Professional indemnity insurance is in danger of generating irrational outcomes for the advice industry. As usual, this is the result of well-intentioned regulations that fail to take into account unintended but predictable consequences.
The ghastly mess of Honister should cause the regulators to think again about PI. It is intended as a backstop to ensure consumers get compensated for the consequences of bad advice. But because the FSA is not doing its regulatory job well, toxic products are sold and very bad advisers are allowed to be in business. PI picks up the costs of the consequent messes but it looks as if its costs could escalate to the point where they inhibit business formation and competition in the adviser sector.
In the long run, I would hope that as advisers become more professional, we move to a system of regulation by what will become professional bodies (initially via the SPS). Then advisers who do not cut it will be removed from practice by the profession itself. That would conform to the usual model of professional self-regulation, which has a lot to commend it. PI costs for those who do cut it can then be expected to fall.
But in the meantime, we do not have such professional regulation. And the FSA has proved so many times that it is incapable of preventing rogue advisers giving very bad advice that the notion that “better regulation” will prevent future problems is simply laughable. Anyone who knows the industry well will share my view that under the current system similar problems are virtually guaranteed to recur.
In this situation, the PI insurers have become the sweepers-up with the brushes and dustpans but they are struggling to cope with the output of elephants.
An obvious solution, which the regulators would love, is to impose higher capital requirements for adviser firms, even those within networks. Knowing that a big chunk of their own capital would be wiped out by a claim might be the best way to ensure that advisers give better quality advice. But it would also prompt another violent response from those advisers who see it as their right to be able to operate with a near-zero capital base, even though they would not accept that for any of the investment or insurance firms they deal with.
Perhaps higher capital requirements would drive out more small firms but they might be the kind of firms we would not miss. Under the RDR model, small firms giving a professional service will have an assured level of annual fee income and if they do not have the capital, they should be able to raise it.
If it was canny, the regulator might be able to sell higher capital requirements to advisers by reducing the scope of the PI they need. If advisers knew that mandatory PI was limited to catastrophe-type cover and that their PI costs would be lower, they ought to feel less anxious about holding more capital in their businesses. Provided, that is, they are doing their best to give good advice.
A contrary view – that the Honister mess is nothing to do with PI but is an inevitable consequence of a fundamentally flawed business model for large advice firms – is unthinkable by people lacking the capacity to think, and can safely be ignored.
Chris Gilchrist is director of FiveWays Financial Planning, edits the IRS Report newsletter and is the author of the Taxbriefs Guide, The Process of Financial Planning