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Address by Mark Burke, Head of Life Insurance Supervision to ‘A future for the Life & Pensions Industry’ conference

31 January 2013 Speech

Introduction

Good afternoon ladies and gentlemen. I am grateful for the opportunity to speak to you at this event examining the future of the life and pensions industry. The topic of my presentation is that of regulation beyond 2012, more specifically, what life assurance companies and their business partners can expect to be on the prudential regulatory agenda in 2013 and how this may impact life assurance business. Obviously, this will include monitoring on-going compliance with existing regulation and legislation and ensuring to the greatest extent possible that Boards of Directors and Senior Management Teams are running their businesses in a sound and prudent manner. However, given the difficult operating conditions domestically and broader macro-economic headwinds, there will be an increased focus in 2013 brought to bear on firms’ business models, the business model of life assurance generally and how these are being adapted to the changed economic reality that we all find ourselves in.

I believe the event today is being held at an opportune moment in that it affords market participants the opportunity to reflect on how to ensure the life assurance market remains relevant to its end consumers going forward - that it finds a way to continue to provide simple products which consumers want at an affordable price. Such a discussion needs to have regard to the interests of all stakeholders, namely the consumer, the intermediary and the product provider so that the economics of the transaction work for all stakeholders. Current economic conditions, weak demand, the low interest rate environment, commission competition and the over-capacity in the market all mean that it is increasingly challenging for life assurance companies to provide pension and savings products which are understood by consumers, priced competitively and offer the desired risk/reward profile.

There are a number of elements to this business model challenge, and I would like to spend a bit of time discussing these today, from a regulatory perspective.

Business Models


Last year was another very challenging year for the life market. New Business volumes fell for the fifth consecutive year. New business was down 9 per cent in the year to the end of September. This brings the total decline in new business volumes since the peak to somewhere in the region of 60-70 per cent. New business volumes have also become much more concentrated. The largest players in the market have seen significant growth in their market share in recent years. It seems that the new business share of the top three players will comprise in excess of 70 per cent and that the dominance of this top tier will be a feature of the market for some time. The declining sales volumes overall represent a very difficult trading environment for all life companies. Unemployment rates remain stubbornly high; Consumer confidence in the investment arena has been shaken by the global financial crisis; Affordability is clearly an issue as consumers focus on the essentials. Some certainty, in the short term at least, returned to the market before Christmas with the resolution of the issue of pensions tax relief. However, it remains the case that few market commentators argue that volumes will return to the level of the 2007/8 any time soon.

Notwithstanding the above, some companies continue to operate with pre-crisis operational capacity/capability. The life and pensions landscape has become extremely competitive as companies strive to maintain volumes and market share. The consequence of all of this is there has been erosion of the profitability of new business activities for the life assurance sector. Profitability is severely challenged by a number of factors, including:

  • The relatively fixed nature of the expense base;
  • The reduced margins overall resulting from an extremely competitive landscape;
  • Higher lapse/surrender rates across the market as a greater number of policies move between providers; and
  • Higher commission paid to intermediaries as companies strive for market share.

 

The profitability of new business written in 2012, for the market as a whole, will be break-even at best. This implies that some companies may see a positive return on their new business activities, while many others will see a negative return to varying degrees. There is a challenge for firms to find more cost efficient business models that reflect the changed economic reality. There is evidence that some firms are beginning to tackle this issue – some have internal cost reduction or voluntary redundancy programmes underway; some have begun to tackle the issue of ‘commission competition’; others have or may exit the market. If measures undertaken are not sufficient, it is likely that we will see greater consolidation as firms merge, scale back or exit the market. This in turn will have an impact on consumer choice, price competiveness and the intermediary market as new business volumes become concentrated around core players with sufficient scale.

