August 2024
“A crafty knave needs no broker” quoted Ben Jonson in a play written in the year 1600.
Yes, insurance brokers and the profession of insurance broking have been around for a very, very long time.
Insurance agents are appointed by and can sell insurance on behalf of up to 4 authorized insurers (of which no more than two may be authorized insurers carrying on long term business). Insurance brokers, by contrast, represent policy holders and there are no limits to the number of insurers they can approach to secure insurance for their clients. This privilege brings with it additional responsibility for insurance brokers in the form of extra regulatory requirements that have to be met.
Firstly, licensed insurance broker companies (unlike agents, brokers must be structured as corporates) are subject to minimum capital and net asset requirements, must maintain professional indemnity insurance, can only receive client monies into a specially designated client account which they must regularly reconcile, and need to submit audited accounts and a special compliance report to the Insurance Authority (the “IA”) every year.
Secondly, when seeking out the right insurance for a client, insurance brokers are expected to compare offerings from a range of different insurers in the market.
We see this additional responsibility at play in the standards and practice of the Code of Conduct for Licensed Insurance Brokers and related Guidelines that insurance brokers must comply with when advising on and arranging life insurance policies, particularly those with saving and investment elements which come with additional complexity (and cost) when compared to pure insurance protection products.
These types of insurance policies result in policy holders either entering into long term premium payment commitments or contractually locking up their liquidity for many years, in return for insurance coverage and benefits that accumulate over such time (and which may form a vital piece of an individual’s financial planning). In the case of participating insurance policies these may include both guaranteed-benefits (being set values which the insurer is obliged to pay) and non-guaranteed benefits where the value is not set but would depend on the insurer’s own ability to make profit (making the choice of insurer, and its track record and reliability in fulfilling non-guaranteed benefits under insurance policies, a crucial element of the insurance broker’s consideration, advice and recommendation to clients).
So that clients are positioned to make informed decisions when considering buying these types of life insurance policies, the scope of work an insurance broker would be expected to perform would include the following:
Applying for and arranging the policy – after assisting the client in making a fully informed decision on whether or not to proceed with an insurance purchase and from which insurer, the insurance broker would represent the client in arranging the insurance policy(ies) with the insurer.
The insurance broker would then continue to serve and advise clients on matters arising on the insurance policy(ies) arranged.
All of these services form part of the “regulated activities” that insurance brokers are licensed by the IA to perform under the Insurance Ordinance (Cap. 41), precisely because the technical representatives that work for a broker company satisfy the minimum educational standards, possess the professional qualifications and have the right character to be fit and proper to be granted such licence.
In sourcing clients it is not uncommon for insurance brokers (as with any other professionals) to receive referrals of clients from third parties who can vouch for the broker’s expertise. This is entirely acceptable and a function of a market that trades on reputation and trust. Some referrals may be one-off from clients who have used the broker’s services before. Other referrals may be part of a more structured arrangement with, for example, a non-insurance business that has built its own client base, the members of which may on occasion need insurance, at which point the client can be referred over to the insurance broker for the right advice and the sourcing of a suitable insurance.
Broker companies that rely on such structured referral arrangements in particular, however, need to take care. They have a responsibility to ensure the referrers (who are not licensed) only refer business (i.e. only introduce clients) to the broker company. Referrers must not themselves stray into carrying on unlicensed selling to clients themselves (e.g. discussing and giving advice on specific insurance products). Taken to extreme, this can have severe negative ramifications.
We have witnessed such negative ramifications threatening to surface in the life insurance market in Hong Kong. A hyper-competitive dynamic to capture Mainland China visitor business has led certain broker companies to warp the referral model. In doing this, they have emasculated their own insurance broking role and threatened to undermine standards of professionalism in the market. This was done principally by the broker companies concerned offering to pass on 90%+ of their commission to referrers, incentivizing the latter to carry on unlicensed selling to source clients. In turn the broker company’s own operation was turned from one which was supposed to be providing proper advice on insurance to clients, into a mere conveyor-belt, rubber stamp for insurance applications sourced by referrers and a post-box through which such applications were submitted to insurers. The abuses this resulted in included (i) the broker company not serving clients in the manner that a broker is expected to; (ii) the unlicensed referrers using promises of illegal rebates to entice policy holders into buying decisions (distracting attention away from whether the policy is suitable to meet the client’s needs); and (iii) the broker company enlisting the policy holder’s to help to misrepresent to the insurer that the broker company performed all the selling in Hong Kong (when this was not the case). This put the validity of the insurance policies being purchased in doubt.
To prevent erosion of market standards and eliminate the risks posed to policy holders by this business model, on 10 April 2024 in a joint action with the Independent Commission Against Corruption, the IA took enforcement action against certain suspected perpetrators. By circular of 22 May 2024, the IA also provided its latest set of guidance on referral business (“Circular”) in order to revert the market to the standards of professionalism that policy holders are entitled to rely on.
