Diamond in the rough: Can something good come out of the broken PI market?

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The clamour to reform advisers’ professional indemnity insurance is growing as trade bodies and the regulator face up to the fact PI cover is not working for advice firms.

Speaking at the Association of British Insurers conference last week, FCA chief executive Andrew Bailey acknowledged advisers’ PI is not adequately covering firm failures.

Bailey said PI cover was not “reliably performing” its role and singled out the advice and investments world as a prime example.

He said: “The contracts are framed often in ways that rule out loss absorption in the context we are dealing with here when the firm fails. What is the consequence of this? It is that the protection of client assets and ultimately the FSCS become the primary lines of defence, and this is what has happened.”

The Financial Advice Market Review recommended the FCA look at the PI market after it reviews the Financial Services Compensation Scheme’s funding model.

Work on a PI review is expected to start early next year, sources tell Money Marketing, with the FSCS funding review consultation paper due to be released before the end of 2016.

As a PI audit ticks closer, what are the key issues the advice profession is grappling with over PI insurance and what are the reforms it considers are long overdue?

Broken system

FAMR flagged up a number of issues with the PI market as it stands. These include smaller advice firms having trouble finding affordable deals because just a handful of firms operate in the market, and cover being restricted through exclusions for certain products and high excess charges.

However, FAMR also said the relationship between FSCS claims and PI insurance should be established before the FCA commits to a fuller review of the PI market.

It is not the PI market failing to function, it is the regulatory regime failing to provide the certainty insurers can work with

According to the FAMR report, insurers have concerns that the potential total PI premiums in the market for advice firms might be significantly less than the market’s total annual redress liabilities. This potentially has implications for the FSCS; if the sector is less able to absorb liabilities and a greater number of firms fail there is likely to be more reliance on the life-
boat fund.

Apfa director general Chris Hannant echoes the concerns of FAMR. One of the biggest issues Apfa members have about PI insurance is the cost of cover.

However, he says many of his discussions about PI – with the insurance sector and with regulators – are now focused on improving PI policies’ cover.

Hannant says: “I have spoken to brokers and they say subtle differences in wordings make all the difference in whether a policy is robust or not. You might get exclusions not covering risky areas – then is it worth the paper it is written on?”

O3 Insurance Solutions managing director Jamie Newell says insurers differ “enormously” in the terms they offer, particularly claims notification clauses.

He says some insurers demand a claim is notified to them immediately, while others specify a notification period of 14 days and some say “as soon as practicable”. Policy exclusions and wordings also vary from insurer to insurer.

Tenet regulatory director Mike O’Brien says directly authorised firms have the most difficulty securing cover. Advisers who are appointed representatives of Tenet use the network’s Guernsey-based in-house captive insurer.

He says: “For DA firms it can be really difficult to secure terms if you have had a claim in the past or if you have written certain kinds of business. That is the noise we hear.”

O’Brien cites issues with the regulatory regime surrounding PI cover which have led to uncertainty for insurers in assessing the risk of advice firms.

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He says: “PI insurers are cautious because the claims they pay are based upon what the Financial Ombudsman Service does in terms of its interpretation of whether a claim should be settled or not, the lack of accountability of the FOS and the fact the rules keep changing, so there is little certainty over what these things are being judged against.”

O’Brien adds: “If you address those things you will probably have a functioning PI market because insurers are having to price for a significant degree of uncertainty. It is not the PI market that is failing to function, it is the regulatory regime failing to provide the certainty that the insurers can work with.”

Walking the walk

Hannant says talks with the FCA have included considering whether to introduce a minimum standard wording, which would protect advisers from wide-ranging exemptions and limited cover.

He says: “It makes sense to have minimum standards. If you mandate that people have PI, it should be a PI policy rather than something that is shot through with so many holes that it is not working.”

He adds: “Some members are concerned about the impact that might have on premiums. It is worth looking at. In a softening market it might be easier to bring in.”

Newell agrees with Hannant that a minimum standard of PI cover would clarify for advisers what their policy covers.

He says: “I have always been banging the drum that advisers should have minimum standard policy wordings in place. At the moment with IFAs there is no minimum standard. All of the insurers change their wordings and advisers don’t know what is in their policy.”

Newell adds: “If there were minimum terms there would be transparency for the advisers.”

All-in-one?

One solution understood to be on the table in the FSCS funding review is combining FSCS protection with PI insurance, meaning advisers would pay into a centralised fund rather than pay FSCS and PI bills separately.

