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Closed consultations

Future client financial protection arrangements

1 March 2011

    The deadline for submission of responses to this consultation was 28 February 2011.

    The information below is for reference purposes only.

    You can now view the analysis of responses.

1. Introduction

Purpose of this consultation

1.1 The purpose of this consultation is to seek views on specific proposals for amendments to our client financial protection arrangements from October 2011 and on further change we are considering proposing for implementation from October 2012 onwards. These proposals follow on from the independent review of the current client financial protection arrangements (PDF, 1.2M), undertaken for us by Charles River Associates (CRA). The deadline for responses to this consultation is 28 February 2011.

Background to our review and this consultation

1.2 Our review of the client financial protection arrangements and this consultation have been prompted by a number of issues. Primarily these are:

  • difficulties arising in the professional indemnity insurance (PII) market. This has been most apparent from an increase in the value of claims arising as well as an increase in the number of firms that have been unable to obtain PII through the open market and have therefore ended up being covered through the Assigned Risks Pool (ARP). The ARP itself has also seen very substantial claims made against firms it is covering. The current Minimum Terms and Conditions (MTC) and the mechanism for funding ARP claims have all caused significant concern to the insurers providing PII and on which the profession depends for the maintenance of the current open-market arrangements;
  • concerns about the overall cost of insurance and Compensation Fund claims arising, and the costs this places on the whole profession, both directly and indirectly, and concerns that the current arrangements, with their very broad and undifferentiated MTC, actually increase risk to the public rather than reduce it;
  • from October 2011 the SRA expects to be regulating alternative business structures (ABS) as well as traditional law firms and, therefore, it is important that our client financial protection arrangements are appropriate to cope with these new structures and with an environment in which we can expect to see relatively rapid changes in underlying business structures and in the ways in which services are delivered to the public;
  • the SRA is fundamentally changing its approach to regulation from one based on compliance with detailed rules to one that is principles based and outcomes focused and where our regulatory activities are based on a clear understanding and assessment of risk; and
  • the current financial protection arrangements, although subject to some detailed amendment in recent years, were largely established before the implementation of the current regulatory structures; importantly the establishment of the Legal Services Board (LSB) as the oversight regulator and the establishment of the Solicitors Regulation Authority as the independent regulator of the solicitors profession and solicitors firms.

1.3 As part of the consideration of the current arrangements, the SRA appointed CRA to conduct a review of the client financial protection arrangements. CRA were asked to conduct a "root and branch" review assessing not only the current difficulties in the market but also examining the arrangements that would be appropriate for the medium to long term. Much of the analysis in this consultation paper draws on their report and relevant sections are referenced for further detail. The SRA does not necessarily agree with all aspects of the CRA report.

PII arrangements and the Compensation Fund

1.4 Solicitors in England and Wales have used different models to deliver PII since it became mandatory in 1976. These include the use of a:

  • Master Policy – where a single insurance policy covers the whole profession and is underwritten by insurers and the premium for the policy is collected through a levy on the profession as a whole (this was the system from 1976 to 1987);
  • Solicitors Indemnity Fund (SIF) - where a single fund is used by the profession, with funds collected through a levy on the profession as a whole, and which is underwritten by the profession who are therefore both insurer and insured (this was the system from 1987 to 2000); and
  • the current regime of using the open market, in this instance within a structured framework provided by the Qualifying Insurers Agreement which stipulates MTC which all insurers must provide.

These are the only three models permitted by legislation and are compared in the CRA report.

1.5 All firms regulated by the SRA are required to ensure that they have a PII policy which meets the MTC set by the SRA. The value of premiums in 2009/10 for the compulsory layer was £246 million, and in 2010/11 is estimated to be around £213m (however, this figure needs to be treated with caution as our view is that a number of insurers have structured policies this year so as to reduce the level of premium payable for the qualifying element of the insurance in order to limit their exposure to the ARP - we discuss this issue further at paragraph 4.48 onwards below). Our best view is that, on a like for like comparison with the 2009/10 premiums, total premiums paid for 2010/11 are likely to be in the order of £260m. Claims arising from conveyancing have been particularly high in recent years. This is a phenomenon that has arisen during previous downturns in the underlying property market which creates conditions where incidents of professional negligence or fraud are much more likely to be identified and thereafter give rise to insurance claims.

1.6 The ARP provides qualifying insurance for firms that are unable to obtain PII cover on the open, commercial, market and also meets claims in respect of uninsured firms. The cover provided by the ARP meets the MTC. Premiums are set at a high level designed to place them at the very top end of those charged in the open market and to ensure that there is no financial incentive on firms to enter the ARP rather than obtain open-market cover. Any shortfall between premiums paid by ARP firms and claims against the ARP is paid by Qualifying Insurers in proportion to their market share of the value of premiums for the compulsory layer of cover.

1.7 In the past the ARP has typically provided insurance for around 50-70 firms, but in 2008/09 this increased to 263 and in 2009/10 this increased further to 320 firms. These figures are higher than those usually quoted because they include all firms in the ARP including those who did not apply but claims against which have been met because they did not have qualifying insurance in place. In 2010/11 it appears that the figure is likely to be similar to that for 2009/10. Similarly, the value of claims in the ARP has increased substantially from around £5 million per year to an estimate of £40 million for 2008/09. This figure remains an estimate as claims still need to be settled in order for the precise figure to be established. Although we do not yet have a complete picture of the likely value of claims against the ARP for 2009/10, current indications are that the figure is likely to be of the same order as that for 2008/09. The cost of the ARP is disproportionate to the number of firms in it – it provides insurance for around three per cent of the profession, yet costs are equivalent to 19 per cent of the total value of premiums.

1.8 The ARP has been identified as conducting a number of different roles including:

  • providing qualifying insurance to firms unable to find cover in the open market and therefore facilitating the rehabilitation of firms in difficulty – CRA identify that for 2008/09 this led to claims of around £3.7 million set against 26 firms successfully exiting the ARP;
  • the provision of temporary qualifying insurance cover – in 2008/09 around 340 firms were temporarily unable to obtain insurance, primarily due to the single renewal date, although they subsequently found open-market cover and did not need ARP cover for a longer period thereafter;
  • client protection for firms that do not have PII – around £2.1 million of costs in 2008/09 related to "non-applied" firms that did not comply with the regulation to obtain insurance; and
  • orderly run-down and the insurer of last resort for firms that close – around £33.6 million of claims in 2008/09 relate to this role where the ARP provides insurance for firms that ultimately close and enter run-off.

1.9 PII does not cover claims where the sole practitioner or all principals of the firm have been dishonest. These are covered by the SRA's Compensation Fund which was also briefly considered by CRA. SRA role in respect of financial protection.

1.10 The SRA has a number of regulatory objectives including client financial protection which it meets by ensuring that there are effective professional indemnity and compensation fund arrangements. The SRA's approach to the client financial protection review should be seen in the light of both our wider regulatory objectives and our broader approach to regulation generally.

1.11 One of the core approaches of the SRA is to ensure that it operates in accordance with the Government's Principles of Good Regulation namely that regulation is: proportionate; accountable; consistent; transparent; and targeted.

1.12 CRA's report sets out that the justification for intervention in markets is the existence of a market failure i.e. the market must be failing to meet the regulatory objectives before regulation is required. CRA also highlight that there may be areas where the existing regulation is either causing problems or may not be as effective as it could be – described as regulatory failures.

1.13 The SRA agrees with the approach set out by CRA that identified market or regulatory failures are an important starting point for the consideration of new regulatory intervention or changes to existing regulatory interventions to be appropriate. Furthermore, the impact of regulatory intervention also needs to be assessed, and amended where necessary, to ensure that it brings overall benefits to clients and is in the public interest.

Objectives and Principles

1.14 The CRA report highlighted that market failures arise because of the inability of some clients to assess the quality of their solicitor or the inability of some clients to protect themselves against the competency or financial failures of their solicitor. This analysis applied in the context of our broader regulatory objectives has led us to establish the following Objectives and Principles against which the client financial protection arrangements should be assessed.

1.15 The Primary Objective of the scheme is to protect clients from financial loss caused by impropriety by firms, such as negligence, dishonesty and insolvency. The Secondary Objective is to maintain the confidence of the public in the regulated profession where the actions of individual solicitors and firms might otherwise lessen it.

1.16 The scheme has to meet eight Principles. The scheme should:

  • 1. Provide a fair, transparent and accessible system enabling those covered by the scheme, who have suffered loss as a result of breach of duty by a law firm, to be promptly and properly compensated;
  • 2. Be the minimum necessary to meet its objective and cost effective in providing client protection in the most efficient manner including the transition from the existing system of protection;
  • 3. Encourage competition between different legal services providers and allow entry and innovation in new business models;
  • 4. Encourage an independent, strong, diverse and effective legal profession;
  • 5. Be targeted, intervening only where there are clear problems that need to be resolved;
  • 6. Seek to avoid unintended consequences in terms of the impact on law firms, clients, insurers or the wider regulated community;
  • 7. Support, but not replace, regulatory supervision regarding professional standards; and
  • 8. Provide appropriate incentives for lawyers and law firms to undertake risk management by incorporating an element of polluter pays into the scheme design.

Question

1. Do you agree with the Objectives and Principles?

Future developments for PII arrangements

1.17 The consultation paper sets out a number of areas where the SRA proposes that changes should be made to the current PII arrangements. It is proposed that some of these changes can be made from 1 October 2011 (these are set out in section 3) while others require additional consideration, including, for some, the collection and analysis of further evidence, and engagement and consultation with stakeholders to assess their impact more fully before detailed proposals are formulated for further consultation and implementation. These further changes, which may be implemented from October 2012 onwards, are set out in section 4.

1.18 However, it is essential for consumers, the profession, legal service providers and the insurance industry to understand the direction of the SRA's approach to any future developments of our financial protection arrangements. As already set out above, the SRA intends to operate in line with the Government's Principles of Good Regulation, the use of market failure analysis and the Objectives and Principles set out.

1.19 One of the implications of this is that in future, where regulatory restrictions can be lifted without causing problems for the Primary and Secondary Objectives, the SRA will seek to ensure that there is greater flexibility in PII arrangements. We believe that this will bring ultimate benefits to consumers through greater flexibility and competition in the market for PII and the development of insurance arrangements more tailored to the individual needs of firms, the business they deliver and the clients they serve. In principle we believe that a competitive open-market system of PII is capable of providing cost-effective and responsive products to firms that will protect clients. Our judgment is that some of our current interventions in the operation of that market are preventing it from realising its full potential benefits. Therefore, consistent with ensuring the appropriate financial protection of those consumers who require our intervention, our ongoing programme will aim to reduce our level of intervention in the operation of the open market for PII.

1.20 The SRA's approach to regulation more generally is developing and it will be appropriate that the requirements related to PII develop alongside this. The SRA has set out elsewhere the details of its movements towards risk based and outcomes-focused regulation. In line with this the SRA will, over time, be seeking to move towards a more outcomes-focused approach to the client financial protection arrangements.

