Tim Goodger, insurance partner of City of London commercial law firm Elborne Mitchell, discusses some of the current issues arising out of the Financial Services Authority's Client Money Rules including the discrepancies between the way intermediaries hold funds for insureds as well as insurers and their contractual obligations as set out in terms of business agreements.

Three years since new rules were introduced governing the way UK brokers hold money when processing premiums and claims, there is still confusion over how they should work. As a result some insurers and brokers are leaving themselves exposed.

One of the main problems is the discrepancy between the way an intermediary may actually hold funds and what in fact it has contracted to do with its policyholder clients and/or each of the insurers it deals with. There are various reasons for this: for example, there may be conflicting terms between the various terms of business agreements (TOBAs), leading to a conflict in the way funds are to be held.

Alternatively, insufficient notice or explanation may have been given to the client/ policyholder about the proposed arrangements, thus leading to a [lack] of (informed) consent about the status and types of account to be used, or there may have been poor implementation of processes to ensure compliance with an insurer's TOBA.

Or indeed, the relationship may have changed over a period of time due to the introduction of new TOBAs or other contractual documents that have had an impact on the way funds are held, or were held before the implementation of the client money rules.

Alternatively, and rarely, the intermediary may have made a conscious decision to ignore the requirements under a TOBA. Whatever the reason for non-compliance, insurers and intermediaries need to consider their respective positions.

Ultimately, however, intermediaries need to ensure they address this properly and swiftly to comply with their contractual and regulatory obligations.

A first point of action for an intermediary is likely to involve collating all of the TOBAs it has in a logical way. It is likely that should include not only current TOBAs but also those that have been superseded. The TOBAs may then be categorised and catalogued.

A second point of action is to consider what the actual terms are and whether they are being applied properly. For example, where there is risk transfer, has the insurer asked the intermediary to hold its money on an express trust, rather than in a non-statutory trust? Or, has the insurer asked for funds to be held in a non-statutory trust account but instead they are held in some other way and the insurer is unaware of that? From the insurer's perspective, this affects its credit exposure, and particularly its rights in the event of the intermediary's insolvency.

A third point of action is to ensure implementation of procedures to assess all further TOBAs that are received. A review needs to cover not only the various terms of business but also how those affect binding authorities and other forms of delegated authority that the broker may have been given, including those areas where risk transfer may have been cascaded down a chain of intermediaries.

Another issue in this area is the approach to legacy business, being business that the firm or insurer is no longer conducting.

This aspect needs to be addressed actively to avoid problems, particularly in relation to unreconciled balances or orphan funds held by intermediaries. These funds are balances that may have been held by an intermediary for many years but which, possibly due to the change in the business type, have not been properly reconciled with the insurance accounts in question.

In essence, the intermediary may not have accounted to the relevant client for funds or not drawn across those funds that are due to it (for example, commission or reimbursement for marine premium that the intermediary funded).

This is where intermediaries need to consider the need for legal advice from lawyers experienced in these issues, including the status of funds and the impact of the various agreements governing previous relationships.

Despite these important issues, some insurers are not deploying the necessary resource to review TOBAs and the extent to which the terms are being implemented. This, however, is not simply a financial audit and a matter of ensuring there is adequate accounting for funds (although that, in itself, is an important aspect of monitoring). Rather, risk and compliance managers in conjunction with financial directors need to ensure there is a co-ordinated strategy to reduce exposures. There is an element of risk management, particularly because of potential exposures on insolvencies that necessitates a regular review of the contractual relationships.

To this end, there may be a misplaced reliance on the regulator to undertake such reviews and investigate any discrepancies that arise. Although the regulator may despatch "Dear CEO" letters, the credit exposure for insurers combined with the potential breaches of contract and regulation for the intermediary warrant proactive steps by insurers and intermediaries.

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.