The centralised fund could address policy exclusions and high excess charges, and would be large enough to cover all payments when firms are likely to go out of business. The idea has received mixed reviews from commentators.

However, 4 Pump Court barrister Peter Hamilton supports the idea and says he submitted a similar proposal in his FAMR response.

Hamilton says: “I was suggesting the FSCS should be viewed as an insurance company of last resort and that it should underwrite companies to work out what their contribution should be.”

The FSCS and PI are so  different that amalgamating them would cause more trouble than it would solve

For example, advisers who avoid selling high-risk overseas property investments should have that taken into account when negotiating a premium.

Hamilton’s caveat is that premiums and excesses must not end up too high: “I have had an IFA client who does carry PI insurance but his excess is so high that, in effect, except for the risk that would close him down, he does not have any insurance, he has got to bear it all.

“There needs to be proper underwriting, and with it, some kind of proper supervision to ensure advisers keep within their categories of business.

“The premiums should be sufficiently low so the IFAs only have to bear a small excess and the combined figure for the average firm for FSCS and PI should be lower than it is now.”

However, independent regulatory consultant Richard Hobbs calls a blending of funds “implausible”.

He says: “The FSCS is a levy-based system and it protects the consumer. PI is a risk-based system and it protects the adviser. They are so different that amalgamating them would cause more trouble than it would solve.”

Taking the lead

Bailey used his ABI conference speech to call on insurers to come up with other ideas on how to make the PI market and the FSCS work more effectively.

Bailey said: “This is rightly a public policy issue, but it is also a private issue too because many advice firms are meeting substantial bills for FSCS payouts. With all this in mind, my request to the insurance industry is to help us to think through how we might solve this problem.”

However, Hobbs is sceptical over how much insurers can solve advisers’ PI problems.

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He says: “The insurers can’t help. They price PI cover rationally. Any kind of help implies some kind of generosity that they have to pay for pound-for-pound in higher capital charges. There is no way they can help.”

Hobbs adds: “The dangerous issue for advisers is that if PI insurance is not working then the implication is that they should put up capital and have their own capital adequacy regime. That is not feasible, which is why PI insurance was adopted as second best in the first place.

“This argument goes back to the 1980s. We have been around this before about 15 years ago. The market really dried up and, for a while, the FSA had to forgo their rule on compulsory PI cover because IFAs could not buy it.”

An ABI spokesman says it will engage with the regulator once a consultation has started and Newell urges the FCA to engage with insurance brokers who are the gateway to their adviser clients.

Expert view

Personal Finance Society chief executive Keith Richards

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As the FCA continues its review into the FSCS, it is crucial that the regulator considers the widest possible range of solutions, including a consideration of the future role that professional indemnity insurance has to play.

Given the link between PII and the FSCS, and the dynamics of how insurance works in relation to the legacy liability of regulated advice, it would make sense for the current review to address the shortcomings of PII.

FCA chief Andrew Bailey said last week that PII was failing to act “reliably” as the first line of defence to prevent advice firms from failing, and is urging insurers to come up with ideas on how to make PII and FSCS work more effectively.

One idea proposed by the Personal Finance Society is a single client protection fund, incorporating both the current PII and FSCS contribution.

Currently, PI insurers can mitigate liability or over-exposure to risk by amending or even withdrawing cover, potentially exposing advisers to the full cost of unforeseen compensation claims. Firms are being asked to set aside additional capital to support potential claims but many firms simply do not have the balance sheet strength to do this.

As a result, financial pressure will often force a firm into administration, with the resulting liability falling to a more vulnerable FSCS.

A centralised fund would have the financial capacity to not only protect advice firms, but also protect consumers from advice firm failures. It could also address common PII exclusions and high excess charges that result from the limited competition currently in the PII marketplace.

A combined fee would also provide certainty to advisers who are currently exposed to the unpredictable costs of the FSCS. A single contribution to a non-commercial “pooled risk” fund, with an excess applying similar to PII, is likely to be lower than the current dual contributions.

I understand this proposal would require a radical overhaul of the FSCS, as well as parliamentary approval, but we need to capitalise on the once-in-a-generation opportunity for reform that FAMR has provided us with.

Out-of-the-box and radical thinking may not be the answer to all of the profession’s problems, but I would argue it should form part of the broadest possible review into regulation that will shape our profession for decades to come.