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The missing link

A recent FSA paper proposes raising capital adequacy levels due to a suggested connection between a firm’s financial resources and its inclination to missell. Here, Martin Archer, legal and claims director at PI insurer Collegiate Management Services, casts doubt on the regulator’s thinking, claiming it has overstated the problems caused by commission bias and failed to recognise how increasing professionalism is already driving better standards across the IFA sector

The FSA has received a barrage of criticism over its discussion paper on prudential rules for personal investment firms. The lack of evidence for its suggestion that there is a link between capital adequacy and the likelihood of misselling and the generally confused thinking have both been condemned.

The paper is certainly lacking in evidence and contradictory but I, for one, believe the FSA should be given some slack.

Too often, the FSA has produced discussion papers far too late in the day, when it has already reached a view as to how it wants to proceed. We then have the charade of a consultation process where the outcome is largely predetermined.

Here, it is obvious that the FSA has hardly thought about the issue and cobbled together some preliminary thoughts without any real idea where the discussion may lead. 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 should read the paper and then make their voice heard. IFAs lack the resources of many of the other vested interests with their sophisticated political and publicity departments. However, there are 5,000 firms which are directly regulated by the FSA and which will be affected by the outcome of this. Reading between the lines, 83 per cent (those with five advisers or less) could be put to the sword. It should be possible to convince the FSA that there is no need to squeeze out smaller firms. If we fail, it will be for want of trying rather than losing the argument.

What prompted the discussion paper? According to “a number of stakeholders”, there are concerns that the current prudential rules are not fit for purpose. No doubt most will finger providers as the main peddlers of these concerns. My suspicion is that the FSA itself sees small IFAs as a problem. We should not underestimate a regulator’s desire for neatness, order and control, irrespective of whether neatness, order and control actually deliver a better outcome on its primary objectives.

Regulation of small firms is undoubtedly a patchy mess. The shift to risk-based regulation has meant that small IFAs more or less slip under the regulatory radar unless something starts to go seriously wrong. The FSA cannot realistically provide much by way of effective monitoring of 5,000 small firms. It knows the majority are perfectly well run and any extra monitoring is not likely to identify those that are not.

But the FSA does recognise the potential for it to be embarrassed by a small rogue firm and the tabloid journalists will drag it over hot coals if clients end up being damaged by a small firm that was not subject to any real regulatory constraints. A neat and tidy solution for the FSA is to drive the 4,150 firms with five advisers or fewer out of independence and into bigger entities, leaving it with perhaps 2,000 bigger firms which would be easier to manage. The alternative of leaving regulation messy but effective needs to be championed.

The FSA paper highlights the issue of market failure, pointing to the information asymmetry between advisers and consumers and the perceived conflict of interest inherent in remuneration by commission.

I have overseen the management of tens of thousands of professional indemnity claims against IFAs on behalf of our client underwriters. Undoubtedly, a sizeable minority have had a flavour of commission bias and the most often cited examples are the pension review and endowment misselling. In both cases, the main alternatives – the occupational scheme and repayment mortgage – would normally produce much less remuneration, if any, for the adviser.

If occupational schemes paid a fee to every adviser who managed to persuade someone to join the scheme, I have no doubt that many more employees would have done so. However, we cannot simply ignore the fact that 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 most endowment policies were being sold, endowments were seen as an appropriate low-risk way of financing the repayment of a 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 they felt were equally suitable and the bias, if it was there, was to choose the one that was in their own financial interest. Despite how bias is portrayed in the media, it is rarely where an adviser cynically and knowingly recommends an inappropriate product purely for the commission.

This is important to recognise that the problem of commission bias is overstated. It did not cause the pension review and endowment misselling. These were caused by ignorance, poor training and 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 IFAs are decent, honest, hard-working professionals seeking to do the best they can for their clients.

A small business understands very well that its reputation is crucial. A satisfied customer may be a great source of referral work but a dissatisfied customer will do a lot of damage to their reputation in the community. Most IFAs that I have dealt with during the various misselling 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 family and friends.

They understandably felt they were being unfairly judged by the retrospective imposition of standards. It is simply not the case that these people were dishonest and I think it is important to recognise that these scandals were not caused primarily by commission-biased dishonesty but poor training and professional standards.

Great strides have been made by the FSA and the industry to improve core standards and principles. I am not suggesting it would not be better if all advice was given on a fee basis but it is dangerous for the FSA to get this bias out of proportion. Until the majority of the public are ready to pay up-front fees for advice, there will be some commission bias but it is 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 still a lot of compensation being paid. The target firms paid redress of 104m to 35,290 claimants in 2005/06, with the Financial Services Compensation Scheme paying an additional 108m.

The FSA makes the point that it currently imposes conduct of business rules and prudential regulation on the target firms but goes 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 whether we agree with that analysis but, in truth, despite the bold numbers, it is not possible to draw any conclusion.

The obvious omissions are any comparisons with the volume of business written. Certainly, upwards of 200m is not to be sneezed at but what volume of business does that represent? How does that compare with the direct providers?

I have no doubt that the IFA sector would come out smelling of roses in any comparison with the direct sector and that there is no basis of evidence on which to link low capital adequacy to a higher risk of misselling. Further, while no details are given, I suspect the majority of compensation payments relate to advice given more than five years ago.

Enormous strides have been made to improve professionalism. The benefit of these developments 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 if the current rules do solve the relevant market failures such that the status quo is perfectly acceptable, backed up by a continued commitment to improved training and professional development, or whether still further regulatory intervention is required.

The FSA does state quite reasonably that if the owners of a firm have a material financial stake in it, they will act to protect that stake. It suggests the 10,000 own fund requirement is too small to be material, such that the incentive to protect it is weak.

Much is made in the paper of the investment by the owner in the business but, to my mind, the absolute key thing is the investment made by the individual advisers. If an adviser has had to work really hard to get properly qualified to call themselves a professional, then they are committed to the industry and have a very significant stake in their own reputation.

It is this issue that explains why product providers, with all their enormous resources and capital, fail to match the claims’ experience of IFAs. It is much harder to be an IFA than it is to be a sales rep for a provider. You cannot rely on a provider’s enormous advertising budget to maintain your reputation. You know your reputation 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, while I am not at all convinced that capital adequacy has any part to play, as the value of a company’s reputation will always be much more, if one were to differentiate between classes of business, then giving an incentive for firms to invest in staff through training and qualifications would make some sense.

If IFAs are to be professional, it is not enough for them to gullibly believe the propaganda pumped out by the sales reps from the product manufacturers. The adviser firms that cost the insurers the most money are not only those that pay lip service to the tick-box compliance world, it is those that lap up some nonsense from a new product provider, do no due diligence and then flog it to their clients.

Many of you may feel that the product provider bears some responsibility in that situation but if you believe in professional advice, then you have to accept responsibility for that advice.

The problem does not lie with capital adequacy or even commission bias. The solution lies with making individual advisers have a true investment in their future in the industry. This can best be achieved by making this industry a true profession by having an onerous and demanding professional development training requirement.

Small firms do not have the advertising budgets needed to polish away the tarnish of misselling. They are vulnerable to reputation risk in their communities and their individual advisers are not anonymous. For this reason, they are less likely to misadvise their client base. To drive them out of business will have the opposite result to that intended. Unless, of course, the goal is not to reduce misselling but make life simpler and neater from the regulator’s perspective.

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