Playing it straight

Since the FSA was handed the remit to oversee the insurance sector, a hands-off approach was never really on the cards. Raj Parker and Nathan Willmott report on developments

The Financial Services Authority (FSA) hit the ground running when it assumed responsibility for general insurers and insurance intermediaries three months ago, and it is now pursuing a number of major projects to improve standards in the insurance sector.

Even prior to the 14 January start date, the FSA was prompted by New York Attorney-General Eliot Spitzer’s legal proceedings in the US to reassess the use of contingent commission agreements by the major brokers. This work has since developed into a wider investigation into how brokers are dealing with conflicts of interest. Similarly, the FSA has been pushed into action on the use of financial engineering by insurers as a result of further investigations by Spitzer. The FSA has also announced that it will improve standards by improving contract certainty and that it will pursue targeted supervision of other areas such as disclosure to retail policyholders and the operation of binding authorities.

Brokers’ management of conflicts of interest

The FSA is currently in the process of visiting a range of insurance brokers to quiz them on their systems for identifying and managing potential conflicts of interest. This project – identified in the FSA’s 2005-06 business plan as one of its major ongoing themes – was kick-started as a result of the issues pursued in late 2004 by Spitzer in relation to the alleged abuse of contingent commission agreements between the major brokers and the insurers with whom business was placed.

In drawing up its detailed conduct of business rules following extensive consultation with the industry, the FSA decided not to ban the payment of contingent commissions by insurers to brokers. It instead laid down high-level rules permitting the offering or receipt of inducements only if the intermediary had in place systems and controls for ensuring that no material conflict of interest arose.

The FSA had also identified that brokers faced potential conflicts of interest where they act for the insurer (as well as the policyholder) in investigating claims. It said brokers could only act for insurers in handling claims where they obtained the informed consent of the policyholder before acting.

There are many other circumstances in which brokers can find themselves facing a conflict of interest. The FSA has made it clear that the identification and management of such conflicts will be a key issue for brokers that wish to remain in compliance with their regulatory duties. Conflict management can be undertaken through a variety of means, including disclosure, information barriers, informed consents from clients and avoiding remuneration arrangements that could encourage representatives not to act in the best interests of policyholders. It is the adequacy of these arrangements that the FSA will be assessing in its round of visits to brokers, and some targeted disciplinary action is to be expected in cases where the arrangements fall substantially short of the FSA’s expectations.

Financial engineering

A further issue where FSA action has been prompted by developments in the US is the question of whether insurance companies should be permitted to use financial engineering to enhance their balance sheet positions.

While the FSA had consulted on this issue in 2002, it was not followed up until finite insurance hit the headlines in February 2005 following Spitzer’s investigations. Within days the FSA announced that it would be writing to all UK insurers to request information concerning their use of finite reinsurance.

As Dr Thomas Huertas, director of the FSA’s wholesale firms division, announced at the FSA’s insurance conference on 7 April, the FSA is keen to prevent insurers using financial engineering to obscure their financial conditions. He requested that firms report any transactions “where the economic value of the transaction differs materially from the value placed on the transaction in the firm’s balance sheet”. The FSA has also asked firms to confirm that they do not have in place side agreements or other transactions that might obscure their true financial positions or which “could place [the firm] at risk of breaching any applicable regulatory requirements”.

Insurers are required to submit their responses by the end of April, following which the FSA has indicated that it will take action against firms where necessary. The FSA has made clear that it will pay particular attention to reinsurance entered into with other entities within an insurer’s group, especially where those other entities are based outside the EU.

Improving contract certainty

In a speech in New York last December, FSA chief executive John Tiner announced another regulation priority: improving contract certainty and moving the industry away from a culture of “deal now, detail later”.

Stating that the FSA’s aim is to “work with the grain of the market” rather than put in place additional rules that could be costly to implement and unnecessarily burdensome, Tiner called representatives of insurers, brokers and market bodies to a meeting on 20 December 2004. He gave the industry a two-year deadline to improve contract certainty, failing which the FSA would have to impose new rules in this area. A working group has been formed which will report to the FSA on the progress being made.

Lloyd’s chief executive Nick Prettejohn, who sits on the working group, has identified January 2006 as a key milestone for the project. “If we haven’t been able to demonstrate real progress, then I believe the FSA will become more intrusive into the way the market operates and we may well see penalties on those brokers and firms that haven’t been able to provide evidence of progress,” he said.

Further issues

A range of other issues in the insurance sector has been identified by the FSA as requiring particular attention. These have included the operation of binding authorities by brokers to ensure that appropriate systems and controls are in place to minimise the risk that insurance is placed outside the scope of the broker’s authority (thereby leaving the policyholder without a valid policy). On the retail side, the FSA is keen to ensure that policyholders are given full disclosure at the right time, including having their attention drawn to key features of the policy and important exclusions or limitations. The FSA has confirmed that it will be addressing these issues on ‘themed’ supervision visits to firms to ensure that standards are being complied with.

Review of FSA’s enforcement procedures

Finally, the FSA has announced a full review of its disciplinary processes as a result of severe criticism from the Financial Services and Markets Tribunal in January. The criticism related to the FSA’s handling of an endowment mis-selling case pursued against Legal & General, in which the tribunal held that the conclusions reached by the FSA’s regulatory decisions committee were not supported by the evidence. The review is to be led by David Strachan, the FSA’s sector leader for insurance. The FSA plans to announce the outcome of the review in mid-July.

The FSA has faced a full and varied workload during the first quarter of 2005, which is set to continue over the coming months. A great deal of work will need to be undertaken in order to improve standards on a range of issues, and this will present a significant challenge for the regulator as well as for the newly regulated sector.

Raj Parker is head of Freshfields Bruckhaus Deringer‘s insurance and reinsurance disputes group; Nathan Willmott is a senior associate in that group and in the financial services group.