The FCA have published a Consultation Paper (CP23/8 – Multi-occupancy building insurance) detailing their proposed reforms to the multi-occupancy building insurance market. Published on 21^st April, the consultation period runs to 9^th June and contains a number of proposals that, if implemented, will have some significant implications not only for insurers and intermediaries involved in the placement of these specific policies, but potentially for the wider distribution chain.

There are a number of specific proposals included in the Consultation Paper that the FCA have explicitly suggested may be extended to other scenarios – and others where it is easy to see how the proposed changes may, in our view, prove to be the tip of the iceberg for insurance firms.

There is implicit in this work that the FCA is likely to consider that there is further work to be done on Broker’s commission arrangements. The most significant concern for brokers and MGAs will be the comments aimed directly at the practice by which brokers commission increases in line with premium increases because the commission percentage remains the same. This practice is embedded in the remuneration arrangements across the market. The FCA is effectively asking the question why that is the case. In their view, an increase in the premium by the insurer does not mean that the value provided by the broker and the workload of that broker has increased, so why should the absolute level of their income?

This is a very significant paradigm shift. It is not moving the goal posts but more akin to moving the entire playing field to a different continent (and possibly leaving the goal posts behind so that the game must also change). There has long been a debate about the value brokers bring and the inherent conflict in commissions. It would be wrong to suggest that brokers do not provide value for the services they provide and while there is an interesting dynamic where commissions increase in line with premium increases, the issue is more complex than that simplistic view. Despite that, the FCA clearly wants to see a change. This may drive an increase in set fee arrangements, particularly for volume products for consumers where the process of binding the risk, for example under a Binding Authority, does not change so there is no added work by the broker/MGA.

Juxtaposed with this for less volume based risks is the underlying issue with income recognition. Brokers are paid a commission for the placing and other services which they provide to the policyholder. Those services also include handling claims on behalf of the policyholder. However, the broker receives the commission and treats it as earned when the insurance policy has been placed. Yet in many cases that claims process may take years and in some cases a claim may not arise for decades. By the time that happens the policyholder may be using the services of another broker. The broker is not required, unlike an insurer, to set aside some of its income to cover the cost of the services it may need to provide later so it needs to continue to earn and utilise the income it receives on placing insurance for a policyholder in order to be able to cover the cost to itself of handing of claims for other policyholders not related to the income it has received. Consequently, there is a disconnect between income and services in the broker business model.

These issues collide at a time like this when the regulators again find themselves having to look at the income model of brokers and MGAs, the services that they provide to policyholders (and the insurers for MGAs) and the value of the service provided. The regulators have not, when considering these issues in the past, mandated commission levels or banned commissions as they have in other insurance related businesses. Their approach is to leave it to the brokers and MGAs to evidence value through the distribution chain and ensure there are no conflicts of interest but the net of what might be considered an acceptable practice is closing and this latest missive drives to a conclusion that commission itself is in the spotlight and in the view of the FCA it is time for a change.

Background

The background to this Consultation is well documented and we have covered it in a number of previous articles:

• Multi-Occupancy Buildings Insurance – Authorised or Unauthorised Activities?
• FCA Update – Multi-Occupancy Buildings Insurance
• Product Governance: The Focus on Insurance for Multi-Occupancy Buildings

For many years, this type of insurance has been something of an outlier in terms of the commission levels paid. Those involved have historically justified the levels with statements about the additional work involved for property managing agents. But to quote the FCA:

“Given the prevalence, amount and impact of commission paid to other parties, the lack of transparency and absence of evidence that these payments represent fair value demonstrates the need for a significant intervention to address this issue.”

In the context of the rules on Fair Value and Consumer Duty, that is a pretty damning statement, mitigated only slightly by the fact that, currently, the impact of that is largely confined to individuals who are afforded no status or protection by the FCA – the leaseholders. Therein lies the need for change.

FCA Objectives

The FCA have set out four primary objectives based on the evidence they have collated and the feedback received to their initial Discussion Paper. These objectives are:

• to ensure the interests of leaseholders (and others in similar positions) are properly considered when firms design their products;
• that prices offer fair value to leaseholders as well as freeholders;
• that the remuneration of all parties involved in the distribution of these insurances has a fair relationship to the benefits provided to leaseholders; and
• that leaseholders have sufficient information to challenge poor practices and unfair costs passed on to them.