1.21 In particular, where possible the SRA will seek to remove unnecessarily prescriptive regulatory requirements and replace them with a description of the mandatory outcome that needs to be met. For example, the SRA will seek to move towards a situation where there are clear mandatory requirements but within which there is the ability for firms to tailor PII cover to ensure that it reflects vulnerabilities given their particular clients and areas of business. Firms would not be able to practise in the absence of appropriate cover, or outside the ambit of the cover they have put in place. Our responsibility would be to deliver a prompt and strong regulatory response where firms do not meet these requirements and ensure that clients were protected, through our overall financial protection arrangements, should a firm practise without appropriate cover and claims arose.

1.22 The SRA recognises that this may involve giving some guidance about appropriate cover. For example, the current MTC requires that firms have either £2 million or £3 million of cover. Since regulation does not currently apply on an activity basis, the CRA report noted that this blanket approach is needed in order to ensure that typical high value cases for individuals are covered but that the levels may need to be kept under review. However, in future, additional flexibility could be included such that the level of cover is appropriate to the line of business. Hence firms that conduct conveyancing activities in their local area where they never have transactions of above £1 million might be able to reduce the level of their cover, while firms that provide very high value transactions might be expected to increase their cover in line with their typical transactions.

1.23 In general, this approach would enable firms and insurers to structure policies with flexibility around the range of client types, categories of business and levels of claims covered that is applicable to the firm.

1.24 As with those changes set out in this consultation paper, future changes would be subject to consultation and an impact analysis to ensure that changes would bring benefits. The SRA would need to be confident that it had sufficient information flow regarding the activity of firms and the protection that they have in place before enabling greater flexibility in the PII requirements. The SRA recognises that there is a balance to be struck between ensuring that Objectives are met while not unduly limiting the ability of firms and insurers to arrange PII cover that is appropriate to the firm's business needs. The SRA does not intend to compromise on ensuring that those clients that need protection get protection, but neither does the SRA intend to regulate in a way that stifles flexibility and competitiveness, or which detracts from the need for the appropriate identification and management of risk.

Question

2. Do you have any comments on our views about the future development of the financial protection arrangements?

Wider regulatory changes

1.25 As well as identifying problems with the current financial protection arrangements, the CRA report also highlighted a number of areas of wider regulatory concern that are having adverse effects on clients. Some of these are also having detrimental effects on the functioning of the PII market. These issues are closely linked to concerns about principle 7 (supporting regulatory supervision). The SRA intends to undertake additional work in order to assess what further changes to our wider regulatory approach may be required.

1.26 CRA identify that conveyancing claims represent around 50 per cent of all PII claims and are responsible for around 85 per cent of the value of claims arising in the ARP. The SRA is very concerned that such a high proportion of claims arises from one activity and intends to investigate the conveyancing process more widely in order to establish whether changes may be required in order to improve the delivery of the conveyancing process, including the regulation of that process, and reduce the cost of conveyancing claims. The SRA will look to work with other regulators and key stakeholders in conducting this research. We will commence this work early in 2011.

1.27 Other concerns identified include:

  • Feedback from insurers that individuals with three years' post qualification experience (PQE) who are able to set up new firms are statistically more risky than others with insurers suggesting that this boundary should be moved to five years' PQE. As a part of the move to OFR we will be introducing new authorisation procedures, including for sole practitioners, and will consider this issue in that context. Our current view is that the issue is not primarily one of setting a simple PQE boundary either side of which a solicitor may, or may not, establish and run a practice. The number of years' PQE an individual solicitor may have is simply one of the factors to be considered in deciding whether or not to authorise a new business. At least as important, for example, is the range and relevance of experience the solicitor has gained in that period and its relevance to the business and the solicitor's proposed role in that business;
  • Concerns expressed by insurers that the Qualified Lawyers Transfer Test (QLTT) is not sufficiently rigorous and that lawyers with the QLTT are statistically more likely to cause claims. We have recently implemented a new Qualified Lawyers Transfer Scheme (QLTS) and we will monitor the impact of these changes in the context of the PII market so as to identify whether further changes are required;
  • Concerns that some firms are not financially viable and therefore impose additional costs on the other members of the profession through PII claims as well as being unable to pay for their premiums including for run-off cover. We regard this as a significant issue given the proportion of claims against the ARP that are in respect of run-off cover. We will be considering this issue in the context of our move to risk-based regulation, including our authorisation procedures and the reporting and notification requirements we establish to inform our risk assessment of firms.
  • Concerns that there are disproportionate outcomes for black and minority ethnic (BME) owned and controlled firms in the open insurance market, with such firms being over-represented in the ARP. This issue is addressed throughout this paper in respect of relevant proposals.

1.28 In the medium term the SRA expects that the more rapid identification of firms which present an unacceptable risk to our regulatory objectives will lead to a reduction in the number of such firms as they either improve their approach or face closure because of failing to meet regulatory standards. Ultimately this would be expected to reduce the value of PII and Compensation Fund claims, which would be to the benefit of clients and the profession.

1.29 Following the completion of the CRA report, some stakeholders have raised questions as to whether the SRA has sufficient enforcement powers to take action against poorly performing firms. In particular questions have been raised regarding the enforcement powers that can be used against firms that fail to pay premiums either to Qualifying Insurers or to the ARP. The SRA will consider the powers currently available and will seek to make appropriate changes if powers are found to be deficient.

Question

3. Do you have any comments on the wider regulatory issues addressed above?

Outline of proposals for October 2011

1.30 The SRA has the following proposals for changes that would take effect from 1 October 2011. These are summarised below and set out in detail in section 3.

Proposal 1 – Remove the restriction of the single renewal date:

1.31 With effect from 1 October 2011, we propose that the requirement for all firms to renew their compulsory PII cover on 1 October of each year will cease. Firms will have freedom to renew their PII cover at any time they wish subject to ensuring that they hold Qualifying Insurance at all times and requirements to provide information to the SRA which confirms the presence and the scope of the cover.

Proposal 2 – Remove financial institutions from the compulsory MTC:

1.32 With effect from 1 October 2011, we propose that the MTC will permit the exclusion of cover for claims by financial institutions conducted on or after 1 October 2011, although claims arising from work conducted before this date will continue to be covered through the MTC. Firms and insurers will be free to arrange cover for claims by financial institutions but this will be a commercial decision for the firms and insurers, i.e. it will be a permitted exclusion from the MTC. The policies of qualifying insurance provided by the ARP would include this exclusion.

Proposal 3 – Increase controls over the ARP

1.33 With effect from 1 October 2011 we propose to reduce the time for which a firm is eligible to be in the ARP from 12 months to 6 months and require ARP firms to develop and implement effective plans to either exit the ARP into the open insurance market or undertake orderly closure.

Proposal 4 – Clarifying obligations on insurers to provide information to the SRA:

1.34 With effect from 1 October 2011, we propose that insurers will be required to provide information to the SRA regarding firms that fail to pay their insurance premiums and firms that insurers believe may have mis-represented information. At present some of these information requirements are permissive rather than compulsory. The SRA will work with the Association of British Insurers (ABI) to agree guidance setting out the situations in which firms should be reported.

Proposals for consultation and views on potential changes in October 2012 or beyond

1.35 In addition to the proposals for changes in October 2011, we are also seeking views on a number of further changes we are considering for implementation in October 2012 or beyond. These are summarised below and set out in detail in section 4. In respect of each of these further changes the SRA believes that, in principle, there is a case for proceeding with them but is not proposing their immediate implementation at this stage because –

  • there are options for the form in which they are implemented and we are seeking views at this stage to assist in further policy development;
  • further research and analysis needs to be undertaken before we can take sound, evidence-based, policy decisions; or,
  • their implementation is dependent on the successful implementation of other changes proposed in this paper.

1.36 We are seeking views on these issues at this stage because it is important that the changes proposed for October 2011 are not seen in isolation but as part of a coherent and long term approach to client financial protection that is implemented in manageable stages and which develops alongside the development and implementation of the SRA's wider approach to regulation. These issues include:

  • Permitting additional exclusions of non-individual clients from insurance cover over and above the proposal for October 2011 to permit the exclusion of financial institutions from the MTC;
  • Changing the role of the ARP
    • either by ending its role as a provider of policies of Qualifying Insurance completely, and so limiting its role to the provider of client protection for firms that do not have PII - this would remove the role of the ARP providing temporary cover to firms and longer term cover (currently up to 12 months but proposed elsewhere in this paper to be 6 months from 1 October 2011) to allow firms to move back into the open-market or close; or
    • by placing restrictions on the work that can be undertaken whilst in the ARP;
  • Altering the manner in which the ARP shortfall is funded through considering either a direct levy on the profession (for example through a SIF mechanism as explained at paragraph 1.4 above) or a levy as a percentage of insurance premiums;
  • Considering whether the functions of the ARP could be added to the SRA's existing Compensation Fund;
  • Considering whether insurers should be able to cancel policies for non-payment of premiums or for fraud or misrepresentation in proposal forms on the part of firms – which would require firms the subject of this sanction needing to find cover elsewhere, including, potentially from the ARP; and
  • Considering changes to the mechanism for funding the Compensation Fund.

Question

4. Do you agree with the SRA's two-stage approach to developing the financial protection arrangements?

Areas of the current arrangements where we are not proposing or seeking views on changes

1.37 As part of its root and branch review, CRA considered a number of other aspects of the current arrangements where they recommended no changes and the SRA proposes to make no changes. In order to provide a complete and coherent picture of the arrangements we propose for client financial protection, these areas are set out in section 2 of this paper.

2. Maintenance of current arrangements

2.1 There are a number of aspects of the current regime and MTC which have been reviewed and where we are proposing no changes.

Basis of insurance arrangements

2.2 The CRA report provides compelling evidence (in Chapter 4) for the continuation of the open market model in preference to a return to using a Master Policy or a model similar to SIF. The CRA report shows that the current arrangement:

  • is cost effective and saved the profession around £1.1 billion compared to the Master Policy and £2.1 billion compared to SIF. It is possible that the total costs of SIF in this comparison are slightly overstated given the large volume and value of claims that were made against the SIF once notice had been given that it was to end. In addition, the Master Policy and SIF included elements not included in the open-market premium figures. However, we are satisfied that CRA's evidence and analysis is, overall, robust. There is no evidence that the Master Policy or SIF were less volatile than the open market;
  • allows prices to be set with reference to a wider range of rating factors than under the SIF or the Master Policy, ensuring that there are clear incentives on firms and insurers for risk management;
  • is targeted, as the open market currently provides insurance to around 97 per cent of all firms and changing the basis for the benefit of the remaining 3 per cent of firms considered by insurers to present an unacceptable level of risk is not proportionate; and
  • encourages competition, as firms are able to choose their provider of insurance; and
  • offers the necessary flexibility to deal with new entry by alternative business structures (ABSs).

2.3 Overall, the current arrangement meets the Primary and Secondary objectives.

2.4 Moreover, the current arrangement directly meets Principles 1, 2 (cost-effectiveness is particularly clear compared to other models), 3, 5, 6, 7 and 8.

