In April 2011, Treasury released an Information Pack on the Future of Financial Advice (FOFA) reforms. Details of these reforms can be found in our previous alert.
As part of the FOFA reforms, Richard St John released a paper entitled “Review of compensation arrangements for consumers of financial services” which can be found here. The paper discusses issues around current compensation arrangements for financial services consumers, in particular professional indemnity (PI) insurance. It also provides observations on a proposed statutory compensation scheme and other reforms.
The paper is focused on the adequacy of arrangements by which investors may be compensated where they suffer loss as a result of misconduct by a provider of financial services and not as a result of a financial product’s failure or general investment losses.
It should be noted that other aspects of the FOFA reform will have an impact upon any compensation arrangements proposed. For example, a change in the definition of retail and wholesale clients will have a flow-on effect for the class of clients to whom compensation arrangements may be directed.
The paper acknowledges that PI insurance is not a direct form of compensation for consumers. Instead PI insurance is seen to play an indirect role where a retail client is awarded compensation for a loss arising from a Australian Financial Services licensee’s (Licensee) breach of a statutory obligation, the Licensee may be able to claim against its PI insurance policy to help meet the costs of the award. In this way PI insurance provides “balance sheet” protection to the Licensee thereby reducing the risk that a Licensee will not be able to meet an award for compensation due to a lack of financial resources.
Under the Corporation Regulations, PI insurance is used to fulfil the compensation arrangement requirements for Licensees (apart from those exempt). Since the introduction of the requirement for PI insurance for Licencees, the paper noted a trend towards higher premiums and a hardening of the PI insurance market, particularly in relation to cover for financial advisers. There has also been an upward trend in claims paid to financial advisers, particularly a large jump in claims incurred from 2008 to 2009.
The paper outlines the benefits of PI insurance as a basis of compensation. PI insurance provides:
(a) a measure of assurance that a consumer’s claim will be met;
(b) through the process of obtaining cover, high risk products may be declined thereby encouraging Licensees to avoid such products; and
(c) the annual renewal of policy provides an indirect check of the operating systems of the Licensees.
However, the paper notes that it is problematic to try to make PI insurance, which is a commercial product, into a compensation mechanism. The main issue is that the obligation to meet a successful compensation claim lies with the Licensee. If the Licensee’s PI insurance policy does not respond to the claim, the Licensee is then left to meet the liability from its own resources. There is then a gap where a Licensee does not have the necessary financial resources to meet the liability.
The paper discusses several scenarios where this gap may exist:
(a) As run-off cover is not generally available to Licensees, PI insurance is of limited value as a way of compensating claims after an insurance policy has ended. Therefore, where a Licensee has retired or otherwise exits the market, consumers may be exposed to claims without available insurance cover.
(b) Where a Licensee becomes insolvent it will generally be required to notify its insurer of its insolvency and in many cases an insurer will cancel the policy. If a claim is made prior to cancellation, then a consumer will have priority to the payments of the Licensee’s debt (subject to exceptions).1 However, where the claim is made after cancellation of the policy a consumer will only have rights as an unsecured creditor in the winding-up of the Licensee’s business. A consumer is unlikely in the circumstances to recover the compensation to which he or she may be entitled.
(c) If the Licensee breaches a condition of a PI insurance policy, for instance a failure to inform the insurer about a claim or loss as soon as possible, the insurer may be entitled to deny payment or reduce its liability in respect of a claim. Further, an insurer may be entitled to cancel a policy where they can demonstrate that the breach has a material impact on the risk associated with the policy.
(d) To the extent that a claim exceeds the cover limit provided under a Licensee’s insurance policy, the Licensee will have to meet a claim from its own financial resources if reinstatement under the policy is not available.
(e) If a Licensee is faced with a large number of claims, the amount of excess or deductible may be quite large. This element of self-insurance will put pressure on the financial resources of the Licensee.
(f) Losses arising from fraudulent or dishonest conduct of Licensees are also typically excluded. Where a claim falls within a policy exclusion, the PI policy will not respond.
Whilst comprehensive data was lacking, the review was informed of cases where consumers have been unable to recover substantial amounts of compensation awarded to them from Licensees.
The paper proposes a statutory compensation scheme as a last resort mechanism designed to provide retail clients with recourse to payments in circumstances where they are unable to recover compensation to which they are entitled from a provider of financial services. This scheme is intended to supplement other schemes such as those offered by the Financial Claims Scheme.
The proposed scheme is similar to the model used in the United Kingdom which offers “second tier” protection for claims which slip through the “first tier” protection which is based on a mix of PI insurance and minimum capital requirements. The paper outlines several issues in relation to any compensation scheme, including:
A proposal to establish a compensation scheme has been prepared by Professional Financial Solutions Pty Ltd on behalf of the Financial Ombudsman Service. The scheme is described as an industry-based scheme, which would be underpinned by legislative and possible financial support from the Government.
Whilst the focus of industry has been on the compensation scheme proposed by the paper, it also proposed other reforms.
Firstly, the paper suggests that incidences of cases where clients suffer loss or damage from licensing misconduct can be reduced through improvements in professional standards for financial advisers and efforts to improve the financial literacy of consumers. Other FOFA reforms such as the imposition of a statutory best interest duty on Licensees who provide personal advice to retail clients will also be relevant.
Another solution proposed is to enhance the utility of PI insurance as a compensation mechanism through:
The paper suggests a more active approach by ASIC in monitoring the financial resources and activities of Licensees. It also proposes that more attention should be focused on the financial resources of a Licensee in order to reduce the risk of their becoming insolvent. Although it stops short of proposing capital adequacy standards required by financial institutions that are regulated by APRA, these measures will impose further compliance costs on Licensees.
The paper also suggests that there should be a review of the Licensee’s disclosure requirements of their compensation arrangements. In their submission, Maurice Blackburn notes that there is no mechanism by which it can be ascertained whether a Licensee holds PI insurance at any given point in time. Maurice Blackburn argues that without this information, it makes it difficult for the consumer to judge the benefits and costs of pursuing compensation. However, as noted by the Superannuation Committee of the Law Council of Australia, merely disclosing the level of cover may not mean clients can meaningfully assess what insurance coverage is available to the Licensee. They note that “Ultimately, the amount of coverage is a blunt measure of protection and true coverage should depend on the scope of policy inclusions and exclusions and these are unlikely to ever be disclosed in any meaningful detail.”
Disclosure of PI insurance policies also touches upon another issue raised by the paper where changes to strengthening existing compensation arrangements may have the effect of skewing claims further in the direction of Licensees whose liabilities to retail clients are underwritten by a compensation arrangement.
In terms of funding the compensation scheme, the Stockbrokers Association of Australia suggests that a levy be imposed on consumers directly by a small levy on contracts similar to levies on insurance contracts . This suggestion highlights the tension in any enhanced compensation arrangements between the effectiveness of such arrangements in protecting consumers and promoting confidence in the financial services sector versus their impact on the costs and supply of financial services to retail clients and to the overall efficiency of the sector.
Submissions in response to the paper have now closed, however Mr St John has noted an intention to continue the consultation process in the period following the release of the paper and leading up to his recommendations to the Government.
 s 562 of the Corporations Act.
 Stockbrokers Association of Australia’s Submission on the Review of Compensation Arrangements for Consumers of Financial Services - Consultation Paper by Richard St. John dated 1 June 2011 at p 8.