Insurance Broker's Regulation

Insurers and reinsurers have been receiving letters from brokers telling them to agree to the terms of their TOBAs or the brokers won’t be able to do businesswith them. Brokers do notwant to run the risk of non-compliance with the FSA rules particularly in the light of the ‘Dear CEO’ letter. In many cases, no consideration has been given to individual business relationships and no negotiation has been entered into.
Amidst all the confusion, it has been forgotten that in order to understand the rules, you must go back to basics.

The basics
A broker acts as the agent of its client, the insured, and the law of agency governs the relationship under which the broker acts as the insured’s agent. It follows that where a broker holds premiums and claims monies, it does so as the agent of the insured. The insured bears the credit risk of the insolvency of the broker. For example, if an insured pays premium to its agent, the broker, and the broker becomes insolvent before the money is passed on to the insurer, the insured may not be on cover and may bear the loss of premium itself (depending, of course, on the terms of the policy). Unless the policy provides otherwise, the insurer bears no loss and
provides no cover to the insured. However, in respect of marine insurance, the broker is directly responsible to the insurer for the premium (section 53 of the Marine Insurance Act 1906 (MIA)).

Similarly, if an insurer pays a claim to a broker, the insured will be deemed to have received the claims monies once they have been paid to its agent, the broker (again, depending on the terms of the policy). The insured bears the credit risk of the broker becoming insolvent before it passes on the claims monies. The insurer has no further liability once it has paid the claim to the broker. However, in respect ofmarine insurance, the insurer is directly responsible to the insured for payment of losses or returnable premium (section 53 MIA). Some intermediary clauses, particularly in reinsurance treaties, seek to reverse the credit risk by treating payment to the broker by the reinsured as payment to the reinsurer.

The Client Money Rules
The Client Money Rules, which are set out in chapter 5 of the Client Assets Sourcebook (CASS), have been designed to provide insureds with a much greater degree of protection than that
provided under the law of agency set out above. The FSA’s General Principles for Business (Principle 10) require firms to arrange adequate protection for clients’ assets when the firm is
responsible for them. Such protection includes the proper accounting and handling of client money. In line with Principle 10, a broker who holds client money must do so in accordance with
the Client Money Rules (subject to certain exceptions, most notably for reinsurance contracts).

The Client Money Rules provide two options:
— money held by the broker on behalf of its principal, the insured, ie premiums and claims money, is client money and must be segregated into a Client Account (which is either a statutory trust account or a non-statutory trust account maintained in accordance with the Client Money Rules), and cannot be used to reimburse other creditors in the event of the broker’s insolvency (CASS 5.3 and 5.4),

— money held by the broker on behalf of the insurer is not client money and does not have to be held in a Client Account (see further below).

Money held of behalf of the insurer
The Client Money Rules permit an insurer and an intermediary to agree that the broker holds money as agent of the insurer (CASS 5.2). This money can include premiums and claims monies as well as other money, such as professional fees. Before a broker can hold any money (whether premiums, claims or other money) as agent of the insurer, a written agreement must be entered into to that effect in accordance with the Client Money Rules. If a broker does not have such written agreement in place with an insurer, it cannot hold any money as agent of that insurer.
If the written agreement provides that the broker holds premiums and/or claims money as agent of the insurer, the insurer (rather than the insured) bears the credit risk of the broker’s insolvency.

This is known as ‘risk transfer’.
The effect of risk transfer is that money held by the broker pursuant to the written agreement are treated as being held by the insurer. This gives the insured protection. For example, it pays
premium to the broker where the broker has agreed risk transfer with the insurer, the premium is deemed to be received by the insurer when it is paid to the broker. Similarly, when the insurer pays a claim to the broker, where risk transfer has been agreed, the claim will not be deemed to be paid to the insured until the broker actually does so. If there is no written agreement in place, the premiums and claims money will be held by the broker in accordance with option A above. In addition, the broker will not be able to hold any other money, eg professional fees, as agent of the insurer.

