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Types of remuneration
Insurance brokers acting on behalf of an insured can be paid for their services in a variety of ways. The most straightforward is a simple fee arrangement between broker and client. More commonly, however, 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 whereby the broker receives 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.
In recent years, the issue of commissions, particularly contingent commissions, has raised difficult questions about lack of transparency and the potential for conflicts of interest between broker and client.
When a broker places insurance, it is usually assumed that he is acting as agent of the prospective insured. As agent, the broker has a legal duty to act in good faith in what he believes to be the interests of his client. This means he must account for any secret profit that he makes, and he is not allowed to put himself in a position in which his interest and duty conflict.
More specifically, an agent must not, without his client's knowledge, acquire any profit or benefit from his agency other than that contemplated by the client at the time client and agent entered into their 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 broker's client.
Other types of insurance intermediary, such as aggregators or tied agents, who act only for the insurer, 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, however, also abide by the FSA's Handbook, including the Insurance Conduct of Business Sourcebook (ICOBS).
At the heart of the Handbook lie the high-level principles for businesses (PRIN). Particularly relevant for brokers are Principle 8, which provides that "A firm must manage conflicts of interest fairly, both between itself and its customers and between a customer and another client" and Principle 6, which requires firms to treat customers fairly.
On 1st April 2009, insurance brokers and intermediaries also became subject to new rules and guidance on the effective management of conflicts of interest which form part of the systems and controls (SYSC) section of the Handbook.
In terms of transparency and potential conflict of interest, a fee arrangement is perhaps the least problematic form of remuneration since the amount will be negotiated and agreed between broker and client.
The broker must provide the client with details of any fee (or the basis of calculating any fee) before the client 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.
The main issue with a normal commission arrangement is transparency.
Under current market practice, the insured, at best, is likely to have only a vague idea of the amount of commission the broker will earn for placing a contract on his behalf. In December 2007, a report by CRA International found that, typically, mid-sized commercial insureds believe commission is around 10% when it is nearer 20%.
A wider question raised by the European Commission in its 2007 business insurance sector inquiry was the extent to which lack of transparency affects competition because commercial clients are unable to make informed decisions about which broker they use.
ICOBS only requires a broker to disclose his commission to a commercial customer if the customer requests it (ICOBS 4.4).
In March 2008, the FSA published a discussion paper putting forward options for reform, including mandatory disclosure of commission to commercial customers.
Following further research and discussions with trade associations, insurers and intermediaries, however, the FSA decided against the compulsory option. Instead, its feedback statement of December 2008 favoured industry guidance aimed at improving the information commercial customers are given during the sales process.
That guidance, published on 1st April 2009, was drawn up by the British Insurance Brokers' Association (BIBA), the London and International Insurance Brokers’ Association, the Institute of Insurance Brokers and the Association of British Insurers (ABI).
It has been given special "confirmed" status by the FSA, which means that the regulator will take into account whether a firm was acting in compliance with the guidance before considering taking any enforcement action against it.
In addition to expanding on the Handbook rules, the guidance suggests model wordings for disclosing whether the firm is acting for the customer, the insurer or both, the extent to which it will search the market for suitable products and how it will be remunerated.
The suggested template for remuneration disclosure identifies how the firm will be paid – by an agreed fee or by commission – how much that commission will be and any additional commission the firm will earn for arranging premium finance and/or as a result of an arrangement with the insurer, such as a profit share or volume commission.
Although intermediaries are still only required to disclose their commission on request, firms are advised to have written procedures in place to enable all relevant members of staff to respond to such requests promptly and accurately. Commercial customers should be reminded in writing at least every twelve months about their right to ask for this information.
The guidance also advises firms not to rely solely on making generic disclosures in their terms of business agreements, which can easily be overlooked during the sales process. It suggests raising customer awareness by setting out the most pertinent disclosures (such as status, capacity and remuneration) in a separate letter or single-page document accompanying the quotation or invitation to renew.
In oral sales, the firm should disclose the information orally and repeat the disclosure in writing as part of its post sale communication, as well as keep a file note of the conversation.
Consumer customers are not covered by the industry guidance. There is currently no provision in ICOBS for the disclosure of commission to consumers and the FSA says it has no intention to change this situation, at least not for general insurance sales.
If a consumer asks for commission information, 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.
But unless the amount of commission is excessive, a consumer client may have difficulty succeeding on a secret profit claim. Provided the level of commission is consistent with the market "norm" for placing that type of business, the client will be deemed to have knowledge of it (whether or not he actually does) so the broker will not be considered to have made a secret profit.
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 will change at the end of 2012 as a consequence of the FSA's Retail Distribution Review (RDR) (see: The RDR and pure protection).
The new RDR rules affect advice given to retail clients (broadly, consumers) about retail investments under the Conduct of Business Sourcebook (COBS), which applies to designated investment products and long-term life insurance business. The rules ban commission-based sales and require financial advisers to agree a fee (the adviser charge) with the client in advance.
Firms are, however, able to choose whether to sell pure protection products under ICOBS or COBS rules.
In order to maintain a level playing field between the two rulebooks, the FSA has confirmed that retail investment advisers selling pure protection products "associated with" investment advice will not have to apply adviser charging, whether the sale is made under COBS or ICOBS. This special rule will mean advisers will still be able to earn commission on the sale.
Firms will, however, be required to explain how they are paid for these pure protection services and to disclose the actual amount of commission received if the customer then goes on to buy a pure protection product.