2.5 The current arrangement may introduce a potential risk to principle 4 (on diversity). BME firms disproportionately fail to obtain open market insurance. Concerns have been raised that this disproportionality arises not from legitimate risk categorisation by insurers but from categorisation based directly, or indirectly, on grounds of race. The insurers and ABI have denied that this is the case and there is continuing dialogue on the matter between the SRA, solicitor groups, the ABI and the FSA. Proposals made later in this paper for implementation in October 2011 will, we believe, increase flexibility in the market in ways which will improve the ability of firms in the categories in which BME firms are over-represented (e.g. small firms) to obtain qualifying PII, thus supporting diversity. The SRA will continue to monitor and act on any evidence of discrimination in specific cases.

Maintenance of Qualifying Insurers Agreement

2.6 The CRA report highlights (in section 6.3) that, due to the number of terms and conditions that must be fulfilled and the current funding of the ARP, the retention of the Qualifying Insurer's Agreement (QIA) assists with monitoring to ensure that firms have appropriate PII cover.

2.7 Overall, the current arrangement meets the Primary and Secondary Objectives and directly meets Principles 1 and 7.

2.8 However, the current arrangement introduces risks to Principles 2, 3, 4, 5, 6 and 8 if requirements on insurers through the QIA provide unnecessary restrictions on the operation of the open PII market. In line with the intention to ensure intervention is limited, and given some of the changes proposed for the future, the SRA will re-consider whether the QIA is proportionate once these other changes have taken effect. The SRA has some concerns that the current approach maintains a perception that the SRA is "running" the profession's insurance scheme. The SRA considers it more appropriate for the SRA to be clearly seen in the role of setting the minimum requirements for PII with the profession and the insurance market left to ensure this is delivered in an appropriate way.

Qualifying insurers: Financial stability/viability criteria

2.9 The CRA report argues (in section 6.3) against the introduction of additional criteria being placed on insurers before they can be eligible to be Qualifying Insurers.

2.10 Insurers are regulated by the Financial Services Authority (FSA) or equivalent regulators in other countries. The SRA, as a regulator of legal services, should not seek to replicate the role of the FSA in regulating the insurance sector – a task for which the SRA does not have the capability. The SRA is also concerned that any attempt to do so may lead firms to view the SRA as taking responsibility for the performance of insurers.

2.11 Simplistic approaches such as using credit ratings are not perfect, impose an extra cost on insurers and act as an extra barrier to entry to the solicitors PII market, leading to extra costs for the profession.

2.12 Firms should continue to take responsibility for their choice of insurer (advised by brokers and informed by representative organisations as appropriate).

2.13 There is no change here that would enhance compliance with Primary and Secondary Objectives. The decision not to introduce additional SRA requirements is consistent with principle 2. However, should the SRA have concerns that it would be appropriate to raise with the FSA about any Qualifying Insurer we will do so.

Scope and purpose of the ARP: Insurance payouts for claims against uninsured firms

2.14 One of the current roles of the ARP is to provide insurance cover in the case of firms that do not comply with the requirement to obtain their own PII. This aspect of the ARP's role is equivalent to that of the Motor Insurance Bureau (MIB) which exists to compensate the victims of negligent uninsured and untraced motorists.

2.15 CRA's report (section 5.4) estimates that the cost of claims related to this role in 2008/09 was £2.1 million. They recommend that this role continues in order to meet the objective that clients are protected even where firms fail to comply with regulation. However, the SRA considers it appropriate to take steps to ensure that, through its regulatory activities of authorisation and supervision, it has visibility of all regulated firms' insurance arrangements and it will be taking steps through the reporting and notification requirements it places on firms to ensure that this is the case. In addition, we will seek to take swift regulatory action in respect of any firm practising without the required PII cover. So, for the avoidance of doubt, firms should be aware that regulatory sanctions will be pursued where firms fail to comply with the requirements to obtain PII. The ARP manager will seek redress from firms where claims are paid out including, for the costs associated to those claims (subject only to this being a commercial decision for the ARP).

2.16 The current arrangement fully meets the Primary and Secondary Objectives as well as the Principles.

Scope and purpose of the ARP: Provider of run-off cover to firms that do not have open-market run-off cover

2.17 Firms that close without a successor practice are required to have run-off cover for six years. One of the roles of the ARP is that of providing run-off cover to firms that close down in circumstances where run-off cover is not provided by the open market. CRA estimates that the cost of claims associated with this for 2008/09 was around £33.6 million (section 5.7 of the CRA report). This is by far the largest single burden on the ARP.

2.18 If the ARP did not play this role it seems likely that many firms would be uninsured with the claims returning to the ARP via its role of the insurer for firms that are uninsured. Explicitly providing for run-off cover means that some firms apply for this cover, enabling the ARP to obtain some premiums in advance.

2.19 However, the extent to which firms pay premiums to the ARP for run-off cover is very poor with CRA identifying that since 2000/01, only £0.3 million of premiums were paid compared to premiums of £5.2 million which were not paid.

2.20 Firms and individuals will be pursued for premiums and allowing a firm to close without paying a run-off insurance premium represents a clear disciplinary issue for principals of a firm. The ARP/SRA will seek redress from firms, and individuals where appropriate, where premiums have not been paid including for the claims that are paid out and any associated costs of managing these claims.

2.21 In addition, there appears to be a clear link between the extent to which firms close and choose not to pay run off cover premiums (or are unable to do so) and the underlying financial viability of firms. As a part of the wider work we will be undertaking in the light of the CRA report we will be examining this issue further. Our position is that it is untenable to continue with an approach that enables firms, lacking underlying financial viability, to continue in practice and then close without the means to purchase the required run-off cover and so place the burden of any subsequent insurance claims on the profession as a whole.

2.22 The current arrangement fully meets the Primary and Secondary Objectives as well as the Principles.

Funding the ARP: Premium setting for ARP firms

2.23 At present firms that are in the ARP typically pay premiums of 27.5 per cent of their previous year's gross fees for cover of £2m for any one claim. Firms that are limited companies or LLPs are required to have cover of £3m for any one claim and typically pay premiums at a rate of 30 per cent of gross fees. The CRA report (section 5.10) states that it is important for firms in the ARP to contribute to the costs of the ARP and notes that the current premium rates act as a strong incentive to avoid the ARP.

2.24 CRA raises concerns that the current premium rate may have the effect of pushing firms towards failure to pay or failure altogether, because firms may not be able to afford the premium. CRA proposed that the flat premium should be replaced by individual underwriting specific to the firms in the ARP. The SRA disagrees with CRA's proposal. Subsequent analysis and discussions between the SRA and stakeholders has indicated that this change could be impractical and expensive. Any firm entering the ARP is one that commercial insurers have already decided presents a risk that they are unwilling to underwrite. Therefore, it does not appear to be feasible to then further differentiate underwriting decisions so as to make fine assessments of the relative levels of risk posed by these firms. In addition, as explained further in section 4, the SRA is seeking views on the proposition that the ARP would be further restricted in its role of providing policies of Qualifying Insurance or no longer provide such policies at all. Hence there is little advantage in making changes to premium rates which may continue to be applicable for a short period of time. In addition, maintaining the current situation has no impact on Objectives.

2.25 Further analysis is required on the appropriate method for funding the ARP more generally. If the ARP continues to provide insurance to firms that continue in business, the premiums paid by these firms will be considered along with this further analysis.

Questions

5. Do you agree with our conclusion that we should maintain an open-market system of PII?

6. Do you agree with our conclusion that we should maintain a Qualifying Insurers Agreement?

7. Do you agree with our conclusion that we should not place additional criteria on insurers in order for them to be eligible to be a Qualifying Insurer?

8. Do you agree with our conclusion that we should maintain the function of the ARP in meeting claims against uninsured firms?

9. Do you agree with our conclusion that we should maintain the function of the ARP in providing run-off cover to firms that do not have open-market run-off cover?

10. Do you agree that we should maintain the current approach to setting premiums for firms entering the ARP?

3. Proposed changes for October 2011 and their impact

3.1 We have summarised the equality and diversity impacts for these proposed changes here and further information is available in the initial equality impact assessment report, attached at Annex A to this paper and in the full CRA report.

Single renewal date

3.2 The single renewal date arose as an accident of history. The Master Policy and SIF had a single renewal date and this has continued as insurance has been delivered through Qualifying Insurers. CRA have identified that "there is no market failure for which the appropriate regulatory solution is a single renewal date". They have also highlighted that the current arrangements are causing problems in the insurance market for firms and insurers alike. Hence the SRA makes the following proposal:

Proposal 1

3.3 Remove the restriction of the single renewal date: With effect from 1 October 2011, the requirement for all firms to renew their compulsory PII cover on 1 October of each year will cease. Firms will have freedom to renew their PII cover at any time they wish subject to ensuring that they hold Qualifying Insurance at all times.

3.4 Resourcing and timing constraints for insurers and brokers mean that some firms have short periods to consider any quotes made by insurers with 10 per cent of solicitors stating that they have difficulty in renewing their insurance because of this.

3.5 The single renewal date also led around 340 firms to temporarily fall into the ARP in 2008/09 and 179 firms to temporarily fall into the ARP in 2009/10. These are not firms that Qualifying Insurers are unwilling to insure since they were able to obtain insurance within 60 days of 1 October. Rather, these are firms that are unable to obtain insurance because of the resourcing and timing constraints imposed by the single renewal date. The maximum period a policy can be backdated was reduced to 30 days with effect from 1 October 2010.

3.6 Further details can be found in section 6.4 of the CRA report.

3.7 For the avoidance of doubt, the concept of an "indemnity year" will remain as the 12 months from 1 October each year. This concept is required for the purpose of funding the ARP and may be necessary for facilitating other parts of the PII arrangements.

Expected impact

3.8 The CRA report (section 6.4) sets out a number of different impacts that would be expected from removing the restriction of the single renewal date.

3.9 Removing the restriction of a single renewal date would reduce the need for firms to seek temporary cover from the ARP. The benefit of this would mainly arise for small firms, up to three partners, that currently suffer most from the resourcing and timing constraints caused by the single renewal date.

3.10 Since this would reduce the number of firms seeking temporary cover from the ARP, this would also reduce the number of firms that end up in the ARP for a longer period because of a claim arising during what would otherwise have been a temporary period in the ARP (which might make an open-market insurer less willing to provide cover).

3.11 Removing the single renewal date may also make it easier for new entrants to the legal services market to obtain insurance at any time of the year. A similar reason would also bring benefits to a small number of firms seeking to exit the ARP as they would be more likely to be able to do so at any point rather than being, effectively, constrained only to do so at the annual renewal date.

3.12 CRA also suggest that moving away from a single renewal date would be expected to increase the time that firms have to consider the quotes provided by insurers, potentially enabling firms to compare quotes from different Qualifying Insurers and therefore to obtain lower prices. This would also be expected to mainly benefit small firms.

3.13 As insurance is currently based around the single renewal date it is expected that it will take some time for a large proportion of the market to move away from the 1 October renewal and it is likely that a peak in renewals will remain on 1 October for a number of years. It will be for firms and insurers to determine the timing of insurance renewal in accordance with their business needs.

