The Law requires Australian Financial Services Licensees to have adequate arrangements in place to compensate retail clients for any losses they suffer as a result of the acts, omissions or misconduct of the Licensee or the Licensee’s representatives.

In the absence of either self-insurance or a statutory compensation scheme, Professional Indemnity Insurance (PII) is the principal way most Licensees demonstrate adequate compensation arrangements. However, PII is neither a Fidelity Fund nor a Compensation scheme – it simply protects you, the Licensee, against some risks and reinforces your ability to mitigate consumer losses caused by your negligence or misconduct (or that of your representatives). 

Unfortunately, in the wake of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, the collapse of Dover and the emergence of Australian Financial Complaints Authority, many Licensees are now legitimately questioning the cost, benefit and adequacy of their Professional Indemnity policies. 

Relevant Guides:

Regulatory Guide 126 Compensation and insurance arrangements for AFS licensees (August 2017)

Regulatory Guide 167: Licensing: Discretionary powers (June 2019)

Adequacy

‘Adequacy’, like ‘materiality’, is subjectivity hidden behind a facade of objectivity; to be clearer, it’s an imprecise, flexible and contextual term that frustrates many Licensees. The frustration may be understandable, but it’s important to appreciate that the regulations require you, as the Licensee, to have arrangements that are “adequate”, considering: 

(a)        the External Disputes Resolution (EDR) Scheme of which you are a member and the maximum liability that could arise in connection with any particular claim against you and all claims for which you could be found to be liable(and your liability for claims brought through the Courts); and

(b)  the ‘nature, scale and complexity’ of your business including

                    i.        the volume of your licensed activity; 

                   ii.        the number and kind of clients; and

                  iii.        the kind, or kinds, of activities undertaken and services offered; and 

                  iv.        the number of representatives.

Please appreciate that ‘adequacy’ is not simply a matter of price or coverage. Like most insurance policies, there are exclusions, limitations and qualifications that also need adequate consideration. 

Art and Science

Before making an offer of insurance, Insurers endeavour to assess the potential risk and exposure they’ll assume by underwriting your activities.

The precise measures they adopt vary (marginally) between insurers, but they generally involve the Insurer’s consideration of both qualitative and quantitative assessments. 

Their embrace of ‘art and science’, they hope, equips them to make a better assessment than their reliance on either quantitative (objective) or qualitative (subjective) elements alone would provide.

Quantitative considerations

The subjective elements might be more interesting, but Insurers will ask for any applicant to provide objective information including, but not limited to: 

• Business model:
  • Insurers will generally require applicants to disclose and list all their business activities in the proposal form. This information will be recorded in the policy.
    • Remember to be both clear and expansive. You need to provide the Insurer with a clear understanding of your current (and anticipated) activities but be particularly careful about how you disclose historic activities – if you don’t disclose those activities that you no longer engage in, you may not be covered in the event of a claim. 
• Representative numbers:
  • Insurers will consider these numbers (and your year to year variation) relative to your governance resources and the ‘nature, scale and complexity’ to assess the likelihood and consequences of misconduct. Insurers are likely to focus more closely on these numbers given the significant costs of remediation.
    • Pay careful attention to the increase in adviser numbers relative to your key resources. Where there is a significant misalignment, for example, where your adviser numbers trebled while compliance resources halved, it may be suggestive of potential risks that will be priced in by the Insurer. Try to contextualise, mitigate or address any inconsistencies between these factors.
    • In 2019, in the wake of the Royal Commission, many Licensees with 30+ Authorised Representatives are finding it increasingly difficult (or increasingly expensive) to obtain Professional Indemnity Insurance. Some Insurers have simply withdrawn from quoting in this market. The reasons for this timidity is obvious; if large, well-resourced institutional licensees are unable to manage the risks and activities of their representatives, how can less well-capitalised licensees do so? The answer may be by engaging external experts, adopting an effective compliance platform and implementing an effective remediation and consequence management framework. 
• Financial Products (and Non-Financial Products) on which you advise and deal, your authorisations and activities;
  • Simple authorisations, basic products and simple retail businesses generally represent less risk than complex businesses offering a diverse range of products and services. Claims follow losses and your use of, or exposure to investment products, particularly volatile or complex products, increases your risk profile.
• Revenue, revenue growth and profit;
  • These financial measures can suggest vulnerabilities or exposures that the Insurer needs to consider and price. Insurers should address significant or atypical revenue growth (without a corresponding increase in controls and resources), increased revenue with decreasing profit (and vice versa) or sustained losses over time.

• Funds Under Management (FUM) and/or Funds Under Advice (FUA);
  • Some Insurers check FUM/FUA against the declared fees to ascertain whether adequate income is generated from the portfolio being.
• Number, type and significance of complaints and breaches;
  • These lag indicators provide a useful insight into the conduct, culture and capability of your business. While Licensees often present these as unrepresentative or atypical events, they are, in fact, a reliable indicator of the risks inherent in the business. The way in which the Licensee addresses complaints and breaches is perhaps a more reliable indicator. 

