PRUDENTIAL AND OTHER REQUIREMENTS FOR MORTGAGE FIRMS AND INSURANCE INTERMEDIARIES RESPONSE BY THE BRITISH INSURANCE BROKERS ASSOCIATION ON THE FINANCIAL SERVICES AUTHORITY CONSULTATION DOCUMENT 174 JUNE 2003 1
CP174 Q1 Do you have any comments on the proposed guidance at Annex 3 of this CP and are there any areas where it would be useful to expand on it? We have concerns about a level of ambiguity over what is regulated and the potential adverse affect this might have on implementation of the regulations. We believe that there is too much left in the hands of the regulator to decide on an individual basis. This could mean that brokers were exposed to uneven playing fields. As an illustration of this in Para 5.7 much of the paragraph refers to whether on interpretation by the FSA something is likely or not. We believe such terminology will make it difficult for brokers to understand their obligations. There is a greater need for understanding and clarity in Annex 3. For example, in paragraph 5.4.4. we would find it helpful to have a clearer understanding on the following Degree of continuity - what does this mean? Is it related to frequency? How are seasonal sales (e.g. caravan sites) treated? Scale of activity - what does this mean? Is this dependent on volume of business? Proportion activity bears to non-regulated activity - what is it based on? Is the main criteria income or perhaps time? Nature of activity - does this mean that some activities are less important or is it only used in conjunction with the above? Similarly in, for example 5.4.7 the examples set out in (2) and (3) will often include commission payments. If they do is it intended they should be included? In Para 5.7 it is not entirely clear what precisely is meant by the terms administration and performance. Some further insight would be helpful. The words surrendering, assigning, converting are unclear in Para 5.8.12. For example what obligations are placed on the authorised firm where it plays no active part in assignment (i.e. the insurance attaches itself to the insured goods - e.g. construction guarantee, freight forwarding). 2
As far as the Business Test is concerned, it is not certain that brokers will have full knowledge of whether all parties in a transaction will meet the tests and will therefore be exempt. Perhaps it would be possible to introduce some form of exempt certification. Q2 Do you agree with our proposal on how to implement the requirements of article 3.6 of the IMD and its extension to mortgage lenders? We have no comments in relation to article 3.6 of the IMD and its extension to Mortgage Lenders. Q3 Do you agree that mortgage lenders should use only the services of authorised intermediaries? We have no comments in relation to whether mortgage lenders should use only the services of authorised intermediaries. Q4 Do you agree that the Principles for Businesses should apply, unamended, to regulated mortgage activities and insurance intermediation activities? We support the Principles for Business set out in CP 174, but would need further guidance on how they would apply for very small businesses. We believe the Principles for Business should mirror the requirement for adequate advice in CP 160. Q5 Do you agree that SYSC should be applied, unamended, to mortgage activities and insurance intermediation activities? We fully support the concept of the Principles for business. However we would seek some guidance on the size of firms which are required to comply with some of the requirements in SYSC and in particular what constitutes a large firm. There would be some considerable concerns about the application of this document to small High Street firms, which clearly would not have the infrastructure or possibly the necessity to meet some of these requirements. We would also wish consistency in relation to SYSC when applications are made to ensure that there are level playing fields. 3
Q6 What are your views on a more limited set of controlled functions for firms which carry on insurance intermediation as a secondary activity? We would have no concerns about this proposal as long as the controlled functions were proportional and that level playing fields were preserved so that regulated intermediaries were not left at a competitive disadvantage. Q7 Should individuals advising consumers on `higher risk insurance policies and `lifetime mortgages be specifically approved to do so? We recognised in our response to CP160 that there were sound arguments for recognising a greater protection for consumers on high risk insurance and we believe that this has been similarly recognised by the ABI and GISC. We suggested that these might involve additional guidelines and practice requirements. We do not see any need for individuals advising consumers in these markets to be specifically approved to do so. Q8 What are your views on our proposals for the approved persons regime for general insurance intermediaries and mortgage firms? We have no concerns with regard to the proposals for the approved persons regime for general insurance intermediaries and mortgage firms as long as they remain proportional. Q9 Do you agree with our general approach to implementing article 4.4 of the IMD? Implementation of Article 4.4 of the IMD only requires one of the four criteria to be satisfied. Strictly speaking the segregated (trust) account proposals would be sufficient for the UK to satisfy the requirements of the Directive. Measures relating to capital and compensation schemes are super equivalent and must particularly be open to question in terms of proportionality and cost benefit analysis. In principle, however, some combination of PI, client money, capital and customer compensation is a reasonable approach. Q10 Is there any demand from within the industry to establish a guarantee scheme as an alternative to this package? A guarantee scheme, as required by the IMD would not be a viable alternative. 4
