Financial Services Compensation Scheme

Financial Services Compensation Scheme FSCS approach to calculating expected thirty-six month compensation costs Ff FSCS approach to calculating expected 36 month compensation costs Purpose of this paper This paper outlines the approach that FSCS is minded to take to calculate expected 36 month compensation costs when determining its annual levy. It involves taking a forward view of the next 36 months expected compensation costs and levying one third of that amount each year, unless the costs in the next 12 months are expected to be higher (in which event, that is the amount levied). Summary It is central to FSCS current approach to levying that we do not raise money from the industry in the absence of the need to meet compensation costs in that year. We do not pre-fund. Our annual levy accordingly reflects the compensation costs which we expect to incur in the year ahead; drawn from conservative assumptions about the claims we will receive. Without moving to a pre fund, in order to increase certainty and manage volatility for the industry, FSCS will seek to determine what levies will be needed over a 36 month period, on the basis largely of past experience but adjusted to reflect any new trends and developments of which we are aware when the levy is set. FSCS will continue to calculate the levy under the current 12 month basis and levy for that amount if it indicates that compensation costs will be higher than under the 36 month view. Under the new rules FSCS will take the following steps when calculating the levy: 1) Establish the compensation costs incurred but not yet raised through levies (less any recoveries made) 2) Calculate the compensation costs FSCS expects to incur in the 12 months following the date of the levy (as per the current process) 3) Calculate the compensation costs FSCS expects to incur in the 36 months following the date of the levy (as per the process outlined in the paper) 4) Add to 1) the greater of 2) or 1/3 of 3) 5) Add to 4) the specific costs element of management expenses Background Following the recent review by FSA of the FSCS funding model, the new funding arrangements allow FSCS to raise a levy for the compensation costs it expects to incur in the 12 months following the date of the levy or, if greater, one third of the compensation costs it expects to incur in the 36 months following the date of the levy (save for the deposit taking class). This rule comes into force on 1 April 2014 and will apply to firms authorised by both new regulators, the FCA and the PRA (the bodies that replaced the FSA with effect from 1 April 2013). The rule, to be at FEES 3.1, will provide as follows (as to be stated at FEES 6.1.14G): In imposing a compensation costs levy in each financial year of the compensation scheme the FSCS will take into account the compensation costs which the FSCS has incurred and has not

yet raised through levies, any recoveries it has made using the rights that have been assigned to it or to which it is subrogated and a further amount calculated taking into account: (1) for claims for protected deposits, those compensation costs it expects to incur (including in respect of defaults yet to be declared) over in the 12 months following the date of the levy; and (2) for other protected claims: (a) the compensation costs it expects to incur in the 12 months following the date of the levy; or, if greater (b) one third of the compensation costs it expects to incur in the 36 months following the date of the levy (see FEES 6.3.1R (Imposing management expenses and compensation costs levies)). FSCS current 12 month levy assumptions are based on FSCS experience of current claims trends, as well as other information from the regulators, the Financial Ombudsman Service and the industry. FSCS monitors claims trends and default prospects and reviews and updates assumptions to help determine the levies required to pay the expected claims within our target service levels. When setting the annual levy currently, FSCS is deliberately conservative in its assessment of trends and default prospects. We do not take into account failures or prospective failures from which claims have not yet crystallised when the levy is determined or potential claims which cannot be quantified. This means that FSCS often has to raise supplementary, interim levies later in the year to meet compensation costs which crystallise after the annual levy is set. Taking a 36 month view of expected costs may allow FSCS to reduce the volatility of annual levies, reduce the likelihood of interim levies, and give the industry greater certainty. FSCS has considered various options to calculate expected costs over 36 months. FSCS preferred model is outlined below, along with mention of some other options that have now been discounted. FSCS favours a relatively simple and transparent approach, which will avoid unnecessary expense to the industry. FSCS proposed approach is based on past claims experience, which will be adjusted to take current claims trends and market intelligence into consideration. FSCS believes historic compensation costs of individual sectors currently offers the best indicator of future costs as, although claims values vary from year-to-year, there have been consistent demands on funding classes, from firms that fail resulting in claims to FSCS. Therefore, in the absence of evidence to the contrary, FSCS considers that it is reasonable to base its calculations on the three previous years experience. This approach automatically allows for any fall in claims trends, as it is adjusted each year. In any event, FSCS will review the claims and costs of the previous years and compare those against such information as may be available to assist the assessment of costs expected over the next 36 months. This will depend on the facts at the time, but is similar to the current process where the 12 month levy draws on our experience. When compared to the 12 month approach, the 36 month model may allow for costs for firms or products which are expected to generate claims to FSCS, but where those firms may have become insolvent recently and claims are yet to be received, or the thematic claims are on a clear rising trend in the industry, even if not yet apparent in claims to FSCS. FSCS will continue to raise levies on an annual basis and will not be able to levy in advance for 36 months of costs. The way the model will operate is outlined below.

