Client money on trust

More than two years after the introduction of the regulation of general insurance sales, the client money rules and related compliance problems continue to trouble the general insurance market.

The regulator’s own thematic reviews have revealed continuing failures of firms’ systems and controls in this area.

The issue of client money handling has also been raised by Lord Davidson QC in his review of the implementation of EU legislation.

His recent report is critical of the detailed requirements which go beyond the Insurance Mediation Directive (IMD) and he recommends the FSA rules be reduced and simplified in line with the movement towards more principles-based regulation.

Although statutory recognition for the title ‘insurance broker’ disappeared with the repeal in 2001 of the Insurance Brokers (Registration) Act 1977, their role as professional intermediaries in the expanding UK financial services market is increasingly significant.

Brokers continue to act on behalf of their clients in arranging cover and providing advice on the suitability of products within the marketplace.

The way in which brokers conduct their business varies enormously depending, for example, on the structure of the firm, the nature of agency agreements, market specialisations, trading platforms and customer profiles. Essentially, in bringing together buyers and sellers of insurance, they transfer money between customers and insurers.

In the normal course of business, money they collect from customers is passed, at the appropriate time, to the respective product providers net of any commission due to the firm.

In the process, substantial funds may be held by the firm pending payment to providers. (Funds held can also include premium refunds and, occasionally, claims settlements due to customers.)

Brokers have always recognised the need to safeguard the potentially large sums of money held in the course of transactions. They have a legal duty to clients and to insurers to do so.

However, there is a risk that money paid by, or payable to, the client might go astray if the money is mishandled within the business or in the case of insolvency. The FSA rules have been devised to address that risk.

Brokers regulated by the former Insurance Brokers Registration Council (IBRC) or by the General Insurance Standards Council (GISC) were subject to strict but relatively simple requirements concerning the handling of all money held in the course of an insurance transaction (referred to as ‘insurance money’).

Inappropriate use

Specific rules requiring segregation of insurance money in an Insurance Bank Account (IBA) prevented the inappropriate use of that money, but it did not protect it from other creditors in the event of failure of the firm. The need for the creation of a suitable form of insurance broking trust account was recognised and relevant proposals put forward by the IBRC in 1997.

The council’s abolition was announced by the government before the requisite changes could be effected.

Compliance monitoring by the IBRC was based on an annual return signed off by the firm’s auditors (Form 5) and the submission of audited accounts which were individually scrutinised. The GISC examined detailed returns, required an auditor’s report in certain circumstances and carried out various on-site monitoring visits.

All former regulatory arrangements for handling insurance money were superseded when the FSA imposed its wide-ranging requirements under the Client Assets Sourcebook.

In response to the money handling requirements of the IMD, the FSA introduced the concept of risk transfer agreements between insurers and intermediaries, whereby money paid to an intermediary for an insurance policy is regarded as having been paid to the insurer.

Where risk transfer is not applicable, the money (known as ‘client money’) must be segregated in a client trust account operated by the intermediary.

The rules are detailed and prescriptive, enabling firms that have permission to hold client money to operate either or both types of trust account.

The statutory trust accouns does not allow the intermediary to make advances of credit to clients. Therefore, payment of premiums to the insurer can be made only from cleared funds received from the customer.

The non-statutory trust account allows advances of credit so that, where appropriate, money can be used to make payments to insurers or clients from pooled funds held in account.

Firms using non-statutory trust accounts are required to implement strict systems and controls and must hold a higher level of capital resources than if they operated using statutory trust accounts.

Under FSA rules, intermediaries may adopt a single method of handling money or a combination of risk transfer and trust accounts, subject to compliance with the detailed rules in CASS 5.

There has never been a standard form of agency agreement or consensus as to the treatment of premiums handled by intermediaries on behalf of insurers.

The IMD and subsequent FSA regulation prompted insurers to review their approach ‘ ‘ to premium collection and their relationships with intermediaries in general.

This led to virtually all insurers revising and updating their agency agreements, but the resulting terms of business still varied significantly in detail, particularly with regard to the money-handling requirements.

Brokers were forced to make a decision as to whether they should rely entirely on risk transfer, and thereby avoid the need to maintain client trust accounts.

That choice would affect the scope of their permission from the FSA and many others. For example, their terms of business with clients, their capital resources, their internal accounting systems, their regulatory reporting arrangements and the nature of their management systems and controls.

In ever-changing market conditions, the decision to operate client money accounts or not is a crucial one as it affects brokers’ flexibility in dealings with clients and product providers.