• Regulatory engagement, administrative actions and bannings;
  • Relatively few Licensees warrant regulatory attention, so Insurers pay special attention to those that do. Depending on the nature, scale and complexity of the Licensee’s business, the banning of a single Authorised Representative is likely to focus the Insurer’s attention on the effectiveness of their controls and materially impact the cost of their cover.
  • Where the regulatory actions are the result of fraud, dishonesty or theft of client money, the Licensee will find it more difficult to renew cover without premiums and excesses dramatically increasing. As a consequence of recent history, many insurers are particularly sensitive to the risk of potential fraud claims. 
• Number and type of clients (retail v wholesale). 
• It’s not a consistent practice but some Insurers prefer wholesale clients who they perceive as more sophisticated/more educated than retail clients (and consequently a lower risk).

Qualitative considerations

Your capacity to influence an Insurer’s assessment of the risk you (and your representatives) represent, depends, to a very great degree, on your “Compliance arrangements”. 

Essentially, your compliance, governance and risk management arrangements (and the culture that sustains, undermines and influences the operational effectiveness of these arrangements) are, and should be, a critical element of your Insurer’s assessment. 

It’s for this reason that a prudent Insurer will seek to understand:

• Your approach to monitoring and supervising your representatives;
• Your approach to, and success with, remediation;
• How you demonstrate your commitment to effective rectification, positive regulatory engagement and continuous improvement;
• Your identification, management and escalation of incidents and breaches; 
• The checks undertaken before appointing representatives;
• The measures, processes and procedures on which you rely to demonstrate compliance with the financial services laws;
• Your workflows and business processes (particularly those that relate to client engagement);
• Internal training records (including training provided to advisers, Responsible Managers and Senior Executives);
• Your Product Selection/Investment Process methodology; and
• Your tolerance or embrace of discretionary trading.

According to Greg Hansen, Director of Professional Risks at Austbrokers Countrywide, insurers really want to see an expansive and integrated IT solution that provides the Licensee with the capacity to see, monitor and regulate adviser activity. OpenAFSL, or equivalent reg-tech platforms, may satisfy the Insurer’s requirements. 

download rg126

“Minimum premiums for Professional Indemnity cover have increased dramatically over time as a result of both decreased capacity and a perception of increased risk. Premiums of $5,000-$10,000 pa are no longer available and, in 2019, the minimum premium hovers around $15,000 pa.

Expect that Insurers will tend to price their cover at 2% of your revenue, but they will increase the cost based on your activity profile or claims history. ”

— Greg Hansen, Director of Professional Risks at Austbrokers Countrywide

Assessing Cover

Not all Professional Indemnity policies are equal; some may not satisfy the requirements of RG126 and others may have exclusions and excesses that limit their utility. Regardless of your relationship with your brokers, check your policy wording, compare the excess and consider the exclusions and endorsements on your policy. 

Practically, in light of your own circumstances, carefully consider the following elements of your PII: 

• Definitions and exclusions. Critically review your policy document and policy exclusions.  Originally, these contracts used ‘negligence-based’ wording, but the contract has evolved over time to move beyond common-law limitations to include a range or relevant duties, regulations and statutes. If the document or the exclusions are unclear speak to your Broker or, if you think it appropriate, another Broker entirely. Remember to read the entire contract, including the inclusions and exclusions, and pay particular attention to the definitions and insuring clauses for specific acts.
  • Watch out for any ‘consequential loss’ exclusions. It’s too vague and uncertain to provide you with any reassurance so you should avoid any underwriter that sneaks this into the contract. 
  • As outlined in RG126, there are a range of factors that cannot be excluded including
    • EDR scheme awards;
    • Fraud and dishonesty;
    • Losses caused by misconduct or misrepresentation; and
    • Incidents notified to ASIC. 
• Costs. Think about whether the policy is ‘inclusive of costs’ or ‘exclusive of costs’. The reason is simple. For practical purposes, the cover provided by a ‘Cost inclusive policy’ may be less than you expect because the cost of your legal/defence costs are included in the limit of liability. If, for example, your legal costs are $1,000,000 then only $2,000,000 of your $3,000,000 policy remains to compensate clients. A costs exclusive policy ensures that the client compensation pool is not eroded by legal costs. To comply with RG 126, you need at least $2,000,000 excluding legal costs. So, if you have a cost inclusive policy, you need a lot more than $2,000,000.
  • You should insist on an ‘exclusive of costs’ contract but in the current environment it can be hard to buy. You could achieve the same net result by obtaining an ‘inclusive of costs’ contract with a higher limit.
• Deductibles. Model the impact of deductibles (and the Insurer’s approach to aggregation). Your policy will have an excess that has to be paid for each and every claim; some policies will apply a single Deductible for any claim (or series of claims) for similar or related acts, errors or omissions. Think about this practically. Imagine that you have an excess of $30,000 per claim and receive ten (10) claims relating to advice provided by one of your representatives. In the worst case, if the Insurer does not aggregate the claims, your liability is $300,000 and the Insurer is only required to pay the remainder of the claim. If the claims are aggregated, you’re only liable for the first $30,000.
  • Investigate whether the proposed excess is either ‘inclusive of costs’ or ‘exclusive of costs’. Where the excess is ‘inclusive’ it needs to be paid as soon as the Insurer starts incurring costs. Where the excess is ‘exclusive’ it only needs to be paid if the claim is settled in favour of the complainant.
    • According to Greg Hansen, Director of Professional Risks at Austbrokers Countrywide, it can be very hard to get ‘costs exclusive’ cover. Some insurers will “never aggregate the excess” regardless of their policy wording. This is a minefield for Licensees and the reason why some brokers believe that the deductible aggregation clause is “a nightmare clause to interpret”. 
• Disclosure. Consider what your Insurer considers as a ‘Notification’ or ‘Circumstance’. Disclosure is one key way to manage your liability, but consider what your Insurer requires you to disclose (or how will they punish you if you fail to adequately disclose notifications or circumstances).

