The Costs and Benefits of FAIS legislation

[PMG note: diagrams not included in website copy]

THE COSTS AND BENEFITS OF THE FINANCIAL ADVISORY AND INTERMEDIARY SERVICES (FAIS) BILL

PRINCIPAL CONCLUSIONS,

EXECUTIVE SUMMARY

AND

MAIN REPORT

Prepared by:

Stephan Malherbe – Genesis Analytics

Morabo Morojele – Independent Consultant

On the instruction of:

The Financial Services Board

South Africa

September 2001

PRINCIPAL CONCLUSIONS ON THE COSTS AND BENEFITS OF FAIS

On an overall basis the quantifiable benefits of the FAIS Bill exceed the quantifiable benefits by a margin of three to one. Benefits have been conservatively estimated and costs include costs to intermediaries of the Policy-holder Protection Rules (PPR).

Assuming, as industry participants do, that all costs will ultimately be passed on to consumers, the aggregate benefits to consumers of FAIS/PPR will ultimately exceed the costs by a margin of three to one.

In the insurance industry, total annually recurring costs are estimated to be approximately a quarter of a percent of premiums paid annually. In return the consumer gets the disclosure, record-keeping and appropriate advice requirements of FAIS/PPR, as well as the complaints resolution mechanism embodied in the roles of compliance officers and the office of the new Ombud for Financial Advice and Intermediary Services.

In the banking industry, where it is assumed that coverage will be limited to advice on deposits of longer than one year maturity, annual costs are estimated to be approximately .40 percent (or 40 basis points) of the estimated aggregate deposits of individuals and unincorporated businesses with a maturity of longer than one year.

The extent to which FAIS/PPR changes the structure of the broking industry depends on the extent to which costs are passed on to consumers (most likely via product suppliers). It is expected that many individual brokers will join or utilise larger groupings to exploit scale in meeting the regulatory requirements. Such groupings include industry associations, new broker networks, corporate brokerages and sales forces allied to particular product suppliers. It is also likely that part-time brokers (including so-called sub-code brokers) will leave the industry.

The way in which FAIS/PPR is applied to emerging brokers needs to be carefully phased, calibrated and monitored, as allowed by the flexibility mechanisms of the Bill. Emerging brokers are characterised by low earnings, limited resources to deal with new requirements and a market position undermined by economic stress and the micro-lending industry.

Following from the above, the economy-wide consequences of FAIS/PPR will be positive as long as its application does not reduce uptake of savings products, and thereby reduce the propensity to save of the economy and of particular communities. A high savings rate is a key pillar of the process through which previously disadvantaged households over a wide base become economically empowered.

To safeguard savings behaviour the following need to be heeded. (1) The regulations ultimately passed must not lead to an undue reduction in the chances of a consumers being visited by a broker. (2) The regulations ultimately passed must not unduly constrict or inhibit the development of new cost-effective direct channels of marketing investment products by telephone or the Internet. (3) There needs to be balance between the regulation of how savings products are sold and the regulation of how its major competition, consumer credit and loans, is sold. (4) The effect of PPR thus far on the sales of products should be investigated and assessed before subordinated legislation in terms of FAIS is finalised.

EXECUTIVE SUMMARY

Introduction

The FAIS Bill is intended to regulate the financial advisory and intermediary services industry, to professionalise the industry and in combination with the Policyholder Protection Rules (PPR) enacted in July 2001, as well as other legislation, to protect consumers.

The cost-benefit analysis (CBA) was conducted for the Financial Services Board and was aimed at estimating the potential costs and benefits of the Bill to consumers and the economy.

The emerging sector

The CBA identified two sectors or markets within the financial advisory and intermediary services industry, namely:

A sophisticated, established sector, generally utilising modern technology and largely able to benefit from scale economies; and

A less sophisticated emerging sector, generally less well-disposed to modern technologies and existing under apparently perilous conditions, on the back of increasing rates of borrowing from the micro-lending sector.

The above descriptions are far from adequate and additional work should perhaps be undertaken to quantify and define these two sectors. Whereas established intermediaries already comply with many of the requirements of the FAIS Bill, this is far less the case for emerging intermediaries, who are additionally encumbered by their low access to information and communication technology systems.

The FAIS Bill gives recognition to different categories of intermediaries and financial service providers. The Bill and its draft subordinate legislation also allows for degrees of flexibility and for the exemption of particular intermediaries from some of the Bill’s requirements. An important issue for assessing the effects of the Bill is how this flexibility will be used to ensure levels of regulation for emerging brokers that are appropriate to their market context.

