The proposals from the Financial Services Authority (FSA) contained in CP180 form the basis of ensuring there is sufficient protection for the client and the industry under statutory regulation, so that any firm operating in the market has the ability to meet its financial commitments ‘ including any damages emanating from ombudsman awards.
In trying to understand the risks that a mortgage broker brings to the table, the FSA has carried out a good deal of research in order to formulate its proposals. Included in that process is its own experience of the investment industry.
However, it is here that, according to some commentators, the FSA is guilty of over complicating the process with the overall effect that its proposals regarding capital adequacy are not proportional to the remit it has been given by the Treasury.
The critical element is the risk. The FSA has admitted that it perceives mortgages to be of a much lower risk than investments, based partly on evidence from average ombudsman claims made against the mortgage industry, which tend to be just a few thousand pounds and therefore extremely low in number. Therefore it is grossly unfair to tarnish the mortgage market with the recent history of the investment world and in particular the fallout from the pension and endowment reviews. And it is the first of these two examples that has applied such pressure onto professional indemnity (PI) insurance premiums and, of course, everyone is aware of the effects of the world stock markets on the endowment market.
But with the proposals for a combination of capital adequacy and a minimum excess of £5,000 for PI insurance the mortgage industry will have a double degree of protection. It is absolutely right that any firm operating in the market must have the required financial strength to meet its obligations but this can be achieved via means other than capital adequacy. All firms have financial returns to maintain so the FSA has the opportunity to check the financial strength at that point. Remember that these returns incorporate financial accounts from qualified accountants who are charged via their profession to ensure stability and an interpretation of FSA criteria.
More to the point, when applying for PI insurance, the insurance provider will want to ensure the required financial strength is there, otherwise cover will not be provided. Hence, the FSA needs to ensure that its excessive proposal of liquidity via capital adequacy is over and above the high degree of interrogation that the PI insurance companies will employ to take on the risk.
Taking a closer look at the capital adequacy requirements, and assuming that they are right to adopt to some degree, there is a balance to be achieved. For example, a small firm of good advisers can easily achieve an income of £1m which would put it into the ‘mid’ band of the application fee process. They will be asked to front £8,750 for early application and then come the (probably very high) annual fees. The FSA requirement is for 5% of their income or £50,000, in this example, to meet the capital adequacy criteria. So, bearing in mind the mortgage industry’s low claims track record and the average pay out of just a few thousand pounds, just how can £50,000 be deemed proportional? And where does the FSA think that the average firm will be able to find such monies? There cannot be too many firms in the UK that can afford to put £50,000 to one side without putting pressure on their business, even if they can create these monies in the first place.
One solution may be to focus on PI insurance. It is already mandatory under the Mortgage Code Compliance Board (MCCB) so every firm will have adjusted to the need of providing such, and perhaps more importantly, paying for it. And the industry has already had to prepare itself for premiums jumping through the roof through no fault of its own but rather the failures of the investment market. A requirement for strong PI insurance cover is the preferred option and far more palatable.
If the FSA does finally insist upon this level of capital adequacy then perhaps, at least, it would care to revisit the definition of such and the proposed minimum levels to reduce the ‘double whammy’ that advisers are looking at via this and hefty PI insurance premiums.
The mortgage industry is thought to be low risk and ombudsman claims are low and infrequent.
The FSA will have the opportunity to check financial stability through firms’ financial returns.
PI insurance alone is preferable and may turn out to be more cost effective all round.