Product governance and intervention powers: the birth of a new regulatory regime
While the focus of Treasury has been on the 2015 Federal Budget and the imminent Tax White Paper, the wait continues for the Government’s response to the Financial System Inquiry’s final report delivered in December last year. The latest indication from Assistant Treasurer Josh Frydenberg has only committed the Government to a response ‘over the course of 2015’; and the lengthy wait has left a wide berth for speculation (and sustained lobbying) over which of the FSI’s recommendations will receive Canberra’s approval.
We have been reporting on two of the FSI’s recommendations that, if adopted, will signal a real change to the regulatory landscape in Australia. The introduction of a product design and distribution obligation (recommendation 21) and granting the Australian Securities and Investments Commission (ASIC) intervention powers (recommendation 22) will represent a philosophical shift from a regime based on ensuring consumers have sufficient information to make informed investment choices, to one aimed at ensuring that the consumer environment is one that promotes good investment decisions. That description might suggest a subtle change, but for product issuers and distributors, the change will be profound – it represents a move away from personal responsibility for investment decisions and towards a regime in which product providers bear the responsibility of ensuring products are targeted and purchased by consumers to whom they are appropriate.
The influence of the UK’s Financial Conduct Authority (FCA) in this area cannot be understated. The FCA has become increasingly proactive and interventionist since the global financial crisis and the payment protection insurance (PPI) ‘scandal’, and it’s representatives have been frequent visitors and presenters at ASIC functions over the last 18 months.
Current disclosure regime
The existing regulatory framework is based on the adequacy of disclosure, the competency of financial advisors and the financial literacy of consumers. This framework was founded on the recommendations in the 1997 Wallis Inquiry and the idea that disclosure ought to be the primary focus of financial services regulation.
The disclosure regime is based on the assumptions that financial investments involve risks and consumers need adequate information in order to make appropriate decisions about the level of risk they will accept. Underpinning the regime is the philosophy that so long as the consumer has the appropriate information, is given competent advice and has adequate financial literacy, the consumer should be responsible for the outcome of their investment decisions.
However, disclosure can be ineffective for a number of reasons. Financial products have become increasingly complex and there can be a misalignment of interests between consumers and those providing financial products and/or financial advice.
The FSI report suggests that current industry-led standards have not been sufficient by themselves to address such serious conduct issues.
The FSI recommendations
The relevant recommendations are aimed at addressing these inadequacies in the disclosure regime.
The FSI has recommended introducing a principles-based regulatory obligation that would require product issuers and distributors to consider a range of factors when designing and distributing products. This will include taking into account the product’s intended risk/return profile, how consumers are affected by the product in different circumstances, implementing controls to ensure the issuer’s expectations for distribution are met and periodically reviewing whether the product still meets the needs of the target market. It means monitoring and overseeing a product throughout its life cycle – and having systems in place to enable such product governance to occur.
It is also recommended that ASIC be empowered in the same manner as the FCA through a broader regulatory ‘toolkit’ of product intervention powers. This would include, among other things, the ability to require providers to issue consumer or industry warnings, prevent marketing of a product to some types of consumer and/or ban or mandate particular product features. The power would be exercisable before any breach of law or regulation has occurred and where ‘there is risk of significant consumer detriment’.
The shift from disclosure to consumer suitability
The FSI’s recommendations clearly indicate a view that it is not sufficient to regulate disclosure alone.
This new approach has its foundations in the study of behavioural economics. Behavioural economics is a method of economic analysis that applies psychological insights into human behaviour to explain decision-making. The FCA has continued to point to a range of studies in which fully informed individuals make poor consumer choices because of a range of other factors, such as personal preferences, the manner in which information is presented or the consumer’s environment. Regulators are therefore not simply grappling with the need to ensure that products are understood by consumers, but the reality that consumers sometimes make irrational choices regardless of the information they possess.
Reading any recent ASIC publication will reveal how the regulator has been heavily influenced by behavioural economics. Whether or not these recommendations are adopted, ASIC has made it clear that it is committed to applying behavioural economics insights to identify consumer problems and to detect when organisations take advantage of consumer biases.
The impact on the insurance industry
A key focus for ASIC in the insurance sector appears to be on add-on insurance products. Add-on insurance products are those sold in conjunction with another primary product (for example consumer credit insurance sold with loans and insurances sold with motor vehicles such as GAP or tyre and rim cover). In a speech to the Insurance Council of Australia as far back as February 2014, the Deputy Chairman of ASIC, Peter Kell, said ASIC would focus on these areas because the products were a perennial source of complaints from consumers, and importantly, because selling practices appear to be ‘exploiting consumer behavioural bias’.
Mr Kell explained that add-on insurance products are not the consumer’s focus at the time of purchase, the consumer has little or no information about the products and therefore they rely heavily on statements made by sales representatives to inform their decision to buy. Drawing comparisons with recent UK experience with PPI, Mr Kell noted how badly things can go wrong with add-on products, highlighting that the enormous capital return on PPI products, along with very low claim ratios, suggested a product offering little value to consumers. These comments about PPI should not be ignored by underwriters and distributors of consumer credit insurance in Australia.
There is a growing global trend towards this shift in regulatory thinking, with the EU close behind the UK in adopting similar measures.
Much attention has been given to the proposed intervention power, but we would urge insurers and distributors to consider the product governance obligation closely. The UK regulator has only used its intervention powers once (to ban the retail distribution of Contingent Convertible Capital Interests or CoCos as they are commonly known) and the way it has been framed in the FSI report suggests it will be a tool of last resort. The product governance obligation on the other hand lacks any real definition and as described potentially has wide ramifications for boards and senior executives, or whoever it is within the organisation that has responsibility to ensure that the obligation becomes part of the culture of the organisation.