Individual intermediaries are the unit of analysis

The Bill in large measure seeks to regulate the behaviour of individuals providing financial advice or certain other services, whether the individual is an independent broker, works for a large ‘corporate’ brokerage, affiliates with one particular insurer only as a ‘tied agent’, sells financial products from a call centre, or works for a bank. Therefore the unit of analysis chosen is the individual intermediary. Costs were estimated on a per individual basis for four categories of intermediaries:

Independent brokers in the established market (‘independent brokers’) who are estimated to number 8,900.

Independent brokers in the emerging market (‘emerging brokers’) who are estimated to number 3,000.

Representatives in the insurance industry, tied either to a product supplier or to a corporate brokerage (‘insurance representatives’), estimated to number 10,950.

Representatives employed in banks to advise clients on traditional banking products (‘banking representatives’) who are estimated to number 8,170.

Main findings on costs

Initial once-off costs to intermediaries of the Policyholder Protection Rules (PPR) and the FAIS Bill are estimated to total R265 million, of which R228 million in insurance and investment products, and R37 million in banking.

Annually recurring costs to intermediaries of PPR and FAIS are estimated to total R334 million, of which R294 million in insurance and investment products, and R41 million in banking. If divided into recurring costs caused by PPR and by FAIS, the amounts are R232 million and R102 million respectively.

These costs is best evaluated against the size of the industry. Insurance-related recurring costs, both short-term and long-term, are .22% (22 basis points) of annual insurance premium flows. Banking-related recurring costs are equal to .40% (40 basis points) of our estimate of bank deposits of one year or longer held by individuals, unincorporated businesses and non-profits.

Table 1. Aggregate estimated costs of FAIS and PPR per category

These cost estimate are based on assumptions, among which (1) that audits will be required only from intermediaries that take client funds onto their books and (2) that intermediaries already generate financial accounts and statements as required for tax purposes. (3) The cost and extent of revenue-generating time foregone have also been estimated for each category of intermediary. The estimates and assumptions are based on extensive industry interviews.

Main contributors to costs are training, meeting the disclosure and record-keeping requirements, and time spent on ensuring that ‘appropriate advice’, as defined by draft subordinate legislation, is given. Direct costs of regulatory oversight and the Ombud office contribute about five percent to total recurring costs.

Average recurring cost per individual intermediary occasioned by FAIS is estimated at R2,791 per annum. The recurring cost of the intermediary-related elements of the PPR is estimated at R6,326 per annum. The industry view is that most of these costs will ultimately not be borne by the intermediaries: the expectation is that product suppliers will incur some of the costs, and that costs will ultimately be passed on to consumers.

Estimated annual costs to emerging brokers are about half of the level for established brokers and may average R7,100 per year. These levels may be significantly reduced by use of the flexibility arrangements provided for in the Bill. Emerging brokers earn, according to industry estimates, in the range of R4,000-8,000 per month on average. The circumstances and interests of emerging brokers are discussed at length in the main body of the report.

Main findings on quantifiable benefits

The benefit to consumers will arise from reduced miss-selling and over-selling of financial products to consumers as the core elements of improved disclosure, ‘appropriate advice’ (requiring a needs analysis, affordability test and priority for the client’s interests) and more professional intermediaries kick in.

Although a precise estimate of benefits is not possible, lower bounds to quantifiable benefits can be estimated.

Every 1% reduction in short-term insurance premiums benefits consumers by R200 million per year.

Every 1% improvement in returns to long-term insurance premiums invested (not recurring, once-off) benefits consumers by R 1.12 billion per year.

Table 2. Estimated benefits to consumers from reduced miss-selling and over-selling

Every 1% reduction in long-term insurance sales commissions saves consumers R60 million per year.

A 20% reduction in the rate of policy lapses will save consumers R275 million per year.

Table 2 shows how the use of these parameters with fairly conservative assumptions yields a benefit to consumers of R1.155 billion per year.

This means that the quantifiable benefits of FAIS/PPR are three times the size of our estimate of quantifiable costs of FAIS/PPR (R334 million).

Main findings on non-quantifiable benefits

Firstly, FAIS/PPR’s improved disclosure and appropriate selling requirements should reduce the incidence of Masterbond-type large-scale ‘financial disasters’.

Secondly, FAIS/PPR creates a complaints resolution mechanism for consumers, with clear grounds for complaints, obligations on intermediaries and financial services providers and an Ombud office to handle and resolve complaints.

Thirdly, the ‘fit and proper’ requirements in FAIS and the obligations for intermediaries created in FAIS and PPR is the start of a process of professionalisation of the industry.

Concerns on non-quantifiable issues

Firstly, the effect on savings patterns. Higher personal savings rates are important for the health of the economy, for the future welfare and stability of individual households, and for accelerating the economic empowerment of previously disadvantaged groups. Therefore there could be a potential cost if FAIS/PPR reduced the access of households to contractual savings products - for example if the legislation significantly impeded direct selling of investment products or dramatically reduced the number of brokers active in the SA market.

