broking business Under Review What does the FCA s market review mean for brokers? INSURANCE The newsletter for insurance brokers and MGAs Rest Assured

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1 PKF Littlejohn LLP broking business SPRING 2018 The newsletter for insurance brokers and MGAs Under Review What does the FCA s market review mean for brokers? Rest Assured Why everyone is talking about Internal Audit Making acquisitions work How your exit strategy should affect your M&A strategy INSURANCE

2 welcome It has been an eventful few months. Since our last issue, the Financial Conduct Authority (FCA) has launched its Wholesale Insurance Broker Market Study the first investigation into competition in our sector for over a decade. We explain what the FCA is likely to be looking for and what its review could mean for brokers. The industry also continues to see an unprecedented level of consolidation. But how can buyers make sure that the acquisitions they undertake add value to their businesses? Our colleagues from IMAS Corporate Finance argue on these pages that management teams need to think about their exit strategies before undertaking acquisitions. If that strikes you as slightly back to front, then it will make sense once you have read their thought-provoking article. Increased regulation also looms large, with the implementation of General Data Protection Regulation (GDPR) and the Insurance Distribution Directive (IDD), and the extension of the Senior Managers & Certification Regime (SMCR) to brokers all scheduled to take place in We explored the challenges posed by GDPR and SMCR in our last edition of Broking Business; this time, we look at how forwardthinking brokers are using internal assurance to help them stay on top of the everexpanding regulatory challenges. Elsewhere, we outline the forthcoming tax changes that are likely to affect brokers offering salary sacrifice, flexible benefits or other cash or benefit schemes. We hope you enjoy this edition of Broking Business and look forward to seeing you at our events. As ever, we are keen to hear your comments and questions. Paul Goldwin Partner Financial Services t: +44 (0) e: Under review The Financial Conduct Authority s (FCA) Market Study on the wholesale insurance sector is the first review of the industry for over ten years. What will the regulator look for? What could change as a result of the study? And what does that mean for brokers? Miles Foxley and John Needham examine the possibilities. The FCA s 2007 investigation into the wholesale insurance sector concluded that a lack of transparency over commission resulted in around 10% of the market operating inefficiently. It determined that the best solution would be to mandate the disclosure of total remuneration paid to all intermediaries throughout the chain, as this was considered most likely to prompt clients to shop around and find a more competitive policy. However, due to the high compliance costs of commission disclosure and the fact that a disproportionate share of this burden would fall on smaller firms, it was concluded that the expected benefits would not exceed the costs. No action was therefore taken. 2 broking business - Spring 2018 broking business - Spring