Q11 Should we consider the 4% capital requirement, a guarantee fund, or perhaps compulsory risk transfer for private customers as alternative options? A 4% capital requirement based on premiums is impractical, in some cases this amounts to more than the net retained brokerage. It would result in an unreasonably large amount of money being tied up in the business. Compulsory risk transfer (not limited to private customers) is an approach already adopted in the legislation of a number of Member States, where it appears to work with little obvious detriment to insurers. However, unless this is made mandatory by the FSA we do not believe that risk transfer is a realistic option for the majority of brokers. Left to commercial forces it is possible that some insurers may be prepared formally to accept the credit risk for some intermediaries, however, other insurers may take a different view of that intermediary. Where an intermediary is trading with a number of different insurers it is very unlikely that all will accept the credit risk. Intermediaries will still therefore have to establish trust accounts for some of their business. Risk Transfer left to market selection could eventually lead to intermediaries seeking to limit the number of insurers they are prepared to deal with (or vice versa) and thus reduce client choice. Q12 Do you agree that the proposed PII requirements for insurance intermediaries are appropriate? Generally we believe the PII proposals are appropriate. We are concerned as to availability of fraud and dishonesty coverage for principals of a company (9.1.8(1)). A consistent approach to defence costs should be adopted (9.1.8(3)). It would be difficult to apply the FSA requirements to a PI policy mid term and we therefore seek confirmation that the Rules would apply from the renewal date post 14 th January 2005. Q13 Do you agree that the proposed PII requirements for mortgage firms are appropriate? No comment. 5
Q14 Do you think there will be adequate capacity in the market for the proposed level of PII cover? We believe there will be adequate capacity in the market but are concerned about the willingness, of insurers to provide blanket coverage of Ombudsman awards, particularly when they extend beyond strict legal liability. Rule 9.1.12 needs to be amended to permit non EU insurers and captive insurers to be used. Q15 To what extent do you think the rules need to deal with the use of client bank accounts outside of the UK and the use of intermediate brokers and settlement agents? We believe the rules should make clear that a wholesale brokers client is the next broker in the chain. As such the rules should not require the broker to ensure that monies held by others are held in accordance with FSA rules. Q16 What are your views on the practical application of our proposals for client money to firms operating in this market? Is there more we should do to make them easier to implement and more cost efficient? Two (or even three) types of account will create considerable systems problems for the vast majority of brokers utilising software house systems. As far as we are aware non of these systems allow a brokers to operate separate bank accounts from a single client database. Brokers will therefore have to create two separate databases and ensure that these are kept under regular review to ensure that customers have not changed their status from private to non private. It will also add significantly to banking costs, particularly for the smallest brokers who may only have a few non private clients Statutory Trust The rules surrounding the proposed statutory account for private customers, particularly as they relate to funding, will create very considerable practical problems for both intermediaries and for insurers. They will require a complete change to the way the industry accounts. Typically, smaller brokers receive 20/25 days credit from insurers. Renewal of a risk incepting on the first of the month will appear on the insurer s accounting statement for payment on 25 th /26 th of that month. The intermediary, therefore, only has some 3 weeks to collect from the insured and remit those monies to the insurer. Intermediaries have to pay insurers whether or not the insured has paid. Typically small business take 30 days to settle their accounts. 6
Under the proposed rules the intermediary will have to fund such premiums out of its own funds, an impractical proposition for the majority of brokers. Many commercial premiums are now financed though premium finance companies, typically such firms take 25 days to process the application and transfer the funds to the broker. Again an element of funding by the broker would be required in most cases. It is also not uncommon for brokers to provide limited credit to small commercial clients and personal customers, allowing them, for example, to pay by 3 monthly instalments while settling in full the account with the insurer. Under the proposed rules such practices would have to cease (unless funded by the broker from his own funds). Intermediaries may have claims settling authority from insurers allowing them to respond promptly to private customers small claims. Premiums and claims monies are accounted for on a balance of account basis typically at the end of each month. We do not see how such facilities, while greatly benefiting the customer, could survive in a statutory trust environment. Non Statutory Trust The proposals for a non statutory trust recognise