Australia: The view of ASIC on PI insurance gaps and what AFS licence holders need to do

In December 2015, ASIC released Report 459 - Professional indemnity Insurance Market for AFS Licensees providing Financial Product Advice. Report 459 summarised ASIC's view of the Professional Indemnity (PI) Insurance market for AFS licensees providing financial product advice to clients.¹

In its report, ASIC found there were five (5) major gaps between PI Insurance Cover requirements outlined in Regulatory Guide 126 (RG 126) when compared to the standard policies generally available to AFS licensees. These five (5) gaps were identified as:

1. Exclusion of defence costs cover did not meet minimum standards
2. Reinstatement clauses did not meet minimum standards
3. Fraud and dishonesty clauses did not meet minimum standards
4. Significant gaps where policies aggregated claims and also applied an External Dispute Resolution (EDR) scheme sub-limit of indemnity
5. A lack of claim aggregation - there was a potential lack of affordability of the total excess payable by an AFS licensee where claims were not aggregated.

The main aim of Report 459 was to help ASIC understand whether the PI Insurance available to AFS licensees is reflective of the requirements outlined in RG126.

In August 2017, ASIC subsequently conducted a targeted review of PI insurance and found that overall, the PI insurance held by most AFS licensees met the requirements of ASIC's RG 126.

This review followed on from ASIC's Report 459. ASIC reviewed the PI insurance policies held by 56 small AFS licensees to determine whether the policies met the requirements in relation to cover for defence costs and fraud and dishonesty.

Defence Costs

Most AFS Licensees will be aware that they are required to have a minimum indemnity limit of $2 million (for small AFS licensees). Small AFS Licensees are considered to be those providers who have 20 or fewer authorised representatives and revenue from financial services provided to retail clients of $2 million or less. Larger AFS Licensees will need to have adequate cover equal to their actual or expected revenue from financial services provided to retail clients, up to a limit of $20 million.

ASIC Findings:

AFS Licensees should review their existing PI insurance policies to ensure defence costs are covered over and above their limit of indemnity. It is also a good opportunity to ensure the limit of indemnity is appropriate given the revenue earned from financial services provided to retail clients.

Fraud and Dishonesty

ASIC highlighted in Report 459 that fraud and dishonesty cover was a particular risk. ASIC requires that PI Insurance policies do not exclude fraud and dishonesty by directors, employees and other representatives. Table 4 of RG126 outlines the minimum requirements in relation to fraud and dishonesty.

ASIC Findings:

Where exclusions are standard terms of the PI insurance policy, this can create uncertainty for AFS Licensees and can lead to the scope of cover being limited and the licensee breaching their obligations under RG126.

ASIC also issued an update to RG126 to clarify that fraud and dishonesty cover is not required for sole traders and corporate licensees that have one director who is also the company's only adviser or representative and shareholder.

Reinstatement

ASIC requires PI Insurance cover to have one automatic reinstatement, meaning that if an AFS licensee's policy is exhausted prior to the end of the policy period, the limit of indemnity is reinstated for the remainder of the policy period. It is important to note that automatic reinstatement is not required where the policy's limit is two (2) times the minimum amount of cover required to be held by the AFS licensee. Table 4 of RG126 outlines the minimum requirements in relation to automatic reinstatement.

ASIC found in Report 459 that most of the Insurers reviewed complied with the provisions outlined in Table 4, however one Insurer advised that only 97% met automatic reinstatement requirements. Another Insurer advised that their PI Insurance policies did not have this provision at all.

Aggregation of Claims - Limit of Indemnity

Policies may include a clause, which aggregates interrelated claims so they are treated as a single claim with a single limit of indemnity. The term "interrelated" is defined by each Insurer and has not been defined by ASIC.

• EDR Sub-Limit of Indemnity:

ASIC identified EDR sub-limits of indemnity as a problem when the clause is joined with an aggregation of claims clause. When claims are joined together they are given a lower limit of indemnity where the claim is also lodged through an EDR scheme. ASIC is of the view that AFS licensees with policies that include both clauses cannot cover the potential gap in indemnity and therefore have inadequate PI Insurance.

Of the four (4) Insurers reviewed, 100% had an EDR sub-limit clause and an aggregation of claims clause included in their policies.

• Misaligned definitions of claim:

ASIC identified that EDR schemes and Insurers have different definitions when defining a claim. This can be problematic for AFS licensees when determining whether complaints will be aggregated. As noted in the report, EDR schemes often apply their jurisdictional limits on claims even though the circumstances and parties involved are the same, where the insurance policy may aggregate these claims.

Aggregation of Claims - Excess Payable

ASIC found that some Insurers do not or would not aggregate claims and separate excess is required to be paid by the AFS licensee. The lack of aggregation of claims can become expensive for AFS licensees who have a number of claims made against them during the same period. Multiple excess payouts may become unaffordable. This problem should not arise if the PI Insurance policy allows for claim aggregation.

ASIC has not conducted a review after its issuance of Report 459 on current PI policies to determine whether the policies met the requirements in relation to automatic reinstatement and aggregation of claims. No new updates have been identified in relation to ASIC's view on PI insurance since its issuance of the 2017 review.

Action to be taken

AFS licensees should do the following to ensure their PI insurance is adequate:

• check their policy covers defence costs over the limit of indemnity;
• check their policy covers fraud and dishonesty by directors, employees and all representatives;
• be aware of the exclusions and limitations of their policy and discuss the implication of these exclusions with their broker or PI insurance provider;
• conduct an annual review of their PI insurance needs and whether the current policy meets the needs of the business.

The obligation to hold adequate PI insurance is the responsibility of the AFS Licensee and is outsourced to an insurance broker. AFS licensees should ensure they are aware of their obligations under RG126 and review the terms of their PI insurance policy against these requirements.

Footnote

¹ In Report 459 an advice licensee is an AFS licensee who provides financial product advice on Tier 1 products to retail clients.