Senior Pensions Consultant
Out-Law Guide | 10 Jul 2020 | 3:00 pm | 16 min. read
The most straightforward method is a simple fee arrangement between broker and client. More commonly, the broker earns a commission, which is agreed with the insurer but taken out of the premium paid by the insured. In some circumstances, the insurer and the broker may have entered into a further arrangement under which the broker received an additional fee or commission from the insurer for bringing in a certain volume of business or reaching agreed profit targets. This is sometimes known as a contingent commission, placement service agreement or market service agreement.
Insurance brokers are also increasingly generating revenue by entering into services agreements with insurers which sit alongside placement service agreements. Under these services agreements, a broker may provide the insurer with services such as data provision, data analytics, consultancy-style reports on specific sectors, insurer feedback services and discussions of pipeline business.
On 1 October 2018, the Financial Conduct Authority (FCA) introduced important changes to the regulation of the UK's insurance broker remuneration regime to implement the objectives and requirements of European Directive (EU) 2016/97 on insurance distribution (the Insurance Distribution Directive or IDD).
The IDD is intended to further the general aim of promoting a level playing field in insurance and reinsurance distribution across EU member states. It is also aimed at ensuring that consumers benefit from an appropriate level of protection, regardless of the distribution channel through which they purchased an insurance product, and to create a level playing field and competition on an equal footing amongst insurance intermediaries.
In implementing the IDD, the FCA also intended to create an environment in which consumers were sold insurance products which better met their needs and were given better product information, thereby allowing consumers to have a greater level of confidence in their insurance purchasing decisions.
The FCA also considered insurance broker remuneration as part of its wholesale insurance broker market study, which ran from November 2017 until February 2019. The FCA's market study was launched in response to reporting competition concerns in the wholesale insurance broker market. Although the study did not find evidence of significant levels of harm to competition, it did identify certain areas which, in the FCA's view, warranted further action, notably around conflicts of interest, disclosure to clients and certain contractual agreements between brokers and insurers.
The FCA concluded that these concerns were not significant enough to require the introduction of intrusive remedies, but would instead be managed through market monitoring, normal FCA supervisory activities and ensuring firm compliance with their competition obligations.
When a broker places insurance, it is usually assumed that they are acting as an agent of the prospective insured, with their relationship based on agency law and a fiduciary duty arising between the broker and the insured. As agent, the broker must act in good faith in what they believe to be the interests of the insured at all times. The broker must account for any secret profit that they make, and they are not allowed to put themselves in a position in which their interest and duty conflict.
In implementing the IDD in the UK, the FCA intended to create an environment in which consumers were sold insurance products which better met their needs and were given better product information, thereby allowing consumers to have a greater level of confidence in their insurance purchasing decisions.
More specifically an agent must not acquire any profit or benefit from the agency agreement without the insured's knowledge, other than that contemplated by the insured at the time they entered into the contract. Where a broker is found to have breached a fiduciary duty, anyone knowingly assisting in the breach of that duty - such as an insurer - can also be held directly liable to the insured.
Insurance intermediaries who act only for the insurer, such as aggregators or tied agents, are not acting as the agent of the insured, and so will not owe the insured any fiduciary duties.
All insurance brokers and intermediaries must abide by the requirements of the FCA's Handbook, including those in the Insurance Conduct of Business Sourcebook (ICOBS).
A simple fee arrangement is perhaps the least problematic form of broker remuneration in terms of transparency and potential conflict of interest, since the amount will be negotiated and agreed between broker and insured.
Under the IDD rules, the broker must notify the insured of the nature and basis of the remuneration – i.e. that it is a fee paid by the insured – in good time before the conclusion of the initial contract of insurance and, if applicable, on its amendment or renewal (ICOBS 4.3.-7R).
In addition to the new requirements, and in accordance with the position before the introduction of the IDD, the broker must also provide the insured with details of the fee, or the basis of calculating any fee, before the insured incurs any liability to pay, or before the conclusion of the insurance contract, whichever is earlier (ICOBS 4.3.1R). This extends to all fees charged over the lifetime of the contract, but not to premiums or commissions or any other type of remuneration that is not payable directly by the insured.
