UK:
Striking The Right Balance: A Proportionate Approach To Conduct Risk In Wholesale Insurance Markets
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Whether you are a marine broker, terrorism underwriter,
or property Managing General Agent (MGA); the Financial Conduct
Authority (FCA) now requires conduct risk (the risk of unfair
consumer outcomes) to be identified and mitigated in wholesale
insurance markets.
This is a huge step change for firms, especially for brokers and
underwriters operating in the Lloyd's and London market (plus
other insurance companies with commercial lines business). With
limited conduct focus until now, many firms have business areas
that have never assessed conduct risk and there is little precedent
or guidance on how to appropriately mitigate the risk.
There is a real danger that firms address conduct risk
disproportionately or without mitigating the actual risks. It is
essential to get the balance right: there are undesirable outcomes
for both firms and consumers if mitigating actions go too far, or
not far enough.
Finding a risk-based and proportionate solution that works for
the Lloyd's and London market is therefore critical to the
market's continued success. However, without any prescriptive
regulatory rules or guidance, the many 'grey areas' of
conduct risk that need to be addressed present a barrier for firms
when tackling the overall conduct risk agenda.
In this paper we explore these challenging 'grey areas'
and offer an approach that firms in the wholesale insurance market
can use to identify and mitigate conduct risk.
Key points
- By tackling conduct risk issues without an appropriate
methodology, there is a danger that brokers and underwriters
address conduct risk disproportionately or without mitigating the
actual risks.
- Firms need to break-down, analyse and prioritise complex
business models to focus on where there is exposure to conduct risk
in a structured, risk-based and proportionate way.
- Firms should re-focus existing processes and controls to
address the identified conduct risk, before complementing these
with additional proportionate steps where necessary.
- Firms that succeed in their conduct risk approach can
expect:
- operational efficiencies
- improved strategic decision-making
- a new perspective for boards and committees
- a forward looking view of conduct risk.
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The expansion of conduct risk into wholesale insurance
markets
Conduct risk was traditionally seen as only a concern for
retailers of personal lines. It was typically these firms making
the front-page news and receiving multimillion pound regulatory
fines for failing to address conduct risk.
However, the FCA has dramatically widened the scope of conduct
risk to cover:
- all firms in the supply chain, including firms operating in
wholesale markets
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"We will take a more assertive and interventionist
approach to risks caused by wholesale activities and, if necessary,
will act to protect a wider range of client relationships than at
present."
FCA – Journey to the FCA, 2012
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- all consumers of general insurance, from personal lines to
commercial lines – including large risks and reinsurance
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"Our responsibilities extend to all consumers, whatever
their age or financial circumstances and whether an individual,
small company or a major participant in the wholesale
markets."
FCA – Approach to Advancing Objectives, 2013
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This scope change has brought new firms, regulated activities,
lines of business and products into the focus of conduct risk. This
has wide-ranging consequences as firms must demonstrate that
consumers are central to their business model, product lifecycle
and culture. It therefore impacts from how firms make strategic
decisions to how people are incentivised, and everything in
between.
|
"We will take action, including enforcement action,
where we consider that part of a firm's business model or
culture – such as its product selection, training and
recruitment, or remuneration practices – are likely to harm
consumers."
FCA – Approach to Advancing Objectives, 2013
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Figure 1. Extended focus of conduct risk
Key conduct risk challenges
Challenges are inevitable given the complexity and diversity of
wholesale insurance markets. Below, we examine a number of key
risks, challenges and 'grey areas' that wholesale insurance
firms must overcome when addressing conduct risk. While this is not
an exhaustive list, we have highlighted those areas where we
believe the need for consideration is most significant.
CONSUMER SOPHISTICATION
Now that all consumers of insurance (from individuals, to
corporates, to regulated entities) are viewed by the FCA through a
conduct lens, how should firms assess conduct risk posed by
different consumers?
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It is generally assumed that the greater the financial
understanding of the consumer – for example, a large
corporate compared to an individual – the less likely there
will be an unfair outcome and the lower the conduct risk.
The traditional segregation of consumers into personal lines and
commercial lines is too simplistic to enable a proper assessment of
the financial understanding of the consumer and how this heightens
or mitigates conduct risk.
For example, what if the purchaser of insurance for a large
corporate is an individual in the HR department, with little
knowledge of the product being purchased? Or is a medium-sized
corporate but a first-time customer or purchaser of the product?
These consumers may not actually be sophisticated buyers regardless
of the size of corporation.
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WHO IS YOUR CUSTOMER?
Who should different firms in the supply chain consider as their
customers and what does this mean for conduct risk?
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We see many firms simply considering the next party in the
supply chain as their customer. For example, wholesale brokers
considering their customers to be retail brokers.
It is unequivocal that all firms should look down the supply chain
to identify and mitigate conduct risk in relation to the
end-insured.
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CAN YOU PLACE RELIANCE ON OTHER PARTIES?
As firms across the market address conduct risk, it is possible
that every firm in a supply chain undertakes similar mitigating
steps, causing duplication, inefficiency and unnecessary cost. This
has happened with other regulatory requirements when expectations
evolve. Can this be prevented by placing reliance on other
firms?
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There are many situations where firms may want to place reliance
on other parties in the supply chain or on firms with whom they
have outsourcing arrangements. For example, a large marine risk
placed in the subscription market – the six following
underwriters place reliance on the lead underwriter to set the
terms of the contract and handle any claims.
