The future of outsourcing in the insurance and financial services industry
Juanita Moolman, partner in the Financial Regulatory Practice at Webber Wentzel.
Opinion by Juanita Moolman, partner in the Financial Regulatory Practice at Webber Wentzel. She specialises in long and short-term insurance, investment and pension funds.
Why Outsource?
Outsourcing is generally seen as a way to reduce and control operating costs, improve company focus, free internal resources for other purposes, increase efficiency and manage risk by sharing risk. Outsourcing by insurers and Financial Services Providers ("FSPs") is closely regulated and will be even more regulated once proposed regulatory changes are implemented.
The FSB's views on outsourcing
The Financial Services Board ("FSB"), who currently oversees the activities of insurers and FSPs under the appropriate legislation, has made its views on outsourcing clear by making the following statements in the 2016 Retail Distribution Review Status Update Document ("2016 RDR Status Update Document"):
1. Historic and recent supervisory experience consistently revealed significant risks of poor customer outcomes in outsourced business models, including but not limited to the risk of conflicted advice. These risks are sought to be mitigated by the range of RDR proposals aimed at limiting and defining the types of services that may be outsourced to financial advisors, placing gaps on remuneration for such services and significantly strengthening governance and operational efficiency requirements in these models.
2. A greater degree of pro-active product supplier monitoring of customer outcome indicators will be required where any degree of ownership, outsourcing or other risks of influence exist. From a supervisory perspective, the FSB will pay more attention to the processes such product suppliers have in place to ensure fair customer outcomes.
During the FSB's Insurance Regulatory Seminar that took place in November 2016, it was specifically stated that if there is no integration, inefficiencies, inability to pro-actively manage conduct risk and poor customer outcomes, there will be no outsourcing and no fees allowed for outsourcing.
Current regulation of outsourcing
Directive 159.A.i was issued under the Long-term Insurance Act, 1998 ("LTIA") and the Short-term Insurance Act, 1998 ("STIA") and directs insurers with respect to outsourcing of insurer activities that includes all activities that enable an insurer to provide policy benefits such as IT systems, asset management and record or data based administration. In terms of Directive 159.A.i insurers currently may not outsource an activity if the outsourcing may materially increase the risk to the insurer, materially impair the quality of governance, impair the FSB's ability to monitor the insurer's compliance and compromise the fair treatment of, or continuous and satisfactory service to policyholders. Directive 159.A.i sets requirements around remuneration with respect to outsourcing, but does not provide specific caps with respect to outsourcing fees.
Binder functions are a sub-set of outsourcing arrangements. These outsourcing arrangements are regulated in terms of the Regulations published under the LTIA and STIA. The Regulations are clear as to who may perform this type of outsourced activity and what the limitations are with respect to these activities. The Regulations set requirements around remuneration with respect to outsourcing of binder functions, but does not currently provide specific binder fee caps.
Future regulation of outsourcing
In terms of the proposed amendments to the Regulations under the LTIA and STIA that were published for comment on 23 December 2016 ("Draft Regulations") remuneration caps will in future be applicable to certain outsourced activities and there will be stricter regulation around the entities that may perform the outsourced activities.
In terms of the Draft Regulations, non-mandated intermediaries that can give advice in terms of their licence under the Financial Advisory and Intermediary Services Act, 2002 ("FAIS") will be limited with respect to the types of binder functions they may provide. This will probably put these outsourced service providers in a position where they would need to choose whether they will keep the advice part of their FAIS licence and no longer provide certain binder functions that they are currently providing, or whether they would give up the advice part of their FAIS licence, and thereby increase the advice gap in the financial services market, to enable these binder holders to continue performing the binder functions they are currently performing.
The proposed fee caps for the performance of binder functions by non-mandated intermediaries will further put these outsourced service providers in a position where they would need to assess whether the business they have built within the regulatory constraints will in future be financially viable.
In terms of the proposed amendments to the FAIS Fit and Proper requirements ("Draft Fit and Proper requirements") that were published for comment in October 2016, an FSP must exercise due skill, care and diligence when entering into, including the selection process, managing or terminating any arrangement for the outsourcing services.
In terms of the Draft Fit and Proper requirements, an FSP that outsources must ensure that the person to whom the function or activity has been outsourced:
1. is able to carry out the outsourced services effectively to which end the FSP must establish methods for assessing the standards of performance of that person;
2. properly supervise the carrying out of the outsourced functions and adequately manage the risks associated with the outsourcing, including any risks to the FSP's clients;
3. take appropriate action if it appears that a person may not be carrying out the functions effectively and in compliance with applicable laws and regulatory requirements;
4. retain the necessary expertise to supervise the outsourced functions effectively and manage the risks associated with the outsourcing;
5. have effective access to data related to the outsourcing activities, including any data relating to the FSP's clients as well as to the business premises of that person; and
6. ensure that the outsourcing arrangement does not compromise the fair treatment of, or continuous and satisfactory service of the FSP's clients.
The above mentioned are a few examples of requirements in terms of the Draft Fit and Proper requirements that suggest labour intensive and possibly costly interventions by the FSP before, during and after the outsourcing relationship. FSPs should consider the requirements in light of the business reasons behind outsourcing and whether the objectives of outsourcing such as reducing and controlling operating costs; improving company focus; freeing of internal resources for other purposes; streamlining or increasing efficiency for time consuming functions and managing risks by sharing risks, would still be achieved when these Draft Fit and Proper requirements become effective.
There will in future be further regulation of outsourced relationships in terms of the Financial Sector Regulation Bill ("FSR Bill") and the Insurance Bill. The Insurance Bill makes provision for the Prudential Authority to impose licensing conditions which may include conditions relating to outsourcing arrangements and the Prudential Authority will be able to prescribe governance principles and requirements relating to outsourcing. The FSR Bill defines financial services and the definition of financial services includes a service provided to a financial institution through an outsourcing arrangement. The FSR Bill also provides for standards that can be made with respect to outsourcing by financial institutions.
It is a good time for insurers and FSPs that outsources relevant functions to start considering the future benefits and obligations of outsourcing and to plan accordingly.
