The bar has risen and the costs to regulated firms of getting this wrong (or right) are potentially high
Threshold Condition 4 (TC4), which has applied to all insurance brokers since they were first regulated by the FSA in January 2005, requires regulated firms to hold adequate financial and non-financial resources on an ongoing basis.
In its January newsletter, the FSA reiterated comments from 2010 stressing that it is scrutinising the way insurance broker firms go about assessing the adequacy of financial resources as required under TC4.
This was on top of a 'Dear CEO' letter of February 2010 and shows how concerned the FSA is about the issue.
As a practical example of the FSA’s more intrusive approach, in recent months many brokers have been required to undertake detailed scenario analysis and stress testing as part of their risk mitigation plans.
Capital requirements will rise
The FSA’s approach reflects its view that the Prudential sourcebook for Mortgage and Home, Finance Firms and Insurance Intermediaries (MIPRU) capital requirements are too low in comparison to the scale and complexity of some broker’s activities.
Specific areas of challenge by the FSA include irrecoverable intercompany balances being included as capital, security over assets granted to lenders and general liquidity and quality of the assets firms are using to meet their MIPRU and TC4 capital requirements.
In this context, financial resources include both cash and regulatory capital, which should not be confused. Both sufficient cash and capital need to be maintained to meet TC4.
In practice, TC4 capital requirements are likely to be significantly higher than the MIPRU minimum against which most brokers will have historically been assessing their capital requirements.
It is likely that further FSA scrutiny in this area will impact all brokers; those brokers that are subject to a transaction should pay particular attention to this issue and factor this into their planning. Meeting TC4 requirements will almost certainly figure prominently in any regulatory due diligence.
It is important to note that, in some cases, the FSA is now requiring firms to hold sufficient cash to cover the cost of an orderly wind down of the broker’s activities (potentially while in an insolvency process).
This is to ensure that client moneys could be paid over to the appropriate party without dilution or damaging the efficacy of the client money trust account and to facilitate a transfer of business to alternative service providers so that there is no gap in clients’ cover.
Brokers under the microscope
On the back of this, the FSA is performing its own assessments of a broker’s TC4 scenarios and assumptions and in some cases putting a loading on the capital and cash calculations arrived at by brokers in a similar way that they load insurance company capital requirements – effectively introducing a risk-based capital requirement.
The amount of cash required to be held could vary in similar-sized brokers, depending on the nature and complexity of their business model and contractual agreements and could be substantial in some cases, given that it may take a considerable period of time to wind down the business particularly for firms operating in the London Market, where the servicing tail could be long.
The implications for brokers are twofold. First, in terms of higher capital requirements, which will depend on the scale and complexity of the business. The cost of this will depend on the broker’s cost of capital. And secondly in terms of the work required to conduct a thorough assessment.
Management needs to set aside sufficient time to undertake the appropriate analysis and demonstrate appropriate governance around the assessment, which should be owned by the board and who may require expert advice and challenge.
It goes without saying that the more risk focused and robust the process undertaken by the broker, the lower any potential capital loading may be.
Like many other areas, TC4 is being used by the FSA as a barometer of regulatory compliance, and getting this right and creating a defensible position should be high up the board agenda.
Mark McIlquham is a Deloitte partner, leading the general insurance regulatory team and Richard Bevan is Deloitte restructuring director