the need for funding and we believe it would be entirely appropriate for this regime to be applied to private customers as well as non private. The rules surrounding the trust, the capital requirements and the FSCS provide adequate safeguards for private customers. A single approach to handling client monies would greatly simplify the process, reducing costs and would avoid the need for significant change to existing commercial practices. There are a considerable number of facilities (e.g. binding authorities) which cover both private and non private customers that are accounted for on a bordereau basis. The dual trust approach would require such items to be split with potential significant systems and workflow costs. Withdrawal of Brokerage The requirement that brokerage cannot be withdrawn until received will have a marked impact on the industry. At the very least it will have a cash flow impact of some 6 8 weeks, representing some 15% of turnover. This will cause problems for some brokers which would be greatly eased if a transitional period of say 2-4 years was granted. As this is not an IMD requirement we believe the FSA should be prepared to allow a period for adjustment, particularly at a time when brokers will be faced with significant extra costs in terms of preparing for and being regulated by the FSA. 7
The proposed rules require that brokerage be withdrawn within 25 working days of receipt. There are many instances where brokers do not know exactly how much brokerage they are entitled to especially where the policy covers several different perils each subject to different rates of commission. This may only become clear when the broker reconciles premiums with the insurer. On new risks this can often take up to three months, the broker would therefore have to retain such brokerage in the trust account for a period significantly longer than the 25 days proposed. In other cases the broker may have been paid by the customer and be awaiting the insurer s statement which, for some brokers, could again mean that brokerage is retained in the account for longer than 25 days. A number of brokers systems are based on the approach that commission is withdrawn when the insurer is paid and it would be expensive to change (particularly as there is no obvious customer benefit). Interest The proposed rules require that a firm must agree the treatment of interest in writing with any private customer. We believe that it is reasonable for this provision to be satisfied by the broker including a provision within its terms of business agreement without the need for the insured to confirm its acceptance in writing. The figures shown in the table in para 9.5.22 are reasonable as far as personal lines business are concerned. However, if small commercial business is included in the private customer definition then there will be many examples where brokers will be unable to take advantage of this provision. We can also envisage practical problems relating to identifying and tracking interest earnings relative to specific clients. We believe that it would be much simpler if brokers were required to advise their customers through their terms of business agreement that they retain interest on insurance monies, without the need for a written acknowledgement from the client. Should a customer require any interest to be paid to them brokers should be entitled to deduct any bank charges incurred in making the payment. Client money handling Rule 9.5.14 allows an AR to accept client money provided it is paid to the principal s segregated account within 3 working days. In the vast majority of situations this is impractical and will add cost to the operation. 8
On the premise that a principal is taking responsibility for the collection of client money, but delegating the activity to its AR, we believe that a longer time frame for transferring money to the principal is acceptable and does not increase consumer detriment. Many of these sales involve very small sums of money per transaction (sometimes even a few pence) and it will not be economic to require such firms to develop separate accounting systems and procedures to identify, reconcile and pay such sums within artificially short time frames. We believe that transfer of client money from an AR to a principal should take place at least monthly, although clearly a principal should be able to require more frequent payments. We believe this corresponds with the terms of payment a principal may agree directly with a customer. Q17 Do these client asset segregation rules appropriately address the risks in general insurance intermediation. We support the concept of properly protected client money accounts. However, we believe the proposed statutory/non statutory account approach is unnecessary, disproportionate and will add considerably to brokers administrative costs and have potential for confusing the client. You accept that few brokers have failed in recent years. We believe that a suitably streamlined non statutory trust approach supported by PI, Capital and FSCS gives customers more than adequate protection. This we believe would present a proportionate response to the very different risks associated with general insurance as compared to the investment world. Q18 Do you agree that intermediary firms not holding client assets should be subject to the financial resource requirement proposed? If not, what level of capital do you think would be appropriate? We believe the proposed capital requirements for firms not holding client assets are reasonable. Q19 Do you agree that 5% of client money balances is an appropriate level for the financial resource requirement of an intermediary holding client funds? The proposal that capital should be a minimum of 10,000 is reasonable, as is the 5% of annual income measure. For many smaller brokers we believe this latter measure will in fact be greater than the 9
