The FCA Wholesale Broker Review has raised again the spectre that there may be a paradigm change to how intermediaries in the insurance sector are remunerated. In addition to the FCA review, Lloyd’s has identified broker remuneration as an area of focus for thematic review in 2018 through its Market Oversight Plan for 2018.

Applying the theory that there is no smoke without fire the fact that both the FCA and Lloyd’s are looking again at this issue suggests some concern on their part and the potential for a change in approach. In this article we look at the issues and explore some of the options.

Historical Relevance

Everyone who works in insurance broadly knows the history of the London market and how it started over 300 years ago in a coffee shop where individuals would underwrite the risks of vessels not making it to their destination or back while Britain expanded its international trade and exploration.

Since that time and for most of the next 300 years insurance brokers were the only distributors of insurance for syndicates at what has become Lloyd’s. Insurance companies were also set up outside of Lloyd’s, but they too were for a long time generally reliant on brokers for distribution of their insurance products. Distribution then diversified. Insurer started to sell directly to customers with door to door sales forces and now insurers, including Lloyd’s syndicates, utilise a myriad of distribution models involving direct (both online and through door to door sales), through agencies such as MGAs, bancassurance and affinity schemes, aggregators and through brokers.

Historically, agencies and brokers have been paid by way of a commission. In practise that has meant that a percentage of the gross insurance premium paid by the insured to their broker would be kept by the broker and the balance of the premium, known as the net premium, paid on to the insurer.

Since the early development of the market there have been parallel developments in the laws relating to agency. These have led to insurance brokers being identified as the agent of the insured and owing their clients duties to act in their best interests and to mitigate actual or potential conflicts of interest. The law has also created a “legal fiction” by which the commission retained by the broker is by law paid by the insurer to the broker because the level of commission received by the broker has not been agreed between the broker and their client as you might logically expect, but between the broker and the insurer.

In the modern insurance market there now exist many permutations of distribution and remuneration arrangements, but a lot of insurance business is still transacted utilising the traditional model where a broker brings business to an insurer who decides whether to underwrite the business or not and if so will agree a commission with the broker.

However, in response to clarifications in the law and increases in regulation a lot of business is now undertaken by insurance agents who are appointed by the insurer to assist them with the distribution of their insurance products. As they do not represent the insured and are not the agent of the insured, they do not have the traditional duties owed by a broker. Many of these agents are owned by insurance brokers and often sit in a distribution chain between the broker and the insurer. They are able to earn more in income because the law of agency does not restrict their earnings.  There are also newer distribution models which see online aggregators earning their primary income not commissions but in sales or marketing on their websites.

So, what is the Issue?

The payment of a broker who is the agent of and representing an insured by an insurer who needs to distribute their product has an inherent conflict of interest within it. Insurers want as much good insurance business as they can get, so as to grow their business and maximise their profits and brokers are also interested, for the same reasons in maximising their growth and income.

The insurers will always want to attract business which is profitable and traditionally the best way of achieving this has been by having the best products, the best service and paying the highest commissions. It goes without saying that the more profitable the business and the greater the margin available to the insurer the more opportunity there is to pay a higher commission.

Brokers, on the other hand, have the ability to offer the business they have been retained to place to whomever they wish. They are looking for the best outcome for their customers and this means finding the right quality product and services from an insurer or insurers who offer the best level of security (i.e. capital coverage).

Where the products and security offered by insurers may be almost identical one dynamic that cannot be ignored is that insurers have an interest in keeping commissions as low as they can to keep premiums down and remain competitive as well as increase their profits. However, without business to underwrite the insurers will have no profit and the party in control of that business is the broker because they choose which insurer is successful. The power often lies with the broker in this arrangement, especially in a soft market such as the current one where there are lots of insurers in the market offering similar products and the broker can choose which insurer (or MGA) is successful, giving the broker the opportunity to control discussion over payment.

In the worst cases of abuse insureds may not be offered the best products or best security at all with a broker placing business with an insurer (or MGA), on the basis of commission alone. It is certainly the case that historically, new insurers or MGAs to the market who may not have offered the best products or represented the highest level of security have had to resort to offering higher commissions in order to attract brokers to their door.

In relation to large risks the dynamics have been tempered since 2004 to 2006 because of the reviews undertaken by the FSA and others following the Spitzer investigations in the US, which are discussed in more detail later in this article. Large commercial insureds are more aware of their rights and often prefer to pay their brokers a fee rather than have the insurer pay a commission, or to ask how much a broker may be getting in commissions from the insurers.