Equality and diversity impact

3.14 The benefits that have been described above for small firms would indirectly benefit BME firms which are disproportionately represented among one and two partner firms and female firms which are disproportionately represented among one partner firms.

SRA impact

3.15 The proposal will also have implications for the SRA. Currently, the renewal of practising certificates is linked to the renewal of insurance. Removing the single renewal date for insurance would break this link. This will require changes to the SRA's oversight and monitoring of firms in order to ensure that firms obtain insurance on a continual basis.

3.16 The SRA will seek more frequent information from Qualifying Insurers regarding the firms and individuals that are insured and the renewal date of their insurance policies in order to monitor this over time. The SRA is confident that appropriate processes can be in place by October 2011 to ensure robust monitoring continues. The SRA will also seek information from Qualifying Insurers regarding firms that do not renew their policies with that insurer when they expire. It is expected that information on new policies and renewals will be sought on a monthly basis. Information on policies that expire may be sought more frequently.

Impact against objectives

3.17 Overall, this proposal meets the Primary and Secondary objectives. This proposal directly meets principles 2, 3, 4, 5 and 6.

3.18 The proposal introduces a potential risk to principle 7 (supporting regulatory supervision) if the SRA systems are not adapted to manage variable renewal dates. For this reason the SRA will ensure that robust systems are in place before 1 October 2011 to capture and record relevant information about each firm's Qualifying Insurance including inception and expiry dates.

Question

11. Do you have any comments on the proposal to remove the single renewal date and the impacts identified? Are there any further consequential impacts of this change that you believe we should consider?

Client Scope of the MTC

3.19 In line with the objectives and principles set out in paragraphs 1.10 to 1.16, it is appropriate for the SRA to regulate the provision of insurance for clients who are unable to protect themselves but not to intervene where clients are sufficiently informed to act in their own interests.

3.20 At present the MTC requires that lawyers obtain insurance for all possible types of work conducted by firms including work for sophisticated clients. As such the current MTC is not a targeted intervention since it goes beyond what strictly is necessary to protect clients. Hence the SRA makes the following proposal:

Proposal 2

3.21 Remove claims by financial institutions from the compulsory MTC: with effect from 1 October 2011, insurance cover for claims by financial institutions will be a permitted exclusion in the MTC. The MTC will not require cover for claims by financial institutions arising from work conducted on or after 1 October 2011 although claims arising from work conducted before this date must continue to be covered through the MTC. Firms and insurers will be free to arrange cover when acting for financial institutions or offering undertakings to financial institutions, but this will no longer be required within the MTC. This exclusion would be applied to policies of qualifying insurance provided by the ARP.

3.22 Section 4 sets out proposals, over a longer period, to limit the scope further to requiring the protection of individual clients and thereby removing corporate clients from the requirements within the MTC. Those proposals will be the subject of further consideration, but this proposal, for October 2011 is consistent with the longer-term proposals, if they were adopted.

3.23 Currently it is common for firms to offer undertakings to financial institutions during the course of conveyancing transactions. Should firms fail to complete all the necessary activities, the financial institutions (the lenders in these transactions) can make claims against the firm that will be covered by the firm's PII policy. CRA's report highlights that around 50 per cent of all claims relate to conveyancing with lender claims around 50 per cent of conveyancing claims (i.e. around 25 per cent of all claims are lender based conveyancing claims).

3.24 One of the difficulties caused by the current arrangements is that insurers are unable confidently to identify those firms that conduct no conveyancing. This is because firms can change their business mix without telling their insurer who would remain liable to cover any risks that subsequently arose. Hence insurers may set premiums to firms on the basis that the firm stating that they conduct no conveyancing could actually provide conveyancing services.

3.25 The current approach may also lead some firms to "dabble" in providing conveyancing when they may not be up-to-date with the appropriate procedures to follow. The SRA intends to conduct further research and analysis into the regulation of the conveyancing process more generally, as set out at paragraph 1.26 above.

3.26 It is proposed that the exclusion of financial institution cover from the MTC will arise through the use of a "permitted exclusion". That is, insurers will be permitted to exclude cover for claims by financial institutions from the insurance that they provide to any given firm. "Financial institutions" are defined in the draft SIIR and QIA annexed to this consultation paper as, "….any undertaking or unincorporated association which carries on a business of lending money (which may include mortgage lending) or otherwise providing or issuing credit including, without limitation, any bank or building society."

3.27 It is important to note that we propose to permit the exclusion of all work undertaken for financial institutions, and not just for conveyancing related work undertaken for such organisations. This is because the primary reason for permitting this exclusion is that we agree with CRA's analysis that we should not seek to put in place regulatory protections for clients that do not require those protections. CRA recommended, on this basis, that we enable the exclusion from the MTC of all corporate clients. As explained below (at section 4 of this paper), we consider that further work is required to ensure that we understand fully the effect of any particular definition adopted to restrict the coverage of MTC solely to "individual" clients. However, we are confident that the definition we have adopted of "financial institutions" does provide a clear and readily identifiable sub-set of corporate clients that we should allow to be excluded from the MTC at this stage. In addition, this exclusion has the additional benefit of addressing the key area for insurance claims, both in the open-market and in the ARP, i.e. conveyancing transactions.

3.28 For the purposes of determining whether a particular claim is covered it is proposed to use the date of the act, error or omission giving rise to the claim as the trigger date. The rules changes have been drafted on this basis. An alternative approach is to use the date of instruction as the trigger date and we would welcome views which would be more appropriate and would provide the greatest degree of clarity.

Expected impact

3.29 The main impact of this proposal is expected to arise in the conveyancing area which is where undertakings to financial institutions acting as lenders are common. Firms and insurers would be free to arrange insurance cover beyond the MTC such that cover for financial institutions is not excluded (as currently).

3.30 The CRA report (section 6.1) sets out a number of different impacts that would be expected to arise.

3.31 Approximately 36 per cent of firms do not conduct residential conveyancing and the majority of these would be expected to gain from lower premiums as they would not seek to include cover to undertake work for financial institutions (or only seek cover to undertake work for financial institutions that excluded conveyancing). This is likely to particularly benefit small firms as these are the firms currently least able to signal to insurers that they do not conduct conveyancing.

3.32 The proposal would also be expected to reduce the number of firms falling into the ARP because insurers would be able to distinguish which small firms do not conduct conveyancing. Given the high risks associated with conveyancing, offering conveyancing services in combination with other factors that make a firm appear to be a potentially poor insurance risk may mean some insurers are not willing to offer insurance to a particular firm. Helping a firm to indicate that they do not conduct conveyancing services could therefore enable that firm to obtain open market insurance.

3.33 The proposal would be expected to reduce the number of firms that dabble in conveyancing. This is because the cost of including cover to undertake work for financial institutions would become explicit and firms that only conduct a small amount of conveyancing would not find it worthwhile to include the additional cover. This would be expected to reduce regulatory concern with such firms, improve the quality of conveyancing advice and reduce the overall cost of conveyancing claims.

3.34 A substantial proportion of firms that conduct conveyancing would be expected to include additional financial institution cover in their policies. For example, in Ireland it is estimated that around 30-40 per cent of the profession voluntarily purchased additional cover when undertakings to lenders were removed from the equivalent of the MTC in Ireland. CRA estimate that 30-60 per cent of firms in the UK may seek to voluntarily include financial institution cover.

3.35 It is also expected that financial institutions would only include firms on their panels that have policies that include appropriate cover. CRA note that there is already a trend to reduce the number of firms on financial institutions' panels. Financial institutions have indicated that if the cost of checking whether firms have the appropriate PII cover is high, then they would be expected to reduce the size of their panels further which may reduce the number of small firms on panels. A centralised database of firms that have insurance to undertake work for financial institutions may be useful – this would be for The Law Society and the Council of Mortgage Lenders to consider.

3.36 Removing claims from financial institutions from the compulsory cover would affect the cover offered through the ARP – as we propose that the policies provided by the ARP would contain the financial institutions exclusion. Since 85 per cent of claims in the ARP are related to conveyancing and 50 per cent of these are claims from financial institutions, this would be expected to reduce the claims arising through the ARP.

3.37 PII operates on a claims-made basis. For this reason we do not consider it appropriate simply to remove cover from the MTC without regard for the date at which work was conducted. That is, work has already been conducted in which undertakings have been made to lenders where lenders understood that they would have protection through the existing PII arrangements. The work already done cannot be changed and therefore protection needs to remain in place for historic work. Hence we propose that work for financial institutions conducted before 1 October 2011 should continue to be covered through the MTC.

3.38 If work conducted before 1 October 2011 was not included in the MTC, it is possible that, before 30 September 2011, this would generate a sudden influx of notifications of circumstances that might give rise to a claim. A similar influx was observed with respect to SIF before the commencement of the Qualifying Insurer regime.

Equality and diversity impact

3.39 It will be difficult to identify any statistical evidence about the equality impact on firms that do offer conveyancing as we do not have reliable evidence of which firms undertake conveyancing work.

3.40 As a result of the disproportionate representation among small firms, BME and female firms will indirectly benefit from the expected benefits for small firms set out above. There may be an indirect detriment from any reduction in the number of small firms on lender panels and they may find it not cost effective to continue with small amounts of conveyancing work.

3.41 The proposal is expected to make it easier for insurers to assess potential risks and non-conveyancing firms should find it easier to obtain open market insurance, reducing the number of firms in the ARP. There would be a corresponding benefit to BME firms which are disproportionately represented in the ARP.

Impact against objectives

3.42 Overall the proposal is consistent with the objectives on the basis that "clients" is read (as we intend) as "clients who need protection". The proposal is consistent with principles 2,3,4,5 and 7.

3.43 There is a risk to principle 6 (unintended consequences). CRA have highlighted that potential unintended consequences could arise, including causing firms to switch to being regulated by the Council for Licenced Conveyancers (CLC) where the Master Policy does currently cover undertakings to lenders. Given the limited scope of services that can be provided by firms regulated by the CLC (conveyancing and probate), this is considered to be a small risk and, in any event, appropriate choice of the regulatory regime under which a business operates is wholly legitimate.

3.44 CRA have also highlighted that lenders could seek to pursue claims through or against individual borrowers. They note that this has not occurred in Ireland but that instead lenders chose to work only with those firms that had the lender cover. This does remain a potential risk in respect of any claims made against the ARP.

Questions

12. Do you have any comments on the proposal to make insurance cover for claims by financial institutions a permitted exclusion in the MTC and to apply this exclusion to policies of qualifying insurance provided by the ARP and the impacts identified?

13. Do you agree with the definition of "financial institutions" that we have proposed?

14. Do you agree with our proposed approach for implementing this change by way of a "permitted exclusion" form the MTC?

15. Are there any further consequential impacts of this change that you believe we should consider?

Increasing controls on the role of the ARP as a provider of policies of Qualifying Insurance

3.45 Our view is that, for 2011 we should maintain the role of the ARP as a provider of policies of Qualifying Insurance. At paragraph 4.17 below, we seek views on whether this should continue to be the case from 2012, or from some later date. We have considered whether, from October 2011, we can take steps that help to address our continuing concerns about the ARP as a provider of policies of qualifying insurance, but without the risks that we believe would arise from removing this role at this stage.

