By Liam Spender
Liam Spender is a solicitor and trustee of the Leasehold Knowledge Partnership. He lives in a leasehold flat in London. The views in this article are personal and do not constitute legal advice.
On 21 September, the Financial Conduct Authority (FCA) published its long-awaited report on insurance in leasehold blocks. The report was requested by Michael Gove earlier this year and had been delayed several months.
The FCA reviews the provision of insurance, including cladding-affected blocks, as well as broader issues of insurance commissions and disclosure of information. The FCA concludes that there are serious issues with how insurance is priced and how commissions are shared.
The FCA also concludes that the government should stand as insurer of last report for a new FireRe pool system of insurance for cladding-affected blocks. It is hoped that such a system would bring down the costs of insurance for cladding-affected buildings.
Crucially, the FCA report undermines the long-standing spin of the insurance industry that recent price rises have been caused by fire risk. The FCA report shows that more than 60% of claims in the period 2016-21 related to causes other than fire. The FCA report also finds that, of the policies in its sample, a 16% increase in premium can be attributed to these leak claims.
The principal issue with the FCA report is that it envisages further action in six months, or longer. Leaseholders have been crippled with the costs of insurance (and associated commissions) for years.
Although there is much to be welcomed, albeit cautiously, in the FCA’s report, we cannot but avoid the feeling that the FCA is not doing enough to protect the end consumer here, the leaseholder. The FCA’s job is to protect consumers. Leaseholders have no consumer rights when it comes to leasehold insurance because no-one is obliged to consider them as their customer. The FCA appears to have missed an opportunity to think of ways of imposing better consumer protection, instead leaving it to the government to pass more leasehold reform.
This piece looks at the technical background to the FCA’s report and recommendations. It also examines the limited rights leaseholders currently have in relation to insurance. It concludes with some thoughts on what could be done to improve the situation.
How does leasehold insurance work?
In virtually all leases, the landlord will have an obligation to insure the building against all risks. Leases typically specify that this insurance is to be arranged to cover the costs of demolishing and rebuilding the building, including all taxes, local authority charges, surveyor fees and so on.
Other leases specify various terms to be included in the policy, such that the interests of the leaseholders and any lender are to be noted on the policy. The policy itself is usually arranged with the landlord as the insured party.
Normally there are at least two policies arranged for each leasehold block. One for buildings and one for terrorism.
Depending on the wording of the lease, landlords and their managing agents may also arrange other insurance, such as to cover communal areas, lifts, water pumps and other risks. Most leases will also allow the cost of employer liability insurance to be passed on to leaseholders.
This set-up means that landlords and managing agents choose the type and level of cover, but are not responsible for paying for it. In all cases, the costs are passed on to leaseholders through service charges. Some leases allow this to be lumped in with other costs. Other leases require the insurance to be charged separately.
Leasehold insurance is not something anyone can buy using a price comparison website. In virtually all cases a broker must be used. Some insurers only work through particular brokers (for example, Zurich will only provide quotes through Arthur J. Gallagher, to whom it has delegated claims handling authority).
At the outset, we can see that insurance involves at least some work on the part of the freeholder, broker and managing agent. The issue is whether the price charged is reflective of the work done.
As we shall see later, where accounts are available to show the costs of the work being done, it often also shows high profit margins are being earned.
How do insurance commissions work?
If you are a freeholder of a large number of leasehold blocks, you can ask the broker to get the insurer to write a policy on your own terms (called a bespoke wording). The bespoke policy will then cover all of your leasehold blocks. This avoids the hassle of needing to insure each block individually.
Theoretically, such policies should be good news for leaseholders.
As a result of bringing a huge amount of business (and therefore insurance premiums) to the insurer, you as the freeholder can also ask that the insurer pays you for the privilege of writing your insurance.
Freeholders (and their brokers) can shop around for the insurer willing to pay the highest commission in exchange for their book of business.
