The Future of Insurance Commissions & Insurance exposures for Strata Management Companies

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1 The Future of Insurance Commissions & Insurance exposures for Strata Management Companies Introduction I have been asked to address the topic of insurance commissions. There has been a lot of noise around our industry about the practice of receiving insurance commissions, and I have been asked to give my views on this practice, and how I see the future of insurance commissions. Of course, the question proposed to me almost presumes that insurance commissions for strata management companies will disappear in the future, through some form of regulatory ban. I must say at the outset that I do not share that view, and will cover off a number of reasons in support of this. I do however see a shift in market practice, and will make a forecast of how I see this playing out over the medium to longer term. I have also been asked to comment on current distribution models under the financial services regime, and how commissions (whether they are in or out) may impact on such arrangements. I consider the issue of proper authorisation under the Financial Services Reform Act 2001 (Cth) (FSRA) to be an area that deserves far more attention by the sector than the issue of insurance commissions. 1 I have also been tasked to answer a number of specific questions, which I will do throughout this paper. What is the general practice that exists now? Current market practice includes the payment of commissions for the placement of Strata Insurance policies via certain Australian Financial Services (AFS) Licensees. The payment of such commissions have been made traditionally because of the number of administrative functions Strata Managers perform on behalf of these licensees, including undertaking training as a part of their authorisation process. In the appendix attached to this paper, I have collated a list of such tasks. This list is not exhaustive and clearly some tasks are more important than others, however it will give readers some ideas around the arguments for insurance related remuneration for strata managers (commission or fee). It is widely known within our industry (via benchmarking exercises) that insurance commission income levels represent about 12% of total income for Strata Management companies, and some 28% of income received from sources other than base Management fees 2. Given this also represents around the profit margin level of Strata Management business, it is fair to say that the beneficiaries of insurance commissions are the Owners Corporations through lower base management fees. Competition amongst Strata Management companies has essentially arbitraged 1 The FSRA has been incorporated into the Corporations Act 2001 (Cth). 2 These statistic requoted at the 2012 SCA NSW Principal s Retreat, Hamilton Island 1 P a g e

2 out any fat that may have existed because of insurance commissions, if indeed such fat was ever present. The structure of the SCA NSW Strata Management Agency Agreement recognises the relationship between base management fees and commission income, with the front page outlining such relationship. The agreed services fee is set out with a Plus commissions in schedule C1 (a disclosure schedule) giving the Owners Corporation transparency to the arrangement and the option to disallow commissions should they wish to do so. Assuming the Owners Corporation elected this option, the Strata Manager would then have the opportunity to uplift the level of their agreed services fee to compensate. It is important to note that if the Owners Corporation did elect this option, they also agree for any commissions to be rebated to them direct, a factor that may be seen as income for tax purposes. Specific accounting advice would need to be taken for a definitive position, but it may be more efficient for an Owners Corporation to adopt a lower agreed services fee and for the Strata Manager to retain commissions. Regardless, if you look at the total cost of services from a higher level for a moment, whether the Strata Manager gets the commissions and charges a lower services fee or the Owners Corporation gets the commission and pays a higher services fees, the cost of the services ought to be a similar level (save for tax implications). It is important to reinforce that there is absolutely no legal impediment to Strata Management Companies receiving insurance commissions, provided however that this remuneration is fully disclosed. In the Alliance Strata Management 3 case the issues of Strata Managers as fiduciaries and their receipt of insurance commissions were tested. In that case Meagher JA reinforced that the law at that time was clear, and: if the fiduciary, before embarking on his fiduciary occupation, stipulates for the retention of commissions as the price of his occupancy, the rules governing fiduciaries have got nothing to do with the receipt of commissions. Whilst this case predated financial services reform (and to my knowledge the issues have not been challenged since), the reforms embedded the principles of remuneration disclosure in connection with general insurance products by introducing the requirement for a Financial Services Guide (FSG) 4. As I hope you all are acutely aware, an FSG must be given to all Owners Corporations by those providing a financial service to it, and it must contain - amongst many prescribed items of information - details on remuneration from AFS Licensees. 5 Severe penalties may apply for failing to provide an FSG ranging up to $11,000 for an individual, or $55,000 for a corporation, and up to 2 years imprisonment. The most concerning practice that exists in our market at present is not about insurance commissions, but rather Strata Managers/Strata Management Companies not being properly authorised by an AFS Licensee for arranging insurance with them and their Owners Corporations. The range of activities outlined in Appendix A, whether some or all of these activities are performed, in my view means that a Strata Manager is arranging a financial service and as such needs to be 3 Real Estate Service Council v Alliance Strata Management Ltd (1994 NSWCA) 4 Section 941B Corporations Act 2001 (Cth). 5 Section 942C Corporations Act 2001 (Cth). 2 P a g e