A key component of a broker's remuneration is commission, in the form of a deduction of a sum from the premium paid to the insurer by the insured. Notwithstanding that the broker is the agent of the insured, it is generally accepted that it is the insurer who is liable to pay the commission for all practical purposes.
One of the main concerns with commission arrangements is their lack of transparency. Under current market practice, the insured is likely to have only a vague idea of the amount of commission the broker will earn for placing a contract on their behalf. While the first draft of the IDD required mandatory prior disclosure of the amount of commission earned by insurance intermediaries, this proposal did not survive to the final draft, which merely requires an insurance intermediary to disclose the type or nature of their remuneration.
Of course, individual EU member states are able to impose stricter requirements than those mandated by the IDD. Following the Supreme Court's decision in the 2014 Plevin case, in which an intermediary failed to disclose commission payments earned in the sale of payment protection insurance, the FCA consulted on whether to introduce additional UK commission disclosure rules which went beyond those in the IDD. Following broadly negative feedback to the proposal, it said that it would instead monitor developments in this area.
Until the IDD, disclosure of remuneration to consumers was unregulated. The new rules require the broker to notify the client of the nature and basis of the remuneration received in relation to the contract of insurance in good time before the conclusion of the initial contract of insurance and, if necessary, on its amendment or renewal (ICOBS 4.3.-7R). When consulting on the rules, the FCA said that it viewed "nature" as requiring firms to disclose the type of remuneration - for example basic commission, bonus, profit share or other financial incentive - while "basis" requires firms to disclose the source of remuneration. The guidance in ICOBS 4.3.-4G is therefore that the disclosure includes the type of remuneration and its source.
The FCA has also clarified that remuneration that relates to the insurance contract "has a direct connection to the insurance contract being sold" (CP 17/07, para 5.23). This will include remuneration provided indirectly by the insurer or another firm within the distribution chain, or provided by way of a bonus paid to the broker or to another firm which is contingent on achieving a target to which the particular insurance contract could contribute (ICOBS 4.3.-3G). Examples include cash bonuses for achieving a sales target, additional annual leave for achieving a high customer service score on sales calls, profit share arrangements, overrides or other enhanced commissions.
In addition, firms should "ensure they disclose the information in a way that is useful to their customers in showing the relationship between firms in the distribution chain, and in highlighting potential conflicts of interest" (CP 17/07, para 5.23). The FCA provided example wording in its consultation paper.
This disclosure rule extends to any payments, other than ongoing premiums and scheduled payments, during the lifetime of the contract. This includes mid-term adjustments, administration fees and cancellation fees.
The IDD has also resulted in changes to the rules on how information is communicated to a customer. A firm must provide the information either on paper, through a durable medium or on a website, so long as the website meets the "website conditions" laid out in the FCA Handbook (ICOBS 4.1A 2R). 'Durable medium' is defined as any instrument that enables the customer to store information addressed personally to them. Examples of a durable medium may include email or a secure area on the product provider's website, if certain conditions are met. If a firm chooses to provide the information by "durable medium" or by means of a website, it must also send a paper copy free of charge, if the customer so requests (ICOBS 4.1A.3R). If a firm chooses to provide the information on a website, regardless of whether or not it satisfies the conditions of a "durable medium", the firm needs to obtain the customer's "active and informed choice or consent" to receive the information in this format (ICOBS 4.1A.4R). A pre-ticked box which is more prominent than the other unticked options or simply not providing any other options is not sufficient.
If a consumer asks for additional information about commission, such as the amount, the broker is not obliged by the regulations to respond – although ICOBS reminds firms that the disclosure rule is additional to the broker's legal obligations as agent of the insured, including the duty to account for any secret profit and avoid conflicts of interest. The guidance also states that if a customer wants to know the amount of the remuneration, the firm must disclose it.
ICOBS only requires a broker to disclose the amount of their commission to a commercial customer if the customer requests it (ICOBS 4.4). The broker should include all forms of remuneration from any arrangements it may have including profit sharing, payments relating to the volume of sales and payments from premium finance companies in connection with arranging finance. The rule is in addition to the general law on the fiduciary obligations of an agent. These rules are unchanged by the IDD.
