Associated Compliance (Pty) Ltd _________________________________________________________
CURRENT LEGISLATION IN TERMS OF FEES AND REMUNERATION IN THE SHORT TERM INSURANCE SECTOR AS IT APPLIES TO INSURANCE COMPANIES 1. Introduction In July 2012, the Financial Services Board (FSB) issued an information letter warning insurers and intermediaries that certain market practises relating to fees and remuneration were in breach of regulation, and cautioned the industry that the FSB will take “decisive regulatory action” against those that continue to act outside the regulatory requirements. The purpose of this document is to provide our clients with insight as to how changes in the regulatory environment regarding fees and remuneration affect them.
2. A Brief Background A number of publications have been produced by the FSB but those that have had the greatest impact on Financial Services providers (FSP’s) in relation to the remuneration that may be paid or received are:
FAIS Fit and Proper Requirements; FAIS General Code of Conduct; The incorporation of Section 48A in the Short Term Insurance Act (STIA); The addition of Regulation 6 to the STIA Regulations; The publication of FSB Directive 159.A.i; The FSB Information letter 3/2012.
We deal with each hereunder. 2.1 FAIS Fit and Proper Requirements In October 2008, the FSB issued Board Notice 106 which, inter alia, addressed the entire fit and proper requirements imposed on financial service providers (FSP’s). Section 8 of that Board Notice relates to operational ability, and demands that an FSP that utilises any third party to render administrative or system functions in relation to the rendering of financial services on its behalf must have in place a detailed service level agreement, specifying the
agreed services, time standards, roles and responsibilities and any penalties that might be applicable. 2.2 FAIS General Code of Conduct In October 2010, Section 3A (1) (a) of the FAIS General Code of Conduct (GCoC) was triggered which clearly identified the types of fees and remuneration that could be paid by an FSP to another FSP. In brief, these are (see Board Notice 55 of 2010 for actual definitions):
Commission as defined in the Act; Fees allowable in terms of the Act for additional services rendered which are reasonably commensurate to the services being rendered; Fees not included in the above if they are agreed to by a client in writing and which may be stopped by a client at any time; An amount of R1000 in the aggregate during any one year to a representative or other FSP (an immaterial financial interest); Any other consideration on condition that the receiving FSP pays fair value.
2.3 Binders (Section 48A and Regulation 6 of the STIA) At the beginning of this year, Section 48A of the Short Term Insurance Act (the Act) was triggered which dealt with ‘binder agreements’ which in essence enables insurers to provide their intermediaries with a facility to undertake up to five functions on the insurers’ behalf, these being (for actual wordings refer to the Act): 1. 2. 3. 4. 5.
Binding the insurer in respect of new business, renewals, and policy changes; Determining the policy wording, including conditions and warranties; Determining premiums and/or premium rates; Determining the benefits that can be paid; and/or Settling claims.
At the same time that Section 48A was triggered, the Financial Services Board (FSB) added Regulation 6 to the Act, which placed definitions to the two types of intermediary to which insurers could offer binder facilities. These are Underwriting Managers and Non-Mandated Intermediaries. Regulation 6 went on to provide the rules under which each type of binder holder would have to follow, which include the principles on which they may be remunerated. These principles affect insurers as payers and binder holders as payees. All new binder agreements entered into from 1st January 2012 have to adhere to these regulations, but those that were signed and/or agreed prior to 1 st January 2012 have to be ‘aligned’ with the new regulations by the end of 2012.