From a prudential regulatory perspective, we do recognise that life assurance business is a medium to long term business and that where investors allocate capital to the life insurance sector, they do so with a longer term investment horizon in mind than many others in the financial services sector and we view this as a good thing!. This means that companies recognise that there will be periods where returns are above normal and periods where returns on capital are more challenging. This is part-and-parcel of the business model of life assurance. However that is not to understate the challenges of navigating such difficult periods and we will work with firms to ensure that short term challenges do not become medium term problems.

So, given the scale and duration of the recession, and the broader challenges it brings, what do we expect to see more of in business model discussions with firms going forward?

  • Formulation of strategies that address current market realities;
  • Tight management of costs to reflect the new levels of demand and pricing of new business accordingly;
  • Focus on the retention of the in-force portfolio;
  • Credible business plans – focussed on core competitive strengths;
  • Seek viable growth opportunities and commitment of resources to support them: new distribution channels (On-line perhaps?) or new products (Fund platforms?); and most importantly
  • An attractive product proposition to the end consumer.

Persistency and its importance to Life Companies

One of the items mentioned above is of the need for continued awareness of the importance of business retention. One of the key drivers of profitability is the earnings on the existing portfolio. The short term focus is often on top-line growth and maintaining market share, but the more significant driver of profitability in the medium term is that of a successful retention strategy. Given that there is such a significant presence from the broker community today, I wanted to spend some time talking about policy persistency or lapses.

Policy persistency, which can be expressed in a number of different ways, is a measure of the length of time that a policy remains on the books of a life company. It is a fundamental driver of the profitability of life assurance companies.

Upon the sale of a life assurance policy, the life assurance company incurs significant set-up costs, including the payment of a commission to the financial advisor. These costs are incurred immediately upon the sale of a policy. The life company will recoup these setup costs over the life of the policy through various fees.

The last few years has seen a period of intense competition in the market place. This has resulted in commission competition between companies as they try to offer a greater incentive to financial advisors. This increases the expense incurred today for the life company. Competition more generally is resulting in downward pressure on other fees charged by the life company throughout the life of the policy. Both of these mean that policies need to remain in-force for a longer period of time in order for the life company to recoup its initial investment.

However, the profitability of a life company is not driven solely by a single years worth of new business, rather the experience of its overall portfolio which includes business sold over many years. A company can more readily withstand reduced margins on new business where this is offset by strong margins on the back-book. However, the trend we have witnessed across the overall market is that policy persistency is reducing and the average policy duration of the entire portfolio is reducing. Some commentators in the market have referred to this as evidence of ‘churning’ or recycling of business. The net effect of the factors – the higher upfront commission, the reduced margins elsewhere within the policy and the reduction in the length of time the overall portfolio remains in force - is to significantly challenge the profitability of firms in the market. Cleary, this type of behaviour in the market is not sustainable beyond the short term.

Reduced profitability and increased competition are not necessarily bad things in themselves, but where they result in very low or negative profitability for the sector in aggregate, it does point to a more pressing need for change.

Within the current model of remuneration between life companies and financial advisors, there is room for greater alignment of the interests of all stakeholders. The financial advisor provides a service to his/her client and receives appropriate remuneration for services rendered. Policyholders benefit from a more competitive landscape. Life companies will need to earn an appropriate rate of return on the capital it has deployed to the sector. Greater alignment of interest, to the benefit of all stakeholders could be achieved by longer commission clawback periods to reduce the risk of early surrender. It could be achieved by a commission structure which favours lower upfront payment for services rendered in return for commission which is earned more evenly throughout the policy term or it could be achieved by introduction of a time based advisory fee disclosed to the consumer as we have seen in the UK. There is room for a greater discussion and collaboration amongst the various industry participants to find an alternative solution as the recycling of business, currently evident in the market, is not in the interests of any of the stakeholders.

The timing of the Retail Distribution Review in the UK and EU consumer retail package more generally, is good in this regard as it allows product producers and financial advisors alike the opportunity to take stock on this dysfunctional behaviour and rebuild for the future with a more sustainable model.