There can be little argument with these objectives.

Key Changes Proposed

The FCA propose a number of changes to their Handbook, covering ICOBS, PROD and SYSC. These address the key issues of:

• remuneration;
• disclosure; and
• product governance and customer’s best interest.

Remuneration

It’s worth noting that alongside CP23/8, the FCA have also issued an update on their work looking at “Multi-occupancy buildings insurance – broker remuneration”.

The remuneration work looked at data from 16 firms (13 brokers and 3 MGAs) representing around 35% of the overall market, using data from January 2019 to September 2022. It noted that:

• • despite reductions in commission percentages, the significant rise in risk premiums drove absolute (£) commissions by nearly 40% during the period;
  • there was little evidence of any specific assessment of the work being done by other parties to justify the large percentage of commission payments being shared;
  • data quality is a major issue, with the FCA noting the work started by BIBA and the ABI on “the need for the creation and implementation of a data code”. Data is a key element of the FCA Business Plan for 2023-24 and it appears likely firms will be expected to adopt new data standards to simplify the future assessment of performance in this area.

Generally, the feedback ranges between pretty negative and a scathing assessment of the broad compliance performance of firms involved in the review, resulting in this warning to all firms:

“While this review has solely focused on multi-occupancy buildings insurance, we see that this issue may be much broader and reflect how some firms have done their FVAs. We expect all firms to consider our findings when assessing how they comply with PROD and deliver fair value, and to act if they identify they are not meeting these obligations fully.”

This approach is unsurprising as it emphasises the need for the policy interventions to address the lack of transparency and absence of evidence that fair value is being provided. The FCA have proposed remuneration changes in CP23/8 to address these issues and also refer firms to the provisions of the new Consumer Duty rules which are of relevance.

Amongst the requirements, firms have been warned to expect:

• • a Senior Management Function (SMF) holder to be required to attest and evidence that the firm is delivering fair value consistently. We expect this is similar to General Insurance Pricing Practices rules found in ICOBS 6B, which require Senior Managers to annually attest that their firm is compliant with pricing rules. It is our advice that you should identify that person now and ensure they are actively involved in overseeing all aspects of the way your firm responds to the necessary changes. If you are a SMF with such responsibility and would like some independent guidance on how to approach this, please do speak with any member of the ICSR team.
  • to be immediately required to take action on remuneration. With that issue very high on the government agenda, we strongly advise firms to begin work on this now, knowing that for many it will entail some elements of system change.

To quote the FCA on remuneration:

“We expect brokers to immediately stop paying commissions to third parties (including property managing agents and freeholders) where they do not have appropriate justification and evidence for doing so in line with our rules on fair value.”

Firms need to ask themselves how quickly they can extend their review of the distribution chain to include the leaseholders, if it is imposed in the final rules.

The Rt Hon Michael Gove (MP and Secretary of State for Levelling Up, Housing & Communities), in a letter to the British Insurance Brokers’ Association (BIBA), indicates the gravity of the issues around remuneration and the outcome expected, being that “inflated broker commissions and unjustifiable payments made to third parties must stop”. There is a push that firms need to ensure remuneration practices are in leaseholders’ best interests and it is very unlikely firms could ever defend the selection of a policy based on commission levels alone in the future. This is evident as Gove has invited detailed proposals from BIBA’s members on “how they will change their behaviour, individually and as a sector, to be more transparent and competitive” within one month.

Disclosure

A new section in ICOBS is proposed, requiring insurers and intermediaries to produce and provide information in relation to all multi-occupancy buildings insurance policies intended for leaseholders. The conditions of that would require insurers and intermediaries to provide disclosure on:

• • A Summary of the policy – the FCA suggest that an existing IPID would be acceptable, or new documents could be created. (Insurers will be expected to provide these)
  • Pricing information – this must come down to a building level and include taxes etc (Insurers will be expected to provide this)
  • Remuneration – this must show the total remuneration and a breakdown, including what is paid to other parties. The FCA acknowledge that:

“Proactive disclosure of remuneration is not currently required under other parts of our rules for retail insurance products. However, we are proposing to introduce this for the multi-occupancy buildings insurance market now because we consider it will make it easier for leaseholders to identify and challenge poor practices by firms.”

