A Guide to AFSL PI Insurance & Compensation Arrangements

Introduction

Maintaining adequate compensation arrangements is a critical requirement for Australian Financial Services Licence (AFSL) holders that provide financial services to retail clients. This obligation, mandated by section 912B of the Corporations Act 2001 (Cth), ensures a licensee has measures in place to compensate clients for losses suffered due to breaches by the licensee or its representatives. For the majority of AFS licensees, the principal way to satisfy this requirement is by holding an adequate professional indemnity (PI) insurance policy.

Securing compliant PI insurance is the responsibility of the AFS licensee, and failure to hold adequate cover can place the entire business at risk, as the ASIC has cancelled licences for non-compliance. This guide provides essential information to help licensees navigate their PI insurance obligations, understand what constitutes adequate cover according to ASIC’s regulatory guides, and implement the necessary arrangements to protect both their clients and their licence.

Understanding Your PI Insurance Obligation

The Legal Requirement for Compensation Arrangements

Under section 912B of the Corporations Act 2001 (Cth), any Australian Financial Services (AFS) licensee that provides financial services to retail clients must have specific compensation arrangements in place. These measures serve a crucial purpose:

• To ensure retail clients can be compensated for any loss or damage suffered due to breaches of Chapter 7 of the Corporations Act 2001 (Cth)
• To protect consumers from potential misconduct by the AFS licensee or its representatives

The legislation clearly mandates that these compensation arrangements must meet one of two conditions:

• Satisfy the requirements outlined in the Corporations Regulations 2001 (Cth), or
• Be formally approved in writing by ASIC

This obligation forms the legal foundation for protecting consumers who engage with the financial services industry.

PI Insurance as the Primary Solution

While the Corporations Act 2001 (Cth) allows for alternative compensation arrangements, obtaining adequate PI insurance remains the most common and standard method for AFS licensees to meet their obligation. The regulations specifically identify PI insurance as the primary compliance pathway.

Alternative arrangements, such as self-insurance, are uncommon and face significant hurdles:

• They require written approval from ASIC
• ASIC will only approve such measures if they provide consumer protection equal to or better than what an adequate PI insurance policy would offer

Consequently, securing a compliant PI insurance policy, guided by ASIC’s Regulatory Guide 126 (RG 126), is the principal way most AFS licensees demonstrate they have met their legal duties.

Determining Adequate PI Insurance Cover

Calculating Minimum Cover by Revenue

ASIC’s RG 126 establishes the minimum PI insurance cover requirements for AFS licensees. This calculation is based on the total revenue generated from financial services provided to retail clients, ensuring a baseline level of consumer protection.

The formula for calculating the minimum required PI insurance cover follows a tiered structure:

Retail Revenue Tier	Minimum Required PI Cover
$2 million or less	At least $2 million for any one claim and in the aggregate.
Greater than $2 million	Equal to the actual or expected revenue from financial services provided to retail clients.
Maximum Required Cover	Capped at $20 million, regardless of how high revenue exceeds this figure.

When calculating revenue, you must include all revenue generated by authorised representatives providing financial services to retail clients. Existing licensees can base this on the previous financial year, while new AFS licensees should use a reasonable estimate of expected revenue.

Assessing Adequacy Beyond Minimum Requirements

Meeting the minimum amount of cover based on revenue is only the first step in ensuring adequate protection. True adequacy requires a broader assessment of your financial services business, as regulations mandate that your PI insurance must be appropriate for the specific nature, scale, and complexity of your operations.

To determine if your PI insurance is genuinely adequate, consider these key factors:

Assessment Factor	Key Consideration
Potential liabilities	A reasonable estimate of maximum liability, including claims via the Australian Financial Complaints Authority (AFCA) and courts
Business activities	The types of financial services and products offered, as higher-risk products, may require increased coverage.
Client base	The number and types of clients (retail vs. wholesale), which directly impacts potential exposure.
Business volume and representatives	The overall volume of business and the number of authorised representatives, which affect potential claims and liability.
Claims history	Past claims experience and the effectiveness of risk management procedures, which inform the level of cover needed.

This assessment of adequacy is not a one-time exercise. AFS licensees should review their compensation arrangements at least annually, or whenever significant business changes occur, to ensure PI insurance coverage remains appropriate for their evolving needs.