The commission is virtually always calculated as a percentage of the underlying insurance premium. As the cost of the underlying premium rises, so does the level of the commission. The recipient of the commission gets more money without doing anything.
The insurer does not pay the commission from its own pocket. The commission is added to the insurance premium. In turn, the premiums are paid by leaseholders.
The commission is therefore usually something that happens in the dark. Two parties (the broker and the landlord) make a deal and the cost is picked up by a third party, who often never finds out about it.
What rules govern insurance commissions?
Arranging insurance on behalf of third parties and dealing with insurance claims are all regulated activities under the Financial Services and Markets Act 2000. It is a criminal offence to carry out a regulated activity without being authorised to do so by the FCA, or without being exempt from authorisation.
One of the gaps in the FCA report is that it assumes that most of the recipients of insurance commission are not FCA regulated. The report assumes that most managing agents are members of RICS and therefore exempt from FCA regulation. The FCA appears not to have done the work to validate that assumption.
This assumption appears to be inaccurate. In the case of the largest landlords, most of them have arms that are either directly FCA regulated, or which are regulated under the umbrella of an organisation that is FCA regulated.
The table below summarises the regulatory status of the largest landlords. Between them, these landlords control approximately 1 in 6 of the estimated 4.5 million leasehold properties in England and Wales:
E&M and The Wallace Partnership are members of the newly formed landlord lobbyist group the Residential Freeholders Association (RFA). Mick Platt – the CEO of The Wallace Partnership – is the leader of the RFA. The RFA has yet to give any public comment on the FCA report, although it is believed to be busy lobbying politicians behind the scenes to water-down the government’s promised leasehold reforms.
Also striking from the table above is that the largest landlords all place insurance business with Zurich through Arthur J. Gallagher. The FCA report does not say which brokers and insurers were approached. We can only hope that the FCA will look closely at the Zurich and Arthur J. Gallagher relationship, given its connection to a large number of residential leaseholds.
What did the FCA look at?
One of the most striking things about the FCA report is that 4 of the 17 insurers it approached to ask for data either refused to supply data, or supplied data that was of no use to the FCA’s work. 4 of 17 is 25%. The same was true of the brokers.
Brokers and insurers have a duty to cooperate with FCA as a condition of being authorised. The alarming thing here is that the FCA still failed to get the data it needed out of them. What chance do leaseholders have of getting information out of landlords if the FCA cannot do so?
It appears that the FCA has therefore only looked at a small subset of the market. The actual issues, as it admits in its report, may be much wider.
What did the FCA not look at?
Importantly, what the FCA has not done is a full market study designed to see how much profit is being made from insurance and insurance commissions. If a market study found that there had been price gouging on insurance and insurance commissions, or other anti-competitive effects, that the Competition and Markets Authority could have looked at whether it should impose fines, or require undertakings from the insurers, brokers and managing agents involved.
The FCA holds open the prospect of such an investigation if insurers and brokers do not cooperate. Will the FCA also exercise its regulatory powers if insurers and brokers continue to refuse to provide viable data?
Another thing the FCA report has not looked at is the issue of resident-managed blocks having fair access to the insurance market. Single blocks have often seen the largest increases in insurance. They lack the heft of the large freeholders to get a better deal because they cannot offer a huge number of buildings over which to diversify risk.
Encouraging a not-for-profit collective of resident managed buildings to help them aggregate insurance may redress the balance. This may be possible to do as part of any FireRe pool scheme, but is should be open to all resident managed buildings.
Another issue ignored in the FCA’s reports is changing excesses on insurance that is offered. The FCA report reveals that the bulk of claims from insurance in the period 2016-21 have come from water leaks and other causes. Insurers have responded by increasing excesses for leakage claims to £5,000, £10,000 or even £100,000 in some cases. The FCA needs to take action on this, because premiums are rising and these kinds of risks are going uninsured.
