Future regulation for insurance brokers

Transcription

1 Report Prepared For: British Insurance Brokers' Association 8 th Floor, John Stow House 18 Bevis Marks London, EC3A 7JB Future regulation for insurance brokers Prepared by: Kyla Malcolm and Charles Xie 99 Bishopsgate London EC2M 3XD Date:

2 TABLE OF CONTENTS EXECUTIVE SUMMARY INTRODUCTION MOTIVATION FOR REPORT METHODOLOGY STRUCTURE OF THE REPORT POTENTIAL RISKS IN INSURANCE BROKING ASYMMETRIC INFORMATION NEGATIVE EXTERNALITIES - REPUTATION NEGATIVE EXTERNALITIES - SYSTEMIC RISK SUMMARY OF MARKET FAILURES LOW QUALITY ADVICE CURRENT APPROACH INFORMATION PROVIDED PRODUCT REGULATION FUTURE REGULATION CLIENT MONEY CURRENT APPROACH COMPLEXITY AND COMPLIANCE FUTURE REGULATION ADEQUATE RESOURCES CURRENT APPROACH POTENTIAL CONTAGION EFFECTS OF FAILURE FUTURE REGULATION POST SALE REDRESS PROFESSIONAL INDEMNITY INSURANCE FSCS COST OF REGULATION Page i

3 7.1. REGULATORY COSTS IN THE UK COMPARING REGULATORY COSTS WITHIN EUROPE SUMMARY OF REGULATORY COSTS Page ii

4 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 Page iii

5 EXECUTIVE SUMMARY (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 Page 1

6 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. Page 2

7 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 Direct cost Indirect cost 3.5% Regulatory cost as proportion of GI revenue 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Sweden France Spain Germany Denmark Netherlands Switzerland Finland Portugal Norway Italy Ireland UK 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. Page 3

8 1. INTRODUCTION (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 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 Page 4

9 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 Directive 2002/92/EC of the European Parliament and of the Council of 9 December 2002 on insurance mediation. Page 5

10 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) 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. Page 6

11 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 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 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. Page 7

12 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 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 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 BIBA, Transparency, disclosure and conflicts of interest in the commercial insurance market. Page 8

13 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 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: Page 9

14 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 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 Reliable data is not available from before Source: Data provided by BIBA to CRA. Page 10

15 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 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 above. Page 11

16 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 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; Page 12

17 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 mediumterm 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. Page 13

18 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 FSA, Address to the IAIS Annual Conference, Speech by Adair Turner, Chairman FSA, 27 October CRA calculation based on Broking Now BIBA regulation questions January Page 14

19 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 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 Page 15

20 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 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 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 (G) Page 16

21 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 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 misselling 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 Page 17

22 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 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 FSA, Discussion Paper: Product Intervention, DP11/1, January 2011, p48. Page 18