3 appointed by an AFS Licensee. 6 This includes authorisation by professional insurance brokers under their AFS Licence. The mere appointment of an insurance broker by the Owners Corporation, or by the Strata Manager on their behalf, does not alleviate the need to have appropriate authorisations from the relevant AFS Licensee/s. That includes circumstances where the Strata Manager may be performing some activities of an arranger without the benefit of an insurance commission! That is, the insurance commission does not in itself dictate the status or need for authorisation, the collective view of level of activities performed is generally regarded as the measure. Severe penalties may also apply to arranging or dealing in insurance without an appropriate authorisation - ranging up to $22,000 for an individual, or $110,000 for a corporation, and up to 2 years imprisonment. 7 If you fall into this category, you are also unlikely to have professional indemnity insurance (PI) protection from the AFS Licensee. Nor would you have provided an FSG, so the penalties mentioned in the preceding paragraph may also apply. The message here don t be bluffed into thinking you re protected. Please take some time out to do two things: (1) review which AFS Licensees you or your Owners Corporations use, and establish what authorisation levels you have; and (2) insist on the level of authorisation you need, or stop trading. It s your responsibility, not necessarily the AFS Licensee s, to ensure you have proper authorisation (albeit both parties may be liable for resulting loss or damage by an Owners Corporation). What is the difference between the representative models under the Financial Services Reform Act? I need to take a step back for a moment to cover off some fundamentals. To be able to provide a financial service and arrange insurance, there is a requirement for financial services providers (such as CHU) to be licensed in accordance with the FSRA. As an AFS Licensee, holders can distribute their own products either: a) Directly to customers; b) By appointing intermediaries to distribute products as their authorised representatives; or c) By appointing intermediaries as general insurance distributors. Option c) was introduced as Class Order 8 in 2005 by the Australian Securities and Investments Commission (ASIC) as a relief for AFS Licensees. The first point to appreciate here is that the authorised representative model and distributor model are different from both a legal and practical perspective. This is contrary to what some in the strata market believe; the incorrect assumption being that both models are essentially the same. Strata Managers are appointed as agents of the Owners Corporation through the application a Management Agreement and, as such, are in a fiduciary relationship for these contracted services. Strata Managers can be tasked to carry out a wide range of duties on behalf of the Owners Corporation, such as organising maintenance and repair works, arranging for quotations for services, 6 The definition of arranging is set out in section 766C Corporations Act 2001 (Cth). 7 Section 911B Corporations Act 2001 (Cth). 8 ASIC Class Order [CO 05/1070] General insurance distributors 3 P a g e