3 The changing face of the insurance broker Much has changed in 11 years. The insurance market has seen a significant influx of capacity as investors seek alternative means to generate a return on their capital. This has led to a fall in premium rates and brokers have sought out alternative lines of revenue to satisfy their shareholders. Furthermore, at the time of the last study, the Big Three brokers Marsh, Aon and Willis were unable to accept contingent commission arrangements following the settlement of the Spitzer Investigation in This ban was lifted in In addition, the larger brokers have started in recent years to provide a wider range of services to insurers such as consulting and data analytics. There are questions regarding whether insurers are being obliged to sign up for these brokers facilities or pay for these additional services. The current situation The FCA wants to review whether competition is working effectively in the market in the light of these developments. It has announced its review which will cover three main areas relating to competition within the wholesale insurance broking market: 1. Market power This element of the study will look at the effectiveness of the market and will assess how easy it is for a client to switch to one of its broker s competitors if its premium increases. The study will also consider if there are any barriers facing new firms wishing to enter the market, as new entrants offering lower prices would help to mitigate the market power of existing firms. 2. Conflicts of interest Conflicts of interest can arise if a broker is incentivised to place a risk with a particular carrier on the basis that it will earn more from doing so, despite it not necessarily being in the client s best interests. The increased popularity of facilities - schemes designed to improve efficiency by allowing insurers to commit capacity in advance to write certain types of risks - has led to a change in the way the typical insurance policy is placed. The FCA is interested to know if the increased remuneration earned by brokers for placing business through these facilities is a factor in the broking process. The FCA is particularly interested in facilities, brokerowned MGAs, ancillary services (such as advisory and data analytics), as well as circumstances where a broker requires that any reinsurance placed by carriers writing a risk must be placed through itself rather than a competitor. In all of these cases, the aim of the study will be to determine whether brokers are operating in their clients best interest or simply favouring the option that allows them to retain the greatest overall remuneration. 3. Broker conduct The final element of the study will consider how certain broker practices may be hindering effective competition. The FCA wishes to investigate whether insurers are being excluded from some risks when they choose to operate on an open market basis rather than signing up to facilities. Furthermore, there is concern that some brokers may be informally coordinating to avoid operating in the same markets in order to limit rivalry with competitors. What might the FCA do? If the FCA decides that the market is not functioning effectively, it has a number of powers that it could exercise in order to promote a more competitive environment. If the operation of facilities or other services are found to be anticompetitive, the FCA could implement market-wide measures to prevent brokers from operating them or to enforce disclosure of the level of remuneration received from these channels. Alternatively, if only certain brokers were found to be practising anticompetitive behaviour, it could take action against only those brokers. At the opposite extreme, it could determine that (as in the 2007 study) the cost of implementing countermeasures addressing any shortcomings in the operation of the market exceeds the benefits of doing so, and that it is best to take no action. Or, if considered appropriate, the FCA could look to reduce existing regulation in order to encourage greater competition. The preliminary findings of the study are expected to be published in autumn of Case study: Bluefin The FCA issued Bluefin Insurance Services Limited with a fine of 4,023,800 in December It determined that between March 2011 and December 2014 Bluefin, which was wholly owned by AXA, had held itself out to be truly independent in the advice that it provided to its clients but was in fact placing the interests of its shareholder ahead of those of its clients. The FCA found that Bluefin had introduced all commercial combined renewals for its SME clients to AXA before showing them to any other prospective insurers. In addition, Bluefin was alleged to have favoured some preferred facilities when placing some lines of business. Although Bluefin had a conflicts of interest policy, the FCA ruled that it had not been implemented properly and that brokers were not performing their duties in line with the policy. John Needham Partner - Financial Services t: +44 (0) e: While this incident arose because Bluefin was owned by AXA and had set targets to place business within the group, the underlying issue was the existence of preferred facilities and that the associated conflict of interest was not managed appropriately. The following were the key controls highlighted by the FCA in dealing with this sort of conflict of interest: A conflict of interest policy should be in place that provides practical guidance on how to manage these situations to ensure fair treatment Practical training should be provided to brokers on how to identify and manage conflicts as they arise A record should be maintained of all conflicts providing the basic details of the transaction, the commercial rationale (including why it was considered to be in the client s best interests) and details of the decisionmaking process. Miles Foxley Financial Services t: +44 (0) e: 4 broking business - Spring 2018 broking business - Spring

4 Developing a successful acquisition strategy When talking to a broker about its acquisition strategy, we often begin by asking them about their exit plans. Many management teams are perplexed by the question but they shouldn t be, writes Olly Laughton-Scott of IMAS Corporate Finance. Many brokers undertake an acquisition in order to enhance their value - but, all too often, they have failed to think through what this really means. As a result, businesses can often make acquisitions that ultimately reduce value. In most cases, value is what the business can be sold for, so the focus should be on what will make their business more attractive to a buyer (and hence more valuable). We tell our clients that we don t sell businesses but find buyers who want to buy the businesses we are selling. That s an important distinction. It means that businesses sell for a premium if they solve a problem for a buyer and at a discount if they bring problems. An acquisition may be attractive to you, but not the buyer of your business when you come to sell. Focus on the issue you are likely to be solving for the buyer. A larger company may want to achieve growth by acquisition, but will not always want to buy a business with numerous small offices. If you can t consolidate your own offices, you will run the risk of reducing value. A wholesaler may be keen to buy another wholesaler, but if the target has a retail operation then that is a potential conflict the buyer may struggle with. Our job is to get our clients the best deal and we are often compared to estate agents. People assume that this is a comparison with which we would be unhappy. But estate agents have a well-developed sense of what adds value to a property - and what reduces value. Swimming pools (at least in this country) typically reduce the value of a property. Even if the prospective buyer wants the pool, he knows he probably won t have to pay for it as the competing bidder could see it is an expensive overhead. So, before they build that pool or expensive stables, canny buyers take advice about how it will affect value or, indeed, make the house far harder to sell. You need to apply the same logic to your broker business. Some owners are keen to acquire in order to diversify their firm and reduce its operational risk. However, most large buyers will already undertake a broad range of activities. They will therefore look for and value specialism and capability, not a general spread of activity that overlaps with part of their business (thereby introducing conflicts and additional rationalisation work/risk). Before a private equity investor will buy a business, they carry out a formal exit review to establish who is likely to buy the business when they decide to dispose and why. This not only determines if they make their investment, but also shapes the development and acquisition strategy. Owners of businesses typically talk to advisers when they are thinking of selling. But they should have those conversations well before then, especially if they are thinking about buying or contemplating major changes. Strategy is a long term game, whether it be focused on development or exit. Olly Laughton-Scott IMAS Corporate Finance t: +44 (0) e: 6 broking business - Spring 2018 broking business - Spring

