The right thing
18 April 2005
The complaint against Marsh & McLennan filed by Eliot Spitzer in October last year turned the spotlight on business practices in the insurance industry. It opened the door to a wide-ranging review of the global and UK insurance markets, with the aim of modernising the insurance industry, increasing transparency and promoting competition.
While the most serious of the Spitzer allegations - of price rigging and market manipulation - are now generally accepted not to be widespread, other areas remain outstanding.
The Spitzer charges also focused on the conflicts of interest inherent in the payment of 'contingency commissions' - the practice of insurers paying higher fees and commissions to brokers based on the volume and/or the profitability of the business. Brokers contended that these sums were proper payments for additional services provided to underwriters, such as for the use of e-trading platforms, the use of distribution networks and for policy documentation and administration. Opponents of the contingency commission model point to the conflict of interest between the role of the broker as an intermediary representing the interests of its client, namely the insured, and the receipt of payments from the underwriter which relate to the profitability or volume of business placed with a particular underwriter. The position of the broker in a transaction can be a complex one, and the legal analysis that they are acting as the agent of the insured is often simplistic given the complex structure of many insurance and reinsurance deals.
Under basic agency law principles, commissions received by brokers should be disclosed to the client, save where the principal was aware, or ought to have been aware, that such commissions were normally payable (ie where the payment of such commissions constitutes customary market practice). In the past, many brokers have sought to rely on the customary practice argument to provide a safe harbour. However, in the aftermath of the Spitzer allegations, brokers would be unwise to continue to rely on this argument and the insurance industry on both sides has been looking at ways of redefining the broking model. The International Underwriting Association of London has established a committee to negotiate new terms of business agreements with the intermediaries, and although some progress is being made towards a new model, the debate continues as to whether the policyholder or the insurer should pay these fees or commissions.
The position of the Financial Services Authority (FSA) on transparency is interesting. When the FSA took responsibility for the regulation of insurance intermediaries in January, it conducted an extensive consultation process prior to finalising its rulebook. Following this process, and in light of representations from intermediaries, the FSA decided, as a regulatory matter, not to make commission disclosure mandatory, but to rely on the general 'principles for business'. While the FSA has been reminding market participants of their obligations of integrity, transparency and the need to avoid conflicts of interest under the principles for business, the market has failed to appreciate the difference between a regulatory and a legal requirement and the interaction between the various components of the FSA handbook. It has tended, instead, to focus on the specific rules on commission disclosure.
Taking the lead from Spitzer, in February 2005 the FSA sent a guidance paper to market participants relating to conflicts of interest and unfair inducements. As part of the FSA's regulatory checks on firms, they will need to show evidence that they have robust systems and controls in place to monitor their conflicts of interest and be able to justify their positions on commission disclosure. It seems likely that the FSA will not hesitate to take disciplinary action against those that fail to adequately disclose commission structures and payments in a manner that complies with the FSA's principles for business, irrespective of the specific rules on commission disclosure.
Contract certainty is another current area of scrutiny. Under FSA regulations, policy documentation is required to be issued promptly. However, in the UK, particularly in the Lloyd's subscription market, the insurance industry has been notoriously relaxed about putting full policy documentation in place at the inception of the contract. This 'deal now, detail later' practice has been criticised heavily by FSA chief executive John Tiner, and the industry is being given a period of time to make progress on the issue. Before the industry can be seen to have made real progress, it will clearly require not only a rethink of the way in which policies are put together, but also considerable investment in IT software. That rethink will have to come sooner rather than later, as Tiner has given the industry two years to get its house in order before he will intervene.
The FSA has also indicated that it intends to look at the use of finite reinsurance in the UK and to assess whether "enhanced disclosure requirements" are required. The FSA last consulted on this subject in 2002 and at the time suggested that, provided there was the necessary degree of risk transfer, financial engineering through the use of finite reinsurance was a legitimate method of strengthening solvency. It now seems likely that there will be a further review, which is likely to focus not only on transparency and risk transfer, but also on the systems and controls for monitoring, managing and controlling exposures to these types of risk.
Finally, and perhaps most significantly, the latest challenge facing the market comes from Europe. Neelie Kroes, the EU Competition Commissioner, has announced plans to launch an investigation into the financial services sector, focusing on several areas, one of which is likely to be insurance. Kroes has identified the sector as one in which competition may "not be functioning as well as it might", and she will be using powers recently granted to the European Commission to conduct the investigation. The proposed financial services inquiry could have very significant consequences for the insurance sector, but, importantly, companies will have the opportunity at the beginning of the inquiry to help shape the Commission's perception and understanding of the market.
With the spotlight set to stay on the insurance sector for some time, and with precedents yet to be set, brokers and insurers would do well to ensure they are best practice-compliant as a matter of priority before the FSA, and potentially the EU, start looking for their first quarry.
Ashley Prebble is an associate in the corporate finance team at Norton Rose