The FSA has confirmed that it will review the FSCS’s funding structure. With liabilities to be covered that include a £14bn loan, we find out what’s at stake for brokers
For months, a war of words has been waging between broker trade bodies and the FSA. It concerns the funding and fees structure for the Financial Services Compensation Scheme (FSCS), which Biba argues could see small insurance intermediaries footing the bill for the global banking firms’ crisis of last year.
To add to the controversy, the management levies paid by small and medium-sized insurance brokers to the scheme have rocketed since 2008. According to Biba, a medium-sized firm with commissions worth £5m has seen its contribution to the scheme jump from £294 to £2,467 in just a year; that’s a 739% increase.
The FSA’s confirmation earlier this month that a review of the FSCS funding structure will start before the end of the year is therefore heartening news. As Biba’s head of compliance and training, Steve White, says: “We’ve been calling for changes to the funding of FSCS for some time. For brokers, change cannot come soon enough.”
So why is the scheme such a bone of contention, and what changes might be introduced?
The current set-up
The FSCS is currently split into five broad classes – deposits; life and pensions; general insurance; investments; and home finance – with each except the deposits class divided into two sub-classes, made up of firms that operate a similar type of business. For example, the general insurance class is split into insurers and intermediaries.
Each of these classes has access to a compensation pot up to a threshold set by the FSA, based on what it calculates a class can afford in a year. In the case of banks, that’s £1.84bn a year, while the general insurance pot is split into the two sub-classes: £775m available to insurers and £195m to intermediaries. Once a broad class reaches its annual threshold, the other classes must contribute to the compensation pool until payments hit £4.03bn, which is the maximum the FSCS can pay out in one year. It’s a structure that Biba and other trade associations have been criticising as unfair since the FSCS was created.
“The current funding and fees structure for the FSCS in no way reflect the low-risk nature of general insurance mediation,” White says.
“No other EU country has a set-up that involves this kind of cross-subsidy between firms in different sectors, and it puts UK brokers at a significant competitive disadvantage to similar businesses across Europe.”
Fallout from the banking crisis of 2008 means the potential for cross-subsidy across the financial services industry is now a reality. The FSCS has already agreed to meet compensation claims at five lenders, including Bradford & Bingley (B&B) and London Scottish Bank, and has taken out a £14bn interest-only government loan to meet its liabilities to B&B customers. That loan is due in 2011 and, under the system as it stands, all five classes would be liable for repayments.
“This is a galling prospect,” White says. “It means that brokers, who have no involvement in offering banking services, could find themselves having to pay for collapsed banks.” Given that intermediaries as a group are liable to a maximum compensation payment of £195m, this roughly equates to each firm paying out around 3.5% of their income to the FSCS.
“Considering small to medium-sized broker firms have a profit line of around 12%-15% in an average year, meeting the cost of this compensation claim, in addition to trading during a recession, could clearly jeopardise some companies’ futures,” White adds.
Biba says that brokers are already being penalised for these bank failures through the huge hikes in annual fees they pay to meet the scheme’s ever-increasing workload and management costs. While medium firms have seen some of the biggest hikes in annual fees, small firms are also paying out more. A small firm earning £73,000 in commission, which paid £8 in 2008, will now pay £39; a 387.5% year-on-year increase.
Time for change
The FSA last reviewed the FSCS’s funding model in 2006/07 before the current financial storm had started to loom. It announced its intention to review the scheme again in a submission to the Treasury Select Committee in June this year, after the government asked the financial services industry to consider the causes of the banking crisis.
But it is only in the last month that the FSA has outlined what the overhaul could involve. It will include an assessment of the composition of classes and sub-classes as well as the annual thresholds each class can be asked to pay. In addition, the allocation of levies among different types of firms will be reviewed, the limits that apply to different types of FSCS levy and the method of apportionment of levies to individual firms will be examined. Importantly, the case for risk-based levies will also be considered.
But will the review cover the specific issue of cross-subsidy across financial sectors? The FSA’s Andrea Kinner says it is too early to talk about the exact details of the review but emphasises it will be thorough. “All we can say at this stage is that the review will be very comprehensive and will potentially consider all aspects of the scheme’s funding,” she says. “But we can’t speculate what the outcome will be for each and every issue. ”
The FSA will begin consulting on possible changes to the FSCS next year, with the upshot that new rules could be formalised in 2011. In theory, it’s possible that any such changes could take effect before the costs of the B&B loan have to be raised across all the classes. The FSA concedes, however, that a precise timeline for any new rules is some way off at present.
Biba is optimistic that its concerns will be taken on board. “Traditionally, the FSA has listened to us,” White says. “For example, when the FSA first structured the FSCS, the authority agreed to separate insurers and intermediaries into different sub-classes to reflect the different nature of these groups’ work.”
Brokers are not the only ones lobbying hard for change: building societies also consider the scheme’s compensation levy grossly unfair, particularly as to date a society has never called on the scheme.
For its part, Biba is unwavering in its mission to reduce the cost of the FSCS to intermediaries, as White confirms. “We will continue to fight tooth and nail for a system that is risk-based and proportionate, and truly reflects the low-risk nature of brokers’ work.”
The Financial Services Compensation Scheme
An independent body, the FSCS was created under the Financial Services and Markets Act 2000 and became the industry’s single compensation scheme on 1 December 2001 when the Act came into force.
Insurance mediation is most likely to give rise to an FSCS claim if:
1) a broker has not passed on a premium to an insurer, which in effect means the customer is an agent of the broker and not the insurer; or
2) if a broker’s professional indemnity cover is not sufficient to cover any faults made.
The FSCS can only consider claims relating to policies arranged on or after 14 January 2005, which is the date when the protection of FSCS was extended to include customers of general insurance brokers. Claims relating to connected travel insurance – where the policy is sold alongside a holiday or other related travel, for example, by travel firms and holiday providers – can only be considered for business arranged on or after 1 January 2009. IT