In our view the flexibility arrangements in the Bill can be used to ensure that regulations are appropriately weighted to encourage rather than discourage savings. (It is noted that a lag in the regulation of the provision of consumer and other credit compared to the regulation of selling of investment and other savings products may compound the problem of low savings and high indebtedness characteristic of the emerging market).

Secondly, the potential quantifiable benefits of the Bill are magnified if there is effectively more competition for the business of consumers, and are reduced if the level of competition among product suppliers and intermediary channels diminishes.

In our view the flexibility arrangements in the Bill should be used in a way that favours rather than inhibits higher levels of competition.

MAIN REPORT

INTRODUCTION

Is there an economic rationale for regulating advice & intermediary services?

Regulation only has a place where market imperfections are present that inhibit the efficient allocation of resources. The market for financial intermediation displays the following characteristics that weaken market discipline:

Extreme asymmetry of information. The client knows virtually nothing first-hand of the product being offered, the nature of the organisation offering it, and, often, the intermediary advising the client to buy it. This lack of knowledge makes it difficult for clients to distinguish between good and bad products, particularly when the latter offers a high pay-off.

Greed clouds judgement. More than other products, financial products can key into the emotion of greed, which, in a way reminiscent of the sex drive, may in some individuals cloud rational considerations such as risk-aversion.

An incentive to ‘promise and obfuscate’. Unscrupulous operators therefore have an incentive to hide as much information as possible while promising high returns. This serves to weaken market discipline at the instant where it is most needed.

Low sunk costs of market entry. The provisioning of both financial products and intermediary and advice services can often be entered into at fairly low cost. This contrasts with other industries, for example auto manufacturing, where the high sunk costs - that is, unrecoverable costs of entry means that early loss of reputation comes at a high implicit cost. The former type of industry is hospitable to ‘fly-by-nights’, whilst the latter is not.

These factors explain why repeated abuse of clients can occur in the intermediation and provisioning of financial services. One may ask whether, in such circumstances, the emergence of reputable firms over time is not enough to ensure an efficient market that serves clients adequately. While this helps - and explains the power of established financial brands - it is not sufficient. Firstly, reliance on reputation alone may inhibit market competition. Secondly, greed and ignorance can conspire to make the consumer forget about the desirability of using a reputable brand.

Regulation can address these market imperfections by firstly ensuring that the client is better informed, secondly, that product suppliers and intermediaries are honest, competent and financially sound, and thirdly by increasing market competition by reducing the reputational barrier to entry.

Cost-Benefit Analysis: approach and difficulties

In view of the limited experience of conducting CBA of regulatory legislation in South Africa, it was agreed to utilise the well-publicised approach of the United Kingdom Financial Services Authority (FSA).

The FSA approach provides for:

The assessment and ranking of different policy options, including the maintenance of the status quo;

Focusing on the incremental costs and benefits of available options, to eliminate complexity and costs in the conduct of the CBA;

The initial consideration of issues according to first principles, to ensure value addition;

The practical use of upper and lower bounds in the analysis of costs and benefits; and

The clear enumeration of costs and benefits that have to be assessed.

Complexity. Inherent to the difficulty of the CBA was the very complexity of the draft legislation intended to regulate the activities of different types and sizes of enterprises, engaged in a variegated activities, through a large number of diverse agents and operating in different and rapidly evolving environments. Compounding the complexity of the Bill and its target environment was the fact of the analysis of legislation that has mutated considerably since its first publication in 1999. Throughout the exercise, it was never clear to which version of the legislation submissions and responses were being offered.

The Critical Role of Subordinate Legislation. The detailed regulatory provisions and prescriptions of the FAIS Bill are contained in its subordinate legislation, which are also repository of its substantive cost elements. Whilst pieces of subordinate legislation did become available during the conduct of the CBA, they were not available to industry representatives and as such no comments were available on them to inform the analysis.

Submissions. The large volume and density of the submissions made to the FSB by industry representatives was the cause of other difficulties. The FAIS Bill is a piece of legislation that has been subject to extensive consultative processes. Considerable time was therefore spent in cross tabulating and analysing these submissions in order to understand their justification and their possible impact on the purpose, ambit, costs and benefits of the Bill.

Data. Whereas most industry players were extremely keen to share their perspectives on the Bill, empirical data was not so easily available, particularly at the lower end of the industry. In addition, there was a lack of comprehensive set of organised data quantifying the problem to be rectified or addressed through the FAIS Bill. Consequently, there was no clear yardstick against which to measure its potential costs and benefits. Nevertheless, hard data has been used to the extent possible. Data estimates where received from industry bodies, whereas cost estimates were collected through interviews of individual industry participants.