4 issuing levy notices, maintaining all accounting records, preparing budgets, organising and attending meetings - to name just a few. In terms of insurance duties, this would normally include arranging and paying for insurance in accordance with Owners Corporations instructions, assisting with the preparation, lodgement and processing of claims, and obtaining insurance quotations and valuations. In my view, the proximity of the relationship between a Strata Manager and the Owners Corporation (as a fiduciary or otherwise) attaches an inherent expectation for advice and guidance to protect the interest of the Owners Corporation. This includes making available the relevant information and providing guidance to allow Owners Corporations to make informed decisions about their insurance requirements. Fulfilling this expectation is difficult at best without the ability to provide some form of advice. As a fiduciary, it is almost essential the Strata Manager is seen to be doing so. Therefore it is my contention that Strata Managers need to be appointed as authorised representatives, to be trained and given authority to provide general advice. In this capacity, a Strata Manager can give opinions and make recommendations to assist the Owners Corporation in making appropriate decisions about insurance. In other words, authorised representatives can provide proactive guidance based on their general advice authority and more effectively fulfil their roles as a fiduciary- enhancing their reputation as the trusted advisor to the Owners Corporation. Authorised Representatives v Distributors a practical snapshot Currently there are very few AFS Licensees who are prepared to appoint Strata Managers as authorised representatives and give them general advice authority. I strongly recommend you get to know who they are a hint in NSW I know of only one underwriting agency, and two brokers who will do it (provide general advice authority) for all Strata Managers as a standard policy - subject to training of course. Importantly, you should know all those AFS Licensees who will not provide authorisation to this level. In my view, these operators are short changing Strata Managers and consumers, and creating unnecessary risk within our sector. Why do they do it? My guess is because it is expensive to operate, and they do not want to take the exposure themselves remember that an AFS Licensee who authorises Strata Managers to give general advice must provide PI protection for them whilst acting in that capacity. As a final observation, SCA (Vic) were so adamant that the authorised representative model was the only model Strata Mangers should adopt, they made it a condition of membership (see also Appendix B) 9 Some key differences are summarised in the following table: P a g e

5 Strata Manager Distributor only Authorised Representative Authority to arrange insurance on behalf of the Owners Corporation. Authorised to impart information that is factual, accurate and objective. Undergo training with regard to insurance. Authorised (empowered) to provide General Advice - an opinion or recommendation influencing a decision regarding insurance, e.g. following major losses from storms or catastrophes Protection under the AFS Licensee s Professional Indemnity cover whilst acting within your authority. Bound by law to act in good faith and in the best interest of the Owners Corporation. Make available to the Owners Corporation all the information relevant to them to make a decision on insurance. No advice = Very little cover, and consumer protection Difficult to achieve with the No Advice restriction Difficult to achieve with the No Advice model Wider authority = Wider cover, and consumer protection Facilitated by the General Advice authority Facilitated by the General Advice authority NB: Strata Managers cannot use their authorised representative status with one AFS Licensee to provide general advice on another insurers product or on behalf of another AFS Licensee. You need to be properly authorised by each AFS Licensee. What is the Strata Manager s exposure if the broker gets it wrong (i.e. doesn t recommend the right cover)? I will address this question in a few ways. Firstly, irrespective of whether a Broker is appointed by yourself or by the Owners Corporation directly, or whether you are properly authorised as outlined earlier in this paper, the relationship (proximity) between a Strata Manager and an Owners Corporation will more likely than not end up with your company being sued or joined to an action where there is a significant financial shortfall. Secondly, if you or your Owners Corporation use a broker, ensure that you as the arranger are appointed as an authorised representative to give general advice. Remember, this is your responsibility to get properly authorised. If they won t provide you the authority, don t trade with them. If you cannot influence that outcome, then ensure you distance yourself administratively so you cannot be deemed to be an arranger, and ensure the Owners Corporation s considerations and final decision is well-minuted around this issue. 5 P a g e

