Insurance intermediaries must take care with CASS
The FSA's avowed intention to zero in on insurance intermediaries' client money systems and controls should set alarm bells ringing.
Although the warning was issued by passing reference to future thematic work in the FSA's policy statement on auditor's client assets report in March (PS 11/5, at page 8), the FSA's intention is clear. Here, I outline firms’ obligations under CASS 5 and possible consequences of failure.
Following a year in which big fines have been imposed by the FSA for breaches of the client money rules, it has confirmed that “the protection of client assets will remain a regulatory priority" and that it plans to continue to develop its policy initiatives in order to ensure its client assets and money rules (CASS) provide "the desired level of client protection, financial stability and market confidence". Until now, the regulator has largely focused its attention on investment firms but it has now identified insurance intermediaries as its next target, warning that future policy work will focus upon a review of CASS 5 – the rules on client money for insurance mediation.
What can insurance brokers expect?
The FSA has punished firms that fail to segregate firm and client money correctly or that are unable to monitor and assess the adequacy of their client money arrangements due to weaknesses in the information provided to senior management.
JP Morgan Securities - In May 2010, the FSA imposed its current record fine of £33.32 million on JP Morgan Securities for failing to segregate and adequately protect client money held by its futures and options business with JP Morgan Chase Bank for a period of seven years following the merger of JP Morgan and Chase. The level of penalty was based on the misconduct not being deliberate and the fact the firm self-reported on discovering the issue and immediately remedied the situation. By working constructively with the FSA during the course of its investigation, the firm qualified for a 30% discount. However, it was still fined 1% of the average amount of unsegregated money it held during the relevant period.
Barclays Capital - In January of this year, Barclays Capital was fined in excess of £1.1 million (after a 30% discount) for failing to arrange adequate protection for its clients' money in that, on an intra-day basis, it failed to segregate client money held in sterling money market deposits in a separate trust account, instead co-mingling the client money with its own funds in breach of the CASS rules. Once again, the FSA took into account that the misconduct was not deliberate and that the firm rectified the situation on discovery.
ActivTrades - BarCap was followed in March by ActivTrades, a foreign exchange broker, fined £85,750 for similar failures. Interestingly, ActivTrades' infringements were discovered as part of an FSA thematic review into the management of client assets and money held by the firm. As a result of the FSA's initial findings, the firm was required to appoint a s. 166 skilled person to review its client money systems and controls. The skilled person's report highlighted that, on several occasions, client money was mixed with the firm's money and that, among other serious failings, the firm had not performed client money calculations or reconciliations accurately and failed to pay interest on client money.
In addition to the enforcement proceedings brought against the company, in May David McGrath, the CF10 responsible for compliance oversight at ActivTrades, was fined £3,000 for breaching Principle 7 of the Statements of Principle for Approved Persons, which obliged him to take reasonable steps to ensure that the business for which he was responsible complied with the relevant requirements and standards of the regulatory system, and he was made the subject of a lifetime prohibition order. The FSA considered McGrath's failings to be serious for a number of reasons. These included: (i) he was the compliance officer and therefore was responsible for ensuring the business complied with regulatory requirements and standards; (ii) the firm's client money deficiencies were identified by third parties rather than by compliance monitoring; and (iii) McGrath relied on an external consultant for guidance with regard to client money matters but did not consider the adequacy of this advice or whether it was reasonable for him to rely on it.
While the CASS breaches identified in these enforcements related to CASS 7 (investment business), they provide a good indication of the way insurance intermediaries may be treated by the FSA in the event that a firm's client money systems and controls are found not to comply with its regulatory obligations. In order to calculate the financial penalty, the FSA will consider a number of factors, including the amount of client money held. As a general rule of thumb, the penalty will be equivalent to 1% of the average amount of unsegregated client money held by the firm during the relevant period.
Brokers' CASS obligations
In short, the FSA requires authorised firms that have permission to hold ‘client money’ to hold that money in a trust account. ‘Client money’ is money which, in the course of carrying on insurance mediation activity, a firm holds on behalf of a client (defined as a customer in the FSA Glossary) or which a firm treats as client money in accordance with the client money rules (CASS 5.1 to CASS 5.5). Monies held by an insurance intermediary on behalf of its client constitute client money. An insurer is not a client, so any money held by an insurance intermediary on behalf of an insurer will not be client money.