It is difficult to see how the FCA could introduce this for leaseholders and not subsequently conclude it would be in the best interests of all customers to have such disclosure. Another example where this may just be the ‘tip of the iceberg’ for insurance firms. (Intermediaries are expected to provide this disclosure)

• • Potential conflicts of interest – ICOBS 4 already deals with conflicts of interest, but the proposal is that the intermediary would be required to proactively provide this for the benefit of leaseholders too. (Intermediaries are expected to provide this disclosure)
  • Alternative quotes – the FCA proposes a new requirement on intermediaries to disclose the number of alternative quotes obtained and a brief explanation of why they have proposed or recommended that the policy is in the interests of both the freeholder and leaseholders. (Intermediaries are expected to provide this disclosure)

Gove’s letter has increased the pressure on BIBA and its members to be more transparent and competitive, not just for the customers but also with the government and the regulator. BIBA have responded to Gove and agreed that the remedy lies in its members evidencing fair value in a more robust and consistent way. BIBA have put forward 6 points in their proposal as summarised below:

• • BIBA will issue guidance of good practice to their members in the construction of fair value assessments;
  • BIBA will work with their members to implement the pledge to their manifesto around fair value;
  • BIBA will ensure their members follow the new common code for the collection of data relative to multi-occupancy buildings;
  • BIBA will liaise with the ABI (Association of British Insurers) to implement the reinsurance pooling arrangement to provide an answer to affordability and risk capacity for impaired multi-occupancy residential buildings;
  • BIBA will work constructively with the FCA on its new consultation to improve transparency and disclosure to leaseholders on their insurance arrangements;
  • BIBA will continue discussions with the government on how to solve the issue of the lack of affordable professional indemnity insurance to accelerate the remediation effort.

Whilst BIBA are acknowledging the responsibility sits with their members (i.e. brokers) for evidencing fair value, it should be noted that not every broker is their member. The question remains whether their proposal is enough to safeguard the commission model? Our view is this a good start but we question whether the FCA will consider that it goes far enough in meeting the regulatory obligations and providing the assurance the government is after.

Product governance and customer’s best interests

At the heart of the complaints by leaseholders has been the fact the FCA rules did not recognise them as having any protected rights under FCA rules. The FCA have addressed that issue directly and propose to expressly include leaseholders as ‘customers’ for the purposes of the PROD 4 rules, meaning:

• • Insurers and brokers will specifically need to show how they have considered the position of leaseholders as a relevant part of the target market when designing, pricing and distributing their products;
  • firms will need to demonstrate the product is providing fair value to leaseholders as well as any other customers. The rule will be changed to remove the reference to “customers who are involved in arranging the insurance.”

The FCA have proposed an amendment to the large risks exception “so it only applies to those products that are used exclusively to effect contracts where there are only commercial policyholders meeting the relevant definitions in the contract of large risk definition and there are no policy stakeholders that are retail consumers.”

In another example of the seriousness with which the FCA appear to view the historic practices, they said:

“We found significant failures in the ability of firms to show their remuneration practices are providing fair value”

What these changes to PROD 4 will mean in reality is:

• • there is a shift which means brokers need to look at total commission received and the value to customers. Increases in commission due to gross risk premium increases would likely breach the rules as it would not reflect additional benefits to customers. With this point being specifically voiced by the FCA in the multi-occupancy buildings insurance issue, it is difficult to see how the FCA could not apply that train of thought more universally. It seems to us that this might be considered yet another nail in the coffin for commission-based remuneration in the longer term.

  • remuneration sharing with Property Managing Agents and other parties must provide ‘Fair Value’. There must be a fair and reasonable relationship between the amount paid and the benefits provided to customers. Where such payments do not have a fair relationship to benefits provided to leaseholders, they will need to either be reduced or cease entirely. The FCA report on remuneration states:

“Brokers were often unable to articulate what insurance related services or benefits of value were provided by the parties sharing commission.”

Again, a fairly damning statement in the context of the wider rules on Fair Value.

• • the new rules will apply to other scenarios where a person has a contractual or statutory obligation to pay for a part or all of the insurance premium or has an interest in or benefits from the subject matter of the insurance. The FCA are referring to these people as policy stakeholders. This is an area where the FCA have tried to be careful not to create unintended consequences. It is an area where insurance firms need to look carefully at other products and consider whether they may now be in scope for these new rules to any extent.

