The Market Reform Group publishes 'Contract Certainty Code of Practice'

FSA moves towards decision time on Contract Certainty - update on FSA Regulation

Timetable and recent developments

December '06: Final date set by FSA for market compliance.

December '05: Formal 'stocktake' by FSA to determine whether sufficient progress has been made to meet the December 2006 challenge and/or whether to introduce further specific regulation. FSA has a wide range of options including additional capital weightings, restrictions on firms and further specific contract certainty rules.

November '05: Key meeting at which the industry will report progress achieved to FSA ahead of the December stocktake.

October '05: London Market Reform Group publishes its Contract Certainty Code of Practice.

September '05: Dane Douetil chairman of the Lloyds' Market Association announces that the inability of insurers to provide accurate loss estimates following Hurricane Katrina is the clearest evidence that contract certainty must happen. Chartered Insurers Institute launches contract certainty certificate which is welcomed by FSA.

August '05: LMBC produce guide to assist brokers to develop their own detailed implementation plans and Contract Certainty Guidance note highlighting FSA threat of rule-based measures unless at least 85% of placements will achieve contract certainty by 31 December 2006. Lloyd's extends mandate of LMP guidelines to preparation of lineslips. "LMP lineslip – June 2005" proposes a standard format and market standard from 1st October.

July '05: Third FSA meeting on contract certainty, Progress Reports from Nick Prettejohn and Duncan Boyle for the Subscription Market and Non-slip Market respectively. FSA highlighted the vital importance of market engagement and cultural change. FSA to:

• Assess the progress of individual firms over next six months
• Ensure unmitigated risks (operational/legal) are considered within Individual Capital
• Market Reform Group addressing volume targets for achievement this year. FSA to assess monitoring of complex aspects of implementation and infrastructure providers.

Contract certainty – what's it all about?

FSA became responsible for the entire insurance industry this year. Its main statutory objectives are "market confidence" and "the protection of consumers". It is concerned about inadequate contracts and documentation in the industry because it poses risks to those objectives. Current practices within firms and at a market level pose operational and legal risks for insurers and intermediaries and unacceptable uncertainty for their clients and insureds. FSA authorised firms are already subject to a range of requirements which may be breached if contractual documentation is inadequate. These include high level standards, such as PRIN and SYSC, more detailed business standards such as PRU* and specific requirements in ICOB and CASS. It is also a key issue in the context of FSA's personal regulation of individual senior managers (approved persons) under APER.

(*e.g. PRU 7.1.30 - A firm should pay close attention to the wording of its policy documentation to ensure that these wordings do not expose it to more, or higher, claims than it is expecting. In so doing, the firm should consider:

1. whether it has adequate in-house legal resources;
2. the need for periodic independent legal review of policy documentation;
3. the use of standardised documentation and referral procedures for variation of terms;
4. reviewing the documentation used by other insurance companies;
5. revising documentation for new policies in the light of past experience; and
6. the operation of law in the jurisdiction of the policyholder)

FSA has a range of "tools" available to combat poor documentation ranging from enforcement action for breaches of existing requirements through to the introduction of new rules or requirements. These includes disciplinary action against senior managers leading to fines, particularly if internal systems are inadequate. Recently FSA has raised the prospect of additional capital requirements (to reflect operational and legal risk) and ultimately it has the power to vary a firm's permissions to restrict or apply conditions to underwriting or mediation business. In short, FSA "holds all the cards" in the current debate about contract certainty.

Contract certainty

FSA is alarmed about the standards of documentation in the insurance industry, particularly when compared to other markets which FSA regulates. It has attacked a "deal now, detail later" culture which poses a clear and identifiable risk to FSA's objectives. In short, FSA's concern is that firms and market participants tolerate substantial operational risk and poor protection for their clients and seem to find it easier to pay the cost of "clearing up the mess" after the event, rather than investing in systems and training to mitigate the risk up front.

"Contract certainty" under the FSA Handbook extends across a range of agreements and processes. This includes contracts of insurance and policies but extends to a wide range of commercial agreements, particularly those which govern the role of the different participants in the chain, such as binding authorities, agency agreements for the collection of premium, outsourcing, claims handling and so on. It also extends to record keeping and systems necessary to maintain related evidence such as material information disclosed to underwriters.

In the London Market, traditional market mechanics (primarily relating to subscription risks) pose substantial risks. FSA has given notice that these risks must be eliminated. Alarmingly from FSA's perspective, the precise terms of an insurance contract can be uncertain at the time of the "placing" and can remain so after "inception" and for a considerable time thereafter. Indeed, some insureds (and insurers) find that when a claim is made, there is still no policy in existence and they have to instruct lawyers to gather evidence and to litigate in order to determine, forensically, the extent of coverage or other terms. The consequences of poor contract certainty were shown by the Silverstein case last year, which followed the World Trade Center terrorist attacks. The policies had not been finalised and insurers held conflicting records of the terms. As a consequence, the parties had to rely on the courts to decide retrospectively what the terms of the contract were intended to be.

Industry Initiatives

A steering group is reporting to FSA on contract certainty. There are two streams beneath the steering group. The MRG is responsible for the slip/subscription/London Market (which includes the International Underwriting Association, the Lloyd's Market Association and London Market Insurance Brokers' Committee).

(MRG announced in July that it was re-establishing its executive committee, the MRGE (whose task it is to convert reform strategy into deliverable projects that have market-wide buy-in) with a new board, the Market Reform Implementation board (MRIB) will be responsible for implementation. MRIB has initially taken on the implementation of the account and settlement (A&S) and claims reform. MRG has also established a Performance Monitoring Group.)