The EU Consumer Retail Package

At this stage, I would like to turn my attention to both of these initiatives, examine what they may imply for the local market and start the debate on how the industry might capitalise on the opportunity presented by these initiatives to drive a growth agenda - the idea being that growth will emanate from greater transparency and consumer confidence in the life assurance market.

The European Commission is updating and reviewing conduct of business rules for sales of insurance products in the EU. The three-part legislative package is dedicated to rebuilding consumer trust in financial markets. The key elements of that package of most relevance today include proposals for a regulation on key information documents for packaged retail investment products (PRIPS) and a revision of the Insurance Mediation Directive (IMD2).

The Minister has already touched on the detail of the Directives, so I wanted to zoom-in on one or two critical components within these initiatives:

  • The scope of IMD2 will be extended by including tighter provisions on professional qualifications and disclosure requirements, and including more stringent rules on conflicts of interest for investment insurance products;
  • It will regulate selling practices for all insurance products from general insurance products through to life insurance policies. Where the existing directive covers only sales by agents and brokers, IMD2 will be extended to include direct sales;
  • Perhaps the most significant change proposed by IMD2 concerns the disclosure of fees and commissions whereby all insurance distributors will be required to inform their consumers about the different elements of their remuneration. This is aimed at contributing to greater transparency, allowing consumers to better assess the total costs of these products and therefore make better informed decisions; and
  • The proposal also introduces additional requirements on the sale of insurance products with investment components. These read-across some MIFID II conflicts of interest provisions, with the aim of harmonising selling practices across all investment products, be they sold by insurance or non-insurance firms. This could potentially mean a ban on commissions and fees for independent insurance brokers selling these types of products. It remains to be seen if these will be ultimately be included in IMD2.

 

Regardless of the exact nature of the final outcome, one thing is clear – that is the drive towards total transparency and reducing conflicts of interest to a minimum.

The other component to this legislative package, PRIPS, will require that consumers be informed of investment product features through a standard Key Information Document, or ‘KID’. The KID must be a short document, written in non-technical language that avoids jargon, so as to be understandable to the average or typical retail investor, and must be drawn up in a common format so that investors are able to easily compare between different investment products.

With regard to the provisions for additional disclosures to consumers, I believe that we as regulators will need to strike a careful balance to ensure that we do not end up in a situation where excessively detailed disclosures only serve to confuse consumers further and distract the customer from the critical policy information. In this regard, regulatory disclosure cannot become a replacement to good proper advice and information and is why I believe the intermediary still can offer a meaningful value add to the ordinary consumer.

I would now like look to look at the UK market to see if trends there may read across to the market here in Ireland.

Likely Market Impact of the EU Consumer Retail Package

The Retail Distribution Review (so called RDR) came into effect in the UK market on 1 January 2013. The new rules, at a very basic level, are designed to make it very easy for customers to see exactly what advice they are paying for, by banning commission.

Although some commission payments will still exist (for example on protection business), pension and investment companies won't be allowed to make a large upfront payment to the adviser for selling the product which is then clawed back through various product charges.

Under the new regime, all charges have to be agreed in advance with the customer. Customers will get a simple document which sets out both the advice charges, as well as the charges for managing their investment.

This might be a fee of €1,000 for 3-4 hours work. Where the client does not wish to make an upfront payment for the advice, it may be possible to deduct this charge from the client’s investment. But this has to be explicit - for instance, where the client wishes to make an investment of €50,000 but does not wish to pay the €1,000 fee upfront for 3-4 hours of investment advice, then it will need to be clear that the investment into the policy is reduced to €49,000 – so it is clear exactly what people are paying for an advisory service.

This change, which is a very significant one, is geared at overhauling the consumer protection agenda in the UK. It will also fundamentally change the business models of life companies and financial advisers alike.