The FCA's market study identified certain inconsistencies in disclosure; with some firms disclosing all types of commission and their amounts voluntarily and others more selectively and only on request. In response, the FCA advised firms to "consider the information needs of their clients, and to communicate information to them in a clear, fair and not misleading way".
The fact that a broker may be earning additional commission if they bring business to a particular insurer gives rise to a potential conflict between the broker's commercial interests and the objectivity of the advice provided to their client.
There is no regulatory ban on offering or accepting "inducements" - that is, any benefit offered with a view to the recipient adopting a particular course of action. However, insurers and intermediaries are reminded of FCA Principle 8 - the requirement to manage conflicts of interest fairly – and that this extends to soliciting or accepting inducements that would conflict with a firm's duty to its customers (ICOBS 2.3.1G(1)). Receiving an inducement "other than a standard commission or fee for the service" is flagged up by the FCA as one of the warning signs of a potential conflict of interest.
A firm should also consider whether offering inducements conflicts with its obligations under Principle 1 (to act with integrity), Principle 6 (to treat customers fairly), and following the entry into force of the IDD, the customer's best interests rule, which requires a firm to act honestly, fairly and professionally in accordance with the best interests of its customers (ICOBS 2.5.-1R). The fact that the broker's client may not be aware that the broker is earning additional commission also raises the question of whether such payment might breach the broker's duty to account for any secret profit.
The IDD introduced a special rule for insurance brokers' remuneration. Insurance distributors must not be remunerated, or remunerate or assess the performance of their employees, in a way that conflicts with their duty to comply with the customers' best interests rules (ICOBS 2.5.-1R) in relation to both general and life insurance. In particular, an insurance distributor must not make any arrangements by way of remuneration, sales targets or otherwise that could provide an incentive to itself or its employees to recommend a particular contract of insurance to a customer when the insurance distributor could offer a different insurance contract which would better meet the customer's needs.
In November 2019, the FCA published guidance for insurance product manufacturers and distributors in general insurance distribution chains in order to clarify its expectations of firms in the general insurance and pure protection sector following IDD changes related to product oversight and governance and broker remuneration. Remuneration is defined broadly and includes "revenue from commission, profit share agreements, fees and all other economic or non-economic benefits received as part of the distribution of an insurance product". Remuneration which could conflict with the customer's best interests rule includes remuneration which incentivises the firm to offer a product which is not consistent with the customer's demands and needs, or where the remuneration does not bear a reasonable relationship to the costs of the benefits and services that the broker provides to the customer. This will capture inducements, as well as fees received directly from the customer.
Brokers are expected to monitor the products they distribute and their distribution arrangements on an ongoing basis to identify situations where the product is not providing the intended value to customers, including where the level of remuneration they are receiving impacts the value of the product so that it becomes inconsistent with the customer's best interests rule. Examples of potential poor value include:
Brokers are expected to inform the manufacturer in this scenario and, if necessary, amend the way they distribute products, for example by stopping the use of a particular distribution method, reducing their remuneration or ceasing to distribute the product. Manufacturers are expected to consider information available to them and to obtain information on fees charged by other parties in the distribution chain in order to identify poor value and, where that is the case, to consider whether the product distribution strategy may need to be changed.
When identifying potential conflict situations ... it is not enough that a firm may gain a benefit if there is not also a possible disadvantage to a client.
Crucially, unlike in situations which give rise to potential conflicts of interest, disclosure cannot be relied on as a satisfactory means of discharging the firm's obligations under the remuneration rules.
The FCA's conflicts of interest rules at SYSC 10 are aimed at helping insurance intermediaries identify conflicts and set up procedures to deal with them effectively. The IDD did not substantially change the conflict of interest rules which apply to general insurance intermediaries, although a new set of conflict of interest rules for insurers has been added to SYSC 3.3.
When identifying potential conflict situations, firms are advised to take into account, as a minimum, whether:
This last proviso distinguishes standard commissions and fees from inducements, but may raise issues as to what is "standard". It is not enough that a firm may gain a benefit if there is not also a possible disadvantage to a client.
The IDD introduced a further rule requiring a broker to consider the interests of a person directly or indirectly linked by control to the firm.
