Coverholders - Client money: Keeping it separate

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Proper segregation of client money is a burning issue at the Financial Services Authority. Ben Hobby looks at what coverholders and their underwriters can do to make sure a clients' money is held correctly.

Since the collapse of Lehman Brothers in 2008, the Financial Services Authority has placed an increasing emphasis on the need for all regulated entities to comply with its client money rules. This is highlighted by the fact that the administrators of Lehman's European business are reviewing £2.1bn of client monies that were not properly segregated.

This is an issue that is now affecting the accounting profession, with the auditors of both Lehman's and JP Morgan being investigated in relation to reports provided to the FSA on client money.

The principal aim of the client money rules is to ensure that such monies are appropriately segregated and ring fenced so that, in the event of insolvency, they do not form part of the funds that are available to be distributed to creditors. The rise in the risk of insolvency during the current recession has underlined the need for an increased monitoring of compliance.

This is a particular issue for those insurers that have a delegated underwriting portfolio — where their coverholders are responsible for the collection of premium from policyholders and for the accounting of this to underwriters. However, while the FSA client money rules apply to UK-based organisations, they do not apply to foreign-based entities.

Appropriate segregation
Given this, what can underwriters do to ensure that premium held on their behalf by coverholders — wherever they are located — is appropriately segregated and correctly accounted for?

First, underwriters should ensure that the coverholder uses trust bank accounts to manage premium funds, these accounts being recorded as such with the bank. This should ensure that the bank does not use these funds to offset against any overdraft operated by the coverholder in the event of insolvency.

It would also be preferable for coverholders to operate a separate trust account for each book of business and year of account that they operate. However, this is not always administratively feasible, given the number of accounts that may result. Difficulties also arise from a practical perspective, in that the coverholder may not always know which book of business certain funds received relate to at the date of receipt, particularly where the coverholder operates multiple books. Consequently, it is common for funds for a specific underwriter to be pooled with those of other underwriters.

Given this fact, it is imperative that the coverholder maintains analyses that show at any point in time, of the funds held in each trust account, the underwriters that these funds relate to. But these analyses, on their own, are not enough to protect underwriters.

At an accounting level, when a coverholder receives premium from a policyholder, the cash received is recognised in the former's balance sheet as an asset, with a corresponding liability being created. This reflects the fact that this amount of money is owed to underwriters.

Therefore, at any point in time, the amount of money held in a coverholder's trust account should reconcile — in total and by underwriter — to the total of the liabilities to underwriters that are recorded in the coverholder's balance sheet. This can be illustrated via a mock table (see below).

The balances held by the coverholder in its trust account are adequate to meet its liabilities to Harrison. However, they are not in respect of McCartney and Starr; while the coverholder is holding more funds on behalf of Lennon than are required to meet its liabilities.

Of perhaps greater concern is that the total amount held by the coverholder in the trust account does not cover its total liability to underwriters. If this coverholder was to enter into liquidation, it is possible that McCartney and Starr would be the parties to suffer a loss.

Reconciling the accounts
This example illustrates the importance of a coverholder regularly reconciling the amounts held in its trust accounts to its liabilities to underwriters. Any reconciling differences that are identified must be immediately investigated and resolved. Failure to do so may result in the coverholder being unable to establish the cause of any difference and, hence, resolve it to underwriter's satisfaction.

As part of their review of coverholders, underwriters should ensure that this reconciliation is occurring and that issues are being resolved on a timely basis. Underwriters can further ensure the accuracy of this reconciliation, as the amount considered to be owed to them by the coverholder should also reconcile to their own records, which will derive from the bordereaux presented to them by the coverholder.

It is clear from the above that the process of ensuring an underwriter's funds are properly accounted for is straightforward. However, it is also clear from the examples of Lehman Brothers and JP Morgan that the consequences of not complying with this process can be severe.

Underwriter Balances held in trust account (£) Amounts owed to underwriters (£) Difference
Harrison 100 100 0
Lennon 250 200 50
McCartney 200 450 (250)
Starr 200 250 (50)
Total 750 1000 (250)

Ben Hobby is a senior manager at RGL Forensics

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