James and Samuel’s article was published in the FTAdviser, 20 March 2023, and can be found here.
What do Gove’s insurance commission proposals means for the property sector?
Michael Gove’s recent statement that he intends to ban freeholders and managing agents from taking building insurance commissions was met with a range of responses from those in the property sector. For residential tenants who have long complained about high service charges, this was a welcome announcement as part of Gove’s larger promise to rebalance their relationship with landlords. For those in the commercial real estate sector, this highlighted Gove’s misunderstanding of the interaction between brokers and landlords and the underlying provisions in commercial property leases.
A summary of the issues and the current law might help to explain the priorities of the Government. However, we would argue that for the change he wishes to see, Gove will need to not only pass new law but fundamentally alter the way that brokers are remunerated for their service. This might lead to a potentially seismic shift in the industry with unexpected repercussions.
The recently reported case of Various Leaseholders (Canary Riverside) v CRM and Octagon Overseas Limited provides the backdrop to the proposed changes to combat the disreputable landlords that Gove argues fills the sector. The leaseholders of a Canary Wharf residential tower block applied for their landlord and the managing agent to disclose details of the insurance scheme provided for them through their service charge. Additionally, they requested that the landlord disclose what proportion of their fees amounted to a commission from the landlord’s managing agent and insurance broker.
In its judgment in December last year, the First Tier Tribunal (FTT) described the respondents’ lack of transparency about commissions as ‘lamentable’ considering that the ‘sums involved are large and constitute a very substantial percentage of the premium towards which leaseholders are asked to contribute’. With a greater number of similar cases making headlines in recent years, Michael Gove commissioned the Financial Conduct Authority (FCA), who regulate insurance brokers, to report on the matter. He stated that he was ‘keen to review how all actors in the insurance marketplace have contributed to high premiums for leaseholders’ and that he ‘will consider all routes necessary to reduce premiums’.
The FCA report, published this summer, makes interesting reading for those unfamiliar with how landlords and brokers do business. They explain that landlords approach brokers with particular requirements for their insurance policy. Brokers will scour the market for underwriters who fit these requirements and will be paid a commission by the underwriters if the landlord eventually uses their policy. The commission is often at least 30% but has been known to range from less than 10% to 62% of the gross premium. The FCA explains that ‘while in some cases customers may be aware of the amount of commission being paid, there is no general level of transparency or standard reporting regarding levels of commission’.
Any commission received by a broker might then be shared with the property owner or the property managing agent as renumeration ‘for the support they provide to procure insurance and then to deliver elements of post-sale service’. Interestingly, the report explains that the commission rate is often a ‘secondary factor or irrelevant in most freeholders’ choice of insurer, although it may play a role in their choice of broker among other things’.
The report concludes with a number of recommendations for Government. It suggests that it consider ways that leaseholders could be made parties to insurance contracts or for leaseholders to challenge insurance costs in a way that is straightforward and easily accessible. The FCA also state that they will review and publish detail of those brokers who charge the highest commissions and consider whether commission to landlords should continue in cases where they do not provide any additional benefit to tenants. They regard that a cap or limit on renumeration would ‘not be justified’ although this would be monitored. Finally, they suggest that government considers imposing an ‘enhanced legal requirement on freeholders and property managing agents to provide minimum information on the insurance policy to leaseholders.’
Michael Gove has welcomed these recommendations, promising to ‘ban managing agents, landlords and freeholders from taking commissions and other payments when they take out buildings insurance, replacing such payments with more transparent fees.’ He states that he will ‘arm leaseholders with more information to enable them to better scrutinise their insurance costs’ whilst not having to bear unnecessary legal fees when taking action against unscrupulous landlords. These are ambitious plans indeed, but only mark the first step for a minister who has vowed to fundamentally reform English property law and remove leasehold interests entirely.
For those of us dealing with the underlying legal transactions, these are interesting recommendations although many of them already exist in some form. Perhaps stronger enforcement and greater exposure might be more effective tools than changing the law as, for residential tenants, there is already a legal right to request information about the insurance providers from their landlord. The Landlord and Tenant Act 1985 includes the requirement for landlords to disclose the amount of insurance cover, the name of the insurer and the insured risks upon written request of the leaseholder. There are opportunities to expand this right, both in terms of what could be disclosed and to including commercial tenants. By way of example, protections over letting fees and tenancy deposits paid by tenants in the private rented sector was improved by the Tenant Fees Act 2019. It is therefore wrong to suggest that tenants have no legal recourse currently.