FSCS proposed approach to calculate expected 36 months compensation costs FSCS is proposing to apply the three-year rolling average of compensation costs, by sector, projected forward three years, and adjusted upwards for identifiable claims trends or sources, and downwards to exclude past one off or exceptional levels of costs (i.e. costs that are not expected to be repeated) or diminishing lines of claims. In taking forward the rule, as explained by the FSA in CP 12/16, FSCS objectives are to: increase predictability of the amount of levy; reduce the risk of supplementary levies; and operate transparently for levy payers. FSCS approach recognises the difficulty of identifying reliable external factors to predict compensation costs. However, FSCS considers that past experience can provide a useful and meaningful indicator of expected future costs and allows us to assess what costs we may expect to incur over a 36 month period. Basing the indicative levy on a three year moving average should smooth fluctuations in annual costs. Any surplus remaining at the end of the year will be taken into consideration and offset against the expected costs for the following 36 months. Any deficit will be added to the levy in the following year. FSCS will follow the steps below to calculate the expected 36 month compensation costs. If the 36 month compensation costs result in a levy that is higher than the class threshold, the amount raised will be capped at the class threshold. 1. assess the average figure for compensation paid by the class over the last three years (as illustrated in the table below, which shows the average that would have been used in the 2012/13 levy calculation). The figures include compensation costs (to 30 June); All amounts '000 For the year ended 30 June 2010 2011 2012 Average Insurance Provision 55,346 60,690 57,195 57,744 Insurance Intermediation 19,629 41,726 44,099 35,152 Life Insurance Provision 7-2 3 Life Insurance Intermediation 13,890 17,916 20,560 17,455 Investment Management 528 184 61 258 Investment Intermediation 113,834 311,190 62,005 162,343 Home Finance Intermediation 198 329 221 249 Notes: (i) The figures include compensation costs to 30 June. The ability for classes to meet the costs in each year is affected by opening balances; for example, in 2010 the amount required for the Investment Intermediation class exceeded the 100m threshold that FSCS was able to levy the class in that year, but there was an opening surplus to the credit of the class that year which

funded the additional costs required. (ii) The 2011 figures for investment intermediation include 258.8m in respect of compensation and expenses in relation to the Keydata default. The subclass costs in excess of 100m were met by the Investment Management class under crosssubsidy rules. (iii) FSCS has included Keydata costs in the three year average as they are not considered exceptional for this purpose. Although a high cost default the type of failure and claims made were not wholly out of FSCS s experience. As such, to exclude these costs would artificially reduce the overall costs figure. In fact, due to the timing of the costs, they will not form an explicit item in the calculation of the 36 month expected costs, in 2014. 2. Identify, and adjust for, any inflating or exceptional factors in the last three years (where the level of costs is not expected to be repeated). Although FSCS does not consider it appropriate to provide a set definition of "exceptional", as by its nature it is difficult to define, without limitation or commitment, relevant factors (subject to the overriding purpose and aims of the levy) might include: the size of the failure and duration of claims, although this is mitigated by the current annual cap on levies, set by reference to affordability, and the three year rolling average; the frequency of failures and claims in the relevant class; and the residual level of potential claims in the sector has been significantly reduced following a default of exceptional size, r.e. the default is so large so as to materially reduce the potential costs of future defaults. Other adjustments could include: a. costs of claims that FSCS has no expectation will need to be levied or reoccur. For example, costs for Welcome Financial are incurred and included in compensation costs, but would be excluded when calculating the three year average as funding for Welcome Financial claims comes from a source other than the levy. As costs for Welcome Financial have not been levied for, the table above has been amended to reflect this change; and b. claim trends that FSCS can see are clearly declining. 3. add costs of known or expected defaults for which claims have not yet been paid, but have been identified as payable over the next 36 months, insofar as not allowed for at 1 above. This would enable FSCS to pick up expected costs from major failures, which are likely to increase the three year average annual compensation costs for the sector concerned; 4. factor in any new or current upwards claims trends expected over the next 36 months. This might allow for PPI claims and in the past could have included mortgage endowment claims; and 5. account for opening balances for each class. Surplus amounts will be used to reduce the total 36 month amount, before that amount is divided into the three 12 month periods for the levy. Otherwise any annual refund would undermine the smoothing effect and could lead to interim levies. Any deficits will need to be levied for in the following 12 months and will not be spread across all 36 months. Management expenses will be added to the final amount required at the end of the five stage process. The actual costs for management expense will be calculated for the following 12 months (not on the 36 month basis). FSCS management expenses are consulted on annually by the FCA and PRA.

