Brokers’ Conflicts of Interest: the FCA is in a Pugnacious Mood
The UK Financial Conduct Authority (FCA) has turned its glare on brokers and perceives a potential conflict of interest amongst those who use “integrated models”, including Managing General Agency (MGA) agreements, as a means to boost income. It is clearly gunning for those brokers whose internal systems for managing possible conflicts of interest they deem to be inadequate. As set out below, the consequences of being deemed inadequate are severe, including expensive Section 166 Reviews (carried out at the broker’s own cost) and potentially large fines. Early action by affected brokers could avoid much larger problems later on.
Following a Thematic Review of seven larger brokers that arrange cover for SMEs, the FCA has released a report that is strongly critical of what it perceives to be a systematic conflict of interest lying at the heart of many of the business models used by the brokers in this area. The FCA directs most of its fire on the growth of ‘Integrated Models’, where the broker undertakes broking activities as agent for insureds in conjunction with activities where it acts as agent of insurers (for example, binding authority or MGA business). Here the FCA perceives a failure of brokers to put in place sufficient procedures to manage the potential conflicts of interest between the broker’s fiduciary duties to its client insured and to the insurer, given the broker’s own financial interest.
We set out the background; the problem as perceived by the FCA; the worrying implications for affected firms (including fines and potentially very expensive Section 166 Skilled Person Reports); and some potential solutions below.
The FCA identifies the root cause of the problem as the commoditisation of SME insurance business. In order to earn a higher proportion of the underwriting revenue, many larger brokers are channelling much of the business into MGA structures: a solution that enables insurers to cut their fixed costs while the brokers take on more of the administrative functions in return for a greater cut of the premium.
The convenience of such an arrangement for insurers and brokers alike means that the structures are popular in the industry but the FCA considers that the “Dual role and the enhanced remuneration that can be derived from it, is likely to give rise to conflicts of interest.”
The FCA canvassed 1000 SMEs as to their expectations of the service to be provided by insurance brokers. They found that many SMEs are unlikely to be sophisticated buyers of insurance and that they may, therefore, require similar levels of protection (on a regulatory basis) as retail customers. Since SME insurance is generally more complex than consumer business, the FCA found that SMEs also rely on their brokers for a greater amount of advice than would ordinarily be the case with consumers.
The FCA’s fundamental concern with Integrated Models is that the conflict of interest set out above could lead to SMEs paying more for core insurance products than they need to; that it could lead to brokers selling to the SMEs add-on insurances and services that are not required; or that the SMEs could pay more for secondary products like premium finance than they would otherwise need to. The FCA is also concerned that brokers involved in an MGA arrangement may, for example, not undertake any broking activity for a particular risk but simply funnel the risk into the ‘house’ MGA.
In breach of the FCA’s “treating customers fairly” principle, and other regulatory rules, the FCA:
- has found that some brokers do not have adequate management and control systems in place to address conflicts of interest (especially in terms of management information and the tender and review processes for new and existing products);
- has found that some brokers place too much reliance on disclosure of the conflict to the customer. The disclosures are often too generic to assist SMEs in understanding the structure and services and do not excuse the fundamental obligations on the brokers to manage conflicts of interest in the first place; and
- gives one example of a broker that permitted communications from internal MGAs to client-facing broking areas which focussed more on the benefits to the broker of the additional revenue arising from the MGA than the benefits to the customer.
The FCA emphasises that such an Integrated Model creates a “Need for clear controls and management information to address potential conflicts of interest in the selection and placement process and to help demonstrate that all reasonable steps have been taken to mitigate the risk these conflicts pose to the interests of customers” [our emphasis]. The FCA believes that failures in this regard are likely to be the result of out-dated control frameworks that have not been grown and adapted to mitigate the new and evolving risk of conflicts of interest that come with increasing numbers of Integrated Models and MGAs.
The FCA has clearly got the bit between its teeth on this issue and, amid rumblings of a desire to ‘make an example’ of at least one of the firms reviewed, it says that it will, among other things, enact “Supervisory engagement with the firms involved in the review to address specific issues identified, using the full range of regulatory tools available to us as appropriate.”
Those regulatory tools, of course, include large fines and Section 166 reviews of the brokers’ businesses. Section 166 reviews involve directing firms to engage third party specialists to check that their practices are up to scratch. The reviewed firm must pay the cost of the review: a cost that will of course vary according to the size of the broker involved but that can range from tens of thousands of pounds to over £1 million. The market will also recall the £315,000 fine levied on Besso for failing to maintain effective systems for countering risks of bribery and corruption.
While the FCA has not said that it would immediately widen the scope of its “supervisory engagement” on this issue beyond the seven brokers which were the subject of the thematic review, there is always a possibility that it will do so in the future.
The FCA has made clear that the issue of conflicts is in its sights and is likely to focus on it in any future reviews of a broker’s business. Their guidance, however, is somewhat nebulous: affected brokers must, “Put in place an effective control framework and [have] taken all reasonable steps to manage and mitigate the conflicts of interest in their business, to prevent them potentially damaging the interests of their SME customers.” That said, by the FCA setting out the problems it encountered in the Thematic Review, it does make it possible to glean what would be acceptable practice.
The key thing to bear in mind is not only that such guidance must be adhered to but that each firm must be able to “demonstrate” this to the FCA. This will require clear paper-trails setting out the policies and procedures of affected firms and within each individual client file. On a more strategic level, firms will have to consider the manner in which they segregate the roles, revenue and information between the insurer focused parts of their business (such as their MGAs) and the more traditional client-facing and broking arms: whether using Chinese walls or other mechanisms.
In the absence of more detailed guidance as to what precisely amounts to an “effective control framework”, this is a difficult task to get right and brokers might well think it advisable to obtain independent advice on their structures and procedures on their own terms, before finding themselves in a position where the FCA orders a Section 166 report.
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