However, on consumer or SME business the position is less clear. For consumer business there is no obligation to inform a consumer what commission is being earned and often it is in any event very difficult to do so if the business is arranged under a facility or binding authority which may incorporate a profit commission. Furthermore, it is easier to assess actuarially the likely profit of consumer or other volume risks compared to large risks and often such a book of volume business (commonly but not always written under a binder or a facility) will have historical and proven profitability. With Solvency II and the need for insurers who underwrite large risks to diversify their portfolios for capital purposes and to smooth their profit and loss swings, books of SME and consumer business are very attractive and more so where they have historically run profitably. Equally, the more profitable the book of business the more opportunity for a broker to earn a higher commission – because the insurer has margin in what they are underwriting. The result can be that profitable books of business attract more competition between the insurers as to who will underwrite the book and attract higher commissions than less profitable books of business.

A common approach to resolving the question of which underwriter may be granted the right to underwrite a book of business is determined by a process not unlike an auction. A broker will present the book of business to several insurers and ask each of them to submit a proposal including their proposed terms and conditions of coverage and their proposals for commissions. The broker, then has the role of selecting an insurer who offers a combination of the best insurance product and the best service levels so as to ensure that their responsibility to their insureds to find the best insurer is satisfied. Where these are equal or very similar the broker may be left with a choice based on differing pricing and commission levels. The inherent conflict between getting the best for their client and maximising their own income arises again.

These auction-like practices do not mean that customers are getting a poor product. Far from it, they are often designed to ensure that the customer is receiving the best available terms and conditions. After all, competition for SME and consumer business is fierce, which also drives the gross premium because if a product is not competitive it will not matter what the historical loss ratios and potential margin are. In addition, there is a valid reason why a broker may require a higher commission on high volume business. Historically it has been proportionately more expensive to process small risks, which has led to volume business being dealt with in this manner. It is not therefore the case that with every book of SME or consumer business the practices adopted by the market are inappropriate. However, because there is opportunity and temptation there can be from time to time in behaviour which may not place the insurance market in the best of lights.

Regulators exist to protect the customers, the market and the financial system from the effects of any such inappropriate behaviours.

The Current Law and Regulation Applicable to Broker Remuneration

Regulation often follows the law but not always, and that is the case with broker remuneration.

1. The Legal Position:

As the agent of an insured a broker is required to:

• Act in the best interests of their principal (the insured);
• Deal honestly with their principal (the insured); and
• Not make a secret profit.

Applying these to the insurance distribution model involving insurance brokers this means that a broker may keep the commission agreed by the insurer provided that the amount and nature of the commission is usual and ordinary for the services provided. No duty of disclosure arises in these circumstances. Usual or ordinary has an important role to play. A commission may be usual or ordinary by amount or usual or ordinary by nature:

• To be usual by amount it must be an amount which is usually paid to brokers in the market for placing that type of business. If 5% is the usual or ordinary amount paid, perhaps the market average, then double that sum is unlikely to be usual and certainly three times that amount could not be considered to be usual.
• To be usual by nature, it must be the type of commission that typically relates to that type of insurance business. An analysis of how long a commission has been paid and how widespread its use is would be required. A type of overrider or profit commission used by one or two brokers does not make that type of commission usual or ordinary if the rest of the market has not adopted it for that type of insurance business.

Importantly, and somewhat circularly, a commission cannot be usual or ordinary, if it is paid illegally in breach of contract or law, or if it is paid in breach of regulation. Thus, a commission which is a secret profit (such as an unusual or extraordinary commission received by a broker who has not fully disclosed its nature and value) cannot be usual or ordinary.

A broker may accept a commission which is not usual or ordinary only with the informed consent of their principal, the insured. This means that the broker must disclose to their client both the nature of the commission and the amount, or if the amount is not capable of quantification at the time of disclosure then how it will be quantified in the future. If the disclosure does not meet these requirements, then the insured is not giving informed consent and the broker is receiving a secret profit.

A bland and broad statement by a broker to the insured that it is receiving a commission from an insurer is not sufficient to satisfy the need to obtain the insured’s informed consent.

2. The Regulatory Position

Regulation provides different approaches depending on whether the customer is a commercial customer or a consumer and it covers both the disclosure requirement and the potential for conflicts of interest.

a. Disclosure:

The FCA rules on disclosure are contained in ICOBS 4.4 which relates to Commercial Customers. It provides:

1. An insurance intermediary must, on a commercial customer’s request, promptly disclose the commission that it and any associate receives in connection with a policy.

2. Disclosure must be in cash terms (estimated, if necessary) and in writing or another durable medium. To the extent this is not possible, the firm must give the basis for calculation.

There is no FCA commission disclosure rule or requirement in relation to Consumers (although ICOBS 4.6 does contains specific disclosure rules for pure protection contracts sold with retail investment products). ICOBS 4.3 also contains rules on disclosures relating to fees which customers are to be charged.

