The FSA has come under a barrage of criticism over its discussion paper on the prudential rules for personal investment firms. In particular the lack of any evidence for its proposition that there is linkage between capital adequacy and the likelihood of mis-selling and the generally confused and often conflicting thinking that is prevalent throughout the entire discussion paper. 

Whilst the paper certainly is lacking in evidence and confused and contradictory, I for one believe that the FSA should be given some slack. Too often the FSA have produced discussion papers far too late in the day, when they have already gathered extensive evidence on the point and in reality reached a conclusive view as to how they wish to proceed. We then have the charade of a consultation process where the ultimate outcome is largely pre-determined and the most that one can really expect from responding is to make minor alterations to the edges rather than materially alter the central thrust of the FSA’s plans. 

Here it is patently obvious that the FSA have hardly thought about the issue at all and have cobbled together some preliminary thoughts and ideas of “stakeholders” into a passable document for discussion purposes, without any real idea as to where these discussions may lead them. This is exactly the sort of discussion paper we need from the FSA.

Anyone who cares about the survival of small firms of professional financial advisers really ought to take an hour out of their busy lives to read the 42 pages of the consultation paper and make their voice heard. Whilst IFA’s lack the capital of many of the other vested interests, with their sophisticated political and publicity departments, there are 5,000 firms out there who are directly regulated by the FSA and who will be affected by the outcome of this. Reading between the lines 83% (those with 5 advisers or fewer) could well be put to the sword and really ought to put pen to paper. It should be perfectly possible to convince the FSA that there is no need to squeeze out the smaller firm and if we fail to do so it will be for want of trying rather than losing the argument itself.

So what prompted the discussion paper? According to the overview “a number of stakeholders have expressed concern to us that the current Prudential rules are not fit for purpose”. No doubt most of us will finger the providers as the main peddlers of these concerns. However my own suspicion is that the FSA themselves see small IFA’s as a problem. We should not underestimate a regulators desire for neatness, order and control irrespective of whether neatness, order and control actually delivers a better outcome on their primary objectives.  

Undoubtedly the regulation of small firms is a patchy mess. The FSA’s shift to risk based regulation has meant that small IFA’s more or less slip completely under the regulatory radar unless something starts to go majorly wrong with the firm. The FSA cannot realistically provide much by way of effective monitoring of 5,000 small firms. They know that from a cost benefit analysis it makes no sense to increase the monitoring of these firms as the majority are perfectly well run and any extra monitoring is not likely in any event to identify those that aren’t. That is not to say however that they do not recognise the potential for them to be embarrassed by a small rogue firm. However much it maybe entirely legitimate for the FSA to say that their model is not looking for a no failure regime, the tabloid journalists will drag them over hot coals if a number of clients end up being damaged by a small firm that was in reality not subject to any real regulatory constraints at all. 

A neat and tidy solution for the FSA is to simply drive the 4,150 firms with 5 advisers or less out of their independence and into larger entities, leaving them with perhaps 2,000 larger firms which would be easier for them to manage. The alternatives of leaving it messy but effective needs to be championed.

Turning to the meat of the paper, in Section 3 they concentrate on the theory of market failure. Here the FSA point to the information asymmetry between consumers and advisers and the perceived conflict of interest inherent in commission remuneration. As the claims director of Collegiate Claims I have had the pleasure of overseeing the management of tens of thousands of professional indemnity claims against independent financial advisers on behalf of our client underwriters. Undoubtedly a sizeable minority have had a flavour of commission bias. The most often cited examples are Pension Review and endowment mis-selling. In both cases the main alternative option, the occupational scheme and the repayment mortgage respectively would normally produce significantly less remuneration, if any for the adviser. 

Had occupational schemes paid a fee to every advisers who managed to persuade someone to join the occupational scheme I have no doubt many more employees would have done so. We cannot however simply ignore the fact that at the time the government of the day was trying to achieve the exact opposite and had itself set out on a campaign to persuade its own public sector employees to go down the personal pension route. Equally, at the time the majority of endowment policies were being sold, endowments were genuinely seen to be an appropriate low risk way of financing the repayment of your mortgage. In the vast majority of cases where it is alleged that there was commission bias the reality is that the adviser was confronted with two options he felt were equally suitable and that bias, if it has been there, has been to then choose the one that was in his own financial interest. Rarely is it, as portrayed in the media, where an adviser cynically and knowingly recommends an inappropriate product purely for the commission. 

This is important to recognise as in my experience the problem of commission bias is overstated. It did not cause the Pension Review and endowment mis-selling. They were caused by ignorance, poor training and a healthy dose of twenty-twenty hindsight. Yes, in my opinion underwriters are right to consider fee remunerated advisers a better risk, but it is wrong to suggest that commission remunerated advisers are a poor risk.