So, what effect may the RDR have on the UK market:

  • The number of advisers in the market may fall and others may move from operating on a standalone basis to being part of larger networks;
  • Advisers may find that the economics of providing advice to those clients making very small contributions are no longer adequate and may therefore seek to focus on the more affluent consumer with larger amounts to invest;
  • This may lead to the emergence of an advice gap in the market. A recent study by Deloitte suggested that as many as 5m people in the UK would be without investment advice under the new regime;
  • Although speculative, it is easy to see how this could lead to more workplace solutions as a means of closing this advice gap whereby streamlined investment solutions are made available via the employer or as part of an auto-enrolment solution;
  • Advisers may make greater use of platforms going forward; and
  • The trend towards passively managed funds and exchange traded funds may accelerate.

 

Many of these may be relevant to the market domestically and others less so. Domestically, one might see a resurgence of the direct sales force. Remuneration structures across sales channels differ and it is possible that direct writers will be at an advantage to intermediaries as they may find it more straightforward to internalise distribution costs.

Product providers may concentrate on the provision of a greater level of services to their intermediaries. Other product providers may concentrate on certain segments of the broker market that target a particular population demographic. In this regard, the basis for distribution decisions going forward may be much more scientific in nature and steeped in analytics. The product provider may be much more focused on what kind of business an agent is producing (and more importantly, what they are likely to produce going forward), as well as how the product providers’ strengths (brand, lead generation, transaction turnaround time) meet the agent’s (and consumer’s) needs.

Product Innovation

In the discussion so far on business models, I have spoken about the challenges facing firms in terms of over-capacity in the market and the issue of commission competition. I have also touched on the regulatory change coming our way vis a vis the European Commission’s proposals on IMD2 and PRIPS and its impact on business models. The other aspect that I wished to focus upon is the need for product providers to continually innovate. This is especially relevant in today’s market given the macro-economic conditions. Long term interest rates remain at, or very near, historical lows.

The collective actions’ of the various Central Banks create the prospect of very low rates for an extended period of time. Much lower yields on investment portfolios make it very expensive for product providers to offer the capital protection so often sought by consumers at an affordable cost to the company. Finding the right solution to the challenge presented by this environment is not easy. Continued product innovation will be necessary where product providers try to find investment and retirement solutions which on the one hand, remain attractive to consumers in meeting their needs and expectations and yet are profitable for companies on the other hand.

Speaking of innovation, the annuity market has seen some innovation recently.

  • One product provider launched a variable annuity product;
  • We have the sovereign annuity initiative;
  • We may see the launch of lifestyle annuities which would see higher annuity values offered to those whose life expectancy is expected to be lower due to certain lifestyle choices;
  • We have also seen the forced removal from pricing of some risk differentiation criteria following the implementation of the Gender Directive. There is also the possibility of a ban on the use of Age as a rating factor. Such developments, which run against the principle of proper risk differentiation, create additional uncertainty for insurers and this is ultimately reflected in higher premia for the consumer.

 

However, it will also be necessary to be cognisant of the dangers associated with taking short cuts to such problems in the name of product innovation. The search for higher yield on investment portfolios is one such potential pitfall and where firms are making such changes to their strategic asset allocations, be it in the life or pensions space, great care and careful consideration is needed of the attendant risks of such actions. This will also be the subject of some of our business model discussions with firms.

Conclusion

At this stage, I would like conclude my presentation. I have spent a lot of time speaking about the various challenges facing firms’ business models. It is a tough market out there, as you know better than I, with regards to commission competition and persistency and I believe some change in behaviour and product will be necessary. However long term savings for old age and retirement have never been more critical given life expectancy and the removal of old style final salary schemes. This presents both a challenge and an opportunity to innovate in order to provide attractive, yet profitable product propositions to consumers that they understand and want to buy. Simplicity and transparency is the consumers’ friend but can also be a real opportunity for the industry to get it right and deliver what customers want to buy. The industry will need to embrace the change associated with the European Commission’s Consumer Retail Package and use the initiative to engage with the consumer in a more transparent manner. I believe that those who embrace these new market realities and establish themselves at the forefront of building and maintaining consumer trust and confidence will emerge as the longer term winners.

On that note, I would like to thank you for your attention and for the opportunity to speak to you this afternoon.

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