It has been a long time coming but the FCA Consultation Paper CP20/20 – “Our Approach to International Firms” has finally arrived. Insurance firms seeking solutions to Brexit which will allow them to continue to underwrite or service EEA insurance business in London have been working on setting up legal entities in the EEA and then branching them into the UK for three years or more. So far over 1500 firms in the UK have applied to join the Temporary Permissions Regime (TPR). That number is expected to increase significantly on 30^th September when the FCA re-opens the TPR for applications.

The PRA set out their proposals for regulation of branches early and now finally we have the FCA view. The FCA also had an approach to regulation of Third Country Branches (TCB) but the number of these is relatively limited and almost exclusively in the insurance sector related to TCBs of insurers. The need to regulate branches of third country legal entities for insurance intermediaries is very different because the prudential rules of the PRA do not apply to them leaving a potential gap. Under the EU structure EEA firms could trade in the UK using a branch or on a cross border service basis with the FCA responsible only for local conduct issues. With the UK leaving the EU the FCA had a bigger issue than the PRA and so it needed more time to determine its approach and philosophy.

The Transition Period ends on 31^st December at 11 pm. At that point FCA regulated firms need to be within the FCA TPR or they will have to cease dealing with new and renewal EEA risks, though they may be able to manage the run-off of any live risks as at 1^st January 2021 under the Financial Services Contract Scheme.

The Purpose of the Consultation Paper is to ensure firms understand how the FCA will view what it describes as International Firms – EEA and Non-EEA firms, including non-EEA firms that are already authorised in the UK. The FCA does not consider that it requires changes to its rules at this point in time. The issue will primarily be about how it applies those rules and the approach it will take to the risks these firms pose.

Both insurers and intermediaries are required to have a Brexit solution if they are a UK entity with EEA customers or an EEA entity with UK customers. Most, if not all insurers in this category have completed or almost completed the transactions they require to undertake in order to be ready for Brexit and made their TPA and Authorisation applications because of the need for regulatory approvals under Part VII of the Financial Services and Markets Act. ICSR has helped many of them, either with their applications or their internal reorganisations to meet the new requirements which will apply to them, covering governance, controls, operations, compliance and risk activities.

In the intermediary space, many brokers and MGAs have set up their new structures including an EEA based legal entity and a branch of that entity in the UK. They have applied to the FCA to join the TPR but there are many more which have not and not many, if any, have applied for their full FCA Authorisation for their new UK branch.

This article is focussed on the intermediary space, that is insurance brokers and MGAs as that is where most of the work remains to be done but the issues contained within apply equally to the dual regulated firms who have outstanding FCA applications.

What happens after 31^st December?

First and foremost, those international firms which have not applied to the join the TPR will have to cease conducting business for customer’s new and renewal risks. International firms that have applied to join the TPR have a period of time in which to apply for authorisation if they have not already done so.

CP20/20 is about how the FCA will assess the EEA firms that apply for authorisation, or those non-EEA firms that are already authorised or seek authorisation in the UK.

The key focus of the Consultation Paper is on the Threshold Conditions which all authorised firms must comply. These Threshold Conditions already exist and apply to all FCA authorised firms whether dual or solo regulated.

Minimum Standards

The FCA’s approach to the minimum standards in their document “Our Approach to Authorisation” applies to all international firms. The key features of that document are:

1. Firms must meet the minimum standards (Threshold Conditions) which require financial and non-financial resources to be appropriate.
2. Evaluation takes account of:
   • Suitability of the business model for the regulated activities being undertaken,
   • The ability of the FCA to supervise the firm effectively,
   • Location of the firm,
   • Appropriateness of its resources, including people, financial and systems to deliver the products or services,
   • The firm must be fit and proper,
   • Individuals must meet the requirements applicable to them (the provisions of SM&CR are of particular relevance to this.).
3. Proportionality is applied having regard to the level of harm that the firm may represent.

The FCA has issued a warning to international firm applicants for authorisation. It will only authorise them if they meet the Threshold Conditions and have “good risk mitigation in place”. The FCA intends to focus on:

• the extent to which they will be able to supervise the conduct of the firm’s UK business,
• the potential outcomes in an insolvency situation,
• the role and accountability of the senior management, and
• the supervisory cooperation with the firm’s home state regulator.

The FCA will have particular regard to what has historically happened with the failure of entities from outside of the UK but trading in the UK through a branch and the impact on UK customers. It considers that there are greater risks with branches of non-UK entities than UK entities because the risks can be exacerbated where there are overlapping regulatory requirements from home state regulators.

The FCA sees the following potential risks being more relevant to international firms:

• Protection of UK retail customers through redress and supervisory oversight might be less effective,
• UK rules that protect client money may conflict with home state insolvency rules which could negatively impact UK clients, and
• Shocks or risks from firms’ overseas offices could impact their UK branch and may be more difficult to detect or prevent.

