Commission impossible - Is the business model of building insurance about to be permanently altered?

Michael Gove. Love him or loath him, a mercurial character, the Secretary of State for Levelling Up, Housing and Communities (DLUHC) divides even those in his own party. But one thing that is beginning to shake the insurance industry to its core, and has received surprisingly little press attention this year, is Michael Gove’s edict to the FCA to remove the commission sharing structures behind procuring buildings insurance.

Transparency is already commonplace in other regulated financial bodies such as home mortgage lending for instance, however this edict goes beyond transparency. Gove is pursuing an outright ban on the ability of landlords and managing agents to receive commissions from insurance brokers. He sees commissions, whether they be secret or transparent, as one of the driving forces that is pushing up the cost of living for ordinary leaseholders, and hence they are now in the firing line.

Talking to property management clients, it is clear that a significant proportion of the insurance premium that leaseholders pay is commission. That proportion has been, albeit in the distance past, 50% of the total or more in some cases, shared between brokers, freeholders and managing agents. Even today, buildings insurance premiums can comprise up to 40% commission, however there are indications that brokers have voluntarily reduced this percentage, incrementally over the last few years, in preparation of the inevitable curtailing of commission totals and commission sharing by the Department for Levelling Up, Housing and Communities, supported by the Financial Conduct Authority (FCA).

This article looks at insurance remuneration from the perspective of insurers, brokers and managing agents.

Who’s to blame for this profiteering?

Freeholders and managing agents have been accused of greed, undoubtedly, but if they are being offered these amounts of commission by insurance brokers, then surely the brokers are to blame too. And where do the brokers receive their remuneration from? Answer: the insurance underwriters (the insurer). Missing from Gove’s missives on this subject is the fact that the insurers have (and have always) held the purse strings.

Gove has his crosshairs aimed at brokers, rather than insurers. Is that fair? ‘A few bad (broker) apples’ have been, to some in the property management sector, to blame for Gove’s mission. The fact is that a handful of insurance brokers dominate the long leasehold buildings insurance market, and some of these are being investigated by the FCA for their practices.

Why is there scrutiny on commission now?

This has been brewing for a year or two. The straw that broke the camel’s back, in my view, was the profiteering by some insurance brokers holding static their commission percentages on buildings suffering from serious fire safety deficiencies. If the risk profile of a building changes for the worse (e.g. because combustible cladding has been discovered), the ‘rate’ at which the premium is calculated increases often markedly – and that means the premium the leaseholders pay goes through the roof. If the commission percentage is static, the rewards for brokers – and the parties with which it shares the commission – are boosted, many fold. This profiteering may well have triggered Gove’s quest.

How are insurance monies shared?

To understand why this is such a huge issue for insurance brokers and managing agents, let’s unpack a buildings insurance premium example and understand where all the money is really going to.

A block of flats composed of 18 residential units is insured for let’s say a declared value (anticipated rebuild cost) of £5,000,000 (£5m).

The annual buildings insurance premium (the cost of the policy to insure the building) is, say, £10,000, and this is collected via the service charge from all leaseholders.

An additional £1,200 (12%) of the premium is insurance premium tax (IPT), and the insurer passes this to the government.

Of the £10,000 premium, between £1,500 and £4,000 (15% to 40%) comprises the broker’s remuneration and the broker will retain this amount and send the rest to the insurer. Up to 40% of the premium sounds like a lot of money. Is it justifiable? At 15 to 20%, yes. At 40%? Perhaps not.

But it can be worse than that for the service charge payers.

Insurance brokers’ commission can be boosted beyond the 40%. The largest brokers in the sector can earn ‘work transfer fees’ which DLUHC and the FCA are well aware of. These can add another 10% to the broker’s coffers and these brokers are highly unlikely to declare this extra income to their clients (or even the managing agent).

The insurer retains the net premium, and like most insurance policies, they are obliged to pay out when it comes to legitimate claims – in this example, up to £5m, the building’s declared value.

Back to the commission on this insurance policy, of between £1500 and £4000. That sum may be retained in full by the broker and until recently, insurers have been more than happy to pay up to 40% of the premium to the broker. Where there is a managing agent in place feeding the broker’s hopper with new opportunities, the broker is content to preserve this pipeline of new business and it will share its commission with the managing agent. In the past, the broker would often – somewhat inexplicably – paid over half of its commission to the managing agent. These days, brokers and managing agents tend to share the broker’s commission 50/50 or say 75/25 in favour of the broker.

Note: Brokers also earning commission from placing terrorism insurance, directors’ and officers’ liability insurance, and engineering inspection/insurance too. Brokers share these commissions with managing agents, just as they do with the buildings insurance commissions.

For decades, managing agents have relied on commissions from the broker to boost their income. You will hear the words “race to the bottom” regularly from managing agents, and many will admit they participate in this race. To subsidise management fees that are simply too low and therefore to make ends meet, managing agents’ accept commissions. Take commissions away, and many managing agents have an irreparable hole in their budget.

Are insurance commissions typically declared to clients?

If a managing agent is a voluntary member of the Association of Residential Managing Agents (ARMA) or voluntarily regulated by Royal Institution of Chartered Surveyors (RICS), it is obliged to declare all forms of remuneration, including insurance remuneration. If the agent is neither but claims to adhere to the requirements of the RICS code of practice ‘Service Charge Residential Management Code’, then insurance commissions need to be declared and agreed. (the RICS code does not apply to managing agents in Wales).

Not all managing agents are members of such bodies, and that means there is no statutory requirement to declare insurance commissions. As you will see below, the likely banning of insurance commission sharing will hit hard those managing agents who have been receiving ‘secret’ commissions.