CASS 5 requires that the trust account in which an insurance intermediary holds client money must be either a statutory trust account or a non-statutory trust account. A statutory trust is brought about by operation of law under s. 139(1) of FSMA and creates a fiduciary relationship between the firm and its client under which client money is in the legal ownership of the firm but remains in the beneficial ownership of the client. A non-statutory trust is brought about by a firm electing to operate a non-statutory as opposed to a statutory trust account. A non-statutory account allows a firm to make credit advances, which enables a client's premium obligations to be met before the premium is remitted to the firm and, similarly, it allows claims and premium funds to be paid to the client before receiving payment of those monies from the insurance undertaking. While the use of a non-statutory trust account is more flexible, an insurance intermediary who operates a non-statutory trust account has a higher capital requirement.
For limited purposes and subject to certain restrictions, CASS 5 also allows for ‘risk transfer’ of money belonging to insurance undertakings to be deemed to be client money and held in an insurance intermediary's statutory or non-statutory trust account. In practice, if an insurance intermediary has entered into risk transfer terms of business arrangements with some but not all of its insurers, the insurance intermediary will be holding some client money and therefore be subject to CASS 5 obligations. However, if the insurance intermediary has entered into risk transfer terms of business arrangements with all of its insurers, then the insurance intermediary will not be holding any client money so CASS 5 will not apply.
Implications for brokers
The FSA's announcement that it wishes to focus on insurance intermediaries' client money systems and controls should set the alarm bells ringing. Insurance brokers who do not have adequate systems and controls in place may find themselves at a greater risk of facing FSA enforcement proceedings.
On 11 May the British Insurance Brokers’ Association (BIBA) published a speech given by their chief executive Eric Galbraith, on delivering the right regulation for insurance brokers. With regard to the protection of client money, he said that BIBA's research has highlighted this area as a significant risk. Galbraith commented that BIBA has "detected an appetite among insurers to find a solution, where monies can be held on a risk-transferred basis, outside the FSA rules, giving insurers, the regulator and customers comfort about the protection of money." In response to a recent FSA consultation, one respondent went even further and suggested that the FSA should mandate risk transfer for all general insurance intermediation business, preventing client money arising under CASS at all.
Moreover, the FSA has recently proposed a new fee-block for firms who hold client money and assets. However, insurance brokers who enter into terms of business agreements with insurers, all of which are on a risk transfer basis, will not hold client money for the purposes of the FSA rules and therefore will not be required to pay the new fee. In light of this, if the new fee-block proposal goes ahead (the FSA's consultation is in its early stages), insurance brokers will be even more enthusiastic to promote the use of risk transfer terms of business agreements.
Implications for insurers
While monies held on a risk-transferred basis may fall outside the scope of CASS and therefore benefit insurance brokers as they will not be required to comply with CASS 5 obligations and will not be subject to the new fee-block, there are a number of issues that insurers should consider, including:
- the risk of the insurance broker becoming insolvent;
- the losses that may be suffered if the quality of the insurance broker's client money record keeping is not adequate; and
- the losses that may be suffered as a result of employee fraud.
Insurers who grant ‘risk transfer’ can take advantage of the FSA rules' protections including the benefits of their money being held in a statutory or non-statutory trust account by contractually setting out terms which, in effect, require compliance with the CASS 5 obligations. If an insurance broker is not subject to the CASS 5 obligations, insurers must consider entering into contractual arrangements to ensure that money held by the insurance broker on its behalf is held on trust and is adequately protected (an issue which would be reviewed by the FSA when undertaking any insurer's ARROW visit).
Insurers should also make certain they have suitable record keeping and audit provisions that they can rely on in order to inspect insurance brokers' client money arrangements on an ad-hoc basis. In effect, such contractual arrangements may lead to ‘the privatisation of CASS’.
In any event, whether subject to the CASS 5 rules or not, insurance brokers and insurers need to be aware that the protection of client monies remains high on the FSA's agenda and that, in line with its credible deterrence strategy, the regulator will come down hard on those firms and individuals who do not implement adequate client money systems and controls.
A version of this article was published in Compliance Monitor's June 2011 edition.