A further issue not dealt with in the FCA’s report is landlords mortgaging insurance proceeds to secure their own debt. Many of the largest landlords use borrowed money to acquire ground rents. Around £1 billion has been lent by Rothesay Life to the Consensus Business Group and E&J Estates to make such acquisitions.
As part of these huge loans, the borrowers are required to offer up security over their assets. This includes giving security over insurance proceeds. If there ever arose a situation where a building suffered a catastrophic incident while these loans were unpaid, the money from the insurance may go to Rothesay Life instead of to repairing peoples homes.
Given that the insurance is procured for the benefit of leaseholders, it seems only fair that they have first call on the policy proceeds, regardless of whether the landlord has paid its debts on time. This is an issue requiring further study.
How much commission have landlords and managing agents being making?
The FCA report estimates an average range of commission of between 10% and more than 60%, with an average of 30%. The FCA report notes that while the percentage commission charged has been falling, the absolute level of commission earned has increased, by 261% for brokers and 132% for freeholders and managing agents. The increase in the absolute level of commission has come entirely as result of premiums rising, not as a result of extra work for the brokers, freeholders or managing agents.
The FCA report did not focus on the profit earned as a result of these commissions. The below analysis of a sample of three large property managing agents’ accounts shows that profit margins on these commissions are between around 40% and 70%. That shows that there is very little cost associated with doing insurance work. The bulk of the commission is profit for the managing agent or landlord.
FirstPort Insurance Services
FirstPort operates its own FCA-regulated insurance broker, FirstPort Insurance Services. This arranges insurance on behalf of FIrstPort’s property managing agent arm. Between 2016 and 2021, FirstPort has made more than £13 million in insurance commissions, as follows:
Insurance commission income increased by 79% over the period. Of that £13 million in commission, more than £8 million was profit for FirstPort, or around 61%.
FirstPort’s profit margins appear to have fallen in recent years from 70% to 48%. This is an accounting trick. The fall in profit margins coincides exactly with higher management fees being charged to the insurance company by other FirstPort companies. The same level of profit is being generated from insurance commissions, it is just that some of it is being taken before it reaches the bottom line in the form of management fees.
The fact that large profits have been generated without any corresponding expenditure on insurance, or insurance related matters,
What is also clear is that none of that profit FirstPort has generated from insurance appears to have been used in relation to insurance activities. Over the period 2016 to 2021, FirstPort Insurance lent out nearly £7 million of the £8 million to other FirstPort companies in the form of intercompany loans. The loans are interest free and unsecured.
Large intercompany balances building up between group companies are generally considered to be poor accounting practice. The loans in question are most likely never going to be paid back. What is most likely to happen is that FirstPort Insurance Services will reduce its capital. The reduction in capital will create reserves FirstPort can use to distribute dividends. The dividends will be paid to the companies that have borrowed the money. The dividend will set off most or all of the intercompany loan balances. In practice, that means FirstPort Insurance Services will use its own money (more accurately, leaseholders money) to pay off other FirstPort companies’ debts. Such transactions are routine in corporate groups.
Cox Braithwaite is Wallace Estates’ in-house insurance broker. Over the period 2016 to 2021, Cox Braithwaite made more than £8 million in insurance commissions, as follows:
Nearly £5 million of the more than £8 million Cox Braithwaite generated in commissions was profit. About half of this appears to have been paid out in dividends. The other half is still sitting as retained earnings within Cox Braithwaite.
Again, the fact that large profits have been generated without any corresponding expenditure in insurance suggests that commissions are excessive.
Rendall & Rittner operates a different structure for its insurance. Instead of acting as its own insurance broker, Rendall & Rittner runs a captive insurance company, so acts as its own insurer. The captive is incorporated in Guernsey and run by a subsidiary of Arthur J. Gallagher.
