The FCA will shortly begin its study into the wholesale insurance broking market, and has recently begun to issue information request letters to market participants. In this article we look at the history in this sector and some of the practices and issues.

The History

Just over 13 years ago Eliot Spitzer, the then Attorney General of New York, issued proceedings on the 14th of October 2004 against a number of insurers and brokers in the US for activities which he considered to be inappropriate practices relating to the distribution of insurances and the close relationship between some brokers and insurers. The fall out of those proceedings was widespread, impacted all the major world insurance markets and resulted in regulators going on the hunt for similar activities and issuing warnings.

There were a number of activities and practices which came under the spotlight but the key concern related to certain types of arrangements which had the potential to result in breaches of duties to the insureds whom the brokers were representing arising through the arrangements and practices with insurers conflicting with the brokers’ duty to avoid or mitigate effectively conflicts of interest. They key arrangements involved:

1. Placing agreements by which insurers paid brokers a higher commission rate or a “bonus” of some form provided the broker produced a certain volume of business or profitable business to that insurer. The payments or increased payments kicked in after a threshold was achieved. Here the issue appeared to be that if the broker was close to hitting the threshold the temptation, in order to receive the bonus or higher commission, would be to place business with that insurer even though it may not have been offering the best terms either on premium or cover.
2. Another practice under the spotlight was the arrangement by which many MGAs or coverholders were paid a profit commission on the profit achieved on a book of business underwritten by the Broker or MGA under a binding authority. Several issues arose here, all related to conflicts of interest issues. There was the possibility that the broker, as the insured’s agent, was also the agent of the insurer in the same transaction and therefore may have had conflicts of interest that they were not managing effectively. Was the broker acting for both? Was the broker still acting in his client’s best interests? Was the broker pooling the most profitable business brought to it by its clients in order maximise its commissions? Again was the broker placing business under the binding authority when better terms were available elsewhere in the market? In many cases the broker or MGA also had authority to handle claims on behalf of the insurer. Was there any evidence that claims were being refused in order to maximise profits?
3. Other practices which were considered included:
   • the provision of soft loans by insurers to brokers (that is loans which had low or no interest and/or where repayment was waived) which created a benefit to the broker and tied them to the insurer with the potential for the broker to only place their business with that insurer regardless of whether they were offering the best terms
   • The provision by insurers to brokers and MGAs of other benefits such as marketing allowances for product launches, free or cheap training, technical support for regulatory compliance and gifts and entertainment.

At the time in the UK the FSA had a rule which it relied on which required regulated entities to ensure that they identified and managed their conflicts appropriately.

Post-Spitzer Activity

In the US legal proceedings resulted in insurers and brokers agreeing to penalties and making remedial payments to insureds who had been affected. Other insureds brought proceedings and there was the usual round of class actions by shareholders.

In the UK though there was little regulatory activity and few regulatory interventions, investigations or fines.

There was a hive of activity in the UK and London Market as brokers, MGAs and insurers all looked at their practices to determine what if any issues they had and what if any practices needed changing. Many put in place conflicts registers and gifts and entertainment registers as well as new policies on what was or was not an acceptable approach to dealings between insurers and brokers/MGAs.

The brokers found themselves short of income. They were no longer receiving income from Market Service Agreements (MSAs) and Placing Service Agreements (PSAs). They reviewed their business models and created new structures and arrangements. Some of these were specifically to mitigate the conflict risk inherent in acting for both the insurer and the insured in the same transaction such as splitting, if not by corporate entity then by internal division, of the businesses which acted for the insurer from those that acted for the insured. Other changes were more entrepreneurial and took many different names and had a variety of different facets, but all were aimed at replacing the income brokers had been receiving from insurers. Most of these saw a restructure of who services were being provided to and who would pay for them, and it is still argued today that the brokers identified a series of services they had historically provided to insureds which were ancillary to the placing of risks they undertook for insureds but inherent in the London Market processes and renamed these as services they were providing to insurers for which insurers should pay.

In 2008 Eliot Spitzer, then Governor of New York, resigned in disgrace after it was revealed that his behaviour may not have been what should be expected of the Governor of New York. It has long been the rumour that he had been pursued constantly since his days as the Attorney General by one of the Directors of one of the insurers detrimentally caught in Mr Spitzers’ web in 2004 who took the opportunity when it presented itself to hold Mr Spitzer up to public scrutiny the way the insurance market had been by Spitzer.

In the same year we had a catastrophic event in the financial markets the impact of which continues to be felt globally. Everyone’s focus shifted from the reforms following Spitzer and onto financial survival.

Since the Noughties

The market has survived, and competition remains. There continues to be a drive to be ever more efficient and profitable. The dynamic arising from the broker’s relationship with their clients and the insurer’s growth desires continues to dominate their inter-relationship. Into this space comes better IT and the increasing ability to use data for pricing and distribution. Brokers can see insurers obtaining more of their business direct from customers and the incursion of the aggregators and comparison websites leaving less of the market for themselves. However, brokers too are using data. They are able to identify pools of business which are more profitable and which in a soft market become very attractive to insurers. Brokers also have identified that bundling risks, commoditising them, reduces their cost base. So now instead of consumer business being the main or only commoditised pools of business we see more and more the treatment of pools of SME business as a commodity.