3.46 We propose to maintain the current roles of the ARP for October 2011 but to implement a further tightening of the rules regarding entry into the ARP and more explicit requirements on firms whilst in the ARP.

3.47 We know that the majority of firms that enter the ARP do not exit successfully and continue as functioning firms. The majority of ARP firms close and a number of them continue to generate new claims whilst in the ARP and therefore pose some risk to clients.

3.48 At present, firms are eligible to enter the ARP subject only to not previously having been in the ARP for longer than the allowed period and not being in policy default. A firm in the ARP has no particular restrictions or requirements placed on it, and is simply subject to the general SRA regulatory requirements.

3.49 From our management and monitoring of ARP firms it is clear that whilst some take active steps to either address the underlying issues that have led to their presence in the ARP or to plan for orderly closure, many do not. For the firms that do not make and implement such plans there is still the prospect for relatively disorderly closure (or intervention) at the conclusion of their time in the ARP.

Proposal 3

3.50 Given these issues, and our underlying concerns about the ARP as set out in this paper, we consider that in October 2011 we should introduce further measures to create a more controlled environment that better aligns with the Objectives and Principles. The proposed changes are –

  • to reduce the maximum period of time a firm can be covered by the ARP from 12 months to 6 months,
  • to provide a requirement on firms in the ARP that they must develop and implement a robust and credible plan, to be reviewed by the SRA, that will either address the underlying reasons why cover was not obtained on the open market such that open-market cover can be obtained, or will enable the firm to close in an orderly fashion within the six month period in such a manner that clients are protected.

Expected Impact

3.51 This reduction in the period for which a firm could operate in the ARP would have the effect of reducing the volume and value of claims which fall to be met by the ARP as a result of work done by firms whilst in the ARP. It would also require firms in the ARP to focus their attention on the steps necessary to either gain open-market insurance or begin the process of orderly closure as ARP cover would only be available for six months. This would be supported by the requirement for explicit planning on the part of ARP firms.

Equality and diversity impact

3.52 We do not see any adverse impact on equality by requiring ARP firms to develop plans for their future. However, the issues are more complex in relation to our proposal to reduce the time a firm can remain in the ARP from 12 months to 6 months. Although we are not seeking to make any firm decisions this year about whether the ARP should in principle provide any policies of qualifying insurance for firms (see our discussion of possible future changes in section 4 below) we recognise that the proposed reduction from 12 months to 6 months, may mean that for an increased proportion of ARP firms, their time in the ARP may have to be spent organising an orderly close down rather than implementing a strategy for successful exit from the ARP. The potential difficulty in obtaining insurance part way through the year, should be reduced by the removal of the single renewal date although it may take some time for the market to fully adjust.

3.53 Given the disproportionate number of BME firms in the ARP there is potential for this proposal to adversely impact on BME firms and as we work further on our equality impact assessment, we need to weigh up the potential benefits to be gained from the wider proposals set out in this paper and the potential adverse impact of the proposed tighter controls on the ARP.

3.54 We will listen carefully to all our stakeholders on the proposed changes for October 2011 and the longer term debate as to the appropriate scope and purpose of the ARP and future changes that may be introduced as a result.

SRA impact

3.55 We consider that the proposal to be able to require more explicit planning by ARP firms will be beneficial to the ARP in our work with firms to ensure that they take appropriate steps to either exit the ARP or close in an orderly fashion.

Impact against objectives

3.56 This proposal would continue to meet the Primary and Secondary Objectives within the context of the overall financial protection arrangements. There would be a better alignment with Principles 2, 3, 5, 6, 7 and 8. Issues arising around Principle 4 (equality and diversity) are addressed above.

Questions

16. Do you have any comments on the proposal to reduce the time a firm may be permitted to remain in the ARP to 6 months and the impacts identified? Are there any further consequential impacts of this change that you believe we should consider?

17. Do you have any comments on the proposal to require detailed planning by firms in the ARP and the impacts identified? Are there any further consequential impacts of this change that you believe we should consider?

Scope of MTC: Information from insurers to the SRA where premiums are not paid or there has been fraud or misrepresentation in insurance proposals

3.57 Currently Qualifying Insurers are prevented from avoiding or repudiating the PII policy on the grounds of non-disclosure, misrepresentation or in the case of fraud in the information provided on proposal forms. Insurers retain recourse to the firm in the case of non-disclosure, misrepresentation and fraud. In addition, insurers remain on risk where firms fail to pay premiums. The substance of these provisions is considered further in section 4 below.

3.58 One of the concerns regarding the current approach is that where insurers believe that a firm may have misrepresented information or where the firm has not paid its premium, they may not report this firm to the SRA because if the firm was subsequently closed down insurers would have to provide run-off cover (for which they may also not be paid). This creates an incentive to insurers which runs contrary to the public interest (CRA report sections 5.5 and 6.10).

Proposal 4

3.59 Require information from insurers: with effect from 1 October 2011, insurers will be required to provide information to the SRA regarding firms that insurers believe may have misrepresented information or where firms have failed to pay premiums (currently some of the reporting provisions are permissive, allowing insurers to report but not requiring them to do so). The SRA will work with the ABI to agree additional guidance setting out the situations in which firms should be reported and the associated procedures.

3.60 The SRA will therefore require insurers to report firms to the SRA in cases of suspected misrepresentation and fraud or non-payment of premiums. The SRA recognises that insurers are likely to require guidance about the circumstances in which firms, or individuals, should be reported to the SRA. The SRA will therefore work with the ABI and its members to provide this guidance.

3.61 We believe that this proposal is clearly in the interest of clients and in the public interest. Information provided will enable the SRA to identify risks posed by such a firm earlier than would otherwise be the case and to take action. It is also, overall, in the interests of the profession and insurers, since it will enable earlier regulatory intervention which may reduce claims.

3.62 CRA suggested that some form of financial penalties could be considered against insurers who do not report firms that should have been reported. The SRA is not proposing to introduce such penalties at the present, preferring instead to make the changes proposed. The SRA will, however, monitor the number of firms that are reported by insurers and, where firms are intervened, will assess whether firms should have been reported earlier. This monitoring will help the SRA to assess whether additional requirements may be required.

Expected impact

3.63 The main impact arising from the proposal is that there would be an increase in the number of firms reported to the SRA by insurers. This would provide the SRA with additional information regarding firms that may need to be shut down. In turn, this would be expected to bring benefits to clients through removing high risk firms from the profession. It would also benefit the wider profession through protecting all firms from reputational damage and through limiting the cost of PII claims.

3.64 It is possible that insurers may over-report firms to the SRA which could impose additional costs on the SRA and limit the SRA's ability to take appropriate and targeted action. The SRA will work with the ABI to limit the extent to which this occurs.

Equality and diversity impact

3.65 We have not identified any particular impact from this proposal, which is designed to improve the flow of information between insurers and the SRA to assist the SRA in performing its regulatory role.

Impact against objectives

3.66 Overall the proposal is consistent with the Primary and Secondary Objectives. The change also brings the PII requirements more in line with Principle 7 (supporting regulation) as well as encouraging better risk management of firms (Principle 8) who will face regulatory examination if they misrepresent information or fail to pay premiums.

Question

18. Do you have any comments on the proposal to clarify the reporting requirements on Qualifying Insurers and the impacts identified? Are there any further consequential impacts of this change that you believe we should consider?

4. Possible future changes

4.1 There are a number of proposals that the SRA wishes to set out regarding future changes to PII arrangements. As explained at paragraph 1.17 above, we are seeking views on these changes, which we are considering for implementation in October 2012 or beyond. In respect of each of these further changes the SRA believes that, in principle, there is a case for proceeding with them but is not proposing their immediate implementation. We are seeking views on these issues at this stage because it is important that the changes proposed for October 2011 are not seen in isolation but as part of a coherent and long term approach to client financial protection that is implemented in manageable stages and which develops alongside the development and implementation of the SRA's wider approach to regulation.

4.2 In the light of comments received on these proposals we will consider them further, alongside further evidence we will be gathering, and further analysis and, if appropriate, undertaking a further consultation on detailed proposals for implementation.

Scope of MTC: Limited to cover for individuals

4.3 As explained in section 3, at present the MTC goes beyond what is necessary to protect clients because it protects clients who do not need regulatory protection. The SRA proposes that cover for financial institutions should be a permitted exclusion from 1 October 2011. However, this does not ensure that regulation is sufficiently targeted and therefore the SRA proposes that the scope of the MTC should be reduced further to protect only those clients that are not able to protect themselves.

4.4 CRA's report (sections 2.4 and 6.1) sets out evidence that individuals suffer from "asymmetric information" and are unable to assess the quality of their lawyer and are in a poor position to take action to protect themselves. It is clear that individuals need regulatory protection. However, larger corporate clients are unlikely to suffer from an inability to choose an appropriate lawyer, often have in-house legal departments and may be repeat buyers. Firms that offer services to larger corporate clients have brands that are recognised by these clients. All of this indicates that these clients do not need regulatory protection.

4.5 CRA suggest that the scope of the MTC be limited to individual clients and highlight that this may lead to competition and innovation in the terms and conditions available in respect of work for corporate clients, although they note that the impact of this may not be dramatic. CRA note that there may be a need to consider the appropriate definition of "individual" and highlight that there could be merit in using a common definition of eligible clients such as that used by the Office for Legal Complaints (OLC) which is as follows:

  • a micro-enterprise as defined in European Recommendation 2003/361/EC of 6 May 2003 (broadly, an enterprise with fewer than 10 staff and a turnover or balance sheet value not exceeding €2 million);
  • a charity with an annual income less than £1 million;
  • a club, association or society with an annual income less than £1 million;
  • a trustee of a trust with a net asset value less than £1 million; or
  • a personal representative or the residuary beneficiaries of an estate where a person with a complaint died before referring it to the Legal Ombudsman.

4.6 These groups of people are also eligible to use other Ombudsman schemes including the Property Ombudsman and Financial Ombudsman Service. Discussions with key stakeholders have indicated two main concerns with this proposal:

  • it is not clear whether small firms are sufficiently sophisticated purchasers of legal services to not require regulatory protection; and
  • it could give rise to disputes along the boundary of the definition.

4.7 The SRA intends to conduct further work examining the appropriate definition of "individuals" in order to assess which type of organisations can be considered sufficiently sophisticated not to require regulatory protection in respect of PII arrangements. This work will include direct research with business consumers building on that which we have already begun to undertake with individual consumers of legal services.

4.8 The SRA will also conduct further work to assess the likely response of insurers to any changes regarding the scope of clients that are covered. For example, it may be the case that many insurers would offer insurance for all work undertaken by firms irrespective of the client. However, removing certain clients from the insurance that must be offered would enable flexibility in the use of exclusions to the policy such that insurers can tailor the policies to the needs and services offered by individual firms.

4.9 Overall the proposal is consistent with the objectives on the basis that "clients" is read as "clients who need protection", which is the view we take. The proposal is consistent with principles 2, 3, 4, 5, 7 and 8. In particular, this proposal is more aligned with principles 2 (minimum necessary and cost effective) and 5 (targeted) than the interim solution of only removing lenders from the cover.