Therefore, when assessing an international firm against minimum standards they will have regard to whether there is heightened potential to cause harm from UK activities and whether the risks can be adequately mitigated.

The FCA will determine whether a firm can offer sufficient mitigation to address the risks of harm. This will be considered on a case by case basis applying the following factors:

• International firms serving UK retail customers will need to demonstrate they can adequately mitigate the risk of retail harm. This may be more difficult if their business or operational model shows a higher propensity for causing harm (e.g. outsourced activities are performed offshore by the head office).
• Firms planning to safeguard client assets (client monies in the insurance world) must show they have adequately mitigated the risks of harm. Essentially for non-risk transferred client monies the international firm must meet CASS requirements but even then that may not be enough because of conflicts with the Home State insolvency laws or other provisions for the protection of client assets.
• Wholesale firms must evidence they have adequately mitigated the risk of wholesale harm. Wholesale harm is going to be less of an issue for UK insurance intermediaries unless they are sufficiently significant in size to hold a dominant market position.

The FCA will look at the home state regulation and the level of international cooperation.

International firms which can evidence that they are meeting the minimum standards (threshold conditions) and can establish that they have appropriately mitigated these risks will be authorised. Those that continue to be a concern to the FCA may find that they are subjected by the FCA to limitations (such as restrictions on activities, products or number of customers) or requirements to take or refrain from certain action.

Approach To Application (And Supervision)

The FCA has set out key areas it will consider, each being relevant on a case by case basis which we will look at under key headings.

Suitability of the Firm

The international firm must be able to evidence that it is meeting the minimum requirements (threshold conditions) for non-financial resources. The FCA will review:

• the nature of their operations,
• the personnel and decision-making,
• existing or proposed systems and controls,
• factors relating to the firm’s home state regulator, and
• the extent to which the firm presents and offers adequate mitigation against the risks of harm.

Capability of being Effectively Supervised

Here the FCA is going to consider:

• the complexity of regulated activities and products,
• how the business is organised,
• access to relevant information and the ability to monitor it on an ongoing basis, and
• the ability for the FCA to make regulatory interventions before harm or events occur.

At the heart of the FCA’s concerns however is the degree to which the FCA has the ability to ensure that the UK branch of the international firm will be able to be subject to oversight and if necessary intervention.

Place of Business

The Branch must have an active place of business in the UK. It is clear that this means a degree of substance in the UK is required, not just a registered office. There can be no doubt, given the rest of the Consultation Paper that substance will be essential and will have to be appropriate to the size and nature of the business.

Appropriateness of Resources

The personnel (management and decision making structures) and systems and controls (including offshore or outsourcing dependencies), must be adequate for UK activities to be effectively supervised which means that the proportionate application of SM&CR must be met and Senior Management Function holders (SMFs) must spend adequate time in the UK in order to exercise their roles and meet their responsibilities for the activities of the UK Branch.

Importantly, the FCA expects those with responsibility for decision making within the UK Branch to have sufficient independent decision-making powers. This will be looked at very closely, but firms will be expected to be able to evidence either in role profiles of Branch Managers of SMFs, the ability to independently make decisions on behalf of the Branch. Perhaps the best way to achieve this is to ensure that the level of authority is appropriately documented. An often-difficult area is where a firm operates dual lines of reporting. The FCA would expect the UK Branch Manager line to be the more substantial line of report. It will also mean that the Branch manager would be expected to have a higher level of authority than anyone reporting to them within the Branch.

As a starting point the UK Branch must have appropriate systems and controls including compliance, risk and operational controls and frameworks proportionate to the size and complexity of the business being operating by the UK Branch. Systems and controls within the UK Branch must also be such that the those responsible for the UK Branch are able to determine whether the systems and controls are operating effectively. Any outsourcing including insourcing to the international firms’ head office, should not impair quality of firms’ governance and internal controls or ability for the FCA to supervise it. The UK Branch must therefore have access to proper reports on services, products, and other metrics such as conduct risk, HR and culture and have the ability to influence the provisions of any direct services provided by the Head Office or any support it provides.

Authorisation

The FCA has made it clear that authorisation of a UK Branch shall involve the authorisation of not only the UK Branch but the firm as a whole in so far as it involves the delivery of products and services by the Branch. The impact is that when considering the availability of suitable resources to meet the Minimum Standards, the FCA will also look at those resources in other parts of the international firm which are involved in the delivery of the products and/or services within the UK. This is quite important for firms filing an application for authorisation as they will be required to outline what those resources are and the level of control over them by the UK Branch.