Caveat. Cost-benefit analysis is an inexact attempt to look into the future and can only reveal broad estimates of the likely impact of regulatory legislation. It is for this reason that the outcome of the CBA is a set of figures reflecting upper and lower bounds, or minimum and maximum costs and benefits.

How the Cost were Estimated

Firstly, costs were divided into two types:

Initial costs, which are once-off

Recurring costs on an annual basis.

Secondly, per individual costs were estimated for four categories of intermediary:

Independent brokers, who operate in the established market, outside a corporate context, and who will need to register as FSPs

Emerging brokers, who also need to register as FSPs and also work by themselves, but serve the emerging market.

Insurance representatives, intermediaries who are employed by or have a mandate of a specific product supplier (these would be tied agents) or corporate brokerage. These ‘reps’ sell insurance and general investment products.

Bank representatives, bank employees who advise bank clients on traditional bank products that fall within the Bill, such as deposits with a term of longer than one year.

Thirdly, based on market interviews account was taken of the digital divide, or differing access to electronic services provide through software or over the Internet. This matters to the cost of compliance as the most effective compliance solutions require access to a computer and/or the Internet. Specifically:

Emerging brokers are assumed not to have access to computers or the Internet.

Independent Established brokers are assumed already to have access to a computer and the Internet.

Fourthly, account was taken of the opportunity cost of time spent on meeting regulatory standards not previously required. In the cost estimates, these should be understood as number of hours forfeited (due to the regulatory activity) which could realistically have been used to generate income at their average rate. In our estimations:

Independent brokers have an opportunity cost of R250 per hour.

Emerging brokers have an opportunity cost of R50 an hour.

Representatives, insurance and banking, have an opportunity cost of R150 per hour.

‘Revenue-producing hours forfeited’ are estimated on an extremely conservative basis, given the ‘lumpiness’ of intermediary activities (‘lumpiness’ means that not every minute saved can be used to generate income because each sales visit takes an appreciable time).

Fifthly, after calculating initial and recurring costs per individual intermediary, these were divided into two categories: those that are already required under the Policyholder Protection Rules (PPR) that have applied to the short-term and long-term insurance industries since July 2001, and those that are required additionally under FAIS. (Readers should note that the PPR costs covered are only those that pertain directly to intermediary activities; other costs of PPR to the industry are not included, and therefore our estimates do not represent the total cost of the PPR to the industry.)

Finally, the initial and recurring costs per individual were multiplied with the number of individual intermediaries in that category to arrive at aggregate costs.

It is apparent from the above that readers should not interpret the ‘independent’ and ‘emerging’ categories in strictly racial terms. While most brokers serving the black market and most black brokers fall into the ‘emerging’ category, some black brokers are firmly in the ‘independent’ category, and some white brokers in the ‘emerging’ category.

The cost-benefit analysis

The intermediary population

The Bill seeks to regulate ‘financial services providers’, which are entities providing advice on financial products or other services necessary for the eventual purchase of the product. FSPs range from independent one-man brokerages to the largest financial institutions in the country. Persons who work for FSPs, either as employees or under a mandate, and who provide advice or an intermediary service, will also be regulated - as ‘representatives’ (or ‘reps’). As this analysis uses individual FSPs and representatives as the unit of analysis, it is important to know their number. But, due to the sector not being regulated thus far, the number has to be estimated (Table 1):

Individuals needing to register as FSPs: about 11,900

Representatives: about 24,800 (of which 16,600 are in insurance and an estimated 8,200 are in banking).

The corporate FSPs that employ them: 638.

Table 1. Estimates of individual intermediaries, etc

Table 2. Reconciliation of Genesis estimates with LOA database

Reconciliation with LOA database. The most comprehensive database on financial intermediaries is that of the Life Offices Association (LOA). On the face of it, the database contains a significantly higher number of independent intermediaries than the estimate used here. However, according to industry experts, a large number of the registered intermediaries are ‘sub-code’ registrees - administrative personnel or spouses of an independent who have been registered along with the full-time broker (the ‘code’ registree) so that they can perform certain administrative functions and also occasionally be compensated from commission flow. When these are taken into account, as Table 2 shows, it becomes possible to reconcile the LOA numbers with the other industry estimates used here.