6 Thirdly, if you are properly authorised, ensure the Broker gives definitive advice for the Owners Corporation s needs on all aspects of an insurance offering, including coverage, exclusions, financial strength, claims-paying reputation and, of course, price. If they fail here, at least you can demonstrate you have been proactive in seeking definitive advice from a professional strata insurance broker, which can aid in your defence to any claims of wrong doing. My experience in the last seven years is that except for a credible few professionals, most brokers do not give what I term a full advice offering. That is, specific recommendations or advice for the benefit of the Owners Corporation on all attributes of the insurance offerings from the range of providers they are presenting. Rather, they just present insurers names, limits, and price (generally price first). Why? Because they are not instructed properly and asked to give specific advice on what is best for the Owners Corporation. And if they don t need to give advice, they won t (its less exposure for them). It also allows them to play the transactional game, where they simply collect quotes, put them together, and rely on price savings as a method of winning new business. To those credible few, well done and keep giving the full advice it will set you apart in the long term. Under the existing Agency Agreement, what happens when the Owners Corporation decides to prevent an insurance commission from being passed on? The standard SCA NSW Strata Management Agency Agreement contractually provides for the agreed services fee (including commissions) to be enforceable for the term of the agreement. The standard agency agreement also provides for the agreed services fee (and therefore the elected option on commissions) to be subject to annual review at the review date within the agreement. Assuming the agreement was properly entered into, and all disclosure (including the provision of a FSG) has been given, a strict reading of these clauses would lead me to suggest that the Owners Corporation cannot prevent a Strata Manager from receiving commissions during the term of the agreement. However, they have the right to review this arrangement at the next review date, and if they elect for the Strata Manager to no longer receive commissions, then the Strata Manager has the right to increase their agreed services fee as a part of this review process. Now I accept that is a purist view, and does not take into account the commercial challenges a Strata Manager may face when a committee member may want to change the rules mid-term. The most practical problem that Strata Managers face is when another insurance intermediary gets appointed by the Owners Corporation (e.g. an insurance broker) and the insurance company or underwriting agency pays that broker a commission following their placement of the cover. The commission entitlement that the Strata Manager would have otherwise been entitled to under Schedule C1 no longer exists. This form of income has gone to another party, and the Strata Manager has a shortfall. The Owners Corporation is no worse off financially, but the practicalities of the Strata Manager getting the agreed services fee reset under these circumstances are difficult. I don t believe the current agency agreement contemplated these circumstances, and there is an opportunity to enhance this agreement by including explicit provisions outlining what remedies are available to Strata Mangers when expected commission income does not get delivered. Here I am thinking of a form of a ratchet clause. I would recommend that any Strata Managers entering into a 6 P a g e

7 new management agreement, or renewing an existing one, consider issuing a side letter to make explicit reference to an agreed outcome, should these circumstances prevail. At the minimum, it would allow base management fees to be reset. The future of Insurance Commissions for Strata Management Companies I stated earlier that my views are that it is highly unlikely that commissions on general insurance products will be banned. To support this view, I will cover off the following points: What is in the regulation pipeline? Why were risk products excluded? What is the case for continuing to support commissions? FoFA The Future of Financial Advice (FoFA) 10 legislation was passed by the House of Representatives on 22 March It followed a federal review into the financial services sector, specifically focussed on financial planning, after the collapse of many highly leveraged investment schemes. Consumers lost large amounts of money (savings) and there existed highly complex commission and remuneration structures. FoFA amends the Corporations Act and introduces 11 : A prospective ban on conflicted remuneration structures including commissions and volume based payments, in relation to the distribution of and advice about a range of retail investment products. The ban will not apply to some products and advice services, including general insurance, where the benefit only relates to a general insurance product. A duty for financial advisers to act in the best interests of their clients, subject to a 'reasonable steps' qualification, and place the best interests of their clients ahead of their own when providing personal advice to retail clients. An opt-in obligation that requires advice providers to renew their clients' agreement to ongoing fees every two years. ASIC will have the ability to exempt advisers from the opt-in obligation if they are satisfied that the adviser is signed up to a professional code which makes the need for the opt-in provisions unnecessary. Enhanced powers for ASIC P a g e