The impact has been the increased use of binding authorities and other facilities to ever reduce cost and increase efficiency. This has given rise to a number of practices and potential issues:

1. Brokers commonly now undertake a process whereby they will select an insurer or a panel of insurers for a book of business, whether under a binder, other facility or on an open market basis by using something which looks like a tendering process. Insurers will be asked to put for their proposed coverage terms and their commissions. Commonly the brokers will be looking to see which are the best terms and security available for their client. There is no available evidence at present but if it turned out that for example, on 30 occasions a broker had undertaken this exercise and on a large proportion of these the insurer or insurers chosen had been those offering the highest commissions, (even if the insurers also offered the best terms and/or all insurers offered the same terms) the broker community may find it difficult to explain this apparent anomaly.
2. Often the books of business are not all of their business in that class or of that nature and have been selected by the brokers. Commonly it has been suggested that the risks selected are those with the highest levels of profit. This makes them attractive to insurers and may result in insurers being prepared to pay more in the way of commissions for that book of business.
3. Where a book of business is put together in this manner the question may be asked what happens to the business which does not form a part of the book put out to tender? Is this placed facultatively in the open market at a higher premium for the insured than if it was within the book of business put out to tender?
4. The arrangements which arose after the restructuring of the market in the Noughties continue in existence. Insurers are paying brokers for data or other services which may or may not be being provided or of any benefit to insurers. Spitzer used the expression “illusory” when describing the services being paid for by insurers in 2004. It may be that there remain questions over the nature and value of these services.
5. The increase in bundling and commoditisation has seen an increase in delegation of underwriting. Profit commissions continue to be paid. There is nothing inherently wrong with a profit commission. However as identified above it can potentially drive the wrong approach in risk selection or the handling of claims.

In 2013 and 2014 the FCA carried out a thematic review on the commercial insurance broking sector looking at conflicts of interest and intermediary remuneration as regards SME business. The findings were that there remained in many cases insufficient controls and frameworks around the management of risks inherent in their business models and the sources of their remuneration, particularly having regard to delegated underwriting arrangements. Where disclosure of potential conflicts took place it was generally deemed insufficient.

This was not a widespread review, involving as it did only seven of the larger intermediaries and a sample of 1,000 SME business owners. Even so the evidence suggested that the lessons from 2004 had been somewhat forgotten. Perhaps with time those involved in that hiatus have now moved on and new management are faced with ever more difficult factors in play given the long term soft market and the incursion by insurers into direct dealing and/or the creation of the comparison websites. There was also evidence that the commission levels for commoditised business were higher than that for similar business on the open market. An argument in response may be that the broker with a binder is undertaking a higher level of service. If, however, it is commoditised business is this correct?

Now

The Insurance Distribution Directive is due to go live in February 2018, if a decision is not made to delay it. The IDD contains new provisions regarding conflicts of interest and remuneration. The FCA rules, which are in effect the original FSA rule albeit considerably expanded with greater detail, already exist. In the FCA rule book they are found under the section on Senior Management Systems and Controls as SYSC 10.1. Broadly speaking the requirements remain the same as they were. Firms must:

• Take reasonable steps to identify conflicts of interest between themselves, their employees, others acting for them and their clients that arise in providing regulated or ancillary services
• Under guidance keep a register of those conflicts
• Maintain and operate effective organisational and administrative arrangements with a view to taking all reasonable steps to prevent conflicts of interest from constituting or giving rise to a material risk of damage to the interests of clients
• If the arrangements to manage the conflicts are not sufficient to ensure with reasonable confidence that risk of damage to a client will be prevented, the conflict must be disclosed

These provisions are in addition to the common law position that an agent must act at all times in the best interests of its client and must not make a secret profit.

As trailed in its 2017/18 business plan, the FCA will shortly be carrying out a further and deeper review called the Wholesale Insurance Broker Market Study. Consultation on the Terms of Reference closes in January. The FCA has begun to issue information request letters to market participants. These may prove challenging for some to extract and provide the information in the format and timescale requested. There are a range of issues being looked at in the study, but they include all of the issues discussed above in relation to:

• Competition and barriers to market access
• Remuneration particularly
• Conflicts of interest
• Broker conduct
• Other issues – some of which were in play in 2004 such as reinsurance tying, a practise by which a broker agrees to place business with an insurer only if the insurer agrees to permit the broker to place the reinsurance (and thus earn the brokerage on the reinsurance placement).

There are several differences to 2004. These include:

1. There is a general rule of thumb in regulatory processes. This is that once an industry has been warned there is little or no excuse for not ensuring compliance. The industry has been given fair warning in 2004 and again in 2014.
2. The ability of a regulator to use IT tools to undertake a search of records if it wishes within a regulated entity has exponentially increased as IT search platforms have evolved and now include AI driven search engines that learn as they go.
3. The records available should be significantly greater because insurers and brokers have, or should have, put in place procedures for the identification of conflicts of interest including conflicts registers and gifts and entertainment registers. A paucity of information in these registers may suggest not a lack of conflicts but a lack of identification or recording and/or a poor culture. Regardless of the registers there should in any event be a greater availability of information as the use of IT has increased since 2004.

No-one can predict the future and in particular the outcome of this latest FCA review but having been there advising many of the London Market players in 2004 and seen the changes since I can predict that the FCA will find that practices in some brokers (and perhaps insurers) are lax. Whether there is evidence of poor practice which has led to actual detriment to any client is an outcome I can’t predict. I can however say with some certainty that if there is the FCA will not look kindly on those who have been involved and that it is likely that by then the SMCR will be fully operative. At a minimum there is already enough in play for those members of management responsible for any poor practices to find themselves the subject of close scrutiny.