2.4 Directive 159.A.i The binder regulations only deal with the outsourcing of the five functions mentioned above. As the outsourcing of additional functions by insurers may materially increase their exposure to risk or materially adversely affect their ability to manage risks, the FSB felt that an appropriate legislative framework should be imposed on insurers to deal with these exposures. In April 2012, the FSB issued Directive 159.A.i. which imposed very strict rules on all insurers that outsource any function which could be deemed to be:
A control function; A management function; or A material Function
These functions are all defined in the directive as follows: A Control Function “The risk management function, the compliance function, the actuarial control function and the internal audit function.” The basic control process involves three steps: 1. establishing standards in all aspects of the company’s operations; 2. measuring performance against these standards; and 3. providing direction to correct deviations from standards. A control function relates to the second and third steps. A good control system stimulates action by spotting the significant variations from the original plan and highlighting them for the people who can set things right. It is unlikely that many insurers will outsource this function, although the Executive might wish to employ a specialist or specialist company to assess and report findings on certain aspects of its operations. A Management Function “A function usually performed by executive management.” After strategies are set and plans are made, management’s primary task is to take steps to ensure that these plans are carried out, or, if conditions warrant, that the plans are modified. This is the critical function of management, and since management involves directing the activities of others, a major activity is making sure other people do what should be done. These activities are usually carried out by internal staff of the insurer, but sometimes
specialist personnel are brought in on a contract basis to set up a management process. A Material Function “Any function that has the potential, if disrupted, to have a significant impact on the insurer’s insurance business operations or its ability to manage risks effectively, including risks to the fair treatment of customers.” This relates to operational functions which relate directly to the provision of insurance cover to policyholders, and would, in the normal course of business, be provided by the insurer’s own staff. Sometimes, it is prudent for the insurer to contract out these functions which would include, but not be limited to: Risk surveys and risk prevention Loss adjusting Provision of information systems Premium management Valuations In a similar fashion to the binder regulations, this directive provided the principles on which outsourced contractors may be remunerated. 2.5 FSB Information letter 3/2012 On 19th July, the FSB published an information letter which provided clarification on the commissions and fees which could be levied by and to the various parties in the insurance supply line. In its opening, the FSB stated that certain market practises relating to the payment of fees may be in contravention of Section 48, Section 48A and the Regulations of the Act as well as the FAIS General Code of Conduct. Some of those practises were identified, a summary of which follows (for the full wording see FSB’s Information letter 3/2012):
Fees for which commission has already been paid; Fees which are duplicated in other service fees; Fees paid where no additional services are actually provided; Fees which are not commensurate with the work actually undertaken; Fees not charged to insurers or binder holders, and which are not commensurate with the work actually undertaken.
Although the information circular was primarily aimed at short and long term insurers and intermediaries with binder agreements, there was also direct reference to all in the insurance sector.
3. The Impact on Insurers 3.1 General Responsibilities An insurer’s function is to ensure that the total premium it collects caters for every expense that the insurer has to pay, and must include the total cost of claims and provide a margin for profit. This is achieved by careful underwriting, cost management and actuarial forecasting which determines the total premium payable. Premium is defined in the STIA as “the consideration given or to be given in return for an undertaking to provide policy benefits”. The manner by which the insurer shows the premium to the policyholder on the policy or policy schedule is not governed by regulation, nor is the premium breakdown required to be disclosed. All that is required is that the total premium payable, including all costs which the policyholder is expected to pay to the insurer, are clearly displayed to the policyholder together with the benefits, terms and conditions of the insurance contract which must be provided in plain language. If the insurer wishes to outsource any of its functions, it may do so on condition that it remains fully responsible for those functions, and must ensure that the company to which it outsources those functions is properly managed. It is the insurer’s responsibility to undertake on-going monitoring of that outsourced company in terms of its operational ability, financial soundness, competence, governance, risk management, internal controls, compliance with applicable legislation and systems management. 3.2 The Payment of Commission Where commission is paid for services as intermediary, reference must be made to the definition in the Act, which is: “Services as Intermediary means any act performed by a person— (a) (b)
the result of which is that another person will or does or offers to enter into, vary or renew a short-term policy; or with a view to— (i) maintaining, servicing or otherwise dealing with; (ii) collecting or accounting for premiums payable under; or (iii) receiving, submitting or processing claims under,
a short-term policy.”
In simple English, this means:
Selling and renewing policies; Maintaining and/servicing policies; Collecting or accounting for premiums; Receiving, submitting or processing claims.