Money held by intermediaries under risk transfer arrangements falls outside the detailed client money rules unless it is

co-mingled in client money accounts. Insurers and other product providers therefore stipulate their own requirements (under their terms of business with the broker) to ensure money is safeguarded.

Some insurers simply require that insurance money be banked separately in trust for the insurer or product provider. Others allow risk transfer money to be co-mingled alongside client money in the broker’s client money trust account subject, as required by the rules, to the subordination of their interest in the account to clients of the firm.

According to the rules, all money in co-mingled accounts, including insurers’ money, is then treated as client money and is therefore subject to the full force of the client money rules including the regulatory audit and reporting requirements.

The FSA has pointed out that some brokers are operating client money accounts which contain purely insurers’ money and suggested that they should relinquish their permission to hold client money.

Again, a decision needs to be made by the firm dependent upon whether it is likely to handle any ‘true’ client money in the future – for example, in placing business with an insurer or product provider where there is no formal risk transfer arrangement.

If a firm does not have permission to hold client money it will usually operate one or more ‘insurer money’ accounts to handle money under risk transfer arrangements. Such accounts may be established under trust deeds, but fall outside the client money rules (hence FSA reconciliation, audit and reporting requirements do not apply).

The lack of any consistent approach by insurers with regard to money handling arrangements appears to have led to confusion among intermediaries as how best to comply.

Different agencies

Typically, brokers operate up to 40 different agencies under varying terms of business with insurers and other product providers. The terms of business differ, for example, as to whether risk transfer applies and the form of account needed to hold monies in the course of a transaction.

Therefore, the process of establishing and maintaining efficient and compliant money-handling arrangements can be complicated.

Firms encounter practical difficulties associated with the client money rules in a number of areas, for instance:

• Recognising when funds from cheques and credit card payments have cleared to facilitate onward payment via a statutory trust account

• The need to separate fees and charges which are generally paid with the premium as mixed remittances

• Processing single payments from clients which cover a number of products or services which may be subject to client money and/or various risk transfer requirements

• The timing of commission withdrawal

• Reconciliation of client money accounts, in particular the client money calculation when the firm holds both client money and non-client money and where money is held by third parties

• Tracking client money through chains of intermediaries.

Reconciliation problems can be exacerbated by software systems that are unable to fully support compliant procedures. There are particular difficulties in connection with product supply chains whereby brokers may be unsure to what extent risk transfer applies and whether they are responsible for client money. The accuracy of the all-important regulatory client money calculation can be affected by this.

The obligations on firms with regard to the non-statutory trust account and the intricacies of the trust deed itself, including the requirement to obtain clients’ informed consent to the use of such an account, tend to discourage many firms from utilising the non-statutory trust account option.

There are particular problems in establishing the equivalent of non-statutory trust accounts in Scotland.

A degree of nervousness exists in the market with regard to the extent of management systems and controls expected by the FSA in relation to trust accounts generally and there remains considerable uncertainty among firms (and in some cases, their accountants/auditors) as to the client money audit process.

Fundamental issues as to the protection afforded to insurance money, which stem from the current widespread reliance on the risk transfer mechanism, deserve consideration.

Insurers’ money held in the course of a transaction can escape prudent control. Many intermediaries qualify for the small firms audit exemption and, if they do not operate client money accounts, are unlikely to undergo any independent financial assessment. There is no evidence that insurers systematically monitor how their money is handled.

As customers themselves are not party to risk transfer agreements, redress from an insurer in the event of intermediary default might not always prove easy to pursue.

Risk transfer agreements entered into between UK intermediaries and unregulated or overseas insurers could prove impossible to enforce.

Over-prescriptive

There is a groundswell of opinion that the client money rules are over-prescriptive. In setting out to protect customers through rigid controls over the way brokers handle premiums, the regulator may have lost sight of the fundamental requirement for firms to ‘balance their books’.

For brokers, that means the total of insurance transaction assets (money held in the firm’s trust accounts plus amounts due from insurance debtors and approved short-term assets) should equal or exceed the insurance transaction liabilities (the amount owed to insurance creditors and any advances on the trust accounts).

The current form of the regulatory return (RMAR) does not specifically address this essential balance, which would clearly demonstrate solvency.

The introduction of simplified client money requirements better aligned with commercial and accounting practice would undoubtedly complement the move towards more principles-based regulation.

At the same time there could be more effective protection for all money held in the course of insurance transactions and many of the compliance problems which vex businesses throughout the land could be eliminated. IT

Ann Peel is head of technical services at the Institute of Insurance Brokers