UK: Insurance Market Update - The Deloitte View For Non Life Insurers

Welcome to the September edition of the Insurance Market Update in which we focus upon the future of CASS 5.

Following a review of its regulation of general insurance intermediaries, on 28 August 2012 the FSA issued a consultation paper on its Review of the Client Money Rules for Insurance Intermediaries (CP12/20) which contains various proposals for changes to the Client Assets rules.

Various concerns had arisen during the course of the FSA review which included a poor understanding of the rules and subsequent poor compliance by the market. The FSA had specific areas including, for example, inappropriate controls over the use of the non-statutory trust, ineffective risk transfer documentation, the application of the pooling rules, infrequent client money calculations, client money held by third parties and client money held as designated investments.

Consequently, in preparing the consultation paper the FSA engaged with interested market participants to discuss key topics to help form the FSA's proposals. Comments to the FSA are invited by 30 November 2012 and the FSA expect to publish feedback and final rules in the second quarter of 2013. We would encourage you to read these proposals and be involved in the process.

In this edition of the Insurance Market Update, we set out some of the proposed changes to the rules together with our views on what it means for firms.

As always we look forward to receiving your feedback: your views, comments and suggestions for future themes or topics are most welcome.

The Future of CASS 5

Background

The FSA's client money rules were introduced in January 2005 and have remained unchanged since then. Most of the market took the option of bringing their existing Insurance Broking Accounts into the new Client Assets (CASS) regime which means that many still carry pre-FSA unreconciled legacy balances in their client accounts.

Whilst the rules may not have changed, the FSA's interpretation has evolved, particularly in the light of the financial crisis and the collapse of Lehman Brothers. The consultation paper represents a key opportunity for the market to respond to the FSA's proposals and to start preparing for the significant changes ahead.

Key concerns with the CASS regime

The consultation paper presents a comprehensive review of the CASS regime for brokers and addresses the FSA's main concerns arising from the supervision process. The main issues that the FSA sought to address include:

• the credit risk arising from funding which, in the event of an insolvency, may lead to a shortfall in the client money trust;
• credit write-backs (specifically in relation to balances that are due but not paid to a third party) are inconsistent with a broker's duties as a trustee;
• conditions in risk transfer agreements create uncertainty whether an insurer would honour the agreement in the event of a broker failing. This uncertainty would lead to delays in returning funds to customers and potential confusion as to whether cover has been provided;
• the mechanism for insolvency practitioners following a pooling event could be improved to make it more practical and secure a better outcome for customers; and
• the existing requirement to record a broker's continuing fiduciary duty after paying client money to third parties is ineffective. The market has adopted inconsistent practices which frequently involve making broad assumptions on when the fiduciary duty is extinguished.

The proposals set out in the FSA's consultation paper have been developed to address these concerns through a series of pre-consultations with brokers, industry bodies and other market participants.

The impact on firms

The consultation paper includes a number of significant changes that firms will need to consider carefully but can start to prepare for now. We have discussed the proposals with a number of our clients and common concerns were raised around system reporting capabilities and the impact on resources needed to carry out the increased controls requirements. There are also a number of areas, particularly in respect of mandatory funding provisions, where further clarity is needed on how the rules would work in practice.

The consultation paper includes a number of smaller, pragmatic changes designed to provide clarity and these smaller changes should be welcomed by the market, including:

• guidance on prudent over-segregation (or 'buffers') and on credit write backs;
• allowing firms to submit an irrevocable instruction to transfer funds on the day of the client money calculation so the money moves the following day; and
• an acknowledgement that CASS will need to be reviewed once the Law Commission has completed its review of s.53 of the Marine Insurance Act (where brokers become directly liable for the premium on a marine policy).

What to focus on now

The consultation paper raises a number of practical and operational challenges for firms. Those responsible for client money should therefore ensure that they have a detailed understanding of the proposals and the changes needed to comply when the rules are introduced. An assessment of the likely impact will allow any additional costs to be included in budgets and forecasts. Much of the guidance provides firms with information on the FSA's interpretation of the current rules.

This includes:

• ensuring that conditions in risk transfer agreements are understood by the Board and are not being breached;
• guidance around prudent over-segregation in the client accounts; and
• treating commission as 'earned' on receipt if individual agreements are silent.

Firms should take the opportunity to start addressing any legacy items before the possible introduction of the FSA's requirement to pay credit write-backs to charity.

