Smaller brokers and intermediaries often rely on goodwill to shore up their capital reserves. But the FSA has ruled that they can no longer do so, from January 2008. David Quick assesses the impact the changes will have on firms
Some new rules and regulations traverse such a long pipeline that it’s a shock when they actually start affecting our lives. The imminent ban on smoking in public places should prove a prime example.
For the broking sector, life will change from January. Tougher financial requirements are in prospect from the start of 2008, when the FSA introduces more demanding capital adequacy requirements. It’s a move that has been signposted well in advance, yet could still take some firms unawares.
As the official line terms it, insurance intermediaries will be required, from early 2008 onwards, to comply with the rules set out in MIPRU 4.
The bottom line is that brokers will no longer be able to include goodwill as a tangible asset for the purposes of assessing their capital adequacy.
The impact could be significant for those firms that have been on the acquisition trail and have included significant amounts for goodwill on their balance sheet.
The change is hardly news. The FSA debated the issue of goodwill with the Biba four years ago and gave notice of its plans back in September 2003.
As the watchdog states: “goodwill is an asset which often cannot be readily converted into cash and may only be realised when a business is sold”.
It takes the view that a regulated firm should count only on the assets on which customers and creditors can rely, should it run into financial difficulties leading to its insolvency or winding up.
And no one could quibble with the motives behind phasing out goodwill as an asset. The FSA says that a more stringent capital resources requirement will reduce the likelihood of consumers losing out and the financial markets being disrupted if a firm suffers financial failure.
Although some of us would suggest that this aim is already the remit of the European Union’s Insurance Mediation Directive (IMD), which, after all, is a Europe-wide vehicle for the protection of customers and creditors.
The UK watchdog apparently feels duty bound to gold plate the IMD’s requirements; the outcome is likely to be a further bout of consolidation in which UK firms are rendered vulnerable to takeover from rivals from across the Channel.
Not that misgivings will cut much ice at this stage. Biba has not seriously opposed the phasing out of goodwill.
Indeed, Biba’s head of compliance and training, Steve White, points out that neither the Insurance Brokers Registration Council or Lloyd’s rules recognise goodwill as a tangible asset, nor has the FSA permitted it in any of the other financial sectors it regulates.
Also, the regulator conceded to the broking sector a three-year transitional period to adapt to the change, commencing from the start of 2005.
The last few months of this period are now ticking away; as of 14 January 2008, statutory regulation kicks in and the FSA can order any broking firm that it considers to still have inadequate financial resources to cease trading.
So the advice to any firm that could potentially fail to demonstrate adequate capital resources, once goodwill is removed is that it has seven months in which to act.
“The advice to any firm that could potentially fail to demonstrate adequate capital resources, once goodwill is removed is that it has seven months in which to act. If hard choices need to be made, it’s essential that they are made over the coming weeks.
It should be assumed that the deadline won’t be extended beyond January 2008. The FSA has also stated that it may ask for evidence from firms of action that they have taken to meet the requirement.
Firms in danger
How many firms are at risk? The figure appears to be at least 400 and possibly as many as 600.
The FSA says it has identified 400 small firms which, based on the data shown in their Retail Mediation Activities Return, currently would fail to meet the capital resources requirement after the deduction of goodwill.
It wrote to each of them earlier this year, along with a handful of larger broking firms, to highlight the apparent shortfall and the need to take appropriate action.
Biba calculates around 900 firms count on goodwill as an asset, but believes around one in three of these will still satisfy the FSA requirements once the new regime takes effect.
Of the remaining 600 the “big unanswered question” is how many are taking steps to ensure they have plugged the shortfall by next January and how many are experiencing problems.
Until quite recently, Biba reported that the goodwill issue hardly registered among members’ most pressing concerns. Even a reminder issued last July, that the clock was ticking and action was needed, failed to elicit much of a response.
Yet there is evidence that some firms have been seeking to make cosmetic changes. The FSA recently warned that it had evidence of “paper exercises” that would fall short of ensuring that firms’ underlying position was strong.
Possibly concerned that a number of firms won’t meet the new test come January, the watchdog also recently posted a document on its website outlining the most frequently asked questions about goodwill.
It outlines a variety of measures open to firms likely to face a capital resources deficit once goodwill has been deducted.
Although the FSA stresses that there is no “one size fits all” solution, it sets out the remedies that would meet with its approval. These range from the use of personal assets by a sole trader or a partner in a partnership – provided they are not needed to meet other liabilities – to plug any capital resources shortfall to the firm setting up a new holding company to which goodwill can be moved.
Inevitably, all of the measures will come at a cost and will probably require the involvement of a good accountant.
If hard choices need to be made, it’s essential that they are made over the coming weeks. In some cases, firms may even conclude that selling up is the only realistic option available to them.
The FSA is adamant that the new regime is not a conspiracy to drive the smaller intermediary out of business.
Assurances are fine, but for firms that are vulnerable and need to strengthen their financial position the end effect won’t be any different unless they act soon.
David Quick is managing director of general insurance network CETA Insurance