With regard to the FCA requirements, Consumers are therefore only protected by the High-Level Principles (1 and 6 are most applicable) and the FCA’ rules on Conflicts of Interest.

b. Conflicts of Interest:

The FCA rule on conflicts which is directed at dealing with remuneration is ICOB 2.3.1 and it provides:

1. Principle 8 requires a firm to manage conflicts of interest fairly, both between itself and its customers and between a customer and another client. This principle extends to soliciting or accepting inducements where this would conflict with a firm’s duties to its customers. A firm that offers such inducements should consider whether doing so conflicts with its obligations under Principles 1 and 6 to act with integrity and treat customers

2. An inducement is a benefit offered to a firm, or any person acting on its behalf, with a view to that firm, or that person, adopting a particular course of action. This can include, but is not limited to, cash, cash equivalents, commission, goods, hospitality or training programmes.

It is important to notice that this highlights clear regulatory obligations for firms offering inducements (insurers) as well as for those accepting them (brokers).

The FSA, FCA and Lloyd’s Reviews

In 2004 the allegations made by the Attorney General of New York, Eliot Spitzer, regarding practices in the international insurance market resulted in a general review by insurers and brokers in the UK and elsewhere of their practices regarding remuneration and conflicts of interest.

The FSA took an interest and issued “Dear CEO” letters as well as asking individual insurers and brokers about any issues they may have had. At that point in time the FSA rules regarding conflicts of interest contained a materiality element by which inducements should not impact a broker’s decision-making to a material extent.

Since then the FSA has become the FCA and the PRA, and the regulatory rules on conflicts have changed. The FCA also undertook a review of commissions arrangements for SME business in 2013 which resulted in little change or impact on the market.

Over more recent times Lloyd’s has improved its oversight of the market and has introduced mandatory quarterly reporting to Lloyd’s by Managing Agents of unusual or extraordinary remuneration arrangements with brokers.

Now in 2018 the FCA will conduct a review of competition in the Wholesale Broker market, and Lloyd’s intends to conduct thematic review work on broker remuneration. It is not yet apparent precisely what the scope of Lloyd’s review work will be, but the FCA has issued the draft scope for its review which is likely to cover:

“Topic 1 – Market power. We will examine whether individual broker firms have market power and, if so, what impact this has on competition. By market power we mean firms having the ability to raise the prices of their services beyond normal competitive levels. We will explore how easy it is for firms to enter the industry or expand their businesses, as the threat of new rival firms offering lower prices may constrain existing players from exercising the market power they might have. We will also look at whether there are sub-segments within the sector with fewer active players and if the intensity of competition varies across those segments.

Topic 2 – Conflicts of interest. We will look at the conflicts in the sector and how they affect competition and client outcomes. When brokers select placement options for their clients, there may be incentives to choose the insurer or product which provides them with the highest remuneration, rather than the insurer which best meets the clients’ needs. There may be other features where conflicts of interest arise and that need to be managed. These include possibilities that brokers look to place business within facilities which earn high commissions which may not always be in the best interest of clients. We will consider whether certain business practices may make this worse. For example, these practices could include channeling business to in-house underwriting services to keep more premium revenue within the group or placing risks with insurers that purchase additional services from the broker.

Topic 3 – Broker conduct. We will examine how certain broker practices have an impact on competition in the industry. We are interested in how some activities may exclude insurers, for example by placing risks through facilities rather than in the open market. When this happens brokers may be excluding certain types of insurers – often smaller firms – from some business and this may harm competition. We will also consider whether there is any evidence of coordination between firms, potentially through an implicit understanding rather than a formal agreement.”

While the consultation on scope was underway the FCA also issued its first round of information requests, primarily to the broking market participants. These requests have been comprehensive and are likely to provide the FCA with information which will identify the levels and sources of commissions being paid across a significant number of classes of business, segmented in a variety of ways including open market, facility and binder books of business as well as by size of risk.

Whether the information request alone will be sufficient for the FCA to identify any of the practices mentioned in my article ‘The Circle of Life: Same Issues, Different Market’ published in December 2017 or outlined above remains to be seen.

One can assume with a fair degree of certainty that the second phase of their review will be to interview those brokers (and insurers and MGAs) whom they identify from the information request as possibly having practices which require further investigation.

Certainly, based on the information requests it should be quite a simple exercise to identify arrangements which may be outliers, in terms of commissions paid or payable. That is, where the commissions are outside of what appears to be usual or ordinary in the market for that class and type of book of business.

These outliers will present the FCA with a conundrum. Unless the FCA can establish that the broker acted in a manner contrary to the interests of its customers because of the payment of these outlying commissions there will be no evidence that the broker and insurer (or MGA) who agreed the commissions have been in breach of the FCA rules.

On the other hand, by law the broker may have received a secret profit because the outlying commissions would be by definition unusual or extraordinary. How will the FCA react in such circumstances? It would need to rely on one of its High-Level Principles and age-old case law if it wanted to take action against the relevant broker. In such cases the FCA would also be faced with a difficulty in relation to the insurer or MGA who agreed to pay the commission as they would need to prove evidentially that the insurer or MGA knew or ought to have known that the broker did not disclose or had no intention of disclosing the commission to its client.