Using the intermediary population as a basis for estimating costs

We have taken as our unit of analysis the number of individual intermediaries, as many of the costs are ultimately determined and borne at that level. Not all intermediaries are in the same position; hence our use of different categories:

Representatives tend to work in the context of corporate parents where some regulatory requirements can be met cost-effectively through investment in systems. These scale economies generally mean that the effective regulatory burden per representative is lower than that per independent broker. The category of representative is diverse, containing four distinct groups: (a) life office representatives, (b) brokers affiliated with the large corporate brokerages, (c) direct sales staff and (d) banking staff advising clients on certain bank products. While it is impossible to assess the size of the last group, we have assumed an average of 2 per bank branch or service centre (of which there were 4,087 in South Africa in 1999, the latest available numbers). In this diverse group, we assume the average opportunity cost of their time to be R150 per hour. For the purposes of estimating other costs the group is divided into insurance intermediaries and banking intermediaries - those that fall under FAIS because they advise on traditional bank products such as deposits with a term of longer than a year.

Brokers in the established market. Based on interviews with market participants, we assume these brokers to have their own offices, have physical record-keeping systems, and to have access to a computer. Because they are electronically connected, they have the option of using the electronic compliance services developed in response to the PPR and FAIS, and therefore to benefit from the type of scale economies enjoyed by representatives. Based on an assumed gross income of R40,000 per month, we assume the opportunity cost of their time to be R250 per hour.

Brokers in the emerging market. Based on interviews with members of the Black Brokers Forum, we assume that while most of these brokers have telephone facilities, they do not to have offices or computers, have rudimentary filing systems and are not able without significant upfront investment to access electronic compliance services. Based on an assumed gross income of R8,000 per month, we assume the opportunity cost of their time to be R50 per hour. In fact, BBF members interviewed estimated that the bulk of emerging brokers currently earn no more than R4,000 per month.

The basis for the estimate of the number of essentially corporate FSPs is contained in Appendix 1.

Investment managers are assumed not to bear additional cost

The roughly 260 investment managers - which includes asset managers, LISPS and other managers of third-party funds excluding members of exchanges - have hitherto been regulated by the Financial Services Board in terms of other legislation. The subordinated legislation regulating investment managers will be transferred in toto into codes of conduct under FAIS. Therefore FAIS will not add any regulatory or compliance cost to investment managers. Additional costs for investment managers have therefore been assumed to be zero.

Costs to intermediaries of PPR and FAIS

Table 3 shows the estimates of initial costs per individual intermediary for each of the four categories. Table 4 does the same with respect to costs that recur annually. A short discussion of the major cost elements follows.

Licensing and cost of regulatory supervision. The cost to the FSB of supervising the intermediary sector is estimated at R10 million per year, which, together with a small margin, translates into an annual fee of R300 per intermediary. The FSB has not yet decided how to divide its cost recoveries between an initial license fee and levy. But the intention is clearly to recover all costs from the market - this per individual charge is the simplest way to assess the cost. Bodies representing intermediaries, such as the IBC or the BBF, will play an initial vetting role in license applications of its members. Based on interviews we have estimated the cost of that at R 200 per year, together with a small initial fee. ‘Representatives’, on the other hand, will need to be registered but not authorised - we estimated the cost of that to their corporate homes at R50 per year.

Fit and proper requirements. To be fit and proper an individual FSP needs to be honest, financially sound and have the required operational capability. Costs are incurred to meet the third requirement. In terms of draft regulations Category I intermediaries will be required to have a qualification at the level of NQF 4 (estimated once-off cost R1,500) and other intermediaries at the level of NQF 5 or 6 (estimated once-off cost R3,500). Course work is assumed to be done after hours, so there is no opportunity cost or loss of income. It should be noted that the other two requirements, while not incurring direct costs, may constitute barriers to entry for outsiders and, possibly, to the continuation of incumbents. The draft regulations have extensive provisions intended to minimise the latter. For emerging brokers, an additional once-off cost of R1,700 is required to set up sound filing and practice management, as well as to ensure fax communications.

Book-keeping and financial statements. The Bill requires the proper keeping of books. This can be expected to be in place for representatives working in a corporate environment, as well as for established brokers. As this is already a requirement of tax legislation, it is not included as an additional cost incurred due to FAIS. (However, emerging brokers not adhering to the requirement will face a once-off cost of R500 for training and an estimated annual cost of R1,920 for book-keeping services.

Accounting audit requirement. Currently the Bill is worded to require the financial statements of all FSPs be audited - a cost we estimate at R4,000 per individual FSP annually, or R48 million annually. However, FSPs may be exempted from this, and we assume that audits will only be required from intermediaries handling client money through their book. There are two such categories: (a) investment managers, who alredy have an auditing requirement, and (b) ST insurance brokers who collect premiums form their clients. The latter category requires some explanation. In terms of the ST Insurance Act collecting brokers are allowed to keep premiums collected for 45 days and to collect and keep interest on these: this income accounts for an estimated 10% of total income of a collecting broker. To do so, the broker needs to have been granted the so-called Investment Guarantee Facility (IGF), which is currently granted to 700 brokers - and already requires audited financial statements from most of these brokers. Brokers who collect less than R500,000 annually in premiums are exempted from the audit requirement, but are a dwindling group. It is only they who would have additional cost of audits were required only of intermediaries handling client money. Hence our view that under those circumstances there would not be an audit cost to the industry as a whole.

