The European Commission's proposals to reform retail investment rules have implications for insurers - and some of the most important consequences are not obvious, as Carlos Montalvo explains
At the end of May, the European Commission came out with its long-awaited – some would say feared – proposal to reform retail investment rules in Europe, so the right investments are made available and accessible to EU citizens.
Through this article, my intention is to share with you some personal views – a blend of opinion and information – on the issue, that hopefully complete what has already been said or written by many.
The chicken and egg dilemma
The first point worth sharing should be built on the basis of the ultimate objective of the European Commission when designing this strategy: "to ensure that consumers can fully benefit from the investment opportunities offered by capital markets", so as to grow retail investors' participation in capital markets.
Lack of participation is linked to lack of trust: the numbers provided by the 2022 Eurobarometer survey should be a wake-up call for the insurance sector.
The lack of trust arises from inadequate information and marketing of products that do not prevent conflicts of interest and embed low value for money, and high costs and fees. Regulation is seen as the main tool available to regain the aforementioned trust, by enhancing the level of protection of customers. I wonder to what extent trust and participation have more to do with quality of service and good products at the right price – as in any other retail business – and whether regulation and enhanced protection are the only way to tackle the issue?
The lack of trust arises from inadequate information and marketing of products that do not prevent conflicts of interest and embed low value for money
At least three important issues must be considered as part of the challenge. Firstly, the capacity by the (potential) investor, not only to assess if the product provides value, but also to understand the cost of opportunity of investing in such product instead of in alternatives that may make more sense for her/him.
Secondly, the value proposition must be linked to quality products, which will benefit from competition and innovation (two of the features that a successful market requires, and which the Commission's proposal – in my humble opinion – is not giving as much attention as they deserve).
Thirdly, a good understanding by the customer of the value proposition may not suffice where there are issues ("problems", using the words from Commission), which must be addressed by regulation, in particular through an exercise of "strengthening" and, when it comes to insurance products, also of "assimilation", i.e. aligning more with the rules of the Markets in Financial Instruments Directive (MiFID).
The "historically hot" issue
Out of the list of topics that has been discussed and addressed as part of this review process, the one that has got the most attention, by far, is the so-called full ban on inducements, based on the assumption that the way distributors are remunerated may create a conflict of interest, leading to customers not getting products in their best interest.
If we take the correct approach of considering that conflicts of interest refer to the potential for them to happen, rather than to the effective materialisation, some of the sensitivities around this debate could be handled in a less passionate way. The fact that remuneration can be a source of potential conflicts of interest is conceptually correct and should not be challenged. It is on the response to this potential detriment to customers where we should put the focus.
A full ban on inducements has not been the silver bullet that some still think it is
At the same time, if we look at the experience of those territories such as the UK or The Netherlands where a full ban has been implemented, it has not been the silver bullet that some still think it is.
Experience in those countries (and others such as Ireland) that took other measures, prior to considering a ban, also shows us how increasing transparency around the level and nature of commissions cannot address, on a standalone basis, conflicts of interest, yet that it can be a contributor, combined with other measures.
In the current proposal, instead of a full ban on inducements, there is a partial one, linked to non-advised sales and to the provision of independent advice, as well as to (less relevant for insurance) execution-only type activities.
However, will it trigger a more profound – and necessary – review around the value for money proposition and quality of the underlying products? Allow me to be sceptical about it.
On similar grounds, the change proposed within the text – by which the current requirement of passing a "non-detriment" test for advised sales in insurance is replaced by a "best interest" test – rather than challenged should be welcomed by both insurers and manufacturers. This is not because it postpones the application of a full ban, but because – coming back to what makes a successful business – there is no room for situations where a client pays for advice that is "non-detrimental" and yet also does not add value.
What will happen in the future, and when? Not having a crystal ball, but based on many years of regulatory experience ("más sabe el diablo por viejo que por diablo", as they say in Spain), it goes without saying that in this round of review a full ban will not end up in the final text; the three-year period to observe if the measures proposed address conflict of interest is simply too short.
This means the full ban should not end up being introduced as part of the next iteration. But what happens after that is less a question of if, and more one of when; not because it is the best solution, but because politically it will be difficult to say no, unless there has been a big change in the value proposition of a large number of insurance products.
A disruptive change of approach
As important as a change in the remuneration model can be, there is a new idea on the table that may have even more impact: the development – to be carried out by Eiopa – of "value for money benchmarks" for use by manufacturers and distributors of insurance-based investment products (IBIPs).
These intend to allow for a comparative assessment of costs and benefits between the given product and the benchmark, so that where there would be a deviation, they would need to demonstrate how such costs are both justified and proportionate.
Hard targets are not a good solution to a complex problem
De facto, this approach opens a backdoor to another heavily debated issue, namely the pros and cons of the regulator setting "hard targets" regarding costs, fees and expenses.
My personal opinion around this has not changed since the days that I was part of the supervisory discussions on the topic: hard targets are not a good solution to a complex problem, in particular because it will push entities towards the boundaries of adopted ratios, rather than allowing for sound and healthy competition, effective and sound cost allocation and incentives to work in the best interest of the client when designing the product.