4.10 There is a risk to principle 1 (fairness, transparency and accessibility) and principle 6 (unintended consequences). There is a risk to fairness, transparency and accessibility if some clients are excluded from regulatory protection when they need this protection. Unintended consequences could arise if the changes lead to an increase in disputes along the boundary or what work is or is not covered by insurance. Further work will consider both of these issues.

4.11 We have not identified any particular impact on equality at this stage, beyond what has been discussed in the context of Proposal 2 above, but will consider this further.

Questions

19. Do you have any comments on whether we should permit a wider exclusion from the MTC such that cover is only required in respect of work done for "individuals"?

20. Do you have any suggestions on the definition of "individual client" that we should consider?

21. What impacts do you consider such a change would have?

Changing the role of the ARP as a provider of policies of Qualifying Insurance

4.12 We have already proposed (see section 2 above) that we maintain the ARP functions of meeting claims in respect of uninsured firms and in providing run-off cover to firms that have not obtained it in the open market. We have also proposed a further tightening of controls on its role as a provider of policies of Qualifying Insurance from October 2011. This section considers further changes to its role as a provider of policies of Qualifying Insurance. This role currently:

  • enables firms to seek temporary cover from the ARP which cover is then not taken up as they find PII in the open-market which is backdated by the permitted 30 days to the beginning of the new indemnity period;
  • enables firms to stay in the ARP for 12 months at the end of which they obtain insurance on the open market (the rehabilitation function); or
  • enables firms to stay in the ARP until they close or are absorbed by a successor practice or for 12 months at which point they close (the orderly closure function).

4.13 Firms have a right to enter the ARP in any of these circumstances (unless they have already been in the ARP for the maximum period allowed, are in default of ARP premiums due, or are in policy default in respect of any premium or other payments due under any QI policy).

4.14 A policy of Qualifying Insurance from the ARP meets the requirements of the MTC in common with policies provided by the open market and, absent any individual application of regulatory restrictions by the SRA, firms may continue to undertake the full range of work undertaken by firms with open-market PII.

4.15 In 2010 we made changes to the ARP rules, reducing from two years to one year the time a firm could spend in the ARP and preventing new firms from obtaining their first PII cover from the ARP. In addition, in the 2009/10 indemnity year we commenced an enhanced programme of scrutiny for ARP firms.

4.16 Notwithstanding these changes already made, we believe it is appropriate to consider further restrictions to the ARP role of providing policies of Qualifying Insurance (over and above those already proposed for October 2011). In particular we are considering changing this role of the ARP:

  • either by ending its role as a provider of policies of Qualifying Insurance completely; or
  • by placing conditions on the work that can be undertaken whilst in the ARP.

These options, on which we seek views, are set out below.

Ending the ARP's role as a provider of policies of Qualifying Insurance

4.17 The original purpose for having an ARP alongside the open market was to ensure that firms would always have access to insurance and therefore insurers would not determine which firms could offer legal services and which firms could not. The intention was that firms would be able to obtain insurance for a period of time (originally up to two years) and, having dealt with any problems that prevented them from obtaining insurance from the open market, to return to obtaining insurance from the open market.

4.18 However, the evidence available (section 5.2 of CRA report) shows that the ARP is failing to facilitate the rehabilitation of firms:

4.19 Over the entire existence of the ARP from 2000/01-2008/09, only 61 firms have successfully returned to the open market after they have been in the ARP. (A successful return is based on the number of firms that are still practising 12 months after leaving the ARP and have not subsequently ceased or faced an intervention);

4.20 The proportion of firms in the ARP that have successfully returned to the open market has fluctuated in the range 3-10 per cent each year; and

4.21 In 2008/09 claims costs of around £3.7 million arose from claims made in respect of work that all firms in the ARP conducted during their period in the ARP, and 26 firms successfully exited equating to a cost of £140,000 per successfully exiting firm.

4.22 In respect of the last point, CRA note that more than half of firms that successfully return to the open market for 12 months subsequently cease practising or face an intervention. Hence the 26 firms successfully exiting from the 2008/09 year represents an upper figure and some of these firms may cease in the course of the next few years. If we assume that, in line with previous experience, some 50 per cent of firms exiting the ARP cease practising in the next 12 months then the best estimate figure for 2008/09 will be 13 firms successfully "rehabilitated" at a cost to the profession equivalent to £280,000 per firm.

4.23 In addition, we consider that the current arrangements go further than is necessary for the SRA, as a regulator, to set the regulatory boundary. The setting of the regulatory boundary is achieved by the SRA setting the minimum PII requirements that regulated firms must have in place to ensure the protection of those clients requiring such protection. Having set that boundary, it is the SRA's responsibility to ensure (through monitoring, supervision and enforcement) that firms comply with that regulatory requirement. Our assessment is that the open market for PII is both capable and willing to develop and provide insurance products to regulated firms that will enable them to meet the regulatory requirements, and that the changes we are proposing for implementation in October 2011 will aid this. Given that, we believe that it is not the role of the regulator to put in place (and effectively manage) insurance arrangements of last resort for firms unable to obtain open-market insurance. No more is it the SRA's responsibility, by analogy, to put in place arrangements to ensure business financing for firms unable to obtain appropriate business financing arrangements from the banks on normal commercial terms.

4.24 Our view is that the current ARP arrangements detract from our regulatory responsibilities and adversely affect clients and the profession as a whole. In respect of the former, the presence of the ARP as an insurer of last resort must lessen the priority that some firms give to the necessity to manage risk effectively and focus on the need to reduce the likelihood of claims and renew their PII cover promptly. In respect of the latter, the creation of, and the funding arrangements for, the ARP are a significant intervention in the operation of the open market for PII. Our view is that there is evidence that this is having the effect of reducing competition in the market for PII and is clearly causing higher overall cost to the profession in order to meet the cost of claims arising from ARP firms. To the extent that firms with poor underlying practices continue to undertake work whilst in the ARP and give rise to new causes of claim, clients are protected inasmuch as they have access to financial redress but would have been better protected if they had not received services of such a nature as to give rise to the need to seek redress.

4.25 The SRA is therefore seeking views on whether we should consider removing the function of the ARP as a provider of Qualifying Insurance. If we were to do so, any firm that failed to obtain insurance from the open market would be required to close. The SRA believes that this change could, potentially, be made from 1 October 2012. It should be noted that, by this point, there will already be additional flexibility in the PII market if our proposals for changes to the annual renewal process and the scope of the MTC have been implemented in October 2011. These changes should increase the ability of firms to obtain appropriate PII cover in the open market meaning that firms not offered affordable cover by insurers are likely to be those judged to be an unacceptable insurance risk. That assessment having been conducted, it is not clear that the rest of the profession should step in and underwrite that risk.

4.26 If the profession believed that it was in the interests of firms to have in place fall back insurance arrangements, the Law Society or another representative body could put in place such arrangements. That is not, however, the role of the regulator.

4.27 It would be important to ensure that the SRA had the necessary enforcement procedures to close firms that failed to obtain Qualifying Insurance and we would wish to review these procedures before implementing such a change.

4.28 Should this change be made, the new arrangement would meet the Primary and Secondary Objectives within the context of the overall financial protection arrangements. Moreover, there would be a better alignment with Principles 2, 3, 5, 7 and 8.

4.29 There is a potential risk to some aspects of Principle 4 (encouraging a diverse profession) if some firms, such as BME firms, face unjustifiable and disproportionate difficulties in obtaining open market PII cover.

4.30 However, based on current statistics, this proposal would cause an adverse impact on BME firms which are disproportionately represented in the ARP. Early indications for the current year indicate (as at 11 November) that 35 per cent of ARP firms are BME as compared to 11 per cent in the overall firm population; a fall from the figures for 2009/10 where 41 per cent of ARP firms were BME as compared to 11 per cent in the overall population.

4.31 As we conduct further work on this, we will take account of the expected offsetting benefits that BME firms are likely to experience from the changes proposed for 2011, which are likely to change the picture. As set out in section 3 changes to the scope of insurance to permitted exclusion of cover for claims arising from work undertaken for financial institutions is expected to lead to benefits for BME firms that do not offer conveyancing but can not currently signal this clearly to insurers. Hence the extent to which BME firms are unable to obtain open-market cover is expected to reduce.

4.32 There would also be a risk to Principle 6 (unintended consequences), particularly in respect of clients. This is addressed further at paragraph 4.40.

4.33 A further role played by the ARP (through providing policies of Qualifying Insurance) is that of providing 30 day temporary cover to firms that subsequently obtain insurance from the open market. CRA highlight (in section 5.3) that the main reason for temporary cover is problems caused by the single renewal date. CRA also state that the current arrangements may also cause additional costs for the ARP. This is because firms that do not have claims during the temporary cover period will be able to obtain cover elsewhere, whereas firms that do face claims will be expected to remain with the ARP since the claim would be indicative of being a more risky firm.

4.34 Since we are proposing the removal of the single renewal date and considering the removal of the ARP facilitating rehabilitation, we also need to consider the removal of the role of the ARP offering temporary cover to firms. (It does not make sense to remove the temporary cover role if the ARP continues to offer insurance to firms continuing in business since it would be desirable to encourage such firms to exit the ARP quickly, thereby causing the ARP to have provided short-term cover to any firm that exits.) The removal of the single renewal date would be expected to radically reduce the extent to which firms required temporary cover anyway.

4.35 CRA proposed that this change could be implemented around three years after the single renewal date restriction is lifted because it would take time for firms to move away from the 1 October renewal date. The SRA considers that this change could be made sooner after the single renewal date change such that temporary cover could be removed from 1 October 2012. In any event there is logic to making this change when the ARP ceased to offer insurance for firms continuing in business (as considered at paragraphs 4.17 to 4.33 above), if that proposal was considered appropriate for implementation following consultation. In this way there would be a clear date after which the ARP would no longer offer insurance for firms continuing in business either on a temporary or medium term basis.

4.36 To facilitate the ending of the temporary cover function, one possibility would be to require insurers to send a renewal notice 30 days before renewal with a statement indicating whether they are willing in principle to renew the insurance with the firm. Whilst this would be subject to the completion of an acceptable proposal form and agreement on premiums, it would be of assistance for firms to know where insurers are unwilling to renew insurance. Early notification of this would provide firms with the opportunity to seek alternative sources of cover within the period of their existing cover and so continue to have cover in place at all times.

4.37 The new provision would continue to meet the Primary and Secondary Objectives within the context of the overall financial protection arrangements.

4.38 There would be a better alignment with Principles 2, 3, 5, 7 and 8. As with the proposal to end the rehabilitation role, additional information flows would be necessary between insurers, firms and the SRA.