Disclosure and record-keeping. Here the different categories have different cost structures. This is firstly a result of the digital divide. For intermediaries who already have access to computers and the Internet, an electronic system ensuring full disclosure in documentation and 5-year record-keeping of transactions and advice is the most cost-effective option. A number of such services have been created for independent brokers, among others by the IBC (IB Direct), Old Mutual (Tradewinds and Navigator) and Sanlam (Icomply). Based on the cheapest of these systems and estimates of remaining costs, the assessed cost per month for independent brokers is R300. The record-keeping and disclosure costs to insurance representatives is somewhat different, as the corporate has to carry the initial fixed costs. Based on the actual experience of a representative large corporate brokerage in adjusting to PPR, we estimate the upfront cost per representative at R3,400, with recurring annual charge of R2,300. We estimate the simpler position of bank representatives at R500 less the recurring cost of their insurance colleagues. The difficulty arises with estimating the costs to emerging brokers, who do not have electronic access. We estimate once-off printing costs of R1,400, a record-keeping system of R600 and an on-going record-keeping cost of 1.5 hours of revenue-earning time per week valued at R50 per hour.

Training re the Code of Conduct. The costs of a training course is estimated at R500 for independent and emerging brokers, with 8 hours of revenue-generating time lost in each case. For representatives we have taken actual costs of training required for PPR in the case of a representative corporate broking firm.

Appropriate advice. On the basis of the draft General Code ‘appropriate advice’ has three components: (a) a needs analysis suitable to the circumstances, (b) an assessment of the affordability of the product and (c) adherence to the principle that the client’s interests supersede the personal interests of the intermediary. For independent brokers and insurance representatives in the established market, the most cost-effective means is to effect appropriate advice is by using software, for which we have calculated the initial and recurring costs. Banking representatives, working in a more simple environment, should not require the software. Emerging brokers will have to compensate for the lack of software through a training course costing R900 in total. In addition, the more complex procedure of giving appropriate advice is estimated to lead to a loss of 30 minutes per week in revenue-generating time in all cases. It should be noted that this is conservative.

Complaints procedure. The Bill is intended to make it easier for clients to lay complaints. For all categories five additional complaints per year is estimated, other than for the emerging market, where the far higher number of individual policies would mean ten. A loss of one hour of revenue-generating time per complaint is estimated.

Compliance officer. For brokers needing to register as FSPs, both in the established and the emerging market, it is assumed that it is most effective for the compliance officer services to be bought in at 8 hours per year at R300 per hour. Based on actual experience, it is assumed that the costs for insurance representatives is R1,000 per representative per year. For bank representatives the cost is estimated at half that.

Ombud. The R6 million annual cost of the office of the intermediary Ombud is divided by the 36,674 individual intermediaries to yield a per individual cost of R164 per year.

Table 3. Initial costs to intermediaries resulting from PPR and FAIS

Table 4. Annual costs to intermediaries resulting from PPR and FAIS

The annual cost tables show the following:

Firstly, the scale economies of the corporate settings in which representatives work bring down the per intermediary impact of the Bill.

Secondly, brokers in the established market face an estimated annual cost of R15,414 in actual and opportunity costs.

Thirdly, emerging brokers face an estimated annual cost of R10,084 in actual and opportunity costs, which will in most cases be considerably more than one month of income, suggesting that the differential impact on this group should be borne in mind in the drafting of subordinate legislation and the exercise of flexibility allowed for by the architecture of the Bill.

Readers should be cautioned that it should not be taken for granted the these costs will ultimately be carried by the intermediary. It is likely that product suppliers, which depend on the intermediary corps for sales, and ultimately the client, will also carry part of of the costs. Again this is an indicator for the flexible application of the Act.

Aggregated costs

From the number of intermediaries per category and cost per individual in each category it is a simple matter to calculate aggregate costs for the industry. Table 5 shows the aggregated costs - initial and recurring annually - yielded by the analysis. Estimated total initial cost is R267 million, while estimated total recurring cost is R352 million.

Table 5. Estimated aggregated costs for intermediaries of PPR and FAIS

While these numbers seem large at first glance, they need to be put in the context of the enormous annual flows in the financial sector. Table 6 contains data on both premium flow and commission income for the insurance sector only. Based on data for last year, the industry sees annual premium inflows of R135.5 billion and annual commission income estimated at R10.2 billion.

Table 6. Annual premium and commission flows in the insurance industry

Table 7. Annually recurring cost to insurance intermediaries as % of premiums, commissions and estimated intermediary income.