5 What does greater assurance mean for you? What does internal audit in a broker look like and will it add value to the firm? Some broking firms are still working out what internal audit looks like. Many brokers already have some sort of file audit or review process and believe that ticks the box. However, these file audits or reviews are mainly compliance focussed and do not consider the adequacy of the wider governance, risk management and internal control frameworks of the firm. By contrast, a robust internal audit programme might typically include: Acquisition and integration process Governance framework Business continuity planning and disaster recovery Human resources and payroll Capital adequacy and cash flow management Insurer selection and management CASS 5 compliance IT general controls Complaints handling IT governance and strategy Conduct framework and product governance IT security Conflicts of interest IT strategy Credit control and aged debt Outsourcing and third-party providers Data quality and management information reporting Project management Data protection Regulatory compliance framework Delegated authority Risk management framework Finance Tax (corporate tax, IPT, VAT, payroll tax) Financial crime, sanctions and AML Internal audit needs to be relevant if it is to be effective and it should not be viewed solely as a compliance activity. It can do this by tailoring its approach and focussing its attention on the key risks and issues that really matter so that it can really add value to firms and its key stakeholders. Another important feature of internal audit is that it is independent and objective. This ensures that it provides positive challenge to the firm and makes sure that it follows best practice. This, in particular, is one area where PKF Littlejohn s internal audit clients say they benefit, as we bring our wider insights of best practice from our experience in the broking sector. A growing number of brokers are recognising the benefits of assessing the effectiveness of their governance and risk management activities by undertaking internal audits. In this article, Jessica Wills explains why this is happening and how more robust internal assurance can benefit your firm. What are the drivers for greater internal assurance? Most importantly, brokers are finding themselves subject to enhanced regulatory scrutiny. This year will see the implementation of General Data Protection Regulation (GDPR) and the Insurance Distribution Directive (IDD), and the Senior Managers & Certification Regime (SMCR) will be extended to all financial services firms, including brokers. The latter will significantly raise the bar for brokers and their senior managers in being more accountable for their decisions and actions. A series of FCA thematic reviews has also put the practices of brokers in the spotlight. 8 broking business - Spring 2018 For example, in 2016 we saw the thematic review of Principals and their appointed representatives in the general insurance sector and the Wholesale Insurance Broker Market Study is currently underway, as outlined elsewhere in this edition of Broking Business. It is clear that the regulatory pressure is mounting, along with the associated risks and challenges. In these circumstances, internal audits can provide valuable assurance that these regulatory risks are being suitably managed. However, greater regulatory scrutiny is not the only factor driving demand for more effective internal assurance by brokers. The unprecedented level of consolidation taking place in the industry means that there are considerable commercial benefits to undertaking internal audit work: Buyers are looking for target firms that are well-run not only from a financial perspective but also from a governance, risk management and internal controls perspective. Effective internal assurance can help firms to ensure that they are well managed. Buyers are seeing their operations expand rapidly as they acquire target firms and commence the integration process. This presents its own risks and challenges, and stakeholders can benefit from assurance that things are under control. - Shareholders will want to know that their investment is being well spent and managed in order to achieve the planned acquisition and growth strategy. An internal audit can provide assurance to shareholders that the firm has established systems of governance, risk management and internal controls to ensure that its strategic objectives will be met. - Senior managers may no longer have the same level of visibility over their operations due to their increased size. Internal audits can provide assurance to senior managers that the firm is continuing to operate effectively and be their eyes and ears on the front line. - For the regulator, the current wave of consolidation presents concerns that governance, risk management and internal controls will not scale to match the increased size and complexity of firms. Undertaking internal audits sends a clear message to the regulator that firms are taking this seriously. Jessica Wills Director - Internal Audit t: +44 (0) e: broking business - Spring