Money held by a broker as agent of an insurer is not client money (CASS 5.1.5R) and therefore does not have to be placed in a segregated account in accordance with the Client Money Rules.
Thismeans, in essence, that the broker is not restricted in the manner in which it can use money held pursuant to the risk transfer agreement and can use the money to meet its other liabilities or to finance its business. Whilstmany insurers have accepted the principle of risk transfer,
they also require that money held by a broker on their behalf are protected from the broker’s other creditors.

In respect of money held by a broker on its behalf, an insurer can apply one of the following options:
— impose no protective measures on the broker and bear the credit risk in the event of the broker’s insolvency or misuse of the money.
— require that money held on its behalf are held in a separate trust accountmaintained for its benefit.
— permit the money to be ‘co-mingled’ in the Client Account maintained by the intermediary in accordance with the Client Money Rules (CASS 5.1.5AR).

Co-mingling
Co-mingling is only an issue if an insurer and a broker have entered into a written agreement providing that the broker holds money on behalf of the insurer. The Client Money Rules permit a broker and an insurer to agree that money held by the broker on behalf of the insurer is to be treated as client money and to be kept in the Client Account (alongside the money held by the broker on behalf of insureds). If an insurer agrees or wishes that money held by the broker on its behalf is kept in the Client Account, the insurer must agree to this arrangement in writing and must also agree that its interests in the Client Account are subordinated to the interests of the intermediary’s other clients. Other than as set out above, an insurer (when acting as such) with whom a broker conducts insurance mediation activities is not to be treated as a client of the intermediary (CASS 5.1.6R).

In entering into a co-mingling arrangement the insurer is still bearing the credit risk rather than the insured but is simply taking steps to protect its own interests. In agreeing to subordinate its
interests to those of the intermediary’s other ‘clients’, an insurer must be careful to ensure that ‘clients’ do not include other insurers whose fundsmay also be held in a Client Account pursuant to a risk transfer agreement. The insurer’s interests should be subordinated only to those of insureds.

Client Account
The holding of client money in segregated accounts means that money in the account are protected in the event of the insolvency of the intermediary. The Client Money Rules set out particular requirements relating to the establishment and maintenance of these Client Accounts.

Reinsurance
The Client Money Rules permit brokers to make an election to apply the Client Money Rules to their reinsurance business. The issues outlined in this article are therefore relevant to reinsurers carrying on business with brokers in those circumstances.

Misconceptions corrected
To clarify some common misconceptions in relation to the Client Money Rules:
— There is no FSA requirement for firms to enter into TOBAs, although clearly good business practice dictates that firms should set out in writing the terms of their business relationships.
— It is not correct that insurers and brokers cannot do business with each other unless they have entered into a risk transfer agreement, permitting the broker to hold money as the agent
of the insurer.
— There is no obligation on an insurer to agree that a broker holds money as its agent (subject to certain exceptions, eg marine insurance). The policy wording may also affect the position of the parties in relation to certain policies.
— If an insurer has not entered into a risk transfer agreement permitting a broker to hold money as its agent, the issues of co-mingling and subordination are not relevant. The broker
will hold premiums and claims money as agent of the insured. However, insurers and reinsurers must note that, in the absence of a risk transfer agreement, the brokers cannot hold other money, eg professional fees, on their behalf.
— The FSA’s 14 July deadline related only to the requirement that insurers agreed to the subordination of their interests in the Client Account and was only relevant where the insurer had already entered into a written agreement permitting the broker to hold money on its behalf and for that money to be comingled in the Client Account.
— Where an insurer has agreed risk transfer, the broker can be restricted to holding only one category of money, eg one (or more) of premiums, claims or professional fees. There is no
requirement that all money must be held as the agent of the insurer.
— The Lloyd’s Model TOBAs are just models. They do not fit all circumstances and should be adapted to the business relationship between the insurer and broker entering into the chosen model.