Medical Indemnity (UMP Support Payment) Act To fund payments made under the IBNR scheme the Government introduced an IBNR contribution scheme, to collect contributions from medical practitioners and other health professionals who were members of UMP as at 30 June While the original announced policy was for United s then members to reimburse the Government over time through an annual levy, the Government later agreed to fund around three-quarters of the IBNR claims as they emerged. The remaining quarter is to be met by doctors who were members of UMP (or other organisations taken over by UMP) at 30 June In reducing the amount to be met by UMP members, the Government renamed the IBNR contribution scheme to the UMP support payments scheme. Act of Grace payments refunded payments of $2.9 million made under the IBNR contribution scheme during Extract from Review of competitive neutrality in the medical indemnity insurance industry - Report, March Retail Client Compensation For Financial Services Licensees 10

24 Prudential regulation - from 1 July 2003 medical indemnity cover must be provided by general insurers under contracts of insurance and as such are subject to prudential regulation by APRA. Prudential supervision and product regulation of providers of medical indemnity cover is required under the Medical Indemnity (Prudential Supervision and Products Standards) Act Approved insurers must comply with certain requirements which include data collection and reporting and risk management. Product disclosure rules under that Act are complemented by product disclosure rules in the Corporations Act Tort law reforms introduced in each state have also had a significant impact in reversing the previous trends of increasing claims costs 9. These reforms were introduced following the Ipp review of the law of negligence 10. There are four independent medical defence organisations in Australia who have captive insurers. United Medical Protection retains the largest market share at around 40%. Schemes performance The Medical Indemnity Policy Review Panel undertook a review of medical indemnity in 2005 and found that considerable progress had been made in achieving the objectives of improved affordability and sustainability in the marketplace. It found that there have been considerable improvements in the affordability of premiums and in 2006 there was no need for a doctor to stop practising because he or she cannot obtain affordable cover 11. These findings are supported by the Review of competitive neutrality in the medical indemnity insurance industry conducted in early which found that the industry (is) back to a state of health All the insurers have reached or are well on the way to reaching the capital APRA requires. Similarly the ACCC found that, in the current market environment, the premiums set by the five insurers were considered to be commercially justified. 13 Summary statistics extracted from Medicare s Annual Report (Appendix 1) indicate that the highest level of Government support has been provided through the Premium Support Scheme and High Cost Claims, Exceptional Claims and Run-Off Schemes have required little or no financial support. Effects of the various schemes on competition and pricing have been covered in the above reports. See for various medical indemnity publications. 9 See, eg ACCC fifth monitoring report on public liability and professional indemnity insurance accessed at 10 Review of the Law of Negligence Final Report, September 2002, Chaired by Justice Ipp, 11 Achieving stability and premium affordability in the Australian medical indemnity marketplace, Medical Indemnity Review Panel, February ACCC Medical indemnity insurance third monitoring report December 2005 Retail Client Compensation For Financial Services Licensees 11

25 2.3 Lawyers Schemes NSW All solicitors practising in New South Wales are required to hold compulsory professional indemnity insurance (PII) under Section 406 of the Legal Profession Act 2004 (NSW). Compulsory PII protects consumers of legal services from loss arising from the negligence of a legal practitioner in the course of practice, and indemnifies the legal practitioner against damages arising from a claim for such loss. Solicitors practising in NSW are regulated by the Law Society and solicitors must have a minimum PII cover of $1.5 million per claim to practise. Additional Top Up insurance is optional. The Law Society established LawCover as a wholly owned subsidiary to provide PII. LawCover issues insurance policies, determines premiums, manages claims and provides risk management services. LawCover Insurance is the only APRA regulated legal profession based insurance scheme in Australia. It was granted its licence in Sample insurance policies are available at The policy provides information on the extent of the civil liability cover available to both the current firm, and its current and former partners and employees, as well as those of a prior practice of the firm. The Policy responds to civil liability for a claim that arises from the legal practice of the firm. Claims arising from any dishonest or fraudulent acts or omissions of a principal or of a corporate firm are excluded. The cover provided by LawCover has been described as Rolls Royce as it has features designed more to benefit the policyholder such as no declinature for non-disclosure, cases will be run if defensible rather than commercial settlements, provides broad cover, usually only small excesses, unlimited runoff cover provided for a nominal premium paid by Law Society. Premiums are calculated based on the size of the firm, the firm s individual risk and its choice of excess. Various discounts also apply. However if APRA considers that LawCover should increase its capital during a period of insurance, LawCover may require additional premiums to be paid. LawCover reported 661 notifications were received for the 2005/2006 insurance year. compared to 684 for 2004/2005. Average claims cost approximately $100,000. LawCover collected $75.5 million in premiums in 2005/ Solicitors Mutual Indemnity Fund LawCover also manages the Solicitors' Mutual Indemnity Fund (SMIF) which was set up as a statutory mutual fund in 1987 as an alternative to accessing insurance through the commercial insurance market. It sits alongside the PII scheme and can only be used for the purposes set 14 LawCover Insurance Pty Ltd Financial Statements for the year ended 30 June 2006 Retail Client Compensation For Financial Services Licensees 12