The Circular focuses on referrals of Mainland China visitors seeking to buy life insurance in Hong Kong. It makes clear that whilst referrals are permitted, they must be performed within certain limitations and under proper controls established by broker companies and insurers, which align with the following three principles:
Principle 1 - Unlicensed referrers must not give any regulated advice to clients and must not carry on any regulated activities or sales activities.
Principle 2 - The broker company (and its technical representatives) must give all regulated advice to the client and carry on all regulated activities needed to arrange insurance policies for the client to the minimum standards required in the insurance regulatory framework.
Principle 3 - If any payments are to be offered to referrers by the broker company for introducing clients, such payments should be calibrated to be consistent with (i) the referrers not carrying on regulated activities (and not being incentivized to do so); and (ii) the broker company being properly resourced to provide regulated advice and perform regulated activities for the clients being introduced.
The Circular gives further detail on the controls, processes and approach the IA expects both broker companies and insurers which accept business from broker companies that focus on arranging life insurance policies for Mainland China visitors, to establish and implement.
At its core, the guidance in the Circular requires simply that insurance brokers serve their clients as insurance brokers are supposed to, and take responsibility for their referral business models. Indeed, insurance brokers advising clients from other jurisdictions who come to Hong Kong to source insurance, have to work harder to dispel any inapplicable pre-conceptions the client might have from the insurance market in their own jurisdiction which may differ from Hong Kong. This is vital to position clients to make an informed decision on their insurance purchases, which in turn is vital to maintaining the Hong Kong insurance market’s status as a trusted place from which suitable insurance may be procured. The vast majority of licensed insurance brokers understand this. In protecting policy holders by cracking down on unlicensed selling, the IA in turn supports those hard-working professional licensed insurance intermediaries who play by the rules.
The Circular also calls on insurers to recognize that their intermediary management control functions are responsible for implementing controls and processes not only on their tied agency forces, but also on the insurance brokers that bring them business. Insurers and insurance brokers are business partners. Insurers should therefore seek to understand the referral models that the broker companies bringing them business, use to source clients, so as to be satisfied that they are aligned with the three-principles referenced in the Circular (and set out above).
Both broker companies and insurers that target Mainland China visitor business can expect these controls and processes to be the target of the IA’s conduct inspections going forward.
The inordinately high referral fees that have been incentivizing unlicensed referrers to sell by using unchecked rebates, were being enabled by front-loaded commission structures. A front-loaded commission structure is where all, or the vast majority of commission payable for a successfully arranged insurance policy is paid out to a broker company in the first year or first two years of the policy term (using this high upfront commission, brokers were paying high referral fees). As our Circular mentioned, these types of front-loaded commission structures merit further regulatory attention.
The regulatory requirements on commission structures for long term insurance policies are principally set out in Guideline 15 (which applies to Class C (investment-linked assurance scheme) business) and Guideline 16 (for long term insurance policies other than Class C business). Both Guidelines, in line with the governing objective of treating customers fairly, make it the duty of authorized insurers to ensure that the remuneration structure for their intermediaries do not create misaligned incentives to engage in mis-selling or aggressive selling.
However, Guideline 15 adds an additional level of detail to this, by citing that paying an overly high commission in the initial years of the policy term may be the very thing to create such misaligned incentive. The notes accompanying Guideline 15 go on to state that authorized insurers should prorate the commission to be paid out for regular pay ILAS policies to ensure better alignment between the interests policy holders and licensed insurance intermediaries e.g. no more than 50% of the total commission payable for a regular payment ILAS policy is to be paid upfront, with the rest to be spread evenly over a minimum of 5 years (or the premium payment term if shorter). Such additional prescriptive detail, however, is not included in Guideline 16 in relation to non-Class C long term insurance products (such as participating insurance policies). This has resulted in the commission structures for participating policies being skewed towards the first year of the policy term and it is this which enabled the unlicensed selling and use of rebates to surface (precisely through the misaligned incentives that Guideline 15 cautioned against).
Is it not, then, time to align the requirements on commission structure in Guideline 16 with those in Guideline 15 so that the same requirements apply across all long term policies? Similar requirements already exist in other jurisdictions (Singapore and Malaysia being obvious examples in the Asia region) so this is an obvious direction of travel in which our regulatory framework should be heading.
Although the enforcement action taken has brought this issue into focus, it is not new. We already touched on it in our article on ‘The “Treating Customers Fairly” Principle in the insurance regulatory framework’ in our 8th edition of Conduct in Focus, explaining that the role of regulation is to correct certain imperfections arising from the market dynamic that create misalignment between the interests of suppliers and buyers of insurance. Where these imperfections exist and misalignment of interests is the result, conduct problems can arise and there is a risk of treatment of customers becoming unfair. That is the point at which regulation must intervene (as it has done with Guideline 15) to bring interests back into alignment.
Such intervention, however, should also be carefully considered, not only in isolation but also alongside other relevant issues that merit attention (such as benefit illustrations on long term policies with savings and investment elements, information to be provided to policy holders on these, and governance around participating insurance policies more generally). Good regulation, after all, is only as effective as it is practical to implement. Hence these matters will be the subject of engagement with all stakeholders concerned in the coming months.