The vast majority of small IFA’s are decent, honest, hardworking professionals seeking to do the best they can for their clients. Contrary to the FSA’s assertion, the advisers incentive to maximise his own income is not only loosely linked to the customers financial outcome. A small business well understands that their reputation is absolutely crucial. Whilst a satisfied customer may be a great source of referral work, a dis-satisfied customer will do a lot of damage to their reputation in their community. The majority of IFA’s that I have dealt with during the various mis-sellings scandals were horrified and bewildered by the vilification of the industry and on a personal level often acutely embarrassed as well, as they had recommended the tarnished product to their own close family and friends. 

Quite understandably they felt they were being unfairly judged by the retrospective imposition of standards that were not “state of the art” at the time. Whatever your views are on what standard ought to have been expected of professionals at the time, it is simply not the case that these people were dishonest. It is I think exceedingly important to recognise that the scandals were not primarily caused by commission biased dishonesty, but by poor training and professional standards. 

Great strides have been made by the FSA and the industry to improve those core standards and principles. I am not suggesting it would not be better if all advice was given on a fee basis as there is some commission bias, but it is dangerous for the FSA to get this bias out of proportion. Until the majority of the British public is ready to pay up front fees for advice there will be some commission bias, but it is simply not the case that small firms fighting to establish a reputation in their area are going to make unsuitable recommendations because of commission bias. 

That said, there is however still a lot of compensation being paid. In 2005/6 the target firms paid redress of £104 million out to 35,290 claimants with the FSCS paying out an additional £108 million. 

The FSA make the point that they do currently impose conduct of business and Prudential regulation on the target firms, but go on to state that the evidence of the significant volume of consumer complaints suggests that the current rules do not entirely solve the relevant market failures. The paper asks us whether we agree with that analysis, but in truth from those bold numbers it is not possible to draw any conclusion.

The obvious omissions are any comparisons with the volume of business written. Certainly £200 + million is not to be sneezed at, but what volume of business does that represent? And how does that compare to the direct providers? I have no doubt at all that the IFA sector would come out smelling of roses in any comparison with the direct sector and that there is no evidential basis on which to link low capital adequacy to a higher risk of mis-selling. Further whilst no details are given I suspect that the majority of the compensation payments relate to advice given more than 5 years ago. 

Enormous strides have been made by the industry to improve professionalism. The benefit of these developments however do take a number of years to bed into the system and then a few more years before the improvements start to filter through to an improved loss ratio. It seems to me that without any analysis of when the poor advice was given, it is impossible to say whether the current rules do solve the relevant market failures such that the status quo is perfectly acceptable (backed up with a continued commitment to improved training and professional development) or whether still further regulatory intervention is required. 

Recognising it is not in the nature of a government or a regulator to be happy to let anything bed down for too long without rolling out some new initiative lest they be accused of idleness, it makes sense to at least consider whether the suggested solutions are likely to improve upon the status quo in a proportionate way, or at all (or indeed make the position worse). 

Looking at Chapter 4, the FSA start quite reasonably with the premise that the owners of a firm have a material financial stake in it and they will act to protect that stake. They go on to suggest that the £10,000 own funds requirement is too small to be material such that the incentive to protect it is weak. The £10,000 own funds requirement was set in 1994 and would apparently be worth £12,500 today if it increased in line with inflation. 

The paper appears quite critical of the PII market and ventures to suggest that there is some evidence that the PII market is not operating in a fully risk based way. It suggests that some insurers do not consider the risk of individual firms in setting premiums. I personally find this an extraordinary claim. The IFA sector is considered to be one of the most difficult classes of professional indemnity to write successfully and those underwriters who have managed to maintain a continuous presence in the market throughout its turbulent history since regulation take risk assessment very seriously indeed. The length of an average IFA proposal form is a testament to that. 

The PI market is of course cyclical and has periods of softness as is the case presently. When capacity is washing round the market, new and less experienced underwriters do venture into this class and whilst the more experienced market may occasionally scratch their head at the recklessness/naivety of some of the new entrants, even they would not suggest that the underwriters are not attempting to carry out any risk assessment at all.

There is however limitations to what can be done by way of risk assessment for a proportionate cost. Not so very long ago when PI rates were double if not triple to what they are today, underwriters could insist on risk surveys with the cost being borne by the proposer or lost within a fat premium. For now those days are gone save for the very large insured’s or distressed risks. As the market reaches its bottom and cash sloshes around looking for something to do, even the poorest risks will find a home with the most desperate/naïve underwriters.