Prudent and well-advised leaseholders will ensure that provisions that require disclosure is in the lease before they sign as well as having an understanding at the current premium. The ‘Code for Leasing Business Premises England and Wales’ (the Lease Code) issued by the Royal Institute for Chartered Surveyors (RICS) recommends in commercial leases that landlords should pass on to tenants the benefit of discounted premiums and should disclose to tenants whether the landlord benefits from insurance commissions. RICS also recommend in the ‘Service charges in commercial property’ that managing agents should ensure that insurance policy terms are fair and reasonable, that commissions ‘should be disclosed’ and that full insurance details are provided on request. Similar provisions apply in the current ‘Service Charge Residential Management Code’ which is the equivalent to the commercial code.
Sadly, there will always be disreputable landlords who will try and evade scrutiny by tenants and look at ways of increasing revenue and changing the law will do little to convince those who have no interest in following it. The FTT in the Canary Riverside case also references the residential RICS code, proving that it remains as industry standard for a vast majority of reputable landlords and managing agents.
In the commercial property sphere, Michael Gove’s promise to ban landlords from taking commissions also suggests that he fails to appreciate how market standard “full repair and insurance” (FRI) commercial leases operate. The evolution of the standard commercial lease since the 1970s has ended up with an institutionally acceptable investment where the costs of the day-to-day running of the property – namely insurance and service charges – are passed to the tenant in full so that the rent received by the landlord is pure profit. The insurance and service charge are not intended to provide any profit element to the landlord. Commissions that landlords receive (or discounted premiums, the benefit of which the landlord does not pass on) may not be due to the avaricious desire of the landlord but rather relate to their ability to negotiate insurance on a far larger scale than the tenants ever could. A landlord with a large portfolio of properties will be in a far stronger position with brokers and underwriters than a single tenant and so typically are able to negotiate lower premiums for the insurance policy, for which arguably they should receive some benefit. Discounted premiums may also arise because of the additional work and management of property portfolio that the best landlord will carry out. Changing the full recoverability of insurance premiums on institutionally acceptable leases which are often used as either security for loans or provide the certain income that insurance companies and pension funds rely on could have an unexpected and unintended impact, especially with all the current uncertainty in the world markets.
The higher insurance premiums due to commissions is especially hard on residential tenants who bear the brunt of the full cost often with little bargaining power or ability to change the status quo. Such a situation has rightly been historically unpopular. However, recent increases in insurance premia are not unexpected given additional risks due to the Grenfell Tower tragedy. Yet it seems unfair for all landlords – both commercial and residential – to be singled out for criticism, in a system that ensures significant benefits for both parties. As the FCA report explained, few landlords will look at commissions when considering which policy to choose and so it remains unclear how removing this might result in better value for leaseholders.
Any change on insurance commissions would have to reflect a fundamental change in how the insurance market operates. The large commissions reported in the FCA report reflect a marketplace where brokers do not work on retainer but instead operate solely from the policies they help to sign. To remove commissions, the government would have to change how brokers are compensated for their time, something that would be challenging to enact and lies beyond the powers of the FCA or the Secretary of State for Housing, Communities and Levelling Up. To place the blame for these fees at the feet of landlords is unfair and will not help resolve legitimate issues facing the sector.
Although arduous and costly, the fact that the Canary Riverside tenants were able to find legal recourse against their landlords and managing agents proves that the law still supports tenants in these instances. As the FTT judgment notes, greater transparency with landlord commissions should be welcomed but it is unclear what more could be done, at least in the residential rental market, to further bolster the already substantial provisions that tenants have at their disposal. Perhaps a solution to tackle the risk of bad actors is to impose harsh penalties on insurance brokers where deliberate impropriety is found. In our view, this would be a simpler and less invasive change that simply banning all insurance commissions. Alternatively, cap the insurance premium including commission to either the rent payable or the value of the property.
The vast majority of landlords are considerate and conscious of their legal duties to their tenants and act in accordance with the law and often in accordance with the higher requirements of regulatory bodies such as RICS. Landlords should not become scapegoats for the complex problems with the way insurance and other service provisions are managed; nor should landlords be blamed for the actions of bad actors who, as in any market, seek to exploit the system for their own gain. Keep the sledgehammer handy but save it for those who truly deserve it.