Industry welcomes FCA review of FSCS thresholds to mitigate ‘unintended unfairness’

It is not often that the Financial Services Compensation Scheme (FSCS) is a source of cheer for insurance brokers.

Over the years, the level of the scheme’s levy has caused constant gripes from the sector. The scheme’s overall compensation costs have ballooned over the past decade from a typical figure of £200m to £300m per annum to £717m in 2021/22.

However, brokers’ complaints finally seem to be landing with the regulator – as demonstrated by a paper snuck out by the FCA in the run up to Christmas.

Published on 14 December 2022, the Compensation framework review: Response to feedback and next steps document outlined how the FCA – which sets the framework for the FSCS – believes the funding for compensation claims should work in the future.

Each type of financial service activity, such as insurance broking, is allocated its own funding class to help to meet the costs of compensation claims.

The underlying principle of this approach is that “as far as possible”, companies are paying for the cost of the failure of firms that conducted similar business.

The FSCS defines the overall threshold or amount of compensation each funding class should provide - in the case of insurance broking, this is currently set at an annual figure of £310m.

If the level of compensation claims within a particular funding class exceeds the sums collected in a given year, allied companies will be called upon to make up the difference.

Insurance brokers are lumped into the FSCS’ retail pool alongside other types of intermediaries, such as those dealing with pensions and life products.

However, many insurance brokers feel that they are being made to carry the can for the failures of companies in some of the pool’s other sectors – a topic that broking trade body Biba has advocated on in its annual manifesto for several years now, based on member feedback.

‘Bailing out’ other intermediaries

The FCA’s December report said the retail pool had been triggered four times over the last 10 years.

It acknowledged that this has created “frustration” and “dissatisfaction among certain firms which have been required to fund the cost of failed firms which they do not associate themselves with”.

This activity included a £23m payout in 2020/21 from the general insurance distribution funding class, which insurance brokers are in, to cover firm failures in the life distribution and investment intermediation pot due to claims exceeding the latter’s £330m threshold figure.

According to a prior FCA report published in December 2021, contributions to the general insurance distribution class have increased by around 466% since 2019/20.

The primary driver behind these increased costs, according to the FCA, is the life distribution and investment intermediation class - chiefly relating to the explosion in compensation claims against advisors over self-invested personal pensions.

Last year’s feedback statement from the FCA acknowledged that many financial services firms no longer view the FSCS as fund of last resort, which is its stated objective.

Of the calls made on the retail pool, 52% of funding has come from the general insurance distribution pot, noted David Sparkes, head of compliance and training at Biba.

“If it does go wrong in the retail pool, it hits [brokers] hard in the pocket,” he added.

At the launch of Biba’s 2022 manifesto last January, the association’s chief executive, Steve White, said that general insurance brokers were not “chipping in” but “bailing out” other types of intermediary firms.

This manifesto stated that “no other regulatory regime in the world exposes general insurance intermediaries to the risk of paying for failures elsewhere in the financial services sector to the extent that we have now in the UK”.

Meanwhile, Biba’s 2023 manifesto - published on 24 January 2023 - is pleased by the FCA’s recent consideration of the FSCS funding approach.

It read: “We welcome the FCA feedback statement and [its] forthcoming review of the funding class thresholds to consider whether the class thresholds remain at an appropriate level.

“A fairer system of ‘polluter pays’ would see those sectors that are making claims contribute a fairer share.”

Review set to dig deeper

Smaller general insurance brokers, in particular, lack the financial ballast to cover the vast compensation sums that other types of intermediary activities can give rise to.

Sparkes explained: “The insurance broker market is made up of small firms and small firms don’t have the reserves you might expect from a major bank, for example.

“Insurance brokers appreciate that they may have to chip in [to cover firms’ failures] on occasions, but there’s no endless pot of money.”

The degree of one-way traffic that currently takes place in the general insurance pot “undermines the rationale for that [retail] pool”, Sparkes added.

Although December 2022’s FCA report noted that “material changes” are not needed to the FSCS’ underlying compensation framework, it did emphasise that the current funding classes must be reviewed to avoid “unintended unfairness”.

This review – which will most likely take place over the next financial year – will look at how the funding classes are constituted, the risks they are exposed to and firms’ ability to meet compensation costs.

Through this analysis, the FCA aims to ensure that the thresholds for each class are set at an “appropriate” level in order to minimise the frequency of calls on the retail pool.

The exercise will also consider whether periodic reviews of the class thresholds are feasible and whether a compensation cap on pension claims should be introduced.

“We will progress the key actions set out in [the] feedback statement over the next year,” the FCA confirmed.

“We expect to consult on any proposed changes to the compensation rules during 2023/24, with a view to confirming any changes by the end of that financial year.”

‘Simply unfair’

Sparkes said the FCA’s review of the compensation framework is “very positive” for brokers.

Branko Bjelobaba, principal at compliance consultancy Branko, agreed. He added: “Insurance brokers and intermediaries should not be lumped in a class of other advisors that they really have nothing to do with.

“When the odd independent financial advisor goes down and leaves a lot in their wake, many others have to pick up the compensation payable and it is simply unfair to expect those that don’t touch this space to have anything to do with it.

“There is a need to review the current funding classes to ensure thresholds remain appropriate and do not result in unintended unfairness.”

But brokers won’t necessarily get all they want out of the FCA’s review, continued Sparkes.

He said: “You’ll never get all firms being happy with one or other alternatives. There’s an element of resistance.

“For example, if we say we want general insurance [brokers] to pay less, that means investment intermediation has to pay more.”

However, after many years of escalating costs, brokers may at last see some relief on their FSCS bills in the short term.