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How does the UK lifeboat service forecast its levy?

Compensation costs, management expenses, recoveries and surpluses/deficits all part of process

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The chief financial officer of the Financial Services Compensation Service (FSCS) said that its process for levy calculation is taken from “many different angles” and “there’s uncertainty at every stage”.

This came during a statement on 6 September 2021 where the FSCS explained its process for levy estimations, at a time where it has come under scrutiny from financial advisers across the UK who continue to suffer from increasing regulatory fees.

The levy funds the cost of compensation for investors, as well as the costs of running the UK lifeboat service and processing claims.

Fiona Kidy, FSCS chief financial officer, said: “We have to look at the levy from many different angles, and there’s uncertainty at every stage. We know how important it is to keep our levypayers and the industry up to date.

“I hope I have demystified the levy forecasting process by explaining its many intricacies and that this explains why the total levy can end up being different to our original forecast.”

The FSCS said that its forecast contains four main elements, which it reviews for each funding class: compensation costs, management expenses, recoveries and class surpluses or deficits.

Compensation costs

The UK lifeboat service added that how much compensation it thinks it needs to pay out each year is “a crucial part” of its forecasting.

It needs to anticipate how many claims it expects to receive and the projected value of these claims and it begins by looking at the firms that have recently failed and the number of claims it is still receiving against them.

Then, the FSCS carries out a “horizon scanning” exercise of the firms that could fail and the related claims volumes and values it thinks it will see.

For this, it works closely with the Financial Conduct Authority (FCA), Prudential Regulation Authority (PRA), Financial Ombudsman Service (Fos), MoneyHelper and the wider industry to include information from their watchlists and monitor any trends.

Kidy said: “Our knowledge of the firms and our resulting predictions are reliant on the quality of data available to us, which does vary, making it even harder to predict accurately.

“We then need to forecast the number of customers and their eligibility to claim with us, the types of financial products the firms sold and the funding class they sit in. We assess the potential cost of each of those claims, according to our rules, historical payment levels and compensation limits.

“We review our assumptions every month and they do change across the year, especially as we learn more about the firms that have just failed, the potential claims they may generate and the actual number of claims we end up receiving, or if an unforeseen event occurs.”

Management expenses

In the second stage, the FSCS uses the same claims assumptions that informed its compensation costs forecast to build its management expenses budget – as this includes the costs of processing claims and making compensation payments.

It also includes its fixed running costs, which don’t relate to paying compensation.

“Behind the scenes, we refine our management expenses calculations every month”, Kidy added.

It updates the industry twice a year in January’s Plan and Budget to announce the management expenses budget for the year and October’s outlook to give the latest forecast.  The Annual Report in the summer then provides the actual numbers for the year.

Kidy said: “If the amount we spend on management expenses is different to what we levied, then we true up in the following year by adjusting that year’s levy.”

Recoveries

The UK lifeboat scheme seeks to recover the money it has paid in compensation from failed firms and third parties, “whenever possible and if it’s cost-effective”, she added.

Kidy said that it is “crucial part” of its strategy to bring down levy costs and the FSCS has recovered more than £280m ($386m, €326m) since the start of the 2015/16 financial year.

“Recoveries play a key role in the final levy calculation but it’s incredibly difficult to predict how much we’ll recover each year,” she said. “Some of our bigger recoveries can take many years to wrap up and in these cases, we won’t know which financial year the money will fall into until we receive it.

“We do forecast which recoveries we are very likely to receive in that year and use these amounts to offset the levy.

“I say ‘very likely’ because recoveries are volatile and difficult to predict, and we only include those that we can be fairly certain of. If we then receive further recoveries on top of those included in the levy, they may generate a surplus.”

Class surpluses or deficits

Lastly, the levy is calculated based on the cash that the FSCS expects to pay out in a year and Kidy said that it does not aim to hold extra funds.

She added: “However, the reality is that the amount we actually pay out, or recover, can be different to what we originally expected and levied for each year. This variance creates a surplus or deficit in our levy funds.

“We constantly monitor our projected year-end surplus or deficit and we look at it on a class-by-class basis. If the deficit for an individual class is significant, normally £20m or more, then we look to raise a supplementary levy on that class.

“We do this even when there are surpluses in other classes because those surpluses were paid for by other, unrelated firms. We keep each class separate because different firms pay into them so shouldn’t cover another class’s shortfall.

“If we expect a surplus, then we normally use it to offset the following year’s levy for the class in question. But if, based on our latest forecast, we don’t expect that class to use the surplus in the near future then we would refund firms that year. As I said before, it’s not our intention to hold surplus funds.”

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