Any levies on the 36 month basis will be capped at the annual class thresholds so the retail pool would not be triggered by this approach. The class threshold applies to both management expenses and compensation costs. Of course, the FCA retail pool may be triggered in the course of any year for sums exceeding the annual FCA FSCS funding class thresholds, for costs to be incurred in a 12 month period. FSCS has modeled the three year averages for the annual levy if we had been using the model above to calculate the expected 36 month compensation costs in 2011/12 and 2012/13. These averages have been adjusted to take in some claims trends, such as an upward projection for employers liability mesothelioma claims, but the figures are not adjusted for expected failures. The respective levy amounts and the amounts actually levied in those years against those classes are shown in Appendix 1. Appendix 2 shows the outcome of step one on the levy for 2013/14 and an example of what the levy might be for two industry sectors based on steps one to five of the above model, with the three year compensation costs capped at threshold limits. Other models considered FSCS considered and discounted a number of alternative options to calculate the expected 36 month compensation costs, including: models based on macro-economic indicators; developing a bespoke FSCS default model; and seeking a correlation from credit default swap ( CDS ) indicators Model using macro-economic indicators FSCS has analysed the historical compensation paid by class and sought correlation with various factors, including: Bank of England base rate; inflation rate; GDP growth; unemployment rate; and household savings rate. In each instance, the correlation between compensation expected or paid in each class and the economic indicator was weak. We do not believe that any of these indicators provides a reliable predictor of likely future compensation costs. Developing a bespoke model In order to pursue a model based on external factors and FSCS costs, FSCS would need to develop a bespoke model which sought to combine a number of external indicators, together with FSCS s exposure to defaults and claims costs. Not only would this be expensive, but it would be unlikely to be reliable, and FSCS does not propose to pursue this option. CDS model There was no clear correlation between FSCS levies and CDS indicators. Industry views

FSCS engaged with the industry in relation to the approach to calculating the expected 36 month compensation costs. Generally the approach outlined by FSCS was welcomed and no alternative model was proposed. FSCS has amended the approach to the model to address certain industry concerns. The aim of increasing certainty and reducing volatility in annual levies was understood, and welcomed by most. FSCS will keep the approach under review. Details of its application will be published when the levy amounts are announced by FSCS.

Appendix 1 Comparison between the levy using the proposed model and the actual levy for the past two years The table below shows the levy the 36 month model would have calculated and the levy raised on the current basis. From April 2014, in accordance with the rules, FSCS will levy the higher of the two. The levies that would have been raised are boxed out below. The only class that would be affected by the cap at the annual limit is the Investment Intermediation class, as the amount required exceeds the class levy threshold: For the year ended 30 June 2012/13 2011/12 All amounts '000 Current basis Model Current basis Model Insurance Provision 60,000 36,057 50,500 36,938 Insurance Intermediation * 36,000 68,740 69,500 92,689 Life Insurance Provision - 184 500 292 24052 Life and Pensions Intermediation 46,000 35,989 21,500 Investment Management - 11 815 2,615 Investment Intermediation 98,000 100,000 94,000 100,000 Home Finance Provision - - - - Home Finance Intermediation 4,500 4,109 1,000 360 * The original levy for insurance intermediation was 36m, with a further 16m raised as an interim levy. As the model figure is higher than 36m, this figure would be used. All the above figures have been adjusted to account for opening balances.

Appendix 2 2013/14 levies using the 36 month model FSCS proposes five steps to calculate the expected 36 month compensation cost. Management expenses would be added to this amount. Step one is the average compensation costs for the previous three years. We have calculated this figure for all classes below and complete the process of steps one to five for an intermediation class and a provider class. Step 1. Average figure for compensation paid by the class over the last three years, capped at the threshold limit where appropriate All amounts '000 For the year ended 30 June 2014 3y Model 12m Forecast Insurance Provision 67,652 118,540 Insurance Intermediation 48,518 44,720 - Life Insurance Provision 1 Life and Pensions Intermediation 20,959 28,310 - Investment Management 105 Investment Intermediation 150,000 64,660 - - Home Finance Provision 183 500 Home Finance Intermediation Example 1: Insurance Provision class 2013/14 levy calculated on the expected 36 month compensation cost model 1. Three year average calculated above showing costs of 68m required for Insurance Provision. 2. Inflating or exceptional factors to adjust for none. 3. Costs of known defaults not yet paid FSCS anticipates 60m will be required over the next three years for mesothelioma claims not captured by the three year average, adding an additional 20m to the figure calculated in step one, bringing the total to 88m for 2013/14. An adjustment is also made for the 10% increase in general damages introduced following the Jackson reforms. A further 9m is added to reflect this, bringing the total to 97m.

4. Trends - No further allowance. 5. Opening balance has been factored in. Final 2013/14 projection for the Insurance Provision class based on the expected 36 month compensation costs is 97m, compared to the 118m projected under our current model. The reason the 12 month forecast is higher is because of mesothelioma claims will need to be paid this year. In this instance FSCS would raise a levy of 118m. Example 2: Insurance Intermediation class 2013/14 levy calculated on the expected 36 month compensation costs model 1. Three year average calculated above showing costs of 49m required for Insurance Intermediation 2. Exceptional factors to adjust for none 3. Costs of known defaults not yet paid - none 4. Trends PPI claims continue to rise. For the purposes of this illustration, FSCS has assumed that PPI claims will continue to rise at a similar rate to the past year. Costs from PPI have increased from 49m to 69m between 2010/11 and 2012/13. On this trajectory, FSCS would need the following amounts to cover PPI claims over the next three years: 2013/14-67m 2014/15-76m 2015/16-85m The average of these figures is 76m. As the historic figure of 52m is largely made up of PPI claims, this would be revised to reflect this trend. 5. Opening balance has been factored in. Final 2013/14 projection for the Insurance Intermediation class based on the expected 36 month compensation costs is 86m, compared to 54m on the current 12 month approach.