FSCS will look at pre-funding

The Financial Services Compensation Scheme will look at pre-funding and introducing a risk component to its funding process as part of this year’s review.

The FSA aims to consult on a review of the FSCS funding model in the first half of the year. The review was started in October 2009 but was delayed a year later due to UK regulatory reform and development of the European investor compensation scheme directive.

At the Insurance Institute of London last week, FSCS chief executive Mark Neale argued that funding reform should look to tackle the unpredictability and fairness of the current levy system. He said: “We should try to find an approach that reduces that unpredictability, perhaps through pre-funding, perhaps by enabling the FSCS to hold modest reserves to provide a buffer against costly failures. We should try to ensure costs fall primarily on the sectors of the industry that impose them, perhaps by introducing a risk component to funding or by borrowing.”

Neale said it was important for consumers to take responsibility for their own investment decisions but difficult for them to understand the risks, given the rise in complex investment products.

He questioned whether the industry should accept there is no such thing as risk-free investment and focus on designing simpler, more transparent products instead.

The FSCS warned advisers last month that compensation costs in relation to Keydata, Arch cru, MF Global, Wills & Co and other stockbroking firms could push investment intermediation costs above the £100m adviser sub-class limit and trigger a cross-subsidy for fund managers.

Paladin Financial Services managing director Tim Purdon says: “I would be most unhappy about paying more for the future. All we are doing is adding more to a bucket that has got a hole in the bottom of it.”

FSCS funding options

Pre-funding through holding reserves The aim of a pre-funded compensation scheme would be to remove the unpredictability of the current levy system by having a pot of money to draw on in the event of firm failure. However, firms would still have to keep paying levies to deal with current claims while also contributing to building up a reserve compensation pot.

Pre-funding through a product levy A popular option among many advisers, this move would see a small charge levied on the sale of each product which would help build up reserves to pay out compensation when required. Risky products would face higher charges. FSCS chief executive Mark Neale told Money Marketing last year that he was unlikely to support what he saw as “a tax on the consumer”.

Risk-based levies A risk-based approach would ensure that those firms undertaking the most risk are contributing the most, and may also remove the likelihood of advisers paying for the failures of non-adviser firms, as happened with Keydata and Wills and Co. However it is likely to be the FSA or the FSCS who define the risk categories, and there could be disagreements over the level of risk attached to certain products or activities.