“It’s prudent for Licensees to disclose client losses (for failed or frozen products for example) even in the absence of a client complaint.”

— to Greg Hansen, Director of Professional Risks at Austbrokers Countrywide

• Legacy advice. Both Licensees and advisers may acquire clients that are exposed to products that neither the Licensee nor adviser would recommend. In some cases, it is not in the client’s’ best interests to dispose of these products. Your insurance policy should contemplate this risk and provide you with cover for complying with your legal obligations. 
• Discretion. This is an issue directly relevant to any Licensee that offers or operates a Managed Discretionary Account [insert link to article] or allows advisers to exercise discretion over the timing or frequency of product acquisition or disposal.
  • Remember, that if you vary your AFSL to cover MDA services, you’ll need to update your policy.
• Timing. Your insurer offers cover from the inception date of the policy and therefore only covers you for subsequent activities. The “Retroactive Date” provides cover from a point in time prior to the commencement of the policy.  This means the policy will only cover work performed after the start of the new policy. Yet policies with an Unlimited Retroactive date offer full retrospective cover. Also, many companies will only give inception as the retroactive date unless you can provide evidence of a current retroactive date from elsewhere.
• Insured Persons. Not all policies automatically include former, current or future officer (Director, Partner or Principal) so you need to be aware of the consequences of any acquisition or corporate restructure. In some cases, even a name change could remove your access to retroactive cover. 
• Claims.“Claims Made” or “Loss Occurring”. For a “Claims Made” policy, liability is triggered not by an actual loss but by a third party making a claim, complaint or suit against the insured. “Loss Occurring” policies look to the date on which the loss occurs. This distinction is important particularly as AFCA extend the scope of their scrutiny. If you have a “Loss Occurring” policy and a client claims against conduct that occurred before the ‘Retroactive date’ of your policy, then you may not have any cover at all for that claim. If, on the other hand, you notified the Insurer about potential claims, they cannot avoid the claim because it relates to conduct proceeding the insurance contract. From a practical perspective, this should encourage you to fully disclose potential claims when applying for cover.
• Cancellation. Not every policy can be cancelled without penalty. Check the Cancellation Clause to see how, and under what circumstances, cover can be cancelled. In any event, before cancelling any policy, ensure you understand the consequences and implications of doing so (particularly in the event of future claims). Talk to you broker about ‘run off’. 

It’s important to understand the real consequences of a lack of competition in the current professional indemnity market. First, insurers don’t seem to make any real effort to properly price risks – they simply don’t need to because applicants’ alternatives are few. Second, when everything is included, their cover will often be priced at 2.2% of the applicants revenue. Third, medium or large licensees might find they’ll be offered an excess of $75,000 to $100,000 rather than the historic excesses of $10,000-25,0000. We need increased competition but, in the current environment, a good broker might be the only real advantage a good business has.

Adequate cover and ASIC’s requirements

It is useful to consider your current, or proposed, cover against the minimum requirements outlined by ASIC in RG126. In their view, adequate professional indemnity insurance must 

• provides cover of at least $2,000,000 for any one claim (or $2,000,000 in the aggregate for smaller Licensees). Where your revenue exceeds $2,000,000 your cover should be equal to the expected revenue (to a maximum of $20,000,000). 
• cover EDR awards
• cover the acts of the Licensee and all its representatives
• cover fraud/dishonesty and infidelity by officers, employees and representatives of the Licence
• cover legitimate ‘switching’ from non-APL products
• provide retroactive cover (if you previously had PII)
• provide at least one (1) automatic reinstatement
• have a sustainable excess (given your financial resources)
• be ‘exclusive of costs’ 

download RG167