4.39 There exists a risk to Principle 4 (equality and diversity) if BME firms face unjustifiable and disproportionate difficulty in obtaining timely open-market PII quotations. However, this concern should be overcome by the removal of the single renewal date itself which should reduce the extent to which resourcing constraints adversely affect small firms (and therefore BME firms). In addition, as explained above, we are working with insurers, the ABI and the FSA to establish the effectiveness of the equality and diversity policies of insurers

4.40 There is a risk to Principle 6 (unintended consequences) flowing from both this proposal and the proposal to end the role of the ARP in the rehabilitation of firms (the combined effect of both changes being to end the role of the ARP as a provider of policies of qualifying insurance). This risk, which we see as a risk to clients, would arise from the potential for there to be some instances of the rapid, and possibly disorderly, closure of firms. Even if both insurers and firms are prompt and organised (as they should be) in arranging the renewal of policies, there will be instances where firms find that they are unable to renew their insurance only weeks before their current insurance expires. This provides a very short period for the firm to close in an orderly fashion or for the SRA to take regulatory action if this is required. The disorderly closure of firms will not be in the interests of existing clients of those firms.

Questions

22. Do you have any comments on whether we should remove the role of the ARP as a provider of polices of Qualifying Insurance?

23. What impacts do you consider such a change would have?

Restricting the role of the ARP as a provider of policies of qualifying insurance

4.41 There is a risk that clients may suffer from the rapid disorderly closure of firms should we implement a complete closure of the ARP as a provider of policies of qualifying insurance (as discussed at paragraph 4.40 above). We have considered whether there is an alternative approach, possibly as an interim step, which would address our concerns about the existence of the ARP as a provider of policies of qualifying insurance but address the risks identified with the approach set out above.

4.42 The alternative approach would be to maintain the current roles of the ARP but to implement more explicit requirements on firms whilst in the ARP. In 2008/09 this would have reduced ARP claims by some £3.7m. This approach would see the ARP continue to provide policies of qualifying insurance (and therefore able to continue to provide temporary cover for up to 30 days) but provide a more controlled environment for firms entering the ARP proper.

4.43 The proposed changes are –

  • to provide a condition of entry that the SRA may require the firm not to accept new instructions during their period in the ARP
  • to provide a condition of entry that the SRA may require the firm not to hold client money during their period in the ARP.

4.44 Views on these proposals are sought together with suggestions for other matters that the SRA should consider.

4.45 This proposal would continue to meet the Primary and Secondary Objectives within the context of the overall financial protection arrangements. There would be a better alignment with Principles 2, 3, 5, 6, 7 and 8.

4.46 There exists a risk to Principle 4 (equality and diversity) if BME firms face unjustifiable and disproportionate difficulty in obtaining timely open-market PII quotations.

4.47 This proposal would remove the risk to Principle 6 (unintended consequences) that we identified with the previous proposal and, in our view, protect clients more effectively than the current arrangements. This is because we would explicitly require, as a condition of entry into the ARP, active planning by firms in the ARP to either exit back to the open PII market, or to close in an orderly fashion.

Funding the ARP: funding ARP shortfall (i.e. excess of claims over premiums)

4.48 Even if all of the firms insured by the ARP pay the premiums that are due, there would be expected to be a shortfall between the premiums paid and the claims that arise in the ARP. Indeed, CRA note that the loss ratio of the ARP over the last 10 years has been around 800 per cent. Hence it is important to ensure that there is a funding mechanism in place to deal with the shortfall in the ARP.

4.49 Currently any shortfall in the ARP is paid via Qualifying Insurers in proportion to their market share of the value of premiums related to the compulsory level of cover. Qualifying Insurers therefore endeavour to take into account their expectations of the cost of the ARP when setting their premiums to individual firms. The current arrangements mean that to the extent that Qualifying Insurers are inaccurate in their expectations regarding the ARP shortfall they face the consequences of this (whether this is an underestimate leading to losses or an overestimate leading to profits).

4.50 CRA note that it is unusual in insurance markets for insurers to face a proportion of the risks associated to firms that all insurers are unwilling to offer cover to on an individual basis. CRA have highlighted (in section 5.11) that the current situation is causing distortions in the market for solicitors PII.

4.51 Since the cost of the ARP is proportionate to market share, when ARP costs are uncertain but potentially large, this causes firms to want to restrict their market share in order to avoid the ARP cost. It is a highly unusual market dynamic when firms want to restrict rather than grow their market share.

4.52 There are attempts to limit exposure to the cost of the ARP through mechanisms designed to reduce the cost of the compulsory cover through particular ways of arranging insurance policies. In particular, insurance companies and firms are arranging very high excesses on the compulsory insurance policy and then arranging a second policy to cover the excess on the first policy. Hence the cost of the compulsory insurance policy is reduced because of the presence of the second policy. While there may be justifiable reasons for large firms to arrange insurance policies in a complex manner (perhaps to take advantage of captive insurance companies), in the main it appears as though complex arrangements are being made in order to avoid premiums being associated with the compulsory insurance policy for the avoidance of the ARP cost. The high cost of the ARP in recent years has particularly prompted these arrangements to be considered, but now that this has been done, the use of multiple policies may remain even if the ARP cost declines.

4.53 In respect of the latter issue, the SRA has early information on the value of premiums for the 2010/11 indemnity year which are estimated as £213 million. This is a substantial reduction in comparison to the £246 million for the 2009/10 year (but see paragraph 1.5 above for our concerns regarding the comparability of these figures). While some of this reduction may be due to the effect of new competitors entering the market, the SRA is very concerned that the majority of the reduction is due to policies being structured in a way as to reduce exposure to ARP claims. It is important to recognise that as well as this causing unnecessary costs in total, this is to the relative disadvantage of those insurers and firms that do not try to subvert the intention of the current requirements.

4.54 Following the completion of the CRA report, discussions between the SRA and insurers have also raised concerns that new insurance regulations (Solvency II) will impose additional costs related to the ARP risk. In particular, Solvency II will require insurers to set aside capital for the risks that they take and this will be especially costly where those risks could be unlimited, as is the case with the ARP cost. In addition, insurers face an additional, and largely unquantifiable, risk through the "insolvency" provisions of the QIA. Under these provisions, should a Qualifying Insurer become insolvent the remaining Qualifying Insurers have, in proportion, to cover the insolvent insurer's ARP liabilities. As well as requiring capital, insurers will also need to set out methods for limiting the risks that they face associated to this. Both of these issues mean that the provision of solicitors PII will become more expensive and it is possible that a response to Solvency II from some insurers may be to withdraw from this market.

4.55 There is a further issue arising from the current arrangements which is that they are economically inefficient. Since the ARP shortfall costs are paid by Qualifying Insurers according to their market share, the premiums set by insurers include their estimates of the likely ARP cost (our best view is that about 15 per cent of premiums paid to insurers are to take account of insurers' likely exposure to the ARP). However, collecting ARP costs from the profession as part of premiums results in a proportion of that money being "lost" to the system through both Insurance Premium Tax (IPT) which is currently 5 per cent and will increase to 6 per cent in January 2011, and through brokers' commissions which are usually around 7.5 per cent of premiums. This is because the ARP element of the premium itself attracts IPT and brokers' commission. It is difficult to calculate the precise value of the proportion of premiums paid by the profession that are "lost" to the system through excess payments to the Exchequer (in terms of IPT) and brokers as a result of this system, but our best view of the impact of this on the 2009/10 premiums paid is that between £5m and £6m of the premiums paid by firms resulted in no direct benefit at all.

4.56 Another way of illustrating the issue is that if the insurers overall needed to collect £40m through premium income to meet their ARP liabilities, firms would need to pay £45m in premiums (including brokers' commission and IPT). This is clearly inefficient, and the profession would therefore potentially save through a more efficient way of funding the ARP shortfall.

4.57 It is arguable that maintenance of the current arrangements could have such a negative impact on insurers' willingness to participate in this market that overall client protection could ultimately be affected by a withdrawal of insurers from the market. The current arrangements provide poor alignment with the Principles, particularly Principles 2, 3, 4, 5, 6, 7 and 8. It is clear that the arrangements are causing unintended consequences (against Principle 6).

4.58 The SRA is seeking views on options to change the method of funding the ARP. There are two different options that the SRA proposes for consideration:

  • a direct levy on the profession, possibly collected and managed through a SIF mechanism (option one); or
  • a levy as a percentage of the insurance premium (option 2).

4.59 Both of these options would involve the regulated community being on risk for the shortfall with insurers no longer facing this risk. Both options would meet the Primary and Secondary Objectives and would remove the risk to continued insurer participation caused by the current arrangements.

4.60 If the direct levy incorporated some risk reflective elements, then both options would lead to better incentives to improve risk management (Principle 8) since the cost of the shortfall levy would be related to the risks imposed by the particular firm.

4.61 They are both expected to be cost effective (Principle 2). Both alternatives would encourage competition between insurers who would not have the incentive to reduce their market share in order to reduce their ARP contributions. The administrative costs associated with a direct levy should not be high, as levies are already collected from the regulated community with which these levies could be combined thereby limiting any additional administrative costs. The administrative costs associated with a levy as a percentage of premiums would not be high since insurers would be able to make periodic payments relating to the value of premiums due in respect of policies sold in a particular period. However, it is possible that option 2 would perpetuate the economic inefficiency of the current model highlighted at paragraph 4.59 above.

4.62 The SRA's preferred option would be a direct levy on those we regulate (option 1). This is because setting a levy as a percentage of the insurance premium has the potential to perpetuate the economic inefficiency of the current arrangements and some might seek to reduce their levy through the use of multiple insurance policies or layering of policies (as we believe is happening in the market now but to the benefit of some insurers) and would therefore not meet Principle 6. The SRA invites comments on the merits or otherwise of these options in principle, and welcomes views on other potential mechanisms.

4.63 Before moving towards either of these options, additional work would need to be done to understand the following issues:

  • the total value of the levy that would need to be raised in order to meet claims;
  • whether or not such a levy should seek to smooth the cyclicality of claims i.e. whether it would be prudent to have a fund that grows in years when claims are small but can be drawn down in years where there are high levels of claims. An alternative would be to set a "backward looking" levy which raises the funds to match the claims that were made in the previous year;
  • how any direct levy should be apportioned to individual firms and in particular the extent to which risk reflective elements can be captured in a direct levy on the profession; and
  • whether it would make sense to combine the functions of the ARP with those currently conducted through the Compensation Fund.

4.64 All of these issues require detailed analysis of technical solutions as well as consideration of the operational challenges that will need to be addressed and the equality impact of various options. The SRA would be interested to receive comments on each of these issues. Subject to responses and the further work identified, the SRA is considering changing the ARP funding arrangements in October 2012.

Questions

26. Do you believe that we should change the way in which the ARP shortfall is funded? Please set out you reasons and any areas of agreement or disagreement with the analysis of the issues set out in this paper.

27. In your view, what would be the impacts and the advantages and disadvantages of maintaining the current approach to funding the ARP shortfall?

28. In your view, what would be the impacts and the advantages and disadvantages of the two possible alternative approaches to funding the ARP shortfall set out in this paper?