The second stream that reports to the FSA steering group, deals with the non-subscription side of the industry and is headed by Duncan Boyle. This stream has proposed a code of practice to FSA. It has been surveying the market to establish the extent of contract certainty issues in non-subscription business.

Developments in the London Market

There are particular challenges in the London market because of the way business has traditionally been conducted. In essence, slip signing and policy production have taken place 'after the event" – as illustrated by the following timeline/sequence:

Placement -> Inception -> finalisation of slip/queries resolved ->closing/slip signed -> policy produced -> policy reviewed -> finalisation of policy/issues resolved -> policy signed -> policy sent to broker - broker sends policy to client.

This sequence often means policies are not finally produced until well into –sometimes nearing the end - of the period of coverage or, in some cases they have not been produced at all.

MRG – Contract Certainty Code of Practice

The MRG members have now produced a Contract Certainty Code of Practice. This extends the original definition of "contract certainty" – "contract certainty is achieved by the complete and final agreement of all terms (including signed down lines) between insured and insurers before inception" – by adding "In addition:

1. The full wording must be agreed before any insurer formally commits to the contract
2. An appropriate evidence of cover is to be issued within 30 days of inception"

Targets have been set for the % of contracts meeting this definition:

• 30% (of monthly volume) by end O5
• 60% by end June 06
• 85% by end 06

Aggregate market progress will be reported to FSA; each firm remains responsible to FSA for its own performance.

The Code of Practice has 8 Principles each with accompanying guidance and definitions:

1. Brokers will provide submissions that satisfy the contract certainty definition and checklist to obtain firm quotes and place firm orders.
2. Each insurer will be satisfied that the submission meets the contract certainty definition and checklist before formally committing to the contract, ensuring that any conditions or subjectivities are clearly expressed.
3. Brokers will notify all terms to their client and obtain their client's agreement before inception.
4. Brokers will calculate signed lines by inception and notify them to each insurer no later than 30 days after inception date, or by inception date on request.
5. Brokers and insurers will not take part in post-inception over-placing.
6. Brokers and insurers will ensure that post-inception amendments are documented and agreed as endorsements.
7. Brokers and insurers will each collect and maintain data on their contract certainty performance at individual contract level.
8. Brokers and insurers will ensure that appropriate evidence of cover, including security, is issued within 30 days of inception.

The new structure builds on previous work in the London Market including:

• The LMP slip and improving compliance with LMP slip requirements;
• De-linking i.e. the separation of payments and invoicing from slips/policy production (part of accounting and settlements (A&S)); and
• Other developments in market systems/infrastructure, including those involving Xchanging and Kinnect.

This new timetable has significant consequences for firms because it pushes policy drafting/conclusion from the leisurely world of back office "admin" into a more commercially sensitive/time critical arena. This will require significant investment to deliver the skills necessary to move policy wording out of the darker areas of the back office.

Policy wordings

MRG have listed 9 attributes in their MRG Contract Certainty Measurement:

1. Wording (e.g. consistent, coherent and complete);
2. Law, jurisdiction and arbitration (e.g. choice of law and jurisdiction defined);
3. Commercial terms (e.g. premium and brokerage defined);
4. Risk disclosures (e.g. clear reference to supporting information);
5. A single agreed version (e.g. available to all, definitive, timely);
6. Compliance (e.g. meets relevant regulatory requirements);
7. Sound legal basis (e.g. several liability clearly established);
8. Comprehensible (e.g. plain English); and
9. Duties clearly allocated (e.g. basis of agreement to contract changes)

FSA has also emphasised the potential legal risks in policy drafting and the need for expert legal advice and regular reviews of policy wordings against market sector practise. The widespread use of "standard wordings" brings potential benefits but also risks which need to be addressed. Standard wordings are particularly important as the basis for subscription business and reduce costs and potentially untested "bespoke" drafting. The dangers, however, are demonstrated by cases such as Dornoch Ltd and Others v Royal and Sun Alliance Insurance Plc, where a number of standard clauses had been used which made no sense in combination; in that case the Court of Appeal refused to re-write standard clauses to give them a purposive or business common sense construction.

Another danger is the uncertain provenance and quality of some standard market wordings; the origins of some may be lost, a "standard" is not necessarily an indication of good drafting and to what extent is there reliable guidance on how the particular wording can be used? Finally, whilst FSA may see the benefits of industry standards, the European Commission remains concerned about the potential effect on competition. The use of standard wordings is subject to specific competition law rules (in the EU insurance block exemption) and the latest EU investigation into commercial insurance may lead to these requirements being tightened further.

Beyond policy wordings, there are a wide variety of commercial arrangements which have traditionally been very poorly documented or not documented at all. One example, which led FSA to adopt specific rules, was the agreements between insurers and intermediaries concerning the basis on which premiums and claims monies are held. It transpired that there was widespread uncertainty. The industry has recently been criticised by FSA for failing to have the necessary documentation in place by the summer deadline (when certain client money transitional rules expired). Another example of poor documentation is the lack of written agreements apportioning responsibility (e.g. for product or sales process design or fulfilment of other regulatory or commercial obligations) between the different participants in the insurance "chain".

Conclusion

Contract certainty has to be addressed at two levels:

• market reform and market initiatives
• action within individual firms. All firms should by now have a well established contract certainty project or initiative. FSA is reviewing progress by individual firms ahead of its stock take in December '05.