A targeted review of professional indemnity (PI) insurance by ASIC has found that most small companies holding Australian financial services (AFS) licences had PI insurance that met regulatory requirements. We found, generally, the small AFS licensees that we reviewed had policies with an overall indemnity limit that complied with requirements.

The review focused on the adequacy of cover for defence (legal) costs, and fraud and dishonesty, in the policies offered by two insurance companies to small AFS licensees. It followed on from ASIC's Report 459 Professional indemnity insurance market for AFS licensees providing financial product advice, December 2015 (REP 459), which highlighted these as areas of concern.

The review found that three of the 56 AFS licensees reviewed did not have PI insurance that complied with the defence costs requirements in Regulatory Guide 126 Compensation and insurance arrangements for AFS licensees (RG 126). Following our intervention, these licensees have obtained improved PI insurance, or are in the process of doing so.

Following the conclusions in REP 459 which highlighted fraud and dishonesty cover as a particular risk, ASIC has worked with the two insurance companies to help them make changes to their standard policy terms to ensure that their fraud and dishonesty cover allows insured licensees to comply with RG 126.

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• Regulatory Guide 126 Compensation and insurance arrangements for AFS licensees

Further detail regarding our review

ASIC reviewed the PI insurance policies held by a sample of 56 small AFS licensees to determine whether they complied with the defence costs and fraud and dishonesty requirements in RG 126. For the purposes of this review we considered small AFS licensees to be retail advice providers that have 20 or fewer authorised representatives and revenue of $2 million or less.

Our review also highlighted that AFS licensees do not appear to always fully understand their PI insurance cover as the policies are complex and their terms may be subject to different interpretations. As well as this, there are also inconsistencies in the approaches AFS licensees take to document their annual review of their PI policies.

Defence costs

RG 126 states that defence costs must be ‘in addition’ to the minimum indemnity limit of $2 million for small licensees, or the indemnity limit must be sufficiently increased to take into account these defence costs. We found that three of the 56 small advice licensees in our sample did not meet this requirement.

We notified the three licensees of the shortfalls, and they are making arrangements to obtain additional cover for defence costs.

Fraud and dishonesty cover

We found that exclusions in the standard terms of PI insurance policies issued by the two insurance companies could create uncertainty regarding the adequacy of cover for fraud and dishonesty in some circumstances.

The two insurance companies have cooperated with ASIC and changed their standard policy wording to clarify and ensure fraud and dishonesty cover is available to the licensees, as required by RG 126.

Update to RG 126 for clarification

RG 126 states that fraud cover is not required by licensees that are sole traders. We have revised RG 126 to clarify that fraud cover is also not required by licensees that are single person companies. We consider single person companies to be licensees that are companies with one director who is also the company's only financial adviser or representative, the only shareholder and only employee of the company.

Checklist for licensees

In light of the observations from this review, ASIC encourages all AFS licensees to:

• read RG 126 to understand the level of PI insurance you require;
• document the annual review of your PI insurance needs;
• obtain defence costs cover in addition to the minimum indemnity level;
• check if your policy covers acts of fraud or dishonesty by directors, employees and all of your other representatives;
• be aware of limitations and exclusions in your PI policy;
• inform the PI insurance provider of any material changes to your advice business, such as an increase in the number of advisers or revenue; and
• remember that, while you can work with an insurance broker, you cannot rely on the broker to ensure your policy complies with RG 126. Ultimately you are responsible for obtaining PI insurance that complies with RG 126.

Background

This review follows the release of ASIC Report 459 Professional indemnity insurance market for AFS licensees providing financial product advice, December 2015 (REP 459), which identified that small advice licensees are at highest risk of having inadequate PI insurance. REP 459 highlighted inadequate defence costs cover, and fraud and dishonesty cover, as particular risks.

RG 126 sets out how ASIC will administer the compensation requirements under s912B of the Corporations Act 2001 (the Act). Section 912B requires AFS licensees to have arrangements for compensating retail clients for losses they suffer as a result of a breach by the licensee or its representative of their obligations in Chapter 7 of the Act. Under these arrangements, licensees must obtain PI insurance that is adequate having regard to the nature of the licensee's business and its potential liability for compensation claims, or be approved by ASIC as alternative arrangements. In determining what is adequate insurance, ASIC will take into account what is available in the market.

While PI insurance plays an important role as a ‘first line of defence’ for consumer claims, it has limitations as a compensation mechanism. PI insurance is designed to protect licensees against business risk, and not to provide compensation directly to investors and consumers. These limitations were identified by ASIC in its recent submission to the Review of the Financial System External Dispute Resolution Framework. ASIC supports the introduction of a last resort compensation scheme that addresses uncompensated consumer and small business losses across the external dispute resolution (EDR) jurisdiction. Such a compensation scheme, if established, would not replace PI insurance but complement it.