And there is a very thin line between a soft target, even if defined as a benchmark, and a hard one (in particular where there is a reversion on the burden of the proof, and costs and charges that deviate from the benchmark are considered to be too high unless otherwise proved... I wonder how that works in practice?).
At the end, it all comes to a question of design and use; let me explain my point with an example taken from Solvency II, and the solvency capital requirement (SCR). Focusing on the number, rather than on how you reach such a number, has brought negative consequences to the framework, as we have ended up comparing apples (eg. 175% SCR ratio) with pears (eg. 175% SCR ratio, but with features such as transitionals, expected profits from future premiums, surplus funds...). This approach has caused misconceptions, laziness – as it is so much easier to look at a number than it is to understand it – and mistakes.
If we are to learn on conduct from what we keep doing wrong for solvency, and focus on how we reach a given number rather on whether the number is right or wrong, then perhaps – and only perhaps – with a good design and use by all parties can benchmarks be part of the solution in terms of enhancing value for money in products (and, as a side effect, stop any temptation around hard caps, similar to those we saw under Pan-European Personal Pension Product legislation).
There is a sound legal basis to extend the use of benchmarks to all insurance products
The reason why I think this is a much deeper change to the way we have seen insurance distributed in the past is simple: there is no objective reason, once the benchmark is set for IBIPs, to justify that it should not be extended to general insurance or to life-risk business.
Furthermore, the Commission proposal aims at linking this additional requirement within the product oversight and governance (POG) article of the Insurance Distribution Directive (IDD), and POG is applicable for all kind of products, even if for the time being the use of benchmarks should be restricted to IBIPs.
Indeed, there is a sound legal basis to extend its use, if so decided, to all insurance products. Should this be the case, I fear that we will struggle, moving forward, to escape from a focus on price that may entail the risk of an increased expectation gap between what the contract covers and what the policyholder thinks that is covered. My view is based on the fact that cutting costs will lead to reducing cover and service, thus eroding the trust in insurance as a whole: a price we cannot afford to pay at a time of growing protection gaps that put at risk people and societies. In my opinion, this is the main reason, rather than the claim that such a benchmark is price intervention, to approach it with caution.
Further high-level considerations
After having zoomed into the two most debated points of the Commission's proposal, allow me to change the approach and provide you with two further – and also personal – reflections.
Firstly, the shift to "digital by default" is a step in the right direction, and hopefully an opportunity to enhance its use by allowing simpler, more streamlined and easier-to-access documentation.
One area where the alignment between MiFID and IDD would make sense is the more granular categorisation and qualification of customers
Secondly, the increased convergence between the MiFID and IDD is here to stay. Yes, we insurance people claim that we are different, but when doing so we tend to forget that the best way to explain differences is by building on commonalities first.
Thirdly, yet directly linked to the prior one: one area where the aforementioned alignment between MiFID and IDD would make sense is the more granular categorisation and qualification of customers. Under MiFID, there are additional categories, beyond retail investors (including professional and eligible counterparties). Currently there seems to be no appetite to open up for a similar approach in insurance, as the Commission deems it unnecessary to do so, considering that the products are all retail.
This ignores both the reality of certain customers but, most importantly, the fact that IDD covers not only IBIPs but all types of insurance, and that at a time where we are witnessing tensions regarding protection gaps in areas such as cyber, allowing for proper consideration around the type of insurance customer and the risk covered becomes both a pragmatic and needed approach.
Last but not least, and regarding marketing practices, just a word of caution: we have witnessed how in Australia the marketing practices known as "hawking", i.e. unsolicited approach to the client to sell a financial product have been banned in the field of IBIPs... again, the question is not if, but when, will we have such debate here. Stand ready for it.
Wrapping up: thoughts and recommendations
As much as we like comparing the EU retail market with the US, particularly in terms of participation ratios, is our market as deep and transparent as the US one? If not, let's try to address not only the demand part of the equation, but also the supply one, and not only in terms of restrictions or limitations.
The Commission's proposal – and rightly so – lists a number of areas that deserve improvements, and whilst the content of the list includes elements that can easily be identified in current practices, it also embeds a relevant gap: it does not identify those elements that are working, to see if and how part of the solution to the challenge can be built from such successful elements, enhancing and extending their use.
Good advice always creates value, but comes at a price
Good advice always creates value, but comes at a price. I wonder to what extent an approach based on banning certain remuneration models endangers putting the focus on ensuring that customers can access quality advice and what it takes for such advice to add value to the customer.
My suggestion to industry: challenge the aphorism from Lord Byron that "the best prophet of the future is the past". The fact that you managed in the past to avoid further alignment of rules on the basis of "we are different" will not work out in the future, unless the value proposition of products offered is increased.
My suggestion to legislators: if financial education today is an issue, and one that requires time to be addressed, making sure that good advice is available to those who need it should be part of any solution considered.
My suggestion to supervisors: remember "Little Red Riding Hood" and beware of shortcuts... they don't always lead to where you want to go (yes, I am referring to benchmarks). Never lose sight of why and how you would make use of them.
Carlos Montalvo is a partner and Global insurance regulatory leader at PwC, and is the former executive director of the European Insurance and Occupational Pensions Authority. Email: [email protected]