Guidance for the commercial insurance market by the FCA's predecessor, the FSA, gave examples of circumstances where conflicts are more likely to arise. These included corporate hospitality and gifts, claims handling and binding authorities, training support provided by the insurer, 'soft' loans from the insurer at below market terms and where insurance placement is used to encourage the insurer to use the same intermediary to place its own reinsurance. Although the FCA has not maintained this guidance, these are useful examples to bear in mind.
The FCA market study drew attention to the fact that brokers designing facilities that different insurers can participate in, and acting as managing general agents (MGAs), can give rise to a conflict of interest when they choose where to place the client's risk. The FCA found that "brokers receive higher remuneration rates from placing risks into their own facilities and MGAs than in the open market" and that this was a "relatively small, but growing, proportion of the whole market", with 8% of gross written premium being placed through facilities. Consultancy-style services agreements could also lead to a conflict of interest for brokers. The FCA did not find a robust correlation between the share of business that insurers win from brokers and the fees that they pay under placement agreements and services agreements, but concluded that it would continue to monitor compliance with the existing conflicts of interest rules.
Where a firm is unable to manage a conflict adequately, it must disclose this to the client before undertaking any of that client's business. Failing to manage a conflict means not being reasonably confident that any risk of damage to the client's interest has been prevented.
The disclosure must:
Firms are also warned not to use disclosure as a means of getting around the requirement to manage conflicts appropriately.
Firms should carry out a thorough risk assessment of their business to identify those activities which have the potential to give rise to conflicts of interest and to assess the risk of such conflicts actually arising. They should then decide what control systems are needed, and who in the management team is responsible for overseeing and reviewing those systems.
The IDD introduced a new proportionality rule: a firm's organisational administrative arrangements for managing conflicts of interest must be proportionate to the activities performed, the policies sold and the type of insurance distributor the firm is. The IDD also introduced a rule requiring a broker to ensure that its management body receives on a frequent basis, and at least annually, written reports on recorded conflicts of interest.
Under common law, a consumer client will be deemed to have knowledge of a broker's "normal" commission, provided it is not excessive, but this may not apply to contingent commission or an inducement. Unless he discloses the fact (and probably the amount) of any contingent commission or inducement, the broker could face a secret profit claim.
In Wilson v Hurstanger 2007, a loans broker whose consumer clients were made aware that he might receive an additional commission from the lender (on top of his normal fee), was found by the Court of Appeal still to be in breach of duty because, without knowing the actual amount, his clients could not give their informed consent to the potential conflict of interest.
The Court of Appeal noted that there was no clear authority to say that it was an agent's duty to disclose the actual amount, but, taking into account that borrowers in this particular market were likely to be vulnerable and unsophisticated, it concluded that disclosure of the amount was necessary "to bring home to such borrowers the potential conflict of interest".
This was not an insurance case, but might by analogy apply to an insurance situation. In most types of retail insurance, however, the amount of contingent commission earned per consumer is likely to be very low (far lower than the £240 in Wilson v Hurstanger), making it less likely that such a claim would be brought - at least on an individual basis.
A successful claim, however, could result in the broker being ordered to pay the insured the amount of commission earned in excess of the market norm. Arguably, the court could order the broker to repay the entire brokerage earned on the account.
Insurance intermediaries who do not act as agents of the insured, such as aggregators or tied agents, will not owe fiduciary duties to the insured so no duty to account will arise.
The disclosure rules for sales of 'pure protection' products - critical illness, income protection and non-investment life insurance - under ICOBS changed at the end of 2012 as a consequence of the FSA's Retail Distribution Review (RDR). The IDD does not affect these rules.
See our Out-Law Guide: the RDR and pure protection products.
The FCA is currently reviewing the RDR and the associated Financial Advice Market Review (FAMR), to ensure that the current rules regulating the provision of advice and guidance in respect of pure protection products meet current consumer needs and remain fit for purpose. The FCA anticipates publishing its final report on this review in the second half of 2020.
Co-written with Charlotte McIntyre and Daniela Ivanova, also of Pinsent Masons.
27 Apr 2015
Senior Pensions Consultant