These two recommendations are being championed by ASIC and roundly supported by a number of consumer affairs advocates; but they are also among the only recommendations that Mr Frydenberg has indicated are under the Government’s active consideration. The sceptics might consider regulatory change unlikely under a Government managing budgetary pressure and that has espoused a clear inclination for deregulation – but it seems equally implausible that the FSI (which was commissioned by this Government) will be ignored. The attention these two recommendations have received is difficult to ignore, and if the Government is considering an industry funding model for ASIC, it is difficult to see any real impediment to their adoption.
For further information please contact Matt Ellis.
Digital disruption in insurance
Innovation and disruption are in reality two sides of the same coin (or Bitcoin, if you will). On one side, innovation may describe the driver of change, the creative thinking and ideas that lead to new technology, new methodologies and new approaches. On the other side, the by-product or necessary consequence of innovation is change to the status quo, the uprooting of traditional models and incumbents and the disruption of markets. And so in one sense, the much hyped concept of ‘disruptive innovation’ might be seen as no more than a descriptor of human advancement. But there is a reason the expression has become the catchphrase of this generation of tech-savvy organisations; and that is because organisations are seeing disruption not merely as the consequence, but as itself a driver of innovation. Where markets can be disrupted, there is opportunity; and so organisations these days are quite proudly identifying themselves as disruptors as much as they are innovators.
The insurance industry is not shielded from disruption, and in fact has been subject to significant disruption in a number of forms already. In this age of the digital economy, it may be that the insurance industry is on the brink of even more seismic change. This article identifies current disruptive innovations affecting the global arena and discusses some potential areas where disruptive innovations have the potential to reshape the industry.
The key to digital disruption
The term ‘disruptive innovation’ has only gained popularity since it was used by a Harvard Business School Professor, Clayton Christensen in his book called ‘The Innovator’s Dilemma’. Disruptive innovation is described as innovation that creates new markets by appealing to new categories of consumers. One aspect of disruptive innovation is the implementation of new technologies, but alternatively, it may involve the development of new business models and exploiting old technologies in new ways.
A major difference between innovation historically and disruptive innovation, as the expression is used today, is the digital aspect of the current surge of innovations. Innovators have capitalised on the availability of mass marketing through the ‘Internet of Things’ and global connectivity and the collection and use of massive amounts of data and information stored on the internet. The expression digital disruption has been coined to describe this most recent movement.
Disruption in the insurance industry
Disruption has been occurring at pace in different forms in insurance. Alternative capital models have encroached on traditional reinsurance markets and are growing ever more popular. Technological advancements such as the use of telematics have encroached into traditional underwriting processes. Online platforms have encroached upon traditional broker-led distribution channels. Nevertheless, it feels as though we are on the cusp of much bigger and more significant change.
There are countless articles on the news every day about new innovation ‘disrupting’ a myriad of service and product based industries including Uber, Groupon, Airbnb, Netflix, iTunes or Spotify, Skype and more recently, ‘Driverless’ or autonomous cars. What these players have been able to capitalise on is the ability to reach the mass market, process sales quickly and target sales to appropriate markets. It may seem that these innovations are far removed from the insurance industry; but when you imagine targeted distribution of insurance products on the scale that the above players have achieved through digital markets, it is easy to see the opportunity and the potential scale of disruption.
Aggregator or price comparison websites
Price comparison websites allow consumers to filter and compare products based on price and other features. These websites have penetrated various markets worldwide. In Australia, websites such as iSelect, comparethemarket.com, Choosi and Canstar are providing comparison data for health and life insurance and motor vehicle insurance. Although they have been resisted by the large insurers and have therefore caused less disruption in Australia than in other markets, they continue to pose a threat to the status quo.
Aggregators have broad appeal due to the perception that they offer consumers the ability to compare products and identify the cheapest insurance option. That appeal means aggregators are becoming the consumer’s first port of call on insurance purchases and as a consequence, in international markets we are seeing aggregators become significant competitors to traditional intermediaries.
This distribution channel is one that is now attracting the biggest digital disruptors. In 2012, Google entered into the insurance industry in the UK by launching a price comparison site, providing comparisons on car insurance, travel insurance, credit cards and mortgages. In March this year, Google entered the insurance industry in the US by introducing ‘Google Compare for Auto Insurance’.
Where else for Google and other disruptors?
It is unsurprising that a great disruptor like Google is seeing the opportunities in insurance. It has the scale and the connection to customers to achieve mass distribution of insurance products.
However, intermediating insurance may only be the start. It can be said that the success of an insurance carrier depends on the skill of its underwriters. An underwriter’s skill is in identifying and pricing risk based on the information provided by its prospective clients. The amount of data collected by the big digital disruptors is staggering. Their ability to filter and utilise that data to personalise and direct marketing is well known. If they are able to utilise information on which sophisticated and automated underwriting could be performed, then the next disruption will impact insurance carriers directly.
Maybe the slogans of disruption and innovation are starting to sound more like spin than substance; but it would be unwise to be dismissive. Digital innovation is quietly, and quickly, shaping the insurance market globally. Insurance CEOs around the world are talking up the importance of keeping ahead of technology and abreast of developments in disruptive innovations. It is therefore vital for current players in the insurance industry to remain aware of potential disruptors and plan ahead to adapt to the inevitable changes the digital market will bring.
For further information please contact Matt Ellis.