Under closer examination

Only an insurance intermediary based on a remote island with no newspaper, radio or television contact could fail to be aware that, from 14 January 2005, they will be regulated by the Financial Services Authority.

Impending FSA regulation has caused considerable concern in the industry.

In a recent survey, 17% of brokers cited regulation as their greatest challenge. Above all, this statistic reflects just how worried brokers are about the application process and their ability to comply with the extensive prudential and conduct-of-business requirements of the regulator.

The increased regulatory burden on intermediaries will be considerable.

The FSA's requirements are set out in their Handbook of Rules and Guidance, which, in printed form, is around three metres thick. Rules relating to insurance intermediaries are contained in the Insurance: Conduct of Business Rules, together with various sourcebooks and consultation papers available in their latest (although not necessarily final) incarnations on the FSA website.

Broadly speaking, intermediaries seeking authorisation should already have reviewed various standards and practices (see box below).

So FSA regulation leads to more work for brokers, but does it also lead to more risk for their insurers?

As a provider of broker's professional indemnity insurance, Markel International has been considering how FSA regulation will affect this market. Two questions are key: will there be greater numbers of insurance intermediaries requiring PI insurance as a result of regulation? And, more importantly, will the brokers seeking PI insurance present an increased or reduced risk to their insurers as a result of their authorised status?

General Insurance Standards Council Rules require all members to carry appropriate PI insurance and, therefore, there will be no marked increase in the number of established insurance brokers seeking such cover. And the number of applications received by the FSA supports this view. However, there will be more brokers seeking PI insurance cover as a result of the introduction of regulation for so-called secondary intermediaries.

Secondary intermediaries are entities that offer or arrange insurance as a peripheral part of their business, and they will need to be authorised by the FSA. Examples include: surveyors/property management companies that arrange insurance for the properties they manage; dentists and vets who offer insurance against the cost of future dental work/pet illness; and car dealerships that offer warranties and/or insurance with their cars. An exception is currently being made for secondary intermediaries in the areas of travel agents providing travel insurance as part of a package holiday and retailers of white goods that market extended warranties.

Nevertheless, the FSA estimates that there are about 25,000 secondary intermediaries in the UK whose business will fall within the ambit of FSA regulation.

From 14 January these secondary intermediaries will have three choices.

They will either have to be authorised, have ceased transacting insurance business or have become the appointed representatives of brokers or insurers that are themselves authorised.

The FSA is concerned that the process of applying for authorisation has been off-putting to secondary intermediaries. At the end of 2004, Sarah Wilson, director of the FSA's high-street firms division, said: "While the numbers of applications from firms selling general insurance as a secondary activity are rising slowly, we are increasingly concerned that such firms are not applying for authorisation in sufficient numbers."

By 11 November 2004 only 4408 of an estimated 25,000 secondary intermediaries had applied for FSA authorisation. They may have been further discouraged by the knowledge that, even after authorisation is received, there will be more hurdles to clear. Along with implementation of the financial, management, training and business reviews and procedures, authorised secondary intermediaries will be required to carry PI insurance for their broking activities in the prescribed amount and terms. But will they be able to find and/or afford this cover?

Some insurers have welcomed the potential expansion of the brokers' PI market and have even devised policy wordings aimed specifically at secondary intermediaries, but it remains to be seen whether or not they have any real appetite for these risks. The scope of the cover required by these secondary intermediaries will be crucial to their ability to obtain insurance and herein lies a problem.

At the time of writing, the FSA had not clarified whether all intermediaries will be required to purchase cover for losses caused by dishonesty of directors, partners and/or employees. If this is deemed mandatory, insurers may well shy away from offering cover to small surveyors, dentists, vets, car dealers and the like against the possibility of an individual pocketing client premiums. Intermediaries that are sole practitioners will, in effect, be seeking to insure against their own dishonesty, which is not only undesirable business for insurers but is also contrary to public policy.

Less than one-fifth of secondary intermediaries whose businesses will need to be authorised have actually applied for authorisation.

Andrew Poole, head of special projects at Stuart Alexander, which offers a secondary intermediaries scheme for property-managing agents, says: "We have been trying to open the eyes of secondary intermediaries for some time now. The sooner they understand the requirements of regulation, including the need for PI insurance, the better."

Even within that fifth there may well be a number that will find it impossible to obtain the statutory PI cover. This leaves around 20,000 secondary intermediaries who will have to chose one of the remaining two options.

They must either cease transacting insurance business from 14 January onwards or become the appointed representatives of other brokers or insurers that are FSA-authorised. The latter option will pose yet further problems for the underwriters of brokers' PI insurance.