One of the current practises is for a commission-earning intermediary to ask an insurer to collect additional fees on its behalf. These fees have a number of different ‘labels’ such as administration fees, policy fees and premium collection or debit order fees. In the latter case, it can be seen from the definition above that the intermediary has already been remunerated for this function in the commission it receives so is clearly prohibited. In respect of other fees, we comment more specifically in paragraph 3.4 later in this document. Where an intermediary uses its agency facilities to assist another intermediary to place an insurance cover, the commission must be paid to the intermediary with whom the insurer has entered an agency contract. How this commission is shared will be determined in an agreement between the intermediaries which has no effect on the insurer. Section 45 of the Act, read in conjunction with Regulation 5.1(3) states that “Irrespective of how many persons render services as intermediary in relation to a policy, the total commission payable in respect of that policy shall not exceed the maximum amount payable in terms of regulation 5.3”. Regulation 5.3 limits the commission paid on any one policy to 20% in respect of non-motor business and 12,5% in respect of motor business. 3.3 Establishing the amount that may be paid by an Insurer for outsourced work Over and above commission, an intermediary may undertake outsourced work on behalf of an insurer. There are three types of work that can be outsourced by an insurer as follows:
Binder work (see 2.3 above but not allowable to mandated intermediary); Other work which is defined as a control, material or a management function (see 2.4 above); Other work (regulated under S8(2) of Board Notice 106 of 2008.
In each of the above, the fees charged and paid must be commensurate with the actual cost of the services rendered plus an allowance for a reasonable rate of return. Whilst the term ‘reasonable rate of return’ is not defined in any legislation, nevertheless it must not be unrealistic. The insurer must also ensure that the fees being paid for outsourced work are not duplicated in any way.
It would be prudent for the insurer to estimate the cost that it would incur in providing the outsourced services in-house, and reconcile this against the fees payable for outsourcing those services. Also, the fee must, where possible, be determined in rand value. Only if this is not possible is an alternative method allowable. Binders may be provided to non-mandated intermediaries and to underwriting managers and although there are a number of significant differences between these two types of intermediaries and the responsibilities they have, these are not dealt with here. The fees payable to each type will be identical and based on the actual work undertaken. In terms of remuneration, the only difference between the two is that an underwriting manager may share in the profits of the insurer. This means that the fee payable to a nonmandated Intermediary for outsourced work cannot be adjusted, upwards or downwards, based on the underwriting results of the insurer. Where intermediaries do not earn commission (underwriting managers and professional collection agencies are good examples), those intermediaries may be remunerated by the insurer for carrying out the function of collecting premium on the insurer’s behalf. The fee is not chargeable to the policyholder as it is included in the premium. All the fees assessment criteria must be taken into account in establishing the amount that should be paid to intermediaries for this service. An outsourced provider may wish to sub-outsource some of the activities for which it has contracted to provide to an insurer. In this regard, it should be noted that such a provider is prohibited from outsourcing any of its binder functions. It can, however, sub-outsource any other function on condition that it is allowed to do so in terms of its outsourcing contract and that it conforms with the terms therein. In these circumstances, the fees payable to the sub-outsourced provider must be borne by the outsourcer, not the insurer. 3.4 Collecting additional fees from the policyholder on the intermediaries’ behalf Where an intermediary requests the insurer to add a fee to the overall premium for services that the intermediary has provided to the policyholder which are not included in the definition of “services as intermediary”, the insurer must be careful to ensure that it complies with legislative requirements. There are a number of ‘labels’ that given to this fee by the intermediary the most common being:
Collection or debit order fees; Policy fees; and Administration fees.