8 What were some of the arguments to have risk products (general insurance) excluded? The federal review included general insurance products, or risk products, such as Strata Insurance products. Many papers were presented by industry stakeholders arguing for the federal government to exclude risk products for several reasons. Here is a sample of some of those arguments: General Insurance (GI) products are short term in nature and renewed annually The risks for consumers was generally less for GI products than Investment products Remuneration structures in GI were less complex than for Advisers in financial planning ASIC inquiries have proven there have been no problems, or in other words they believe their conflict of interest policies are working The Financial Ombudsman Service (FOS) has dealt with very few cases of commission-related disputes Globally, no other regulator has gone as far as banning commissions on GI products. In the UK, the Financial Services Authority regime is that commission disclosure on GI products is optional There are many detriments to banning commissions on GI products, and they collectively outweigh the benefits on introducing a ban. Some of these include: - Reduced availability of personal advice - Increased cost to consumers - Reduced competition on insurance terms - Increased under-insurance/non-insurance Insurance is a grudge purchase, investments are designed to increase wealth Different thought process on whether to pay on a fee/time cost basis or not Additional arguments included that a commission model within GI products has some consumer benefits, including: Intermediaries only get paid if the deal gets done The commissions cover services such as claims assistance, which could be a significant additional cost for consumers if charged on a time cost basis There is an overall public benefit to encourage adequate levels of cover It is an extremely efficient form of distribution, and Commissions align remuneration with transactional volumes Importantly, whilst there was acknowledgement from the insurance industry that the receipt of Commissions does not always link with value to consumers, so was the argument that Fees will result in consumers pushing back if value is not seen. So, irrespective of either remuneration model, it is essential for financial service intermediaries to be able to demonstrate a value proposition for consumers in an ongoing capacity. There s your hint my good friends! 8 P a g e

9 Conclusion: How do I see the issue of Insurance Commissions for Strata Management companies in the future? In my view, over the medium to long term, insurance commissions will be sticky for small to medium sized risks (the majority of schemes in Australia). Larger schemes and/or schemes where complexity exists will more likely than not transition to full fee for service based arrangements. It would be wise to prepare for that eventuality over the short to medium term. Paul Keating, Managing Director CHU Group of companies August, P a g e

10 Appendix A Why Strata Managers are entitled to revenue (insurance commissions) for insurance related activities? Strata Management companies discount their base fees in anticipation of other sources of income, such as insurance commissions. I have prepared a quick download of a number of reasons practicing strata managers can use in conversation they have with their Executive Committees during the disclosure process. Owners Corporations need to insure it s a key function performed by Managers. An Owners Corporation is an unlimited liability legal entity, and insurance is finite. This creates financial risk for Owners Corporations and in turn Strata Managers. Under FSRA law, Strata Managers need to be trained and then appointed (as distributor or authorised representative) by an AFS Licensee. The Owners Corporation is the beneficiary of the knowledge gained through this process. Once appointed, and depending on the level of authorisation, Strata Managers are then subject to supervision and audit. This provides a direct benefit to Owners Corporations through good consumer governance. When appointed as a representative, the AFS Licensee must provide PI protection for the activities of the strata manager within that authority. This provides a direct consumer protection benefit to Owners Corporations through having the AFS Licensee business and assets standing behind the strata manager. It is the Owners Corporation that decides where to place the insurance, but they seek guidance from their trusted advocate that is you as their Strata Manager. Managers have a fiduciary responsibility, so they need to give general advice, in addition to the administrative functions, such as; Maintaining risk data and claims histories to negotiate best options Maintaining a schedule of business activities for commercial premises Completion and lodgment of documentation Collection and payment of premiums Receipt of certificates Assistance with obtaining certificates of currency Coordination of repairs and administrative activities in the event of a claim. Any vagaries between accidental damage and maintenance (repairs) will ultimate see the Strata Manager perform work. If you lose that income stream to a third party, you would need to apply additional charges. So it will cost the Owners Corporation more. Competition ensures that management fees are subsidised by commissions. Benchmarking studies support the fact that Owners Corporations are the ultimate beneficiary of such commissions. In the absence of these commissions management fees would need to increase commensurately. An Owners Corporation can outsource the insurance function, i.e. to a broker, or deal direct. Premiums will be the same (save for the practice of netting ). If insurance related activities (such as insurance valuations) are still performed, the Strata Manager will retain a higher PI exposure for any large loss insurance claims. 10 P a g e

