Far from incidental

The current system of investment business regulation which was introduced by the Financial Services and Markets Act on 1 December 2001 will be dramatically expanded to include the regulation of mortgages and general insurance business from 31 October 2004 and 14 January 2005. Any article on investment business regulation is usually considered quite dry and uninteresting to many in the profession who have no involvement in this area of work. However, the changes to the investment business regulatory regime operated by the Financial Services Authority (FSA) and the Society will have an impact on a great many more firms than are currently authorised or licensed for investment business, due to the future regulation of insurance business.

The two-tier system

The Financial Services and Markets Act 2000 introduced a two-tier system of regulation for solicitor firms. Firms wishing to carry on a regulated activity (often referred to as mainstream investment business) can only do so if they are authorised by the FSA. There are currently just over 100 firms of Scottish solicitors authorised by the FSA.

The other principal option open to a firm is set out in Part XX of the Act which allows a professional firm to conduct exempt regulated activities subject to certain conditions. The Society’s regime for exempt regulated activities is better known as the incidental investment business regime. A firm licensed by the Society for incidental investment business can undertake certain activities which would otherwise be regarded as regulated activities for which authorisation from the FSA would be required. One of the main conditions attached to any incidental investment business is that the work must be incidental to the provision of another professional service. This means that a firm cannot have stand-alone incidental investment business work. There are currently 475 firms licensed by the Society for incidental investment business.

Those firms who are neither authorised by the FSA nor licensed by the Society either undertake no form of investment business work or refer clients to independent financial advisers.

More regulation, new regime

The current system of regulation split between the FSA and the Society and the other designated professional bodies has been in place for over two years, but over the course of the next nine months will expand dramatically. This expansion arises from mortgage and general insurance business coming within the definition of regulated activities under the Act. The extension to the Act has been brought about by the Financial Services and Markets Act 2000 (Regulated Activities) (Amendment No 1) Order 2003 in relation to mortgage business and the Financial Services Act 2000 (Regulated Activities) (Amendment No 2) Order 2003 with respect to insurance business.

The key dates for the regulation of mortgage and general insurance business over the course of the next nine months are:

1. Regulation of mortgage business and long term care insurance – these activities will become regulated activities on 31 October 2004.
2. Regulation of insurance business – this activity will become a regulated activity on 14 January 2005.

The changes to the definition of regulated activities to incorporate mortgage and insurance business will result in a parallel extension to the Society’s incidental investment business regime to include incidental mortgage, incidental long term care insurance and incidental insurance business with effect from the same dates. As a result of these changes the Society’s incidental investment business regime will be wound up and a new incidental financial business regime will be introduced with effect from 31 October 2004.

The most significant area of change is in relation to insurance regulation, which encompasses much more than just the buying and selling of insurance policies such as household contents insurance.

Insurance – it’s all mediation

The impact of the future regulation of insurance business will not be confined to those firms which are currently licensed by the Society for incidental investment business, due to the definition of insurance business within the Insurance Mediation Directive (2002/92/EC). This is the directive from which the regulatory changes for insurance regulation arise. It is “insurance mediation” which will become a regulated activity. The definition of insurance mediation includes the following activities:

1. Introducing, proposing or carrying out other work preparatory to the conclusion of contracts of insurance;
2. Concluding contracts of insurance;
3. Assisting in the administration and performance of such contracts, in particular in the event of a claim.

Firms are likely to carry on a number of activities which fall within the definition of insurance mediation, including introducing, arranging and advising on the following types of insurance – after-the-event legal expenses insurance, defective title indemnity insurance, buildings insurance, term assurance, missing beneficiary indemnity insurance and unoccupied property insurance. However, more significantly, as the definition of insurance mediation includes “assisting in the administration and performance of contracts of insurance, in particular in the event of a claim”, firms which are involved in handling personal injury claims and/or involved in assisting an insured in bringing a claim against his own insurer will fall within the new regulatory regime.

Firms involved in these activities will be caught by the Insurance Mediation Directive, but provided that the insurance services arise out of or are incidental to other professional services, a firm will come under the Society’s new incidental financial business regime.

It is therefore essential that those firms who are currently outwith the Society’s existing incidental investment business regime review their activities to ascertain whether they have insurance activities which will fall within the Society’s new incidental financial business regime later this year.

Those firms which are currently licensed by the Society for incidental investment business will have to apply for a new incidental financial business licence in August after the draft Incidental Financial Business Practice Rules are considered at next month’s Annual General Meeting. A firm can currently only be licensed by the Society for incidental investment business and in future incidental financial business if less than 50% of the firm’s total income derives from incidental investment/financial business. Firms which have 50% or more of their total income arising from investment business can only be authorised by the FSA.

Homing in on mortgages

The regulation of mortgages will fall under the FSA’s regulatory regime with effect from 31 October 2004. Regulated mortgage activities will broadly be:

1. Entering into a regulated mortgage contract as a lender;
2. Administrating a regulated mortgage contract;
3. Advising on a regulated mortgage contract; and
4. Arranging a regulated mortgage contract.

In principle, the mortgages covered by the FSA’s regime will be those secured by first legal charges on first UK property, where at least 40% is residential accommodation to be occupied by the borrower or his or her immediate family. This new system of regulation for mortgages means that if a firm wishes to give its own specific advice on a mortgage product, that firm will require to be regulated by the FSA.

Options and outcomes

There are a number of options open to firms under the new regime which can be summarised as follows:

1. Firms currently authorised by the FSA – these firms can seek an extension to the relevant permissions they have from the FSA to include mortgage and/or insurance business. It is important to remember that firms who are authorised by the FSA for mainstream investment business are also covered by the FSA’s rules for incidental investment business and not the Society’s incidental investment business rules.
2. Firms which are currently licensed by the Society for incidental investment business – such firms will have to apply for a new incidental financial business licence from the Society in August of this year.
3. Firms which are currently neither authorised by the FSA nor licensed by the Society – these firms will have to consider whether under the new regime they will require authorisation from the FSA or a new incidental financial business licence from the Society.
4. None of the above – there may be some firms, principally those which restrict their work to criminal court work, who will not require any form of authorisation or licence as they will not be undertaking any form of financial business under the extended regulatory regime. It is also possible for a firm to restrict its work to referring financial business to an independent financial adviser. This form of introductory business will not require FSA authorisation or an incidental financial business licence from the Society.

CPD to keep you right

The Society’s Update section will be running a series of seminars on the new incidental financial business regime in June. The seminars will cover the changes to the existing regulatory regime arising from the future regulation of mortgage and insurance business. The seminars will also deal with the application process for the new incidental financial business licence. All firms are encouraged to send a representative to one of the seminars. Details of the seminars are available direct from the Update section, in the Update brochure or on the Society’s website, as well as the programme on page 31 of this issue.

David Cullen, Registrar and Director of Financial Services