Section 8(5) of the Act provides that an independent intermediary shall not charge, in addition to any remuneration contemplated in section 48, any fee which is payable by a policyholder unless the amount thereof is disclosed expressly and separately to the policyholder by the intermediary. However, Section 8(5) must be read with the definition of “conflict of interest” and section 3A(1) of the General FAIS Code, specifically 3A(1)(iii) that requires any fee authorised under the STIA to be reasonably commensurate to a service being rendered. This means that an additional fee over and above the premium determined by the insurer may only be charged to a policyholder if:
it does not duplicate anything included in the commission; it does not relate to services referred to in section 48A of the Act; it does not relate to any services provided to insurers in terms of Directive 159.A.i. it is reasonably commensurate to a service being rendered; and the amount thereof is disclosed to the policyholder as per section 8(5) of the STIA.
Section 3A(1)(a) of the GCoC effectively states that fees for the rendering of a financial service in respect of which commission is not paid must:
be specifically agreed to by a client in writing; and may be stopped at the discretion of that client.
A miscellaneous fee or a fee which is unjustified or has no ‘value-add’ which is charged to a policyholder is clearly prohibited. Prudence therefore dictates that an insurer should take adequate precautions to ensure that if asked by an independent intermediary to add additional fees, such practise fully complies with all legislation.
4. Considerations 4.1 Reviewing the business model It would be prudent for every insurer to revisit its business model, particularly if it has previously paid additional fees to intermediaries which are over and above commission, as this practice is about to be carefully regulated. In paragraph 3.3 above, we discussed the duties that an intermediary can undertake to earn additional fees. These include premium management, i.e. reconciling re-debits and follow-
ups, the provision of systems which are being provided by the intermediary for the benefit of the insurer and any other service which would have to be undertaken by the insurer. In these examples the activities would fall under the definition of ‘material functions’ and be addressed by an outsourced agreement in terms of Directive 159.A.i. 4.2 Specific considerations when dealing with administrators The terms ‘administrator’ and ‘placing broker’ are used broadly in the industry to refer to a variety of business models involving a range of administrative services to insurers and intermediaries, some of which fall under the definition of binders, some outside the definition of binders and some within the definition of commission. The fact that administrators play an important role in the supply mechanism is unquestionable; particularly where they provide services to other intermediaries that for a number of reasons do not have access to insurers that supply the same or similar products. A common model is for the administrator to have a specific scheme or facility (binder agreement) for which a sub-agent will be given access. The administrator will pay the subagent the maximum commission allowable and will add a fee to the premium charged to cover its own costs and margin. The problem is that the administrator is charging a fee to a policyholder without the provision of any value-add service, and it will be seen from the above notes that this strategy is not acceptable. In such arrangements, the administrator is the ‘official intermediary’ and is entitled to the full commission. Where the administrator is also carrying out binder functions or other administrative services on behalf of an insurer, the administrator is also entitled to charge a fee to the insurer as a NMI (discussed in detail in the above notes). The amount that the administrator wishes to pay the sub-agent is entirely up to the administrator, but such payment must be made from the income of the administrator and no additional fee beyond premium can be levied to the client. Moreover, the administrator in such circumstances is unlikely to have a direct relationship with the policyholder, and if the sub-agent decides to charge a fee to the policyholder in terms of paragraph 3.4 above, the administrator will have similar responsibilities as an underwriting manager. In these cases the administrator must be careful to ensure that these additional charges relate to value-add services that are being provided by the subagent and that the policyholder has agreed to that additional fee in writing. An administrator can, of course, provide non-insurance services to the policyholder for which a fee can be charged but such contact with the policyholder is often prohibited, and usually seen as unethical, by the sub-agent.
4.4 Compliance Monitoring As compliance officers we have to consider all legislation that applies; this is in accordance with Section 12(c) of the General Code of Conduct which states a provider must structure the internal control procedures concerned so as to provide reasonable assurance that all applicable laws are complied with. This naturally embraces the fees and commissions charged and earned in terms of current business models as well as the obligatory disclosures needed which may well necessitate upgraded documentation. Unlike the binder regulations which incorporate a transitional period, legislation on fees and commissions is not new. Until now, it would appear that the FSB has turned a ‘blind eye’ to additional fees charged by Intermediaries, but this activity is now clearly in the spotlight.