10 February 2012

TC4 – Adequate Resources for Brokers and MGAs

2

Agenda

• Why is this important?

• What does TC4 mean - Rules and Guidance

• How to do a TC4 assessment – Approach and Forecasts

• Stress testing

• Future developments

3

TC4 – what does it mean?

• Is directly derived from FSMA

• Applies to all firms undertaking regulated activities

• Requires firms to have adequate resources to fulfil obligations re those regulated activities

• Is not really about capital (which is MIPRU)

4

TC4 - what does it mean (COND 2.4.1)

• Adequate =

– Quantity

– Quality

– Availability

• Resources =

– Financial

– Non-financial (people, premises, broking/accounting systems)

– Risk management systems

5

TC4 – FSA focus at approval (COND 2.4.1)

• Group relationships

• Indications of current or future potential insolvency

• History (any insolvency in the past)

• Risk Management systems

• Business Planning

• The extent of client money risk

This is all about risk

6

TC4 – what risk do the FSA see

• In an insolvency:

– IP might charge client money funds with costs of run-off

– Insurers might not get paid risk transfer funds

• In a going concern:

– Management might raid client money to meet “temporary” cash-flow needs

– Management might raid insurer’s money to meet “temporary cash-flow needs

7

TC4 – Guidance• Dear CEO 23 February 2010 – financial resources

– Focus on liquidity

– Recognise client money/insurer money issues

– PII arrangements

– Group arrangements (eg cash sweeps, inter-company balances)

– Analysis of working capital needs

– Robustness of cash-flow forecasts

– Specific liabilities (e.g. pensions, cross-guarantees)

This really means do a proper forecast of free cash-flow

8

TC4 - Guidance

• Smaller Wholesale Insurance Intermediaries Newsletters Number 3 (Oct 2010) - issues

– Stress test assumptions too optimistic and not documented

– Little scenario testing

– Assessments not embedded in operational and risk management of firm

This means risk-manage liquidity as a core management activity

9

TC4 - Guidance• Smaller Wholesale Insurance Intermediaries Newsletters Number

4 (Jan 2011) – risk factors

– Threats arising from generally poor economic environment (investment returns, pension liabilities, little/no growth)

– Complex business models/group relationships

– Third party funding, and assets given as security

– Acquisition strategies

This means that times are hard and anything not completely straightforward increases risk

10

TC4 – what is happening in practice• Engaging with some firms not all

• Review of TC4 assessments and comment on technical aspects (assumptions and stress tests, and treatment of group arrangements)

• Default to worst case of orderly winding up

• Requirement for separate funds to be held to cover

• 3 months expenses as benchmark

11

TC4 Assessments – approach

• Cash-flow forecast

• Document and validate assumptions

• Stress test

• Document and validate stress tests

• Highlight areas which depend on future management action

12

Cash-flow forecasts

• Management tool, so should be structured to support management action and monitoring

• Separate elements of cash-flow to reflect separate operational and management processes

• It’s only free (corporate) cash that matters

– No set-off ?

– No charges ?

13

Cash-flow forecasts – main elements• Insurance income flow into corporate accounts

• Other income (eg return on corporate balances, PCs. ORs)

• Fixed overheads (eg rent)

• Quasi-fixed overheads (eg payroll)

• Variable overheads (eg production bonuses)

• Other balance sheet receipts/outgoings

14

Cash-flow forecasts – insurance income

Cash movement

• Debit notes/bordereaux

• Receipt of premium/fees etc

• Cash-matching

• CMC/Extraction of surplus

Activity

• Technical

• Credit control

• IBA accounting

• Client Money Procedures and TOBA Terms

15

Cash-flow forecasts – other balances

• Fixed assets – acquisitions/disposals

• Inter-company – realistic settlement plan

• Prepayments – non-cash

• Accruals – payment pattern

• Bank Loans – origination/repayment

• Leases/HP – origination/repayment

• Income Taxes – payment dates

16

Cash-flow forecasts – other balances (continued)

• Payroll and indirect taxes – payment pattern (eg monthly)

• Purchase ledger – payment pattern (eg monthly in arrears)

• Other debtors/creditors – realistic settlement profile

• Provisions (eg PI) – realistic settlement profile

• Capital – issues/redemptions

17

Stress tests - Income

• Loss of key clients/facilities/territories – business-specific

• Loss of key individuals (if different to above) – business-specific

• Worsening business terms (e.g. commission rates) – general

• Effect of worsening performance on significant PCs

• Loss of key facilities – business-specific

• Worsening premium rates - general

18

Stress tests – Income (continued)• Fall in investment return - general

• Exchange rate movements – general

• Irrecoverable brokerage debts – business-specific

• Think about correlated stress tests (e.g. groups of clients/territories)

19

Stress Tests - Overheads

• Think about linkage to income stress tests (eg bonuses)

• Quasi-fixed take longer to change (eg redundancies)

• Are there discretionary spends that can be changed in the short term by management actions (eg lifestyle)?

• Gains from good housekeeping?

20

Stress Tests – balance sheet• Funded bad debts in the insurance ledgers

• Inter-company – change in debtor entity circumstances

• Bank Loans – Potential effect of covenant breach/facility renewal

• Provisions – changes in pension scheme funding requirements

• Provisions – early settlement of litigation

• Capital – redemption if at discretion of holder

• Think about correlated stress tests (e.g. effect of bad debts or increased pension liabilities on bank covenants)

21

Stress test – orderly wind-down

• Assume not insolvency so pooling arrangement and distribution rules do not apply

• Focus on meeting all obligations re insurance business

• Transfer of book in < 3 months not viewed as realistic

• Need people/premises/systems during wind-down

• Not necessarily all of them

• Costing legacy

22

Stress test – orderly wind-down (continued)• Think how it might be brought about

– Loss of key people

– Loss of income

– Uninsured E&O claim

– Uninsured other (eg employment) claim

– Insolvency

• Model your view of what the wind-down will look like

• Don’t assume calm and stable environment

• If it happens, re-forecast based on actual circumstances

23

Re-forecasting under stress• Plan your way out of the difficulty

– You must be confident (with reason) the plan is achievable

– The plan must be fundable from free resources

– You must then get on with doing it

• If you can’t devise a plan that gets you through with reasonable confidence, you are probably insolvent

– Consult an IP

– Tell the FSA (probably bad outcomes)

24

TC 4 - Moving forward

• FSA see insolvency as a real risk in current and near-future economic environment, so heat re TC4 will not drop

• Orderly wind-down provision only applied currently to top “x” brokers

• FSA think that the approach is right so logically may want to extend (subject to FSA supervisory resources)

• FSA likely to collect more information (thematic or Gabriel)

• Role for broker run-off specialist in assessing cost of run-off?

25

TC4 – moving forward Does it have to happen to you• What might attract the FSA’s attention

– Becoming large (say > £25m commission/brokerage)

– Change of control

– Client money issues

– Bad ARROW

• If you’re not large, stay clean!

26

This seminar and the accompanying handouts cover topics only in general terms and are intended to give a wide audience an outline understanding of issues relating to accounting applicable to entities in the insurance sector, and therefore cannot be relied upon to cover specific situations; applications of the principles would depend on the particular circumstances involved. Furthermore, responses given in the seminar to questions are only based on an outline understanding of the facts and circumstances of the cases and therefore do not form an appropriate substitute for considered specific advice tailored to your circumstances. We recommend that you obtain professional advice before acting, or refraining from acting, on any of the contents. We would be pleased to advise you on the application of the principles demonstrated at the seminar, or on any other matters, to your specific circumstances, but in the absence of such specific advice, we cannot be responsible or held liable.

© Littlejohn