In the period 2016 to 2020, the most recent year for which Rendall & Rittner has filed accounts, re-insurance premiums totalled £7.5 million, as follows:
While there is no dispute that placing the insurance involves some work, why do the people doing it need profit margins of 38% (Rendall & Rittner), 57% (Cox Braithwaite) and 61% (FirstPort) to do it?
Do landlords and managing agents do work in exchange for the commission?
Landlords and managing agents claim that they do work in exchange for the commission. As above, this usually involves generating significant profits for themselves as a result of that work.
The issue is whether the work done justifies the commission being taken. From the limited data available, the answer appears to be no.
It is also unclear why the commissions being generated need to be shared with parties who do no work at all in relation for the insurance.
Examples of this include the ARC Time Freehold Fund, an FCA regulated fund run by Alpha Real Capital LLP. Until 30 June 2022, the ARC Time fund prospectus used to contain a statement showing that it receives 85% of the insurance commission received by Freehold Managers. Up until June 2022, the ARC Time Fund prospectus used to say “buying block insurance on a large scale generates commission income that can be added to the Fund’s returns.”
The statement, and the reference to the 85% cut of commission has been deleted from the most recent version of the ARC Time Fund Prospectus. The new prospectus makes no reference to the commission earned, or that it is shared 85/15 with Freehold Managers.
FCA-regulated Freehold Managers claims it performs a long list of services in exchange for the insurance commission. If so, why can it afford to pass on 85% of the commission to an investment fund that provides no service in return?
ARC Time is not the only fund that receives commission as profit for its investors. The most recent Ground Rents Income Fund annual report says “Ground rent collection has remained in line with pre-pandemic collection rates but ancillary income has fallen. This fall is due to a challenging insurance market that has restricted commissions.”
The Ground Rent Income Fund offering document says that the fund receives 50% of all insurance commission. The offering document does not explain what, if anything, is done in exchange for that commission.
Will managing agents and landlords just increase service charges if they cannot earn commission?
It is notable that the British Insurance Brokers Association’ — of which the managing agent lobbyist ARMA is a named associate – has already said in response to the FCA report that if commissions are abolished then service charges will rise.
As can be seen from the three examples above, between 40% and 70% of the insurance commissions being generated are profits for managing agents and landlords. The commissions being paid are far in excess of any cost that is actually being incurred in relation to insurance.
Even where commissions are shared between brokers and landlords – for example the 85% share taken by the ARC Time Freehold Fund and the 50% share taken by the Ground Rent Income Fund – these are also being described as profits.
If commissions were abolished, we would expect that costs to leaseholders would be significantly lower, not the same or higher, because these unearned profits would be eliminated.
Is this commission legal?
In most cases the commission has never been challenged because leaseholders do not know about it. Even once the commission is discovered, it is often difficult to challenge.
English residential landlord and tenant law is divorced from the rest of English law. A landlord is allowed to keep an insurance commission without disclosing it to the leaseholders provided the landlord provides some service in exchange for that commission (Williams v Southwark LBC).
More recent authority provides that the outcome of any insurance (including the commission) must be reasonable (COS Services v. Nicholson).
The issue is that “reasonable” in this context is almost meaningless. It certainly does not mean “fair”. What is means is that the outcome must fall within a range of possible outcomes ranging from the least to most expensive. Provided the outcome is within that range, it will be deemed reasonable.
In the rest of English law, a party may not receive a secret commission (or a commission that has only been partly disclosed, called a half-secret commission) paid at someone else’s expense (FHR European Ventures LLP and others (Respondents) v Cedar Capital Partners LLC (Appellant)).
Cedar Capitalalso decided that it is not necessary that a relationship of trust and confidence (a fiduciary relationship, for example between a trustee and a beneficiary) exists in order to establish a right to reclaim the commission. Fiduciaries have long owed a duty not to make secret profits (Boardman v Phipps).
In most commercial contexts, commissions must normally be disclosed. You may have heard about the Plevin case. Plevin v. Paragon Personal Finance concerned a personal loan. The loan was accompanied with payment protection insurance (PPI).