Firms should also start looking carefully at their systems to ensure that the correct data is captured and understand how reports can be developed to meet the new rules. For example, it is likely that broking systems do not capture whether money arising from the wholesale market is held or when it has been received by an insurer.

The impact on Threshold Condition 4 (TC4)

An increasing number of brokers are being asked by the FSA to carry out complex reviews to determine the level of financial and non-financial resources required under TC4. The reviews include stress testing, an orderly wind down scenario and a gone-concern scenario. In all cases, the level of risk inherent in the client money accounts is a key element of the calculated resource requirements.

Whilst there are significant costs associated with improving systems capabilities (particularly if firms determine that a new system is required), the improvement to reporting could reduce the likely costs of an orderly wind down or insolvency. Accordingly, firms should review the impact of the proposals on their TC4 requirement.

At a glance – the key proposals

Non-statutory trust controls

• Client money calculations will be required every 7 business days or 14 business days if <£250k of client money is held.
• Bank reconciliations must be completed for every client money calculation within 2 business days.
• Mandatory provision for funding is set at 45 days for client funding and 90 days for insurer funding.

This should be calculated on a net basis per counterparty, but it is unclear how it would operate where there are multiple concurrent transactions which cause the third party to dip in and out of a net funded position.

Conditional risk transfer

• Agreements with insurers would need to state explicitly that the agency status of money held is not subject to any conditions.
• Firms are requested to review their risk transfer agreements in order to identify any conditions and check that they are compatible with their business model.
• CASS resolution packs and changes relating to pooling events
• Firms would need to hold and keep current a pack of information to be provided to an insolvency practitioner within 48 hours of a failure.
• Insolvency practitioners would be given a three month period in which to sell a business after a pooling event, instead of being required to distribute pooled client money immediately.
• Small changes to the way in which a loss arising from secondary pooling events would be allocated within the trust and the way that an insolvency practitioner deducts his costs from funds received after a primary pooling event.

Pre-consent for transfers between trusts

• A new clause to be introduced to client agreements providing pre-consent for a transfer of funds between client money trusts. The aim is to reduce the number of waivers arising from the sale of a book of business where firms are unable to obtain 100% consent from all affected clients. The change would not impact balances held in the trust in respect of monies held prior to this. Accordingly, a degree of positive confirmation will be needed.

Unallocated cash

• Unallocated cash required to be returned to source after 90 days.

Money held at third parties

• Wholesale brokers required to report on money held (including the date when it was paid to an insurer) on a monthly basis.
• The current rule allowing firms to de-recognise their fiduciary duty after 12 months in respect of money paid to overseas third parties would not change.

Credit write backs

• The FSA will allow the current system for credit write backs to continue for 13 months after the new rules are introduced. After this, firms would be prohibited from crediting money to the income statement where a third party could not be identified or contacted. A new mechanism for such balances would pay these balances to charity.

Prudent over-segregation

• Guidance given on the process required to justify prudent over-segregation (or 'buffers') in the client accounts. This confirms the FSA's existing interpretation through supervision.

Designated investments

• Designated investments to be restricted to money market funds (FSA found that very few firms invested client funds in any other product).

Client matching

• An annual exercise to demonstrate that 95% of balances held could be reconciled by client within one month. This reflects the FSA's more recent interpretation of the rule in CASS 5.5.69.

Approved person for client money

• Boards to nominate responsibility to an existing approved person for oversight of all client money operations and related management information. This is in addition to the client money manager required under the non-statutory trust regime and will apply even where no client money is held.
• If an audit is not required, the approved person would need to obtain approval from the Board.

Is it a done deal?

The consultation process provides firms with an opportunity to present their views on whether the new rules can work in practice. Whilst we are encouraging all our clients to participate in this important process, responses will need to recognise that the proposals have already been subject to a cost-benefit analysis and a number of pre-consultation reviews.

Fundamental changes (specifically requiring better systems reporting) are unlikely to change, but a few key decisions are left open in the consultation paper, including:

• whether the 12 month rule for de-recognising balances held by overseas wholesale brokers needs to be modified; and
• whether client money audit reports should be sent to the FSA as a matter of course for all firms or just those with a higher risk or serious breaches.

Firms should carefully consider the impact on their business and ensure they respond to the FSA with any fundamental issues.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.