A Checklist for Comparing PI Insurance Policies

Key Policy Definitions & Exclusions

When comparing PI insurance policies, it is crucial to critically review the definitions and exclusions. The specific wording can significantly impact the scope of your insurance cover, and you must ensure it aligns with the requirements of ASIC’s RG 126.

An inadequate policy can leave your financial services business exposed to significant liability. According to ASIC, an adequate PI insurance policy must not exclude cover for certain key areas.

When reviewing a potential insurance policy, verify that it does not contain exclusions for:

• AFCA awards: The policy must cover awards made by the AFCA.
• Fraud and dishonesty: It must cover losses arising from fraudulent or dishonest conduct by the licensee’s directors, employees, and other representatives, which is crucial given the significant liabilities of directors of AFSL holders.
• Misrepresentation: Claims arising from misrepresentations made about the financial services provided cannot be excluded.
• Incidents notified to ASIC: The policy must not exclude claims related to incidents you have already reported to ASIC, such as through a breach report, which could trigger an AFSL audit or investigation.

How Defence Costs Impact Your Limit of Indemnity

A critical factor in assessing the adequacy of a PI insurance policy is how it treats legal defence costs. These costs can be substantial and may significantly deplete the amount of cover available to compensate your retail clients if not structured correctly.

Policies typically handle these costs in one of two ways:

1. Some policies provide defence costs ‘in addition’ to the limit of indemnity, which is ASIC’s preferred approach. This means your legal expenses do not reduce the total funds available for client compensation.
2. Alternatively, a policy may be ‘costs inclusive’, where defence costs are paid out of your total limit of indemnity.

To be considered adequate under RG 126, a costs-inclusive policy must have a significantly higher limit to account for these potential expenses.

Understanding Reinstatement Clauses & Retroactive Cover

To ensure continuous and adequate protection, your PI insurance policy must address what happens if your cover is exhausted or when you switch insurers. This is managed through reinstatement clauses and retroactive cover.

AFS licensees must confirm their policy includes at least one automatic reinstatement of the policy limit. This means if claims exhaust your limit of indemnity during the policy period, the full amount of cover is restored to protect against any new claims for the remainder of that period. An exception exists if your policy’s limit is at least double the minimum amount of cover required by ASIC.

Retroactive cover is equally important as it protects your business against claims arising from acts, errors, or omissions that occurred before your current policy began. This feature ensures there are no gaps in your PI insurance history, particularly when you change insurers. RG 126 requires that if you had a previous policy, your new one must provide retroactive cover back to the start date of your continuous insurance period.

Ensuring Correct Fraud & Dishonesty Cover

One of the most critical minimum requirements for an adequate PI insurance policy involves cover for fraudulent or dishonest acts. ASIC has identified this as a key area where AFS licensees’ insurance arrangements can be non-compliant, creating a significant risk for both the business and its clients.

Coverage Aspect	Requirement / Exception Detail
Required Coverage	The policy must cover losses to retail clients from fraud or dishonesty by the licensee’s directors, employees, and other representatives.
Exception to Coverage	An exception is made for sole traders or corporate licensees with only one director who is also the sole adviser, shareholder, and employee.

How Your AFSL Authorisations & Business Model Impact Premiums

Quantitative Business Factors Insurers Assess

When determining PI insurance premiums, insurers conduct a thorough risk assessment by analysing a range of objective, data-driven factors. This quantitative analysis helps them understand the potential exposure they will assume by underwriting your financial services business.

Insurers typically require AFS licensees to provide specific information, including:

Quantitative Factor	Insurer’s Assessment Focus
Business Activities	A comprehensive list of all current, anticipated, and historic business activities to prevent coverage gaps.
Representative Numbers	The number of authorised representatives relative to governance and compliance resources.
Financial Products	Authorisations held and the types of products on the approved product list, with complex products indicating higher risk.
Financial Performance	Metrics like revenue, revenue growth, and profit are reviewed to identify vulnerabilities or atypical growth without increased controls.
Funds Under Advice (FUA)	Comparison of FUA against declared fees to assess business stability and income generation.
Complaints and Breaches	The number and nature of client complaints and compliance breaches, which can trigger AFSL audits and investigations and serve as reliable risk indicators.
Client Base	The number and types of clients, with wholesale clients sometimes perceived as lower risk than retail clients.

