The retail client compensation system is fundamentally flawed and an overhaul is needed to avoid the exit of smaller financial planning firms, according to the FPA.

"The FPA recommends that, as a matter of urgency, Treasury should undertake a review of the retail consumer compensation system and hold extensive non-confidential consultation with industry, consumers and other stakeholders," the FPA said in a submission to the Parliamentary Joint Committee on Corporations and Financial Services.

The major flaw in the system for holders of an Australian Financial Services Licence is the reliance on professional indemnity insurance as the main method of compensation.

"As a mechanism to deliver financial redress to consumers, it is inadequate and can be avoided by unscrupulous operators," the FPA said.

The association is also concerned about the reduction in the number of insurance providers over the years, which has made premiums more expensive.

"Such premiums represent a sizable proportion of a small firm's operational costs," the FPA said.

"This could result in many smaller firms exiting the industry and larger firms restricting service offerings, substantially reducing choice for consumers."

But ASIC deputy chairman Jeremy Cooper said in February this year that there is still a reasonable range of providers.

He did, however, promise to continue to monitor the situation when policies come up for renewal this year.