In Mrs Plevin’s case, the commission on the PPI insurance amounted to about 72% of the PPI insurance premium. Mrs Plevin was not told of the commission. Sections 140A to 140D of the Consumer Credit Act 1974 allows a court to review agreements of this nature to see if they create an unfair relationship between lender and borrower. If a court finds the relationship is unfair, under section 140B it has a wide range of options to address the unfairness. In particular, the court may order that some or all of the money paid under that agreement is repaid.
In 2014, the Supreme Court decided that the secret insurance commission was so large that it did amount to an unfair relationship between Mrs Plevin and her lender. The Supreme Court remitted (sent back) the case to the Manchester County Court to decide what changes should be made to address this unfairness.
Plevin has led to banks, insurers and others paying back billions of pounds in excessive commissions. In most cases where the commission was above 50% and not disclosed to the borrower. The borrower is typically repaid the excess.
What rights do leaseholders have in relation to insurance at the moment?
The answer is very few. And the few rights leaseholders do have are worthless because of a problem that pervades the leasehold sector: there is no effective means of enforcement. Landlords get away with ignoring anything they do not like are rarely – if ever – held to account for that.
There is no express legal right for a leaseholder to force a landlord to disclose commission. The system depends on landlords’ honour. It is no surprise that is has led to the current situation of huge commissions being concealed in the premiums charged.
The FCA report recognises this and proposes better disclosure of commissions as a starting point. As explained below, better disclosure will only go so far. What leaseholders really need is a better way to challenge excessive unfair costs.
How can leaseholders challenge insurance at the moment?
With great difficulty.
In order to challenge the cost of the insurance, leaseholders have to make an application to the First-tier Tribunal. They have to prove that the cost has not been reasonably incurred.
There are two ways of doing that. One is to show that the cost of the insurance itself is not reasonable. The second is to show that the services said to have been performed in relation to insurance commission are not of a reasonable standard.
Neither is an easy task. Aside from the fact that that it is often difficult to know what the commissions are, the First-tier Tribunal process is structurally biased in favour of landlords. The Tribunal often orders that witness statements are served at the same time as pleadings. The landlord usually puts on its witness evidence after the leaseholders. The tenants then have no opportunity to address gaps in their case.
A simple procedural reform would be to require that the tenant sets out its case, the landlord responds. The tenant should then be given, as now, a further opportunity to respond to the landlord’s pleaded case. Only then should both parties put in the evidence on which they wish to rely.
A further difficulty in the tribunal process is that if the costs of insurance are challenged, the Tribunal expects a like-for-like quotation to be obtained showing a cheaper price. Where a block policy has been arranged on bespoke wording, it is impossible to get a like-for-like quote. The landlord then wins by default because it says there is no proper evidence of a cheaper policy being available.
It may also be difficult to challenge services said to have been provided in exchange for commission on the basis that they have not been performed to a reasonable standard. Too often the Tribunal is willing to believe lists of things said to have been done even where there is evidence showing that such tasks have not actually been performed.
The final kicker is the costs regime in the First-tier Tribunal (and above). Many leases will allow a landlord to recover its costs from the service charge, or from leaseholders, even if the landlord loses the case.
There is limited costs protection in the form of an order under section 20C of the Landlord and Tenant Act 1985, but this only protects those leaseholders who join the claim. A landlord can lose a case brought by half of the residents and not make any adjustment to the service charges of the other half. A landlord can also be banned from recovering its costs from one-half of the residents, but put through its full costs on service charges paid by the other half of the residents.
This one-sided costs regime means landlords and managing agents never lose and are never held to account.
The FCA outlines various areas of action, but what action should it be taking?
The FCA has two different sets of rules dealing with insurance and insurance products. The first is the Insurance Conduct of Business Sourcebook (or “ICOBS”). The second is the Product Intervention and Product Governance (or “PROD”).
