This article was first published on the EC3 Legal website prior to its merger with Birketts on 30 April 2020.
Every year, new brokers and managing general agents (MGA’s) are set all around the UK. Some are teams coming out of larger broking and underwriting agencies, and some are simply overseas interests who do not wish to wholesale their account through the larger brokers, but wish to own their own entity. These can include large corporates, risk retention groups, and even overseas insurers placing their reinsurance accounts.
Starting a broker or MGA is no different from any other business in the UK. The difficult parts relate to the regulatory aspects, and the conduct of insurance business in the UK.
- What form of entity?
It is most likely that a limited company or a limited liability partnership (for these purposes, collectively called “NewCo”) will be used. LLP’s have become more fashionable recently e.g. Lockton and NMB. Each has advantages, but tax and ownership issues will often prevail. There is no difference in reality in relation to regulation. The ultimate question relates to what is intended for the future of the entity. Is it a short term operation, or intended as a long term play? If a capital value is to be sought in the future, which vehicle is most likely to realise the greatest value?
- What sort of regulated vehicle is needed?
The first aspect is to look at the business conducted. It is widely assumed that the conduct of intermediated insurance business is regulated under the Financial Services & Markets Act 2000 (FSMA). However, not all insurance business is regulated business e.g. commercial or reinsurance risks outside the EU. There is no legal requirement for the conduct of such business to be undertaken within a FSMA authorised intermediary. However, commercially, this may be unacceptable to the counterparties with which the intermediary deals. They may only wish to deal with FSMA regulated entities.
There are two methods of undertaking regulated insurance intermediated business in the UK:
Direct authorisation – this process can take up to six months, requires detailed business plans, and the provision of much information relating to controllers, the Board, the systems, PI insurance and the business. It is a long and sometimes expensive process, and the continuing costs of regulation thereafter should not be ignored.
Acting as an Appointed Representative – here an already regulated intermediary (the “Host”) effectively hosts NewCo, and takes on all the regulatory responsibility and liability for this. The process of appointment and approval by the Regulator takes little time, and the costs are considerable less.
Which of these routes is preferable will depend on the circumstances surrounding NewCo. However, supporting start ups through the appointed representative route has become increasingly popular. Not only are authorised intermediaries offering to do this, but a number of other providers are now offering full start up and turnkey options as well. Cost is obviously an issue with each of these. However, since these independent providers are not aligned to broking houses, and thus are not likely to be potential competitors for NewCo’s clients forward, there is an attraction in using them. Even so, many of these providers will not have the name and associated goodwill that goes with the established intermediaries, and questions of service delivery may arise.
The other aspect of undertaking London market business is Lloyd’s accreditation which is outside the scope of this paper. However, the Host may need to be required to provide Lloyd’s passes, and some service providers are not able to offer this.
- Route to Market?
The preferred chosen route to market at present seems to be to use the hosted Appointed Representative route. This is perhaps not difficult to understand when the UK has the most highly regulated and expensive intermediary regulatory regime in Europe. These costs, and the time taken, are often seen as prohibitive for start up businesses, where budgets are tight, and the future relatively uncertain in many cases. In the longest soft market experienced in the UK, this is perhaps inevitable. Perhaps matters will change when the market eventually hardens.
Therefore, this article now focuses on what is needed in order to set up a hosted Appointed Representative structure. It is assumed that the Host will agree to host NewCo as an appointed representative for a finite period of time (usually three years is suggested but it can be any period), and thereafter, NewCo will become standalone.
In this context, it should be remembered that Host is effectively responsible for conducting the business and that after the arrangement comes to an end, it will remain responsible for running off this business (unless agreed otherwise). There will also be a need to sever legal obligations, for example, to employment, property and IT, and the actions needed to do this should not be underestimated.
- The Legal Agreements
The principal agreements are:
– The incorporation documents of NewCo (being either the memorandum and articles of association of a company, or LLP Agreement and profit participation deed for an LLP);
– If a company, a shareholders agreement regulating the rights, obligations and benefits of the shareholders;
– The appointed representative agreement;
– The “turnkey” agreement;
– The employment contracts of the employees of NewCo; and
– A Loan/ Working Capital agreement.
(a) The Incorporation Documents – in a company, the articles of association are a statutory contract between the members and the Company. There are many aspects to these, but the most important ones will often relate to the types of shares (and relative benefits and rights attaching to those) and pre-emption rights on the issue of new shares and transfer of existing shares.
LLP’s will often have a longer agreement between the members. The cost of setting one up is commensurately greater. However, they will often cover many of the same issues as upon an incorporation of a Company.
In brief, the main differences and benefits are:
– They both offer limited liability;
– Salaries to corporate employees attract c 14% national insurance, whereas partners drawing attract 2%;
– Employees attain statutory employment rights – partners do not do so (they are not employees);
– For entrepreneurs relief to apply, in a company, the shareholder must hold 5%. There is no such restriction in an LLP;
– Restrictive covenants in LLP agreements are generally more enforceable than the comparative restrictions in employment contracts;
– Unlike a company, there are no capital maintenance rules to restrict capital movement and profit shares within an LLP, thus giving greater flexibility regarding rewards structures; and
– LLP’s do not have share capital as such and thus raising external venture capital finance is more difficult (but not impossible).