Whilst it appears the FSA is currently lamenting the PI markets willingness to support their poorest firms the market will turn, as it has always done, and at that point not only will the rates for all insured’s start to drive up, but those firms that are weakest will run the real risk of becoming uninsurable. The FSA does appear to have a very short memory. In 2002/2003 PI rates were very hard indeed and there was a very restricted number of insurers prepared to write the class. Capacity restrictions on those insurers willing to write the class still meant that many IFA’s could not find cover. A significant number of those IFA’s did need driving out of the industry and the current numbers from the FSCS appear to be a testament to that. 

Unfortunately there were many good firms who found themselves unable to find cover. Some good firms had been insured with an insurer who was fleeing the market and found the established players who were in for the long haul, giving priority to their own renewal book. As we know because of the number of good firms in difficulties the FSA started signing waivers to get the firms through the hard market but in doing so, they did throw a life line to some firms who the industry would have been better off without.

The PI market does to some extent police the market by driving out poor risks and at the peak of the market it can be very brutal indeed. In the trough of the cycle as now, its effect is weak. In the ideal world there should be a happy medium. However to reach that one would need to tame the insurance cycle and to date no one has worked out how that can be done and I do not see the FSA solving that particular problem any time soon. 

In any event ultimately the PI market is not there to be the police force of the IFA industry, the onus must be on the regulators to identify the genuine bad apples and remove them from the market. As insurers we have a small part to play, and IFA’s need to be concerned about their loss experience as the hard market will return. Equally we, as insurers, are looking to the regulators to identify and remove the worst offenders as it is extremely difficult to identify them from a few tick boxes on a proposal form and the average premium does not allow for the sort of in depth risk analysis that would be required to identify the truly rotten risk. 

The FSA also looks at the issue of whether “claims made” rather than a “business written” base of insurance would motivate insurers to carry out a better assessment of risk. The answer to that is a theoretical yes it would. I say theoretical because I cannot see any Underwriter being prepared to write this class on a “business written” basis. I say yes it would, because if they could be persuaded, then the premiums would be so enormous that it may well be possible to build in some extra risk assessment.  It is however in my view a complete non-starter. No other UK profession is written on that basis and with all due respect to IFA’s this class would be the last profession that anyone would want to trial run a shift away from “claims made”. 

To write on a “business written” basis you really do not want to fear that 10 years later the regulator is going to suddenly decide that for the last 10 years the whole profession has been negligently mis-selling billions of pounds worth of policies which will belatedly need looking at. In other jurisdictions that do have “business written” insurance, there is normally a short discovery period of perhaps only 5 years, which brings its own set of problems.

Later in the paper the FSA has a dig at the PI market by suggesting that there are terms within a PI policy which tend to make it difficult in practice for firms to claim. The Pension Review did throw up some difficult issues for insurers. However with the issue of blanket notification largely behind us (at least for now) my experience is that IFA’s have very little difficulty in claiming under their policies. Short of notifying the matter promptly as soon as you become aware of it and not agreeing to spend your insurers money without their prior consent there really is not much more to it. Ultimately of course IFA’s are underwriters clients, underwriters care about their reputation within the market too, particularly those who have spent a long time building a lot of expertise in the market and have every intention of being there in the hard as well as the soft market. 

The paper also touches on whether or not the excess level ought to be reduced. The FSA has gone down the route previously of trying to be overly prescriptive about what cover firms should have. If this is set too tightly, whilst it may work in the soft market it will unravel in a hard market. Any limits need to be set with the hard market in mind. In any event it is not normally in an insured’s interest to pound swop with his insurers by setting the excess too low.

Having perhaps perceived correctly that it is going to be very difficult to make PI insurers any more effective than they are already in driving out poorer firms, the FSA is looking at whether they could adopt a risk based capital resource requirement themselves to assist the process.

The FSA state that there is “no agreed wisdom on which parameters is the best or even a reliable predictor of mis-selling that would support a variable capital resource requirement”. To my mind that is the start and end of it. Though I have had the privilege of working with many of the best underwriters in the class it is ultimately an art and not a science. Whilst you can introduce formal systems to try and sort the wheat from the chaff there are no hard and fast rules and ultimately it comes down to the individual underwriters skill and judgement. If it were to be carried out by a regulator and the resultant bill imposed by dictate, (rather than just a competing quote in a free market) it would be impossible to justify.

The FSA suggests it could look at qualifications, areas of business, turnover, compliance systems, audit, length of tail, but how they inter-relate to risk is extremely complex and ever changing and would be a wholly unsuitable way in my opinion for a regulator to try and set capital adequacy. Not only would they utterly fail in getting it right to any reliable extent, the cost of attempting to do so would be completely disproportionate to the benefit of any marginal difference in capital adequacy, which in any event bears no relation whatsoever to the likelihood of mis-selling. 