Table 7 shows the size of costs ot the insurance industry relative to flows. It shows that in that industry total annually recurring costs are:

.23 percent of total premium inflows.

3 percent of total commission earned.

4.57 percent of net intermediary income (if we assume a 66.6% net profit margin for intermediaries).

Potential benefits

Policy lapses. With the help of industry experts we have estimated the costs to consumers of the high rate of long-term insurance policy lapses in South Africa. While this rate has been improving, policies with a total annualised premium of R1.6 billion lapsed in 2000. By using reasonable assumptions of the point at which policies were surrendered, we estimate that policyholders lost a total of R1.4 billion in forfeited premiums as a result of the lapses.

But not all the lapses could have been prevented by sound intermediary interaction. By assuming that two-thirds of first-year and one-third of later lapses could have been remedied by better intermediary interaction, we calculate a ‘remediable’ loss to clients of R550 million (see Table 8). Assuming that FAIS could remedy the situation in 50% of cases yields a potential benefit of R275 million.

Table 8. Analysis of long-term insurance policy lapses

Other advantages. At the heart of the PPR/FAIS approach lie vastly improved disclosure, greater intermediary responsibility and better client assessment. Together these improvements should mean more effective competition in the market and a reduced incidence of miss-selling. It can be expected that the following other advantages will flow from a healthier selling process:

Savings in commissions generated by the inappropriate selling of LT insurance products. Every one percent saved in LT insurance commissions means a R60 million saving for consumers (in our assessment a saving of 2 percent is assumed).

Improved returns on LT insurance premiums invested. Greater competition and improved level of client knowledge should lead to divergence to more sound products away from dubious investment offerings. If that lead, in one year only, to a 1 percent increase in return on premiums invested, the benefit to consumers would be R1.1 billion. (We assume, conservatively, only a .5 percent increase, for one year only, in the returns to LT insurance premiums invested).

Greater disclosure and competition should lead to a reduction in ST insurance premiums paid. For every 1 percent reduction in premiums around R200 million will be saved by consumers.

Table 9. Readily quantifiable annual benefits (projected)

All these quantifiable benefits, pitched at conservative levels, are summarised in Table 9, which shows expected quantifiable benefits flowing from FAIS/PPR of R1.2 billion per year.

Projected benefits that are not readily quantifiable. Not all benefits can be quantified. Two such potential benefits are:

The benefits of the gradual professionalisation of the industry.

The benefits of avoiding consumers abandoning the market because of uncertainty about the soundness of products being sold and the of the selling process itself.

On the other hand, the flexibility features of the Bill should be used to pre-empt the real possibility of a reduction in the volume of sales flowing from the additional costs placed on independent and emerging brokers - whose position is described in the next section.

Comparison of quantified costs and benefits. Expected quantifiable annual benefits, at R1.15 billion, are approximately three times larger than expected quantifiable annual costs, at R353 million.

The emerging broker

In common with the rest of the South African economy, the insurance industry can be bifurcated into two sub-sectors, namely a large, formal and extremely sophisticated sector, comprised of highly innovative product types and an a poorer, emerging, unsophisticated and mainly black sector.

Limited data was collected on this emerging sector during the CBA and an important task for the immediate short-term will be to collect such data in order to understand its size, its structure and composition and emerging trends within it. It is not possible therefore to discuss this sector on the basis of empirical data. Rather, the subjective views of industry players, in particular of the Black Brokers’ Forum (BBF), will be used as the basis of analysis and commentary.

Largely anecdotal and unconfirmed information indicates that the emerging sector is characterised by:

A relatively short history as compared to the formal sector, with the first black brokers commencing operations only in the early to mid 1980s;

The beginnings of its decimation on the back of the liberalisation of the lending industry which has impulsed higher propensities towards consumption and away from savings on the part of the black community. (Ironically, the FAIS Bill makes for the tight regulation of the savings regime whilst imposing few and very soft obligations on the lending regime. This is discussed in greater detail elsewhere in this report.) The purported decline of the emerging sector may also have been exacerbated by the effects of the liberalisation of gambling and the rise in cell-phone usage, which are posited as some of the reasons for increasing propensities to consumption in South Africa. Black brokers describe their declining incomes, averaging between R3,000 and R7,000 per month per broker and increasing rates of exit from the industry in support of their view of the decline of the emerging sector;

Low levels of product affordability, due amongst things to growing levels of unemployment and poverty;

Shifts away from health insurance and towards investments and funeral policies largely on account of the HIV/AIDS pandemic, which is reckoned to ill-dispose individuals from taking mandatory health examinations and to render funeral cover increasingly essential to households, on account of increasing mortality rates.