Will commission sharing be banned?

The FCA announced in late September 2023 that “insurance firms will be forced to act in leaseholders’ best interests, treat leaseholders as customers when designing products and will be banned from recommending an insurance policy based on commission or remuneration levels.”

Whether or not brokers and managing agents have in the past selected insurance policies for their clients based on commission levels, is unclear. Going forward, they will be unable to do so, which is good news for leaseholders.

From the FCA’s announcement: “…the Department for Levelling Up, Housing and Communities has announced that it intends to ban the payment or sharing of insurance commissions with property managing agents, landlords and freeholders. The FCA will work with DLUHC to ensure that this action is fully delivered, including changing FCA rules if required.”

Rather depressingly for managing agents, brokers have generally been slow off the mark to hold discussions with them about this potential ban. I guess they didn’t want to be the bearer of bad news. Some brokers, I am pleased to say, have been talking to their managing agents for a sustained period of time, preparing them for the inevitability of justifying their earnings from brokers or insurance fees that that they charge directly to clients.  

Should an FCA regulated managing agent be prevented from earning insurance commissions?

This is an important question. Sector analysis for early 2023 of around 750 residential managing agents in England and Wales – essentially all the main practitioners showed that around 50% of them had no regulation at all and were either procuring insurances for their clients unlawfully or they were relying on their status as the client’s company secretary to act as the client rather than as an agent of the client. The other 50% were fully authorised and regulated by the FCA, or appointed representatives of a particular broker or brokers, or they take advantage of an exemption through their regulation by the RICS (designated professional body status).

Putting aside the extremely concerning fact that around half of managing agents have no regulation to conduct insurance mediation business, why should the regulated half be restricted from earning commissions?

Well, there is a strong argument for allowing them to do so, subject to fair value assessments and other checks and balances to ensure that the remuneration is justified and proportionate. As someone who works closely with managing agents and brokers alike, I would encourage DLUHC to take this reasonable path.

If a blanket commission ban results, how do managing agents make up the shortfall?

The answer is simple: switch from commission to fees. In other words, instead of receiving commission from insurance brokers, managing agents can charge their clients fees for procuring insurance, dealing with claims, arranging reinstatement cost assessments, putting into place risk mitigation measures and other insurance activities. Naturally, the fees must be agreed with clients and they should be justifiable and reasonable in the eyes of the law.

It is concerning that some brokers are inviting their managing agents to claim that they are receiving zero commissions, and at the same time, inviting them to invoice them (the broker) for “administration fees”. This sounds very much like a get-around and I am sure the FCA would be keen to prevent that sort of deception.

Will leaseholders be better off if there is a ban?

This is not clear cut. Let’s look at a simple example. A managing agent asks a broker to place buildings insurance where the insurance premium is £10,000 of which a total of 30% is commission, shared 50/50 between broker an agent (£1500 each). Once a ban comes into place, the broker needs to decide if they will retain the full £3000 that the insurer has paid them, or to voluntarily reduce their commission total to 15%. If they do the latter, the leaseholders immediately benefit by the £1500 saving.

However, if the managing agent replaces the £1500 commission with £1500 of fees, the cost to the leaseholder is in fact £1500 plus VAT = £1800, as the VAT-registered agent is obliged to charge VAT at the prevailing rate (20%).

Even if the broker reduces the total commission to 15%, when the managing agent’s fees are brought into the equation, they are losing out overall.

The reality has yet to be determined. I suspect agents will indeed try to replace their lost commissions with a corresponding fee. There will be push back from some leaseholders, RMCs and RTMs, no doubt.

Commission impossible

It appears that a level of commission banning is coming, whether that applies to all managing agents or just to those without regulation. If the latter, then there will be a rush to seek FCA regulation directly, or appointed representative status. The sector analysis referred to earlier also concluded that brokers have slowed up in their acceptance of managing agents as their appointed representatives, demonstrating their increasingly risk averse approach. We need to ensure people don’t seek RICS firm status solely for the back-door FCA regulation that this affords.

Why ‘commission impossible’? Michael Gove’s intention is to save leaseholders from unscrupulous profiteering in a hard insurance market – and who would disagree with that objection? Yet, it is possible that leaseholders will be worse off, possibly because replacement charges billed on an hourly rate or fixed fees, may be higher than the commissions earned, not merely because VAT comes into the equation.

More worryingly, some managing agents are willing to leave the insurance procurement to their lay clients, which is terribly risky, not least as buildings insurance for blocks of flats cannot be procured safely from Money Supermarket.com and in any case, buildings insurance for multioccupancy properties is not a generic product.

A word on reinstatement cost assessments (RCAs)

I have strayed from familiar ground (RCAs) to tackle this topic of insurance commissions. But I finish on some words on RCAs in the context of the total premium paid.

In a cost of living crisis, every pound counts as many leaseholders are struggling to pay their mortgages and service charges. The insurance premium is often the biggest item on the service charge budget, therefore scrutiny of the insurance arrangements for any block of flats is a worthwhile exercise. RCAs all too often are not given the attention they deserve. The RCA decides the declared value of the building which when multiplied by the ‘rate’ the insurer charges, the premium is determined. The lower the declared value, the lower the premium, everything else remaining equal. A lean but accurate RCA is a critically important piece of the jigsaw puzzle, and in this commission related fog, we must not lose sight of the reinstatement cost assessment – which is where I come in.

James Paul MRICS is a Director of EK Reinstatement Cost Assessment Ltd