For ICOBS sales, this marks a significant departure from the current disclosure rules, where there is no requirement to disclose commission to a consumer. The FSA, however, denies that it has changed its general approach to remuneration disclosure:
"For standalone sales not associated with investment advice, our view remains that the customer's main concern is the premium he will have to pay rather than his adviser's remuneration," its policy paper states.
"It is only in the specific circumstances where the customer is also paying an adviser charge that we are concerned confusion could arise about what the adviser charge covers. We think it is important that the customer understands the entirety of his adviser's remuneration in these circumstances."
The fact that a broker may be earning additional commission if he brings business to a particular insurer gives rise to a potential conflict between his commercial interests and the objectivity of the advice he provides his client.
The fact that the broker's client may not be aware that he is earning additional commission also raises the question whether such payment might breach the broker's duty to account for any secret profit.
Despite these concerns, the FSA's research into contingent commissions has shown that, although their use is widespread, they account for only about 1.5% of intermediaries' total income.
There is no regulatory ban on offering or accepting inducements (defined as any benefit offered with a view to the recipient adopting a particular course of action). But insurers and intermediaries are reminded of the Principle 8 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 2.3G).
Receiving an inducement "other than a standard commission or fee for the service" is flagged up as one of the warning signs of a potential conflict of interest in SYSC 10.
A firm should also consider whether offering inducements conflicts with its obligations under Principle 1 (to act with integrity) and Principle 6 (to treat customers fairly).
The normal rule about disclosing commission to commercial customers on request applies to all forms of remuneration, including arrangements for sharing profits, payments relating to the volume of sales, or payments from premium finance companies in connection with arranging finance (ICOBS 4.4).
The new industry guidance on transparency and disclosure advises firms to give their commercial customers regular written reminders about their right to ask for this information and to have procedures in place to ensure the firm is ready to respond to such requests.
The suggested wording for such disclosure specifically identifies any additional commission the intermediary may receive and explains how it will be earned, for instance for achieving pre-agreed profit or volume targets.
The model wording suggests stating the maximum additional amount the firm could earn (in percentage terms) should these targets be met, and the maximum extra commission (as an actual amount) that the firm could earn in respect of this particular policy.
As well as helping to keep firms on the right side of the regulator, following the industry guidance may also help to protect intermediaries from claims that they are in breach of legal duties owed to their commercial clients. A broker who discloses a contingent commission cannot be said to be making a secret profit.
It is less clear what the position would be if (in accordance with the guidance) a commercial customer is clearly reminded of his right to request commission information but chooses not to do so.
Without knowing that the broker is receiving a contingent commission (and arguably how much that commission is), it is difficult to see how the customer's failure to ask could amount to consent to the arrangement. Potentially, the broker could still be vulnerable to a secret profit claim.
In addition, of course, the guidance only applies to commercial customers. Intermediaries are currently under no regulatory requirement to disclose commission, contingent or otherwise, to consumers.
In 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. Unless he discloses the fact (and probably the amount) of any contingent commission, 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.
Detailed rules and guidance on managing conflicts of interest came into force for insurance intermediaries on 1st April 2009. The provisions in SYSC 10 are aimed at helping firms identify conflicts and set up procedures to deal with them effectively.
When identifying potential conflict situations, firms are advised to take into account, as a minimum, whether the firm is likely to make a financial gain at the client's expense, has a vested interest in the outcome of a transaction, an incentive to favour one client over another or will receive an inducement other than a standard commission or fee for the service.
This last proviso distinguishes standard commissions and fees from inducements, but may raise issues as to what is "standard".
There is also a new rule that, where a firm is unable to manage a conflict adequately, it must disclose this to the client before undertaking business for that client. Failing to manage a conflict means not being reasonably confident that any risk of damage to the client's interest has been prevented.
Firms are, however, warned not to use disclosure as a means of getting round the requirement to manage conflicts appropriately.
The recent industry guidance on transparency and disclosure includes advice on managing conflicts of interest as well as suggested wording for disclosing the intermediary's status, services and remuneration.
Firms are recommended to 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. It is also suggested that firms make conflict management a standing agenda item at board meetings.
The guidance gives examples of circumstances where conflicts are more likely to arise. In addition to profit share agreements and volume over-riders, these include corporate hospitality and gifts, claims handling and binding authorities, training support provided by the insurer, "soft" loans (where an insurer offers credit at below market terms) and where insurance placement is used to encourage the insurer to use the same intermediary to place its own reinsurance.
The message to intermediaries is clear - be proactive. "It is not sufficient to have informal management processes and controls to deal with potential conflicts of interest" the guidance states.
Firms need to be able to "demonstrate that the management of conflicts is a live and ongoing activity within the business and one that is championed by senior management and at board level".
The European Commission is currently reviewing the Insurance Mediation Directive with the specific aim of introducing clear and effective rules on managing conflicts of interest (see IMD2: the review of the Insurance Mediation Directive). These are likely to use the MiFID conflict of interest rules as a starting point.
In the UK, insurance intermediaries are already required to comply with MiFID-style rules under the SYSC 10 regime.
But it also seems likely that "IMD2" will include remuneration disclosure in some form.
Whether disclosure would be compulsory (rather than at the customer's request) and whether it would apply to all types of insurance and insurance customer is not yet clear. In a consultation paper published in November 2010, the Commission simply states that "requirements regarding a disclosure of remuneration could be introduced" but gives no further details.
The consultation runs until the end of January 2011 and the Commission plans to produce a revised text early in the year.
Contact: Alexis Roberts ([email protected] / 020 7667 0259)
Out-Law Legal Update