(b) Shareholders Agreement – this will regulate the rights of the shareholders between themselves dealing with constitution of the Board, dividends policy, transfers of shares, and “restricted matters”. This is usually a list of those material things upon which all shareholders need to agree. The Host may wish to consider whether it wishes to be a shareholder or have an appointee on the board. This is a matter of individual negotiation in each case. It is suggested though that if such an interest is taken, it is for less than 20% which is one of the FSMA threshold controller limits going forward (assuming NewCo subsequently moves to its own authorisation), and avoids issues of accounts consolidation under accounting rules. However, there is also usually a mechanism by way of options that allow for this stake to be bought or sold on a pre-agreed basis at a certain future date or upon certain agreed events occurring.
(c) Appointed Representative Agreement – this agreement is important since it is the agreement that gives NewCo the authority to operate. However, it should also give the Host full protection against NewCo breaching FSA regulations, and full rights of inspection. However, it should be understood that no policies or cover notes are issued by the NewCo, and that all premiums and claims monies are accounted for within the Host, not New Co.
(d) Turnkey agreement – this agreement basically provides for all of the back office arrangements and is largely uncontested. However, there are a number of pressure points, which typically include:
(i) PI insurance – NewCo will be insured on the host intermediary’s insurance. NewCo should be obliged to pick up the total cost of claims not covered by such insurance in respect of its own defaults (including excesses and deductibles). It should also pick up the additional premium cost arising as a result of such claim.
(ii) Employees – The Host will not want to pick up any costs of NewCo’s Employees of any nature, or any liabilities relating to those employees ceasing to be employees of the Host, and the Host should ask for an indemnity against these.
(iii) Run-Off – termination can occur in many ways. However, ostensibly the Host has the regulatory responsibility for the run-off of polices broked or underwritten through it by NewCo. Consideration should be made by the Host as to whether to request that a claims provision be set aside for this.
(e) Employment Contracts – these can either be with NewCo, host intermediary or both. It is suggested that both is the correct approach, since the employee can be deemed an employee of NewCo, and that his employment with the Host will terminate when the appointed representative arrangement ends without liability to the Host. This employment with Host gives the employee the authority to conduct business.
(f) Loan/ Working Capital Facility – these are often needed because NewCo will struggle for cash for the initial working period of NewCo. This facility is bides them over this period, and is repaid from commissions going forward. Alternatively venture capital or subordinated debt can be provided from external sources.
- The Key Issues
– The Employees of NewCo – the Host will not wish to take on any cost or liability in respect of them. Their contracts must novate across;
– PI Insurance – this is both an issue during and after the hosting relationship. The Host will need to add NewCo to its PI policy, but NewCo should properly bear the cost of this insurance, the excesses and deductibles in relation to claims relating to NewCo originated business, and excluded claims also. NewCo should indemnify against any such exposure, whether arising before or after termination, and pay the costs of any premiums arising as a cost of its participation in such PI Policy of the Host. Host will also need to make sure that NewCo and its employees remain ready and available to help deal with claims on Host’s PI Policy.
– Regulatory Risk – the Host will not want any risk of regulatory censure against it, or to bear any cost in relation the hosted NewCo, and will require indemnification against this;
– Run-Off – once NewCo decides to leave the Host, the Host will not wish to bear the cost or conduct the run-off of risks introduced through NewCo. Indeed, NewCo will not wish to leave this behind since it is part of its goodwill. Arrangements need to be put in place to effect this transfer. The issue is that the primary responsibility remains with NewCo unless the clients novate the entire historic relationship across. This is cumbersome and unlikely to occur. As a result, Host should ensure that it is protected against this both in terms of contractual terms and indemnification, but ensuring the run-off PI cover remains in place at the cost of NewCo;
– Retention of Business – NewCo and its founders will want protections from the Host that the client s and business that is warehoused through Host for NewCo belongs to NewCo. As such, it is proper for NewCo to ask for restrictive covenants from Host that they will not solicit or undertake business after termination for such clients (apart perhaps from regarding the run-off of pre-termination business). Confidentiality is also important.
– Client Monies and Monies Held subject to “risk transfer” – Host will receive all of these monies during the hosted period. NewCo will not hold or receive these. Host will be responsible for payment of these to insurers and clients (as the case may be). Upon termination, those monies held in relation to the business of NewCo must be dealt with. Legally, they cannot be automatically passed across, even if, after authorisation, NewCo has its own client money/NST account. The permission of the client is technically required. However, many intermediaries choose to do so against undertakings from the transferee to discharge all balances, and indemnity against loss. In practice, this seems to work best. Approval from the FCA to this course of action is recommended beforehand.
– Client Documentation – both Host and NewCo will wish access to these both during and after the hosting arrangement. If NewCo is to take these over, the client will need to consent, but if they are transferred, Host may need to retain access for the purposes of access and dealing with any PI claims.
The contents of this article should not be relied upon alone. If you require further detailed advice please contact a member of our Insurance Team.
The content of this article is for general information only. It is not, and should not be taken as, legal advice. If you require any further information in relation to this article please contact the author in the first instance. Law covered as at April 2020.