Low education and literacy and numeracy levels within the sector, which in addition to contributing to a poor understanding of the purpose and value of savings, have also rendered obsolete or impracticable, some of the provisions of the FAIS Bill, particularly its provisions for disclosure;

The low educational profile of the majority of black brokers and financial service providers;

Low and declining office and infrastructure densities amongst black brokers, including the low usage of information and communication technology, which will also render their compliance with some of the provisions of FAIS Bill difficult; and

The black-listing by credit bureaux of the majority of black brokers (who consider themselves a microcosm of black South African society which is also highly blacklisted), which constrains access to credit and resources.

The establishment of the Black Brokers’ Forum (BBF) in 1999 is some testament to the difficulties experienced by black brokers operating in the emerging market. With a membership of some 3,000 brokers, the BBF was established in large measure in response to the promulgation of the FAIS Bill and the need for the distinct and separate representation of black brokers at the FSB and in the industry as a whole. The view of members of the BBF is that the other industry associations in which they have enjoyed membership have not sufficiently represented their particular interests.

Some of the more specific institutional and policy related objectives of the BBF are to:

Acquire membership of or representation in the FSB Advisory Committee, which will have critical discretionary power under the FAIS regime;

Influence policy and rule making at the FSB, which is currently alleged to be driven by interest groups and staff who come from "first world" constituencies; and

Build relationships with other industry bodies including the LOA, LUASA, IBC and SAIA amongst others, in order to access resources, capacity and the intangible benefits of networks.

The characteristics of the emerging market as described earlier and the likely cost implications of the FAIS Bill to emerging intermediaries as detailed in the cost and benefit tables would suggest the need for the possible reconsideration of obligations of financial advisors operating in this sector as spelt out in the FAIS Bill.

The FAIS Bill does acknowledge the reality of different characters of advisors and intermediaries through its provisions for three categories of FSPs. However, through this recognition, it only provides for their different levels of education and experiential qualification and for their future professionalisation.

Consideration should therefore perhaps be given to the phased introduction of all or discrete parts of the FAIS Bill, to take into consideration the specific characteristics and conditions of emerging brokers.

Consideration should also be given to the phased implementation of the FAIS Bill due to low infrastructural densities amongst emerging brokers. Emerging brokers have limited and apparently declining access to offices and to computers and have rudimentary filing systems and as demonstrated in the cost tables, will therefore incur larger initial compliance costs than brokers in the traditional market. In addition, emerging brokers will be unable to benefit from the electronic compliance systems developed by associational bodies in response to the FAIS Bill and to the PPR.

Appendix 1

Corporate FSPs

Short-term insurers. SAIA have 53 members, of whom 51 exclusively sell through third parties. The two insurers that use direct marketing clearly need to register as FSPs. Whether the other 51 need to register as FSPs depends on the effect of the exclusion of ‘intermediary services’ in Clause 1(3)(b)(ii).

LT insurers. All long-term insurers that have direct sales or tied agents need to register as FSPs.

Banks. As it is likely that deposits with a term of longer than one year will be subject to the Bill, all banks wishing to offer such services to the public will have to register as FSPs.

Corporate brokerages. The significant corporate brokerages belong to SAFSIA, who have 235 members. These firms will be required to register as FSPs.

Investment managers. The roughly 260 investment managers - which includes asset managers, LISPS and other managers of third-party funds excluding members of exchanges - have hitherto been regulated by the Financial Services Board.

Appendix 2

Table A2.1. Reconciliation of estimates used with data drawn from with LOA intermediary database.

Appendix 3

Table A3.1. Estimate of initial and recurring cost of intermediary supervision by the FSB

Note: this estimate excludes the costs of the intermediary Ombud, which are projected at R6 million per year.

Appendix 4

The method applied
The key steps of the methodological approach were:

The identification of the overall justification and rationale for regulation, including the quantitative and qualitative justifications for regulation;

The assessment of the overall integrity and coherence of the proposed legislation;

The distillation and analysis of different perspectives on the proposed legislation;

The identification and itemising the separate parts of the proposed legislation likely to impose costs;

The assessment of their likely costs in terms of upper and lower bounds;

The identification and dis-aggregation of the sectors and sub-sectors within the industry due for regulation;

The assessment of the differential costs to these different sectors and sub-sectors;

The quantification and assessment of the benefits consequent to the legislation;

The evaluation of costs against benefits for the industry as a whole and for its different sectors and sub-sectors;

The evaluation of the economy wide implications of the costs and benefits of the proposed legislation;

The evaluation of the cost and benefit implications of the proposed legislation against other regulatory options (if they exist), and against the status quo; and

The drafting of a summary document, detailing the methodological approach, including all assumptions made to derive costs and benefits and the core findings and recommendations.