11 Appendix B SCA (Vic) membership requirements Source: %20Authorise%20Representative.pdf Why do l need to be an Authorised Representative? As a consequence of the Financial Services Reform Act (FSRA) in early 2004, the owners corporation and insurance industries in Australia have undergone radical changes as to how they provide financial (insurance) services to clients. The owners corporation is responsible for ensuring that it holds building and liability insurance in accordance with the requirements of the Owners Corporations Act If the owners corporation does not have insurance to protect it, the individual unit or lot owners will be liable for property damage and legal liability. This could result in financial hardship and may result in fines and penalties for the owners corporation. As the Manager, your duties may include obtaining valuations for insurance purposes, obtaining insurance quotes, arranging and paying for the insurance in accordance with the owners corporation instructions and assisting the owners corporation to make insurance claims. Arranging the insurance and paying the premium are both financial services under the FSRA. Your duties may also include answering questions about insurance, which might involve providing a financial service under the FSRA. To be able to provide a financial service and arrange insurance under the Corporations Act an Owners Corporation Manager must choose to be appointed as either (1) a Distributor or (2) an Authorised Representative of an Australian Financial Services (AFS) Licensee. The financial product information that can be imparted by Distributors and Authorised Representatives does vary. It is to your advantage to understand why SCA (Vic) has chosen to support the appointment of all of its OC Manager members as Authorised Representatives. We believe as an Authorised Representative, you are equipped to deliver a higher level of customer service to your clients as a direct result of holding this authority. Also as an Authorised Representative, you have a broader authority to service your clients when delivering Licensee s insurance products by being able to provide General Advice as well as Factual Information to your clients, as compared to other distribution models which are limited to providing Factual Information only. The financial product information that can be imparted by Authorised Representatives is very specific and it is important to understand the advantages of holding the authority of being an Authorised Representative. Some OC Managers who are appointed as Distributors of other AFS Licensees may only arrange Financial Products they are not allowed to provide any advice (General or Personal) at all in relation to the OC insurance product. These Distributors are only able to provide Factual Information about the insurer and the OC insurance. 11 P a g e

12 An Authorised Representative however can provide Factual Information as well as General Advice, in addition to arranging the OC insurances. Advice authorities are dependent upon the level of training undertaken and the authorisations issued by the AFS Licensee. A General Advice authorisation allows a Manager to compare the features of different OC insurance and provide additional guidance to the client about OC insurance. This additional General Advice authorisation can also reduce an OC Managers business risk. If you give advice pursuant to your authority and a claim results, you are protected under the Insurance Licensees cover. You cannot provide any advice/information outside the authority appointed by a Licensee. If you do so you will need to rely on cover being provided by your Professional Indemnity Insurer, which may or may not exist. Consequently Distributorship which provides factual authority only, consequently increases your business risk. It is also important to remember that a fiduciary relationship exists between an Authorised Representative and their client through the application of the Contract of Appointment, and through the relationship developed. This relationship is also based on trust, honesty and confidence, which arises when one person is bound to act in good faith and in the interests of another person. The relationship that is developed between the two parties can be seen as a relationship of reliance. SCA (Vic) believes the Authorised Representative model most appropriately allows OC Managers to fulfil their fiduciary obligations to their clients and provide an appropriate level of advice on insurance matters in order to properly service their clients. At the centre of any fiduciary relationship, a duty exists that requires an OC Manager to make available to the client, all relevant information, which will then enable the client to make an informed decision. For example the necessity for the OC Manager to provide all required information regarding variances between Insurers, including cover, security etc, when multiple policies are presented, to enable the OC to make an informed decision on which insurance policy to select. As the OC industry becomes more complex and more competitive SCA (Vic) believes that OC Managers will be expected to provide an improved level of service to their clients, which will include some form of advice required at some point by the client. To successfully discharge this duty, an OC Manager would need to become an Authorised Representative with the appropriate advice authorisations issued by an AFS Licensee. The Authorised Representative model represents SCA (Vic) s commitment to you and demonstrates the SCA (Vic) s position of ensuring that the best level of support is provided for OC Managers. This is reiterated by referring to the Business Licensing Authority [BLA] web site at where you will find the BLA / Consumer Affairs Victoria publication, Guidelines for Registered Owners Corporation Managers. For these reasons SCA (Vic) requires proof of an OC manager s A/R status on applications for membership. 12 P a g e