6 Cash or benefit agreements - are you ready for the new rules? Any broking firm offering salary sacrifice, flexible benefits or other cash or benefit schemes should be aware of new rules affecting PAYE reporting, writes Guy Charles. Since April 2017, HMRC s Optional Remuneration Arrangement rules have applied when employees give up the right to an amount of earnings in return for an employer-provided benefit, either via salary sacrifice or a contractual salary offer. Although the new rules are subject to certain exceptions and transitional rules - for example, pensions and childcare are exempted they could result in significant increases in employee tax and employer Class 1A National Insurance Contributions. We encourage you to review your existing arrangements as soon as possible and advise staff of any tax implications, as the changes could affect their 2017/18 P11Ds. You should also consider seeking expert guidance if you suspect any benefits you currently provide require an amended amount to be reported on a P11D form (and subsequent employee PAYE coding notices). transfer was (and still is) a taxable benefit, the P11D calculation is now based upon the higher of either 20% of the value per year (except for the final year) or the annual salary sacrifice. The overall total will remain the same, but the amounts will potentially be spread differently over the relevant years. Are there any exemptions? Broadly speaking, the following benefits will be exempt from the changes: 1. Death and retirement schemes 2. Pension savings 3. Company funded pension advice 4. Bike to work schemes 5. Childcare vouchers 6. Ultra-low emission cars What are the main changes? The two most likely areas of concern for employers are expected to be: Benefits that were previously non-taxable may become taxable if provided via an optional remuneration arrangement. For example, car parking, loan of IT equipment and mobile phone provision used to be tax free if work related. Employers offering these in exchange for a gross salary variation are now creating a taxable benefit. Items that were already taxable but the method of calculating the taxable benefit figure has changed: - Employers offering employees a benefit or cash alternative. Typically, the provision of cars and/or fuel can cause problems. If the cash option offered is greater than the car/fuel benefit alternative, the cash alternative is now the taxable benefit - even if the car/ fuel option is taken. - The transfer of assets to employees will also now require a different benefit calculation. Although the 7. Buying holiday Provided they meet the same individual criteria as in previous years, the above will remain as non-taxable benefits even when paid for via an optional remuneration arrangement. When do the rules take effect? Employees already in contractual arrangements before 6 April 2017 will become subject to the new rules in respect of those contracts at the earlier of either: an end, change, modification or renewal of the contract, or 6 April 2018 (except for cars, accommodation and school fees the new rules for these benefits come into effect by 6 April 2021). Guy Charles Senior Manager - Tax T: +44 (0) e: What should you do now? Review what is currently contractually in place for your employees. It is not uncommon for salary sacrifice or flexible benefit schemes to have been set up incorrectly at inception. Is there an either/or contract on record? Has this been agreed by the employee? Compile and report the P11D benefit changes Communicate effectively and positively with your employees. What are the rules and how will they effect their benefits and tax liability? What must the employee do? Consider what the business is currently offering and whether it is now beneficial to adapt the benefits package. For example: - Adapt the contracts to a) no longer offer cash or car, b) reduce any cash offer to the level of the car benefit or c) only offer the car. A greater cash alternative is then no longer relevant to benefit calculations - Car parking offered free to staff is non-taxable. Is it an option for the employer to not charge staff for parking? Or, if the employer owns outright the parking facilities, arguably the employer cost is nil. The taxable benefit would then only be the amount sacrificed by employees for a space. Can this be decreased? 10 broking business - Spring 2018 broking business - Spring

7 Meet the team Paul Goldwin Partner t: +44 (0) e: John Needham Partner t: +44 (0) e: Chris Riley Partner - Tax t: +44 (0) e: Jessica Wills Director - Internal Audit t: +44 (0) e: Will Lanyon Transaction Services t: +44 (0) e: Luigi Lungarella Director - VAT t: +44 (0) e: PKF Littlejohn LLP, 1 Westferry Circus, Canary Wharf, London E14 4HD Tel: +44 (0) Fax: +44 (0) This document is prepared as a general guide. No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the author or publisher. This information is in accordance with legislation in place at February PKF Littlejohn LLP, Chartered Accountants. A list of members names is available at the above address. PKF Littlejohn LLP is a limited liability partnership registered in England and Wales No. 0C Registered office as above. PKF Littlejohn LLP is a member firm of the PKF International Limited family of legally independent firms and does not accept any responsibility or liability for the actions or inactions of any individual member or correspondent firm or firms. PKF International Limited administers a network of legally independent firms which carry on separate business under the PKF Name. PKF International Limited is not responsible for the acts or omissions of individual member firms of the network. March 2018