Can these followers rely on the lead in the same way to
appropriately address conduct risk? How should alternative sources
of insurance capacity (for example, side-cars) get comfortable with
the conduct risk profile they are absorbing on an open market
basis? And can other parties in the supply chain rely on each
other? For example, can an insurer or wholesale broker rely on the
retail broker who has the main customer relationship?
Following underwriters have exposure to conduct risk but they can
place reliance on the lead underwriter's conduct risk
mitigating actions to increase efficiency. However, this should not
be 'blind reliance' – it requires firms to gain
assurance over any reliance placed.
The same goes for any type of outsourced activity (including all
types of delegated authority, from Coverholders to Third Party
Administrators) and parties in the supply chain relying on each
other.
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GEOGRAPHIC LOCATIONS
Wholesale insurance is a global business. So what are the conduct
risks for a UK regulated entity when the end-insured and/or other
parties in the supply chain are domiciled outside the UK? For
example, an Indian consumer has an Indian broker who instructs a UK
broker to place the risk at Lloyd's.
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There has been recent debate in the Lloyd's and London
market over the extent of conduct risk responsibility in relation
to non-UK domiciled consumers.
We believe that UK regulated firms have a responsibility to
identify and address conduct risk in relation to the end-insured,
no matter where they are based in the world. This may include
mitigating the conduct risk from any information asymmetries with
the Indian broker, for example, if the Indian broker has
insufficient information on the product to properly represent the
end-insured.
While information can be harder to gather, a regulated activity is
taking place in the UK and it could be indicative of poor culture
within an organisation and damaging to market integrity if
decisions are made that produce poor outcomes for consumers based
outside the UK.
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WHAT IS A 'PRODUCT'? AND WHEN IS IT
'NEW'?
Different insurance products present different conduct
risks. However, to assess these risks, each firm will have to find
a suitable definition for a 'product' and 'new
product' that works for them.
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These definitions are likely to vary by firm. The challenge in
defining a 'product' comes from the many types of business
where each risk is a bespoke product. While it is relatively
straightforward where the product is broadly homogeneous, the
conduct risk from bespoke products may need to be assessed at a
line of business level, although there is often more homogeneity
across bespoke products than first appears.
An inappropriate definition of 'product' results in
assessing conduct risk at a level that is either too time and
resource consuming, or doesn't consider the risks in
appropriate detail.
With corporate consumers increasingly de-risking their business
through the purchase of insurance, new insurance products will be
designed to suit new risks they face.
A challenge comes from ensuring that risks posed by these new and
amended products are addressed. Products with little or no history
(for example, historic claims data) can present a higher risk of
unfair consumer outcomes; and similarly, there is conduct risk when
hiring a new team of underwriters or brokers to diversify into new
areas that the firm is inexperienced in.
While there has been debate in the market about whether it is the
broker or underwriter that has responsibility for product design;
in reality, products are frequently designed by both parties
working together. This challenge must therefore be addressed by
both brokers and underwriters.
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CONFLICTS OF INTEREST
Conflicts of Interest (COI) is a key area of focus for the FCA.
Firms need to consider the conduct risk presented by different
types of COI and how these relate to different areas of their
business, but what types of COI should be identified and how should
firms mitigate the associated conduct risk?
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COIs are the subject of a FCA thematic review that started in
2013 and we have seen standards of identifying and mitigating COIs
rise across the market.
It is challenging for firms to keep up with the FCA's evolving
expectations around COI. In particular, the type and volume of COIs
to identify and how these should be mitigated.
For example, if a broker is choosing which market to place a
consumer's risk, it is advisable that the broker is unaware of
the multimillion pound consulting contract, or sizeable volume
commission, his or her firm has with an individual insurer. And on
this point, how responsible is the insurer for this COI?
If the broker has the option of placing this risk with a
Group-owned MGA, then what steps should the broker take to
demonstrate this is in the consumer's best interest? If this
risk is placed with a market that pays profit commission (PC) and
has delegated claims authority to the broker, the claim handler
should be unaware of the PC and not influenced to unfairly decline
the claim.
While incentivising brokers and underwriters is central to driving
long-term commercial success; incentive structures, such as pure
volume-based financial incentives, can also drive undesirable
behaviours that conflict with the consumer's interests.
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CLAIMS AND COMPLAINT HANDLING
Do firms understand their conduct risk profile in relation
to claims and complaint handling?
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Claims and complaints are also thematic review areas for the FCA
and while personal lines claims have been the main focus in 2013,
it is likely that the FCA will turn its attention to commercial
claims.
With the FCA's 'follow the money' approach, claims
ratios are an important conduct risk factor to consider. Profitable
business does not automatically mean unfair consumer outcomes.
However, firms should make sure that profits are due to good
underwriting or broking, and not because the product has onerous
limitations that the consumer is unaware of or offers little value
for money.
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CHALLENGES FOR REINSURANCE
The consideration of conduct risk in reinsurance is in its
infancy. So what are the conduct risk exposures for
reinsurance?
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If a reinsurer reinsures an insurer's motor book, the
insurer is able to underwrite more business. If the insurer's
book contains products that cause consumer detriment, the reinsurer
could arguably be said to have facilitated this outcome.
So while reinsurance brings a degree of conduct risk, it is
proportionately lower risk given the sophistication of the
reinsurance-buyer and relative remoteness from the underlying
end-insureds.
The conduct risk with Treaty reinsurance is more of a challenge to
address than Facultative contracts. For example, a South American
risk placed into London through Facultative reinsurance has a
similar conduct risk profile as placing the insurance element.
However, if a Treaty book is populated with comparable products or
with products designed using similar approaches, a conduct risk
assessment starts to look less impractical.
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To read this article in full, please click here.
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.
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