Being prepared and waiting for the outcome

Over the last few weeks we have conducted client seminars, workshops and one-to-ones on the Financial Conduct Authority’s (FCA’s) forthcoming thematic review into broker conflicts of interest. The review was announced by Simon Green, Head of General Insurance and Protection at the FCA, on 2 July 2013.

The FCA is to review practices at about a dozen Category 3 and 4 firms. At the time of writing, selected firms have received FCA information requests and questionnaires – a prelude to on-site visits and meetings.

A number of clients, both brokers and underwriters, have asked us what, if anything, they ought to be doing prior to the commencement of the review and the publication of the FCA’s findings and recommendations.

Business as usual…

It should not be assumed that the FCA will recommend very substantial changes to commercial insurance practices, or that it will find that existing practices are deficient. The FCA’s conflict rule is a permissive one. ICOBS 4.1.8, for example, provides guidance to insurance intermediaries using panels of insurers when advising on a “fair analysis” basis. The guidance says:

“Selection [for the panel] should be based on product features, premiums and services offered to customers, not solely on the benefit offered to the firm.”

We doubt that there will be many, or even any, instances where insurers have been selected solely (or, for that matter, predominantly) because of benefits to the broker. It may be that, while the FCA has concerns about certain arrangements, it takes the view that it would not be appropriate to criticise firms for historic compliance with the standards then operating.

That said, a thematic review does not relieve a firm from its ongoing obligations to satisfy itself that it is complying with FCA requirements. The issue of broker conflicts is inextricably linked to broker remuneration. This is a topic on which the FCA will expect to see firms’ boards fully engaged. Below we offer some tips, simple dos and don’ts, for those who are to be subject to the review, and for those who are not but are keenly awaiting its conclusions.

Do…

  • Ensure that broker conflict and remuneration discussions take place in the context of the relevant FCA Principles, in particular Principles 1 (Integrity), 6 (TCF) and 8 (Conflicts Management). We recommend that Directors at board meetings frame their discussions and debates via overt reference to the Principles. Not only does this shape attitudes, it also helps in producing board minutes which show a progressive governance orientation.
  •  Focus on Management Information (MI). We expect the FCA to try to identify examples of bad practice in the firms it reviews. What may be more of a problem is where a firm fails to collect and distribute MI sufficient to enable the board to identify that poor practice itself. It is sometimes said that MI in this area is difficult to obtain, but this need not be the case. A starting point would be the remuneration received by brokers from markets and what business they place with those markets. Outliers and oddities can be earmarked for investigation. Poorly managed conflicts often present as unusual financial flows.
  • Ensure that staff understand the firm’s processes and controls. Any firm might be identified as having a poor practice in one area or another. What would be disappointing though is to find that a practice is satisfactory, but a concern arises because staff cannot clearly articulate what the procedures are, and what risk control objective they are intended to meet.
  • Be cautious when concluding that a particular commission rate is standard in the market. The FCA will expect evidence to support such an assertion.
  • Continue to progress compliance projects and any outstanding RMP points. The fact that a thematic review is to be conducted does not mean that projects that deal with areas that might be addressed by the review should be held in abeyance pending its outcome.
  •  Make sure Non-Executive Directors (NEDs) are informed and understand the issues thoroughly. The FCA will regard NED input as crucial. Issues around whether particular practices connote a lack of integrity or create an unacceptable risk of a poor customer outcome are particularly susceptible to NED input. While NEDs will be expected to have good risk management instincts, their effectiveness will be seriously diminished if they lack knowledge of on the ground practices. NEDs are expected to be consumer champions. In our experience, there is a real gap between that ambition and the current reality, but that is not to denigrate the work of insurance NEDs. Often, the problem is that they have not been told what is expected of them.

Don’t…

  • Bring long standing practices to a summary end simply out of a fear about the direction of travel. For example, if a firm decides that profit commission arrangements should be terminated because they raise conflicts which cannot be appropriately managed then ending such arrangements would be the right thing to do. But we would advise against bringing them to an end because of a belief that that is what the FCA will ultimately recommend. We do not think that the FCA will be quick to ban longstanding market practices unless the threat to customers’ interests is clearly evidenced. Try and insulate the business. It will be impossible for this review to be dealt with by the board and compliance and risk control functions alone. Business stakeholders should not only be consulted, but encouraged to take personal responsibility.
  • Hesitate to react swiftly to obvious bad practice. When individuals deliberately subvert Chinese walls, seek to buy business, or create misleading documents (for example, describe a luxury overseas trip as “education” when there was no educational element) the FCA will expect a proper investigation, swift remediation, and a considered analysis of what the breach reveals about the firm’s culture and controls.
  • Rely on, as a defence to challenge, that particular practices which may be criticised are carried on by numerous other market participants. If a firm is asked to justify a practice it must be able to do so by showing that the practice is consistent with FCA Principles. As the Retail Distribution Review (ban on product provider commission for investments) and LIBOR investigations (LIBOR submissions influenced by a setter’s risk positions) show, the FCA is not averse to investigating, reviewing and changing longstanding market practice.
  •  Alter files prior to submitting them to the regulator. To ensure that this is not done, file collation, copying and dispatch should be overseen by a senior individual.
  • Fail to see the connectedness with other FCA thematic initiatives, for example the reviews into risks to customers from financial incentives and other general insurance studies. While these are separate pieces of work operating to different timetables, they are all obviously relevant topics.
  • Use the review as leverage in commercial negotiations. For example, an insurer would be unwise to fail to honour a contingent commission agreement on the basis that the fact that such a review is being undertaken suggests the agreement is unlawful. Such behaviour might be seen as lacking in integrity.
  • Be heavy-handed when assisting people to prepare for meetings with the FCA. It helps the FCA for the interviewee to understand the firm’s systems and procedures. It would though be wrong to seek to persuade an interviewee that a practice about which he has concerns is appropriate and acceptable. The FCA will expect to hear individuals’ informed views, not just towing of the corporate line.

The top can change, but not the bottom…

It is possible that the review will result in the effective banning of certain practices. However, we think that improbable. More likely will be a conclusion that the current rules permit a broad range of approaches, but there are certain cases where firms are using that latitude to the detriment of customers. It would be wholly in keeping with the current trend for failures to be attributed mainly to overly detached and disengaged boards. In the event of poor practice the FCA will ask what cultural precepts and example the board has set, how it has communicated its risk appetite to the firm, what MI it sought and how it has challenged and properly orientated commercial practices within the firm. These are areas that the board can be working on now.

What cannot now be changed are the historical facts. But firms are entitled to begin the process of explaining and putting into context what has happened in the past. Firms cannot mislead the FCA, they must be frank and open with it, however that does not mean that any individual should head into an encounter with the regulator unprepared for the questions that might be put.

Firms and senior individuals should be prepared to state their view of the future. In Scandinavian countries provider commission has been replaced with a fee based structure. The implications of that change are much discussed, but there are few prepared to say that all the consequences have been good. Should commission remain?

Are certain commission arrangements always problematic? Can all structural conflict situations be cured by disclosures? These are questions that the FCA will be putting to trade bodies, but there is much to be said for the leaders within firms having their own views, and being prepared to advocate them.

The FCA has said that it expects to deliver its findings and final recommendations by the last quarter of the year. Possible outcomes might be an extension of the review to cover other firms and/or the FCA’s current favoured tool, the “CEO attestation”. Firms not being reviewed, at least in this round, therefore have some time to consider, and act on, the state of their internal controls.