I am a great believer in training and qualifications as a way of minimising the risk of mis-selling. It seems to me that there are two key factors in play with qualifications and training. The first is simply the more you understand about the very complex area of financial advice, the less likely you are to make errors and/or gullibly believe the promotional patter of provider representatives. Second, is the pure investment of time and effort committed by the adviser. Whilst much is made in the discussion paper of the investment by the owner in the business, to my mind the absolute key thing is the investment made by the individual advisers giving the advice. If an adviser has had to work really hard to get properly qualified to call himself a professional then he is committed to the industry and has a very significant personal stake in his own reputation. 

To my mind it is this issue that explains why the product providers with all their enormous resources and capital fail to match the claims experience of the independent financial advisers. It is much harder to be an IFA than it is to be a sales rep for a product provider. You cannot rely on your product providers enormous advertising budget to maintain your reputation. You know that your reputation in your area is down to you and you cannot be anonymous. The more a person invests in their career the less likely they are to be reckless with their reputation for short term gain. For that reason whilst I am not at all convinced that capital adequacy has any part to play as the value of a companies “reputation” will always be much more, if one was to differentiate between classes of business then giving an incentive for firms to invest in their staff through training and qualifications would at least make some sense to me.

Looking at the final section on the paper dealing with the burden of the FSCS, it has always amazed me the sheer number of sole traders and partnerships that are declared in default by the FSCS. In my experience the reality is not that the sole traders or partners are bankrupt, rather that they simply fail to return the FSCS’s form or co-operate with the FSCS’s enquiries. To minimise any inconvenience to the consumer the FSCS then declares the firm in default and pays claims. 

Whilst theoretically the FSCS takes subrogation rights and can pursue the non-co-operating sole trader/partners, the practical difficulties associated with subrogated claims are such that the majority of recovery actions get written off. 

If the industry was serious about wanting to reduce the FSCS levy, a good place in my opinion to start would be to refuse to consider a consumers claim against a sole trader or partnership until at least one consumer had obtained an unsatisfied judgement against the firm. If the sole trader or firm is really without assets then the consumer can obtain this with the minimum of fuss by way of a judgement in default. However in the majority of cases these claims would end up being defended and successfully at that. Those consumers that had good claims would more often than not be paid by the firm as the firms do have assets and often run off PI.

The FSCS pays many millions of pounds out to undeserving claimants because, being fair to them, it is very difficult to defend claims if the adviser does not provide his file or assist the defence. If the FSCS were a lot slower to declare sole traders and partnerships in default until they truly are satisfied they are not able to meet their liabilities then this would reduce significantly in my opinion the FSCS levy and would encourage more firms to buy run off cover. 

With limited liability companies, it is much more likely that they will fall into default once they have ceased to trade. Once there is no income coming into the business, there is no good reason not to advertise for creditors and then carry out an orderly winding up, with the remaining assets returned to shareholders. Claims will invariably come in after the winding up and fall to the FSCS. It seems to me there is a very great difference between a sole trader/partnership and a limited liability company. Any professional trading as a sole trader or a partnership is going to be very concerned about mis-selling claims because they know that if the system is working correctly they take those liabilities to the grave. Clearly on that basis there is some rationale for a making a capital adequacy distinction between sole trader/partnerships and limited companies. Making a higher capital adequacy requirement for limited companies would however probably serve no purpose because on liquidation the capital would still be exhausted on fees. However there is an argument that a limited companies contribution to the FSCS’s levy ought to be higher than a sole trader or partnership, particularly if the FSCS raised their game on who they declare in default.

The suggestion that product providers take some responsibility for their products ought not to be a serious one if IFA’s have any claim to being a profession. Product providers ought to have the freedom to put toxic, dangerous, useless products out there and IFA’s ought to be confident that they will not sell them.  We need product providers to be innovative and unfettered. If they give advice on their products then clearly they are responsible for that, but the advice industry, if it is to be a profession, must grow up and accept responsibility for spotting rubbish products. 

Hiscox Insurance Company Limited and Collegiate Management Services Limited today announced that Hiscox will now provide capacity for the general professional indemnity business of ‘Collegiate Underwriting’.

The new deal between Hiscox and Collegiate brings together two organisations with a common target market and allows Hiscox to continue its strategic drive to become the UK’s premier insurer for SME professionals in Europe. Collegiate is already well established in the Independent Financial Advisers market and this new partnership will assist Collegiate in expanding its traditional and emerging SME professions business.  

Hiscox will utilise Collegiate’s claims handling arm allowing brokers and customers to benefit from an in-house specialist legal team ensuring that claims are defended by a dedicated resource that understand the needs of these clients.