29. Are there other approaches to funding the ARP shortfall which you believe the SRA should consider?

Cancellation of policies for non-payment of premiums

4.65 At present, insurers are not able to cancel PII policies if firms fail to pay their premiums. The CRA report (section 6.5) suggests that insurers should be able to cancel policies for non-payment of premiums. This is argued on the grounds that it is counter to normal business practice for insurers to honour an insurance contract even when firms do not honour their requirement to pay for this. In addition, the ability to cancel policies would improve the incentives for insurers to inform the SRA when a firm fails to pay premiums.

4.66 The SRA agrees with the proposal that insurers should be able to cancel policies because of the non-payment of premium. However, if this change were to be made currently, it could have the effect of placing more "non-applied" firms into the ARP i.e. firms that do not pay their insurer may not pay the ARP either. This would therefore run counter our aim of reducing the ARP exposure. Furthermore, as highlighted in section 1, the SRA may require further enforcement powers in order to take action against firms that have not paid premiums and it is therefore appropriate to ensure that these powers are in place before altering the arrangements in respect of non-payment of premiums.

4.67 Moreover, insurers can avoid the problem associated to the non-payment of premiums by requiring firms to pay their premiums upfront. Arrangements with premium credit providers can assist firms with smoothing this payment over time.

4.68 In light of the above, the SRA has decided to maintain the current rule at present but seeks views as to whether this change should be implemented at a later date.

4.69 This change would maintain compliance with the Objectives. The proposal to allow insurers to cancel policies if premiums are not paid would give better alignment with the Principles, particularly with Principles 2, 5, 6, 7 and 8.

4.70 In the interim the SRA will require insurers and firms to immediately notify the SRA that premiums have not been paid. Once wider regulatory powers are in place the SRA would expect to close down firms that do not pay premiums.

Question

30. Do you have any comments on whether we should permit the cancellation of policies for non-payment of premiums?

Cancellation of policies for fraud or misrepresentation in proposals

4.71 Currently Qualifying Insurers are prevented from avoiding or repudiating the PII policy on the grounds of non-disclosure, misrepresentation, or in the case of fraud in the information provided on proposal forms. Insurers retain recourse to the firm in the case of non-disclosure, misrepresentation and fraud.

4.72 The CRA report (sections 6.7 and 6.8) identifies that these criteria are unusual in insurance markets although not uncommon in PII markets. Without these provisions, clients would lack protection unless the ARP/Compensation Fund took over the liability. CRA suggest that insurers are in a better position to seek to prevent misrepresentation and non-disclosure from arising compared to leaving the ARP/Compensation Fund to pay out after the event without any ability to limit the problem in the first place. The current provisions may also limit disagreements between firms and insurers regarding the scope of cover. Similar arguments apply to the issue of fraud.

4.73 Maintaining the current arrangement does not affect compliance with the Primary and Secondary objectives. One concern regarding the current position is that it may weaken the incentives for risk management (Principle 8) because insurers are less able to distinguish between good and bad firms, cannot set appropriate risk reflective prices and may reject some applications because of this concern, potentially causing unintended consequences (Principle 6).

4.74 However, one of the concerns is that this causes a misalignment of incentives between insurers and the SRA (CRA report sections 5.5 and 6.10). In particular, where insurers believe that a firm may have misrepresented information, they may not report this firm to the SRA because if the firm was subsequently closed insurers would have to provide run-off cover (for which they may also not be paid).

4.75 As set out above in section 2, the SRA is proposing to require insurers to report firms to the SRA in cases of suspected misrepresentation and fraud. The SRA recognises that insurers are likely to require guidance about the circumstances in which firms, or individuals, should be reported to the SRA. The SRA will therefore work with the ABI and its members to provide this guidance.

4.76 CRA suggested that some form of financial penalties could be considered against insurers who do not report firms that should have been reported. The SRA is not proposing to introduce such penalties at the present, preferring instead to set out clear guidance about when firms should be reported. The SRA will, however, monitor the number of firms that are reported by insurers and, where firms are intervened, will assess whether firms should have been reported earlier. This monitoring will help the SRA to assess whether additional requirements, such as financial penalties, may be required in future.

4.77 Views are therefore sought on whether the SRA should make changes at a future date to enable insurers to cancel policies in circumstances where there has been fraud, misrepresentation or fraud in the information provided to insurers and which formed the basis for the acceptance of the proposal by the insurer. These views should be set in the context of the SRA's overall approach to the development of the financial protection arrangements set out in this consultation paper, and should set out the basis on which such a change might be made, the consequences, and any additional measures the SRA should consider to address those consequences where they do not align with the Objectives and Principles.

Question

31. Do you have any comments on whether we should permit the cancellation of policies for fraud or misrepresentation in proposal forms?

Compensation Fund

4.78 CRA's report (chapter 7) supports the principle that there should be a single Compensation Fund for both ABS and traditional law firms. CRA state that this is because:

  • differentiation on the basis of legal structure is not an appropriate basis on which to have separate Funds since there is no reason to suppose that firms undertaking the same work but with different legal structures would impose different risks; and
  • the separation of funds on this basis may discriminate against ABSs. It could cause problems for ABSs that are first movers because a new compensation fund would need to be built up from scratch.

4.79 This approach meets the Primary and Secondary objectives and is in line with Principle 3 (encouraging competition between legal services providers).

4.80 It is also important to note that the SRA intends that the exclusion of financial institutions from the MTC of PII should not lead to claims being made via the Compensation Fund instead. That is, the SRA does not expect the Compensation Fund to exercise discretion in favour of financial institutions in the event of theft of client money. More generally, the SRA sees benefits in having the same client scope for both the MTC of PII as well as for the Compensation Fund although further work may be required to assess whether or not this is appropriate. The SRA would welcome views on this issue.

4.81 The current contributions to the Compensation Fund are based on £10 per solicitors and £120 per firm that holds client money. CRA have raised concerns that the existing method of funding the Compensation Fund may not be sufficiently risk reflective (thereby potentially failing Principle 8). This is because the current approach does not distinguish between firms that undertake different activities that may give rise to the ability for dishonest actions, or between different types of firms that may give risk to different levels of dishonesty. Making the contributions more risk reflective would be in line with Principle 8.

4.82 Assessing the appropriate method for funding the Compensation Fund raises similar issues to those set out with respect to funding the ARP shortfall as set out above. The SRA also seeks views on whether the functions of the ARP should be combined with those of the Compensation Fund.

4.83 We will be working further on this and considering any potential equality impact that may arise.

Questions 31-35

32. Do you agree with our approach of having a single Compensation Fund which covers all regulated organisations, i.e. both traditional law firms and ABS?

33. Do you have any comments on the interaction between the scope of cover provided by the MTC (i.e. with the proposed permitted exclusion of claims by financial institutions) and the Compensation Fund?

34. What are your views on the basis for assessing contributions to the Compensation Fund? Should we seek to establish a contributions formula that is more risk reflective and, if so, what approaches should we consider?

35. If the purpose of the ARP was changed so that it no longer provided policies of Qualifying Insurance, do you believe that the ARP and Compensation Fund should be combined into a single fund?


Annexes

Annex A: Initial Equality Impact Assessment

Annex B: Draft SRA Indemnity Insurance Rules 2011 (PDF 55 pages, 486K)

Annex C: Draft Qualifying Insurer's Agreement 2011


Summary of questions

1. Do you agree with the Objectives and Principles?

2. Do you have any comments on our views about the future development of the financial protection arrangements?

3. Do you have any comments on the wider regulatory issues addressed in this section?

4. Do you agree with the SRA's two-stage approach to developing the financial protection arrangements?

Maintenance of current arrangements

5. Do you agree with our conclusion that we should maintain an open-market system of PII?

6. Do you agree with our conclusion that we should maintain a Qualifying Insurer's Agreement?

7. Do you agree with our conclusion that we should not place additional criteria on insurers in order for them to be eligible to be a Qualifying Insurer?

8. Do you agree with our conclusion that we should maintain the function of the ARP in meeting claims against uninsured firms?

9. Do you agree with our conclusion that we should maintain the function of the ARP in providing run-off cover to firms that do not have open-market run-off cover?

10. Do you agree that we should maintain the current approach to setting premiums for firms entering the ARP?

Proposed changes for October 2011 and their impact

11. Do you have any comments on the proposal to remove the single renewal date and the impacts identified? Are there any further consequential impacts of this change that you believe we should consider?

12. Do you have any comments on the proposal to make insurance cover for claims by financial institutions a permitted exclusion in the MTC and to apply this exclusion to policies of qualifying insurance provided by the ARP and the impacts identified?

13. Do you agree with the definition of "financial institutions" that we have proposed?

14. Do you agree with our proposed approach for implementing this change by way of a "permitted exclusion" form the MTC?

15. Are there any further consequential impacts of this change that you believe we should consider?

16. Do you have any comments on the proposal to reduce the time a firm may be permitted to remain in the ARP to six months and the impacts identified? Are there any further consequential impacts of this change that you believe we should consider?

17. Do you have any comments on the proposal to require detailed planning by firms in the ARP and the impacts identified? Are there any further consequential impacts of this change that you believe we should consider?

18. Do you have any comments on the proposal to clarify the reporting requirements on Qualifying Insurers and the impacts identified? Are there any further consequential impacts of this change that you believe we should consider?

Possible future changes

19. Do you have any comments on whether we should permit a wider exclusion from the MTC such that cover is only required in respect of work done for "individuals"?

20. Do you have any suggestions on the definition of "individual client" that we should consider?

21. What impacts do you consider such a change would have?

22. Do you have any comments on whether we should remove the role of the ARP as a provider of polices of Qualifying Insurance ?

23. What impacts do you consider such a change would have?

24. Do you have any comments on whether we should implement these restrictions on firms in the ARP?

25. What impacts do you consider such a change would have?

26. Do you believe that we should change the way in which the ARP shortfall is funded? Please set out you reasons and any areas of agreement or disagreement with the analysis of the issues set out in this paper.

27. In your view, what would be the impacts and the advantages and disadvantages of maintaining the current approach to funding the ARP shortfall?

28. In your view, what would be the impacts and the advantages and disadvantages of the two possible alternative approaches to funding the ARP shortfall set out in this paper?

29. Are there other approaches to funding the ARP shortfall which you believe the SRA should consider?

30. Do you have any comments on whether we should permit the cancellation of policies for non-payment of premiums?

31. Do you have any comments on whether we should permit the cancellation of policies for fraud or misrepresentation in proposal forms?

32. Do you agree with our approach of having a single Compensation Fund which covers all regulated organisations, i.e. both traditional law firms and ABS?

33. Do you have any comments on the interaction between the scope of cover provided by the MTC (i.e. with the proposed permitted exclusion of claims by financial institutions) and the Compensation Fund?

34. What are your views on the basis for assessing contributions to the Compensation Fund? Should we seek to establish a contributions formula that is more risk reflective and, if so, what approaches should we consider?

35. If the purpose of the ARP was changed so that it no longer provided policies of Qualifying Insurance, do you believe that the ARP and Compensation Fund should be combined into a single fund?

Annex A - Initial equality impact assessment

36. Do you have any comments on the initial equality impact assessment?

Annexes B and C

37. Do you have any comments on the draft SRA Indemnity Insurance Rules 2011 or the draft Qualifying Insurer's Agreement 2011?


Downloadable document(s)