Qualitative Compliance & Governance Factors

Beyond objective data, an insurer’s assessment of your AFS licensee involves a subjective review of your compliance and governance frameworks. The operational effectiveness of these arrangements is a critical element in determining the risk you and your representatives present.

A prudent insurer will seek to understand the quality and culture of your compliance program by examining:

Qualitative Factor	Insurer’s Review Focus
Supervision of Representatives	The approach to monitoring and supervising representatives, with a focus on robust systems for overseeing adviser activity.
Compliance Framework	The measures, processes, and procedures used to demonstrate compliance, favouring integrated IT solutions for monitoring.
Incident and Breach Management	Processes for identifying, managing, and escalating incidents, which provide insight into compliance culture and capability.
Remediation and Rectification	The approach to and success with remediation, demonstrating a commitment to effective rectification and positive regulatory engagement.
Appointment of Representatives	The due diligence and checks undertaken before appointing new authorised representatives to gauge the effectiveness of controls.

Navigating the PI Application & Renewal Process

Preparing Your Application for Underwriters

When applying for or renewing PI insurance, preparing a thorough and well-articulated submission for underwriters is crucial. Insurers conduct a detailed risk assessment involving both quantitative and qualitative factors to understand the potential exposure of your financial services business.

To facilitate this assessment, AFS licensees should provide comprehensive information, including:

Information Category	Details to Provide
Key Personnel and Representatives	Qualifications, experience, and background of key individuals; number of representatives relative to compliance resources.
Business Activities and Products	A comprehensive list of all current, anticipated, and historical activities, including the approved product list.
Client Base	The number and types of clients, distinguishing between retail and wholesale.
Financial and Operational Metrics	Key data points such as revenue, revenue growth, profit, and Funds Under Advice (FUA).
Compliance and Risk Management	Evidence of the compliance framework, supervision approach, and processes for managing incidents and breaches.
Claims and Complaints History	A record of past client complaints, compliance breaches, and any claims lodged under a previous insurance policy.

Common Gaps & Mistakes to Avoid in PI Insurance

AFS licensees are responsible for ensuring their PI insurance is adequate and compliant with ASIC’s RG 126. Overlooking key policy details can lead to significant gaps in cover and place your licence at risk.

Common pitfalls to avoid when purchasing or renewing a PI insurance policy include:

Common Pitfall	Description & Compliance Requirement
Improper Treatment of Defence Costs	Accepting a ‘costs inclusive’ policy where legal expenses erode the funds for client compensation. A compliant policy must provide defence costs in addition to the minimum limit of indemnity, or the limit must be significantly increased.
Missing Automatic Reinstatement Clauses	Failing to secure a policy with at least one automatic reinstatement. This is required by RG 126 to ensure the limit of indemnity is restored if exhausted during the policy period (unless the policy limit is at least double the minimum required).
Non-Compliant Fraud and Dishonesty Exclusions	Accepting a policy that excludes cover for losses from fraud or dishonesty by the licensee’s directors, employees, and representatives. This cover is a critical minimum requirement.
Problematic Aggregation of Claims	Using policies that aggregate multiple interrelated claims into a single claim, which becomes an issue if a lower sub-limit (e.g., for AFCA awards) is applied, creating a coverage gap.
Unaffordable Excess from Lack of Aggregation	Using policies that do not aggregate related claims for the purpose of the excess, meaning a separate excess is payable for each claim, which can become financially unsustainable.

Conclusion

Securing adequate PI insurance is a critical obligation for AFS licensees under the Corporations Act 2001 (Cth), requiring a thorough assessment of minimum cover, policy terms, and business-specific risks to meet ASIC’s standards. This process involves navigating complex requirements, from calculating sufficient cover based on revenue to scrutinising policy details like defence costs, reinstatement clauses, and fraud cover.

Contact the AFSL compliance experts at AFSL House to ensure your compensation arrangements are fully compliant and strategically aligned with your financial services business. Our specialised AFSL lawyers in New South Wales can provide the trusted guidance needed to turn these regulatory challenges into opportunities and secure your licence.

Frequently Asked Questions (FAQ)