The ICOBS rules require that a party paying for insurance is given disclosure of a broad range of remuneration charged by the people involved in that insurance. Under ICOBS, leaseholders are not defined as the customer of insurance. The broker and insurer is therefore not obliged to give disclosure of commission to the people paying the bill.
The PROD rules are more broadly targeted, but contain no express obligation to give disclosure of commission.
The FCA says it is too difficult to change the ICOBS rules because that would impose too much work in assembling leasehold insurance. If the FCA is not willing to change the ICOBS rules, then it should develop a bespoke rule should be for leasehold insurance. A bespoke rule is necessary to recognise that leasehold insurance has both serious conflicts of interest and that this gives rise to moral hazard. Insurers and brokers are behaving differently because they know that are not paying the cost of any bad decisions they make in relation to placing insurance.
Any bespoke rule the FCA develops should require, as minimum, full disclosure of all remuneration of any kind earned by anyone involved in any insurance policy paid for by leaseholders. That should include how much commission is shared with landlords and managing agents and why it is shared.
A bespoke rule could also deal with more exotic structures, such as the Rendall & Rittner captive insurer. Unless the FCA adopts broad-based rules, it is likely many more landlords and managing agents will shift to using to structures to continue receiving their unearned insurance profits.
What can the government do?
The FCA leaves the lion’s share of the work to government. As above, it appears that the FCA already has the ability to influence landlords who control about 1 in 6 leasehold properties. The FCA can move much quicker than the government, which will most likely require an Act of Parliament to intervene.
Other changes that could be made to leasehold law to stop this may include:
- Some means of encouraging resident-managed buildings to form a collective to buy insurance in bulk. Resident managed buildings have been among the worst affected by cladding-driven increases in insurance. They lack the bargaining power of the large landlords. A not-for-profit collective could aggregate these buildings and make it easier for them to buy insurance.
- Introducing a duty on landlords not to charge unreasonable service charges could be expanded to include a duty not to make charges which create an unfair relationship between landlord and tenant.
- Amending the costs regime in the First-tier Tribunal (and above) should be amended to prevent landlords being able to recover their legal costs from leaseholders, or through service charges. There should either be a true no costs regime, or landlords’ costs should be limited to modest fixed amounts. This would prevent the current practice of landlords using leaseholder money, often tens of thousands of pounds, to defend themselves from leaseholders, even when they lose the case.
- Changing the law to make the First-tier Tribunal (and above) apply ordinary English law on commissions and fiduciary duties. As explained above, the rest of English law requires commissions to be disclosed to the party paying them. The rest of English law also requires a fiduciary not to make a secret profit, which is exactly what happens when a landlord arranges insurance with a commission for its own benefit.
- Amending section 69 of the Commonhold and Leasehold Reform Act 2002 to require a statement of all income earned by the landlord and managing agent to accompany every ground rent and service charge demand. If that information was not provided, it would not be possible for the landlord and managing agent to collect service charges or ground rents.
Lord Kennedy of Southwark already has a private members bill in the House of Lords with a similar aim.
- The RICS Service Charge Code of Practice already requires the amount of income earned by managing agents. This should be extended to cover landlords. There is currently no sanction for breaching the RICS Code, although the First-tier Tribunal takes into account when deciding whether the agents and landlords have acted reasonably. The RICS Code should be toughened up by changing the law so that it becomes an implied term of every lease that service charges will be managed in accordance with the RICS Code.
The bottom line
The most important thing the government and the FCA can do is not be blinded by special pleading from insurers, brokers, managing agents and landlords. Even the small sample of accounting data covered in this article shows that any cost incurred in relation to placing this kind of insurance is often only one-third to one-half of the commissions that have been received in recent years.
The FCA report also envisages a process that will take another six months to produce rules for consultation. Any Act of Parliament could also take more than 2 years to pass.
Leaseholders are already bearing the burden of inflated insurance and bloated commissions. They do not have time to wait. We need action this day.