There are potentially interesting times ahead on such individual cases.But what of the Bigger Picture. Will the FCA leave the rules as they stand and leave it to the market to be regulated by competition on price notwithstanding the inherent conflict with commissions arrangements?

The answer to this is likely to depend on what it finds and how well the market has behaved as a whole rather than whether one or two brokers or insurers have not behaved as well as they might.

The Options

Following the FCA’s factual review there are a number of potential outcomes in relation to the regulation of commission arrangements in the general insurance sector. The following are some of the most likely.

1. No Change

If there is no evidence of market-wide misbehaviour the FCA may take the view that there is no need to change the current rules.

If there is some evidence of misbehaviour but it is sporadic and with limited impact on customers’ then again, the FCA may be consider the current rules to be appropriate. They would likely apply proportionate sanctions to those who have misbehaved and perhaps encourage improvements to market-wide awareness through training and other activities.

2. Full Commission Disclosure

The FSA had reasons and opportunity in the noughties to change the rules to require such transparency and decided not to. Is it now the time to change this philosophy? My view is that there would have to be persuasive evidence that transparency through commission disclosure would drive better outcomes for customers, perhaps in terms of increased value for money (e.g. by reducing the total cost of obtaining insurance, and/or increasing the total value of services received) or through some other benefits.

One of the arguments made against this kind of transparency has historically been that it will not produce any benefit as most consumers do not know or care what commission is paid to their broker provided the gross premium (i.e. insurer’s premium plus broker’s commission) is competitive and the product appropriate.

However, it has been proven with large risks that customers do care about commission levels and are interested in getting value for money from their brokers as well as their insurers. It’s simply wrong to consider today’s sophisticated consumers and smaller commercial customers to be incapable of understanding the roles of broker and insurer and considering the costs and benefits of each. In fact, the main contrary argument supporting commission transparency, which is favoured by a client of mine, is that if it really does make no difference to SMEs and consumers then there is no reason not to be transparent, and that transparency equals honesty and that is good for the market.

There would be some difficulty achieving full commission disclosure with some forms of commissions such as profit commissions, but these obstacles are not insurmountable.

3. A Ban on Commissions

This is the ‘nuclear option’ and would have the most significant impact on the market (witness the positive and negative effects of the Retail Distribution Review which banned commissions for retail investment advice). There is business which is already undertaken in the market on the basis of no commissions being payable. This is primarily for large risks where the insured pays the broker a fee for placing the business and no commission is agreed with the insurer. In addition, there is at least one country in Europe which has a ban on non-life insurance commissions. Insurance is still distributed successfully in this country.

After some operational changes, the impact on insurers would be generally small as they establish price and actuarially assess risks based on net premium. There would undoubtedly be some insurers who would welcome what is known as ‘net underwriting’ i.e. business brokered without commissions.

However, a commission ban would be a seismic shift in approach and cause significant upheaval and risk for brokers. One issue for brokers, which does not exist for insurers, is that brokers’ financial models are based on the current arrangements. Unlike insurers they do not put away some of their commission income from an individual risk to pay for future services to that policyholder. That is, the commission they earn in one year is used to cover their costs of servicing business for their clients in that year. Thus, if a broker earns commission on a risk placed in 2018 and the policy is still in force at their financial year end, they do not put a part of that commission away for dealing with any claims or other servicing which may arise on that policy in their following financial year. They plan their costs for 2019 based on their assumptions for income in 2019 not what they earned in 2018. To change their income structure could significantly impact their ability to trade going forward.

This may not be a reason not to move to a ban on commissions, but it does provide a very good reason to act cautiously. If the FCA were to take a step like this it would be appropriate to consider some transitional approach, not only to lower the risk to brokers’ business models but also because their IT systems may need significant changes.

Additionally, banning commissions in a market like London where it is not uncommon for risks to be presented to the market after passing through a chain of brokers or other intermediaries, all of whom are paid portions of the total commission on the risk, presents challenges, particularly if some of those in the chain operate in jurisdictions where the law and regulation is built around commission arrangements.

However, these are not insurmountable challenges. There are already some jurisdictions which do not permit commissions and the brokers continue to trade.

Summary

The next few months are going to be interesting ones for a spectator but could be trying for some of the participants. The FCA’s review is much wider than just commissions but this area alone has its interesting facets and challenges.

It will not be until we see or hear about the factual findings that we will begin to see a picture emerge from the mist and be able to understand what the outcome and consequences of this review will be.

In the meantime, the market must cooperate with the FCA and seek to help ensure that whatever outcomes arise they ensure the continued prosperity of the London and UK insurance markets and protect their good reputations.