5% of client money balance requirement. For example, a broker handling 12m of premiums, will on average retain 1m on deposit, this would give rise to a capital requirement of 50k. However, assuming an average brokerage of 13% (say 1.5m) this would require capital of 75k. The position is very different, however, for brokers who also handle claims monies. Q20 Do you agree that no liquidity adjustment is required? We agree that no liquidity adjustment is required. Q21 Do you agree that credit risk requirements are unnecessary? Typically brokers are not liable for premiums and therefore the capital requirements are more than adequate to protect against any credit risk exposure. Q22 Do you agree with our capital proposals for currently unauthorised mortgage lenders and administrators? No comment. Q23 Do you agree with our capital proposals for currently authorised firms proposing to carry on insurance intermediation or regulated mortgage activities? We agree with your proposed approach. Q24 Do you have any comments in respect of the proposed computation of capital resources? The proposed definition of capital is reasonable other than the treatment of goodwill, which will create a number of immediate problems for some brokers. Goodwill is a recognised feature of accounting practice in the Financial and Services Industries and firms that have been pursuing acquisitions will have imported a variable degree of goodwill into their balance sheet that will be amortised at variable rates. This proposition will have a number of implications for such firms: 10
The ability to acquire businesses will be affected as such acquisitions will have to be made for cash. Borrowings will not be able to be offset by the asset of the goodwill acquired. Such a move will compromise succession issues as they will make management buyouts difficult, if not impossible. Normal accounting practice does not allow businesses to account for inflated values on goodwill, indeed the directors have a duty to write off goodwill quicker if it is impaired. In all cases, goodwill as stated is lower than the actual value of the business imported. In view of the impending capital adequacy directive in 2006, it would be prudent to have a transitional period whereby businesses are allowed a period of say, 5 years, to amortise existing goodwill over that period. Such an approach would not compromise continuing acquisition programmes. Indeed, without a transitional period the consolidator firms will be limited in their ability to acquire. Through 2004, a large number of smaller firms facing the FSA regime will be looking to exit the industry and consequently would not be in the position to do so, or at best have their value severely diluted. Q25 Do you agree with our proposals to extend the FSCS to customers of intermediaries? The proposed extension of the FSCS to cover general insurance intermediaries was widely anticipated. We would however, welcome confirmation that the Scheme will only apply in respect of activities relating to contracts of insurance or renewals entered into after 14 th January 2005. The FSA regime will bring large numbers of previously unregulated intermediaries within its scope. It would be unreasonable for the FSCS to provide protection for such unregulated activities even if the claim is lodged post 14 th January 2005 but prior to the renewal of the contract. While in theory no firm should be able to trade post 14 th January unless authorised by the FSA, we would like confirmation that the FSCS would not cover failures of any firm trading without authorisation. Q26 Do you agree that a separate FSA fee block and FSCS contribution group should be set up for general insurance intermediation. In principle we support a separate fee block for general insurance intermediation. However, we wish to understand in detail how the scheme would work in practice before committing to this approach. Intermediaries income largely consists of their net retained brokerage and we would expect any scheme levy to be based on this amount. 11
The insurers scheme is capped at 0.8% of net relevant premium income and a similar limitation based on net relevant retained brokerage would be equitable. In practice we believe the scheme should be capped at 48,000 per insured for it not to place too great a contingent liability on the sector. Q27 Do you agree all intermediaries holding client money should be subject to an auditor requirement as proposed? While we support this proposal in principle, the requirement does not sit comfortably with the Government s efforts to reduce the burden of regulation for small businesses. Currently an enterprise with a turnover of less than 1m has dispensation from an audit and discussions are taking place with a view to increasing this limit. SUP 3 also has an exemption from appointing an auditor for the defined small personal investment firms. However, we accept that independent verification of correct operation of the trust account is desirable, given that small firms will typically fall into category D. We would suggest that for businesses with an income of less than 1m the Accountants Form 5 as required by the Insurance Brokers Registration Council Rules would be a proportionate response. This would be less expensive than a full audit but provide comfort for the FSA, as regulator. Q28 Do you have any views on the concept of a small firm? We are of the view that a firm with an income of less than 1m would constitute a small firm. Mike Williams Chief Executive June 2003 12