Under the appointed representative regime, those unable or unwilling to obtain FSA authorisation can exempt themselves from the requirement for authorisation by becoming appointed representatives. Such representatives are authorised to act as agents for a principal, which itself must be authorised by the FSA.

The quid pro quo is that the FSA-authorised principal "is responsible to the same extent as if he had expressly permitted it, for anything done or omitted by the representative in carrying on the business for which he has accepted responsibility".(Financial Services and Markets Act 2000, s.39 (3)). The onus is therefore on the principal to ensure the representative's compliance with FSA regulations. If a claim results from the appointed representative's non-compliance, then its principal will be liable.

Moreover, the FSA's Prudential Requirements state that the principal must purchase PI insurance to cover "claims for which it may be liable as a result of the conduct of ... its appointed representatives" (Prudential Sourcebook, Section 9.2).

An authorised intermediary can have as many appointed representatives as it wishes. Recent indications are that a considerable number of secondary intermediaries are opting for appointed representative status. The Institute of Insurance Brokers commented in September 2004 that it knew of large brokers signing up swathes of secondary intermediaries, particularly in the motor sector. This is worrying news for brokers' PI insurers, as the brokers concerned will almost certainly be looking to cover liabilities arising from their appointed representatives' professional services (those same small surveyors, dentists, vets and car dealers) under their own PI insurance.

So, under a single PI insurance policy, brokers could be seeking cover (including dishonesty cover) for any number of appointed representatives.

Their PI insurers may have no insurance history with the representatives and know little about them.

David Armes, PI underwriter at Markel International, comments: "From 14 January onwards, brokers should be prepared to provide their PI insurers with full details of how many appointed representatives they have, who they are and the business relationship they have with them. Brokers should also be very selective in their choice of appointed representatives or be prepared for a significant increase in their insurance premium."

Another aspect of regulation that could increase brokers' PI risk profile is the extended role of the Financial Ombudsman Service. From 14 January brokers' 'consumer' customers will have free access to this service, which can only encourage a greater volume of complaints. The FOS is initially expecting some 5000 extra complaints per annum relating to the conduct of insurance intermediaries. The FSA Prudential Sourcebook also requires intermediaries to have insurance "cover in respect of Ombudsman awards made against (them)". This will be an extension to the standard cover currently on offer under most policy wordings.

In addition, the high-profile media coverage that has accompanied the run-up to regulation, may lead clients to expect higher standards from their brokers, and make them more likely to bring a claim when things go wrong.

Extensive use of appointed representatives, the publicity accompanying regulation and the extension of the FOS will increase broker risk from a PI insurers' point of view. It must, however, be remembered that FSA regulation will also have positive effects. The authorisation process is forcing all brokers to examine their business more carefully. The FSA Rules should lead to improved record-keeping, with advice to clients clearly documented, and better checks, controls and training of staff. The majority of brokers' PI claims arise from a lack of understanding of the client's needs and/or failure to communicate key terms, conditions, warranties or exclusions to the client. For these reasons, the risk of an FSA-compliant broker should ultimately be reduced.

STANDARDS AND PRACTICES

- Management responsibility - under the new regime, firms are required to take reasonable care to organise and control (their) affairs responsibly and effectively, with adequate risk-management systems. Management tools such as organisational charts, business plans, reporting, risk and compliance structures, logs and procedures should already be in place.

- Business practice and records - the FSA places obligations on brokers concerning advertising, commissions and terms of business. Transactions with clients will have to be documented and the client provided with clear, written information at all stages, including status disclosure, demands and needs statements, product disclosure, policy summaries, statements of cancellation rights and procedures with regard to renewals and claims handling.

- Training and competence - brokers must ensure that their individual staff are (and remain) competent for the work that they do. They must be appropriately supervised and their competence should be regularly reviewed.

- Complaints procedure - full internal and external complaints procedures should be in place, with a complaints log and regular reviews to identify and address recurring problems.

- Regulatory processes - procedures should be in place to ensure prompt and proper reporting of relevant matters to the regulator.

- Financial safeguards - the FSA has set requirements for minimum capital resources, the segregation of insurance client money and/or risk transfer, compensation arrangements and compulsory professional indemnity insurance.

PROBLEMS FOR PI INSURERS

Overall, FSA regulation should be a positive influence on industry standards, but will pose the following problems:

- Regulation will see a number of 'unknown quantity' secondary intermediaries seeking compliant brokers' PI insurance for the first time.

- Publicity surrounding regulation will make clients more - not less - likely to sue or make a complaint to the Financial Ombudsman.

- Appointed representatives present a significant new area of risk.

Brokers should choose their appointed representatives carefully and be prepared to pay increased premiums if this is their preferred way of doing business.