Assessing Degree of Harm

In assessing a firm against the minimum standards (Threshold Conditions) the FCA will consider the potential for harm to be caused by the international firm. Three main ones have been identified by the FCA as follows:

Retail Harm

For international firms conducting regulated activities with UK retail customers, the key harm identified by the FCA is the potential lack of redress under UK rules particularly under the Financial Services Compensation Scheme. The FCA provides examples in the event of both firm solvency and insolvency and their root cause analysis resulting in a commitment to watch closely for indicators of such causes including:

• • Poor governance,
  • Inadequate product disclosure,
  • Inadequate conflicts management,
  • Flaws in design of controls including Financial Crime controls,
  • Failure of Professional Indemnity cover, and
  • Failure of IT.

Client Asset Harm

International firms will need to comply within their UK Branches with the provisions of the FCA rulebook relating to Client Assets as contained in CASS. The issue the FCA is concerned with is where Home State laws, particularly around insolvency and policyholder protection, conflict with UK laws to leave UK policyholders less protected. The FCA will look at cooperation arrangements with the Home State regulator and the implications of any conflicts of laws when considering the arrangements in place or proposed.

In the case of non-UK insurance customers this needs to be looked at on a case by case basis because the local legal position and requirements for EEA insured entities varies considerably, from the situation where all premiums are risk transferred on payment to the local in-country broker to the situation where risk transfer as a concept does not exist.

Wholesale Harm

The FCA is concerned with the potential for an international firm to cause a market impact though a shock or event impacting the international firm at head office or in other overseas offices which could cause a shock to the system in the UK or the UK Branch over which the UK Branch and the FCA have no control (or line of sight). This is particularly so if there is a significant degree of inter-connectedness between the UK Branch and the other operations of the international firm.

Factors the FCA will look at include:

• • Lack of substitutability of products,
  • Whether the international firm or its UK Branch has an important or dominant position in the UK, and
  • Whether the international firm is interconnected to other firms in the UK market and could spread or amplify the risk.

This is very unlikely to have any significant implications for UK Branches of an EEA legal entity which has been set up to ensure that EEA sited and domiciled risks can continue to be placed in the London Market.

Mitigation of the Risks

Firms will be asked to explain how these three key risks are mitigated.

Where the FCA has residual concerns, it will be act by either not authorising the UK Branch or it may authorise the UK Branch subject to limitations or requirements. Depending on the level and type of risk this could include, for example, limiting the number of UK retail customers the UK Branch may have (or refusing to let the UK Branch deal with UK retail customers) or requiring additional reporting.

Summary

The FCA has given considerable thought to how it should approach the authorisation and subsequent regulation of international firms wishing to operate in the UK through the use of branches after Brexit.

There is no doubt that UK Branches of international firms pose greater risks to the FCA of not meeting its Statutory Objectives, particularly in the areas of policyholder protection and protection of their assets under CASS for UK retail customers. Therefore, international firms will have a higher burden to evidence that they should be authorised. This may not be an increase in the burden of proof so much as an increase in the number of issues that the firm must satisfy the FCA about in order to evidence that it meets the Threshold Conditions.

UK Branches of EEA based firms (including the EEA based entity of a UK broking or MGA group) which are not dealing with UK customers, particularly retail customers, are likely to represent less risk to the FCA than those firms which will be dealing with UK customers. Intermediaries, including MGAs, should therefore consider whether their UK Branches should not involve themselves with UK risks. UK risks, together with Rest of the World risks may be best dealt with by any UK based and already FCA authorised intermediary, whether broker or MGA as appropriate.

UK Branches of EEA firms where a portion of the support and/or even some of the direct services, are provided by the head office (or another non-UK office) also present a higher risk to the FCA because of the potential need for cooperation by the Home State regulators. Where there is this inter-connectivity the international firm will have to make sure the branch has a degree of independence on decision-making and the ability to oversee those offshore activities. The documentary evidence supporting an application for a firm in this category is going to be closely looked at by the FCA for an assessment of the risks posed.

Dual regulated UK Branches with UK policyholders should represent a lower risk to the FCA than a solo regulated broker or MGA as it they will be required to maintain ring-fenced minimum capital in the UK offering a level of greater policyholder protection but that will not allay the FCA’s concerns about conduct issues and policyholder protection.

The FCA is currently seeking feedback on this Consultation Paper, with submissions to be provided by 27th November. That leaves little time before the Transition Period ends on 31st December at 11 pm and international firms should consider carefully how they will respond to this approach if implemented.

ICSR has considerable experience working with dual and solo regulated firms on Brexit issues and FCA authorisation applications.

If you would like to discuss any of these issues in complete confidence, please contact us.

Kenneth Underhill

Director
Implement Compliance Solutions & Resources