FSCS publishes paper confirming approach to calculating 36 month compensation costs following engagement with industry

5th September 2013

Today, FSCS has published its position papers setting out its levying, borrowing and recoveries policy, and its approach to calculating the 36 month expected compensation costs. The ability to raise levies based on 36 month compensation costs will be available to FSCS from 2014/15.

Drafts of both policies were published on the website on 3 July 2013, and the industry was invited to comment.

The reaction to the policy statement on levying, borrowing and recoveries was positive and regarded as a helpful consolidated statement of FSCS's approach - which was already understood by most. The paper has now been published in final form without revision:

FSCS's Funding Policy

FSCS's approach to calculating expected 36 month compensation costs

The paper on the calculation of the 36 month compensation costs received some more detailed feedback. Generally, the approach was welcomed and no alternative model was proposed. The aim of increased certainty and less volatility in annual levies was understood, and welcomed by most.

A handful of particular issues were raised which FSCS has considered and comments as follows:

It was suggested by some that the costs incurred as a result of the failure of Keydata Investment Services Limited should be regarded as exceptional, and as such excluded from the 36 month calculation methodology.  FSCS was requested to provide further guidance on what constituted "exceptional" costs for this purpose.  FSCS concludes that the Keydata costs should be retained.  Although a high cost default, the nature of the failure and level of claims made were not wholly out of FSCS’s experience. As such, to exclude these costs would artificially reduce the overall costs figure.  In fact, due to the timing of the costs, they will not form an explicit item in the calculation of the 36 month expected costs, in 2014.  

Although FSCS does not consider it appropriate to provide a fixed definition of  "exceptional" for this purpose, as by its nature it is difficult to define, without limitation or commitment, relevant factors (subject to the overriding purpose and aims of the levy) might include:

  • the size of the failure and duration of claims, although this is mitigated by the current annual cap on levies (set by reference to affordability) and the three year rolling average;
  • the frequency of failures and claims in the relevant class; and
  • the residual level of potential claims in the sector has been significantly reduced following a default of exceptional size i.e. is the default is so large as to materially reduce the potential costs of future defaults.  

FSCS confirms that management costs are not to be included in the calculation.  The rule is applicable to compensation costs only.  Management expenses will be collected to meet costs incurred or expected to be incurred on an annual basis as now. The final paper now makes this clear and the illustrative figures in the paper have been adjusted to reflect this.

As set out in the draft paper, any end of year surplus is intended to be set against the total figure for expected costs for the following 36 months, and not just the costs for the following 12 months - the "smoothing" benefit of this approach would be lost or reduced if FSCS exercised its discretion to return any “surplus” on an annual basis.

FSCS will continue to calculate the levy under the current 12 month basis and levy for that amount if 12 months compensation costs will be higher than under the 36 month view. The 36 month compensation costs will be revised on an annual basis and may allow FSCS to reduce the volatility of annual levies, reduce the likelihood of interim levies, and give the industry greater certainty.

There was some concern that the three year average could deliver an erroneous calculation if the period had an uncharacteristic level of claims, either too low or too high. However, the model allows FSCS to adjust the compensation costs and acts as a check on the three year average. 

In summary the process FSCS will use when setting the levy in future will be:

  1. Establish the compensation costs incurred but not yet raised through levies (less any recoveries made)
  2. Calculate the compensation costs FSCS expects to incur in the 12 months following the date of the levy (as per the current process);
  3. Calculate the compensation costs FSCS expects to incur in the 36 months following the date of the levy (as per the process outlined in the paper)
  4. Add to 1) the greater of 2) or 1/3 of 3)
  5. Add to 4) the specific costs element of management expenses.

 

FSCS will keep the policies under review from time to time.

 

Jargon Buster

  • Investment

    a financial product in which money can be invested to earn interest or profit (although the value of investments can go down as well as up).