Under ICOBS, the FCA propose extending the customer’s best interests rule to apply for the benefit of all policyholders and policy stakeholders. This will mean firms will need to act honestly, fairly and professionally in leaseholders’ best interests, including ensuring their communications are not only clear, fair and not misleading but also transparent and relevant to its audience.

It is worth noting that the FCA have chosen not to make leaseholders a customer in relation to other elements of the ICOBS rules given the significant complexities that would entail. The FCA have recognised the impracticality of such an approach, despite pressure from some leaseholder respondents for such an approach.

Nevertheless, under SYSC 19F.2 firms are required to ensure their remuneration practices do not conflict with their duty to comply with the ICOBS customer’s best interest rule. The FCA propose to include leaseholders and other policy stakeholders as ‘customers’ under this rule too.

To discuss what these changes to PROD 4 will mean in reality for your firm, please speak to your usual contact in the ICSR team.

Other Parties

Whilst the FCA cannot directly regulate the other parties (regulated or unregulated such as an exempt professional firm under RICS DPB scheme or an exempt Appointed Representative) involved in the distribution chain (and it remains to be seen how the Government might approach this), the FCA have proposed changes to the rules for intermediaries that will go a long way to enforcing transparency, with:

• firms being required to consider all the remuneration they receive as part of their value assessments, not just the element they retain;
• a new requirement banning incentives paid to third parties which are designed to encourage the use of the firm. Such payments would be considered in breach of SYSC 19F 2.2R on Remuneration and the customer’s best interests.

The Department for Levelling Up, Housing & Communities has promised to:

“ban managing agents, landlords and freeholders from taking commissions and other payments when they take out buildings insurance, replacing such payments with more transparent fees.”

We suspect it won’t be very long before those parties are having to address this issue directly rather than as a consequence of the new rules being proposed for regulated firms involved in the distribution of multi-occupancy building insurance.

Next Steps

The consultation period runs until 9th June, but given the FCA made a point of stating how pleased they were with the level of feedback and challenge received prior to the Consultation Paper being issued, we suspect it is unlikely that any subsequent feedback will lead to material change. Indeed, the FCA describe the feedback as being from a wide range of parties and broadly supportive with good challenges around areas where unintended consequences may arise. Those have been addressed and with Gove requesting implementation plans be presented by Summer 2023, it is a fair bet that when the FCA say they will publish their Policy Statement and Handbook changes in Q3 2023, that is likely to be nearer to July than September.

The FCA have already indicated that affected firms will have 3 months to implement any necessary changes – if that includes IT changes, then the reality is that firms placing or underwriting multi-occupancy buildings insurance probably need to begin planning for change now.

Conclusions

This is a scenario where much ‘reading between the lines’ can be done, but it is our firm opinion that the changes being proposed now in relation to multi-occupancy buildings insurance may well prove to be the ‘tip of a very large iceberg’ for more fundamental change across our industry. The government has made it clear it will legislate to address the changes that are beyond the perimeter of the FCA, as stated in Gove’s letter, if necessary, he “will act to ban commissions on insurance contracts”. Where it has the authority, the FCA has been clear that it expects significant change both in terms of specific practices but also culture.

For an organisation that is generally very measured in its use of language, the use of terms such as ‘significant failures’ and ‘lack of transparency’ give a clear indication the degree to which it feels the current practices are failing to meet the standards it expects and causing significant harm to parties it feels should be afforded the protection that it can offer. With those protections now very likely to be extended to other ‘policy stakeholders’ in scenarios similar to that which occurs in the placement of multi-occupancy buildings insurance, all firms need to be taking action to identify any similar scenarios where additional parties may now need to be considered as part of their fair value assessments.

In our view, this has been a long time coming and it is disappointing that despite warnings in 2004 during Spitzer (where inappropriate practices proceedings were issued in the US against a number of insurers and brokers relating to distribution of insurances which impacted all the major world insurance markets and resulted in regulators investigating similar activities and issuing warnings), the insurance industry has forgotten the lessons and now there may be a deeper intervention and impact for the larger market.

If you would like to discuss any aspects of these proposed changes to Handbook rules with us, please feel free to speak with the author in complete confidence.