Behavioural economics is fast becoming the driving force behind financial services regulation in the UK, and it is an approach that has the potential to bring about significant changes to the regulatory framework in Australia. This article explores recent developments in Australia and how a change in regulatory philosophy may impact on insurers underwriting add-on products.
There is real potential for the regulatory landscape in Australia to undergo a significant shift in coming years - from one based on ensuring consumers have sufficient information to make informed investment choices to one aimed at ensuring the consumer environment is one that promotes good investment decisions. While the language may suggest only a subtle change of focus, the reality is a monumental shift in philosophy with disclosure based regulation giving way to targeted market intervention. That this is the direction we are heading can be gleaned from ASIC’s submissions to the Financial Services Inquiry (FSI) where it has called on government to provide it with a broader regulatory “toolkit” to enable it to intervene in product design and development and address market challenges that disclosure based regulation, according to ASIC, has proven incapable of remedying.
While any legislative changes resulting from the FSI recommendations may be some time away, recent ASIC publications suggest it has already begun a re-alignment towards this new regulatory philosophy. For the insurance market, this new philosophy appears to be already influencing the approach to add-on insurance products, where ASIC will be deploying some of its resources over the next 12 months.
The influence of ASIC’s UK equivalent, the Financial Conduct Authority (FCA), in this area, cannot be understated. Driven by theories of behavioural economics, and empowered by a suite of temporary product intervention powers, the FCA is lighting a path that ASIC is eagerly following.
ASIC’s approach to add-on insurance products
In a speech to the Insurance Council of Australia (ICA) in February 2014, the Deputy Chairman of ASIC, Peter Kell, announced that ASIC’s focus in the area of general insurance would include add-on insurance products. While not the main products in the market, Mr 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”.
Add-on insurance products are generally those sold in conjunction with another primary product. The primary product may be a financial services product (such as a mortgage or other type of insurance contract) or it may be another type of product altogether (such as a motor vehicle). Examples of add-on insurance products include consumer credit insurance sold with loans and insurances sold with motor vehicles such as tyre and rim cover.
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. Sales practices for add-on products are often aggressive, with a tendency to overstate the risk of loss and the value of the product. Drawing comparisons with recent UK experience with the payment protection insurance (PPI) scandal, 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.
Shortly after Mr Kell’s announcement at the ICA meeting, ASIC invited the Chief Executive of the FCA, Martin Wheatley, to talk about behavioural economics. In a speech delivered at ASIC in March this year, Mr Wheatley said that the PPI scandal had brought about a re-think on the approach to financial services regulation in the UK, and evidence now supported a theory that consumer choices did not correlate to the extent of information available to them. That is to say, regardless of adequate disclosure about a product, consumers still made wrong, or sub-optimal decisions. Whether because of product complexity, consumer inertia or poor sales conduct, the historic approach simply has not delivered appropriate results for consumers. Mr Wheatley described behavioural economics as a game changer “not just for firms, not just for consumers, but potentially for the shape of regulation for many years to come”.
ASIC clearly agrees. In its submissions to the FSI, ASIC has adopted the same critique of disclosure based regulation, and called on legislative change to provide it with a regulatory “toolkit” that enables it to achieve results where disclosure has not worked. ASIC has requested that it be empowered in the same manner as the FCA through a broader regulatory “toolkit” of product intervention powers. Borrowing directly from the UK, ASIC has suggested that these powers should include:
- requiring providers to issue consumer or industry warnings
- requiring that certain products are only sold by advisers with additional competence requirements
- preventing non-advised sales or marketing of a product to some types of consumer
- requiring providers to amend promotional materials
- requiring providers to design appropriate charging structures
- banning or mandating particular product features
- in rare cases, banning sales of the product altogether.
The approach to product intervention in the UK
The UK market is now well aware of the willingness of the FCA to use these powers, having seen the recent banning of the sale of CoCos (contingent convertible securities) to the mass retail market with effect from 1 October. The FCA has also used its powers to require changes to policy terms and condition and intervened in a raft of areas following a thematic review of mobile phone insurance.
In terms of add-on products, the FCA has yet to take any action. However it is clear that there is an intention to do so. In his speech to ASIC, Mr Wheatley referred expressly to research the FCA had commissioned concerning add-on insurance products, noting that their behavioural studies showed that 65% of consumers did not look for alternative products, 25% were not aware they could get the product elsewhere, 58% made no comparison to alternative products and consumers were six times more likely to make mistakes in respect of their product choice.
He also noted that claim ratios for add-on products had fallen below “acceptable” levels – for Guaranteed Asset Protection insurance at 10% and for personal accident at 9%. These studies are prompting the FCA to look at such things as a ban on pre-ticked boxes to challenge consumer inertia, publication of claims ratios to reduce information asymmetries and improvement in the manner in which add-ons are offered through price comparison websites. In many respects, these criticisms were also made by the UK’s Competition and Markets Authority in its recent review of the car insurance market.
What to expect in Australia
The release by ASIC of the Strategy Outlook 2014-15 makes it clear that lobbying for product intervention powers and collecting evidence of consumer behaviour will be a key focus for ASIC over the next 12 months. ASIC has identified as one of the four 'key risks' in its recent Strategy Outlook, the existence of a gap between the expectations that consumers have of the regulator and the reality that under the existing regulatory framework ASIC is unable to deliver on those expectations because it does not have an appropriate remedy. If ASIC achieves what it is after, this "expectations gap" will be plugged with product intervention powers similar to those available to the FCA.
Of some concern is the statement in the Strategy Outlook that ASIC is presently unable to "ensure compensation for investors who lose money" – a telling glimpse at the approach ASIC may take to its product intervention powers if it gets them. The statement suggests an assumption that losses incurred by consumers are a result of a poor consumer environment and are therefore compensable, while dismissing the reality that informed investors sometimes make poor investment choices. For a regulator whose role is to ensure market integrity, a tendency towards compensating poor consumer choices may deter new capital, stifle product innovation and reinforce poor consumer behaviour, all of which undermines the market it is regulating. This is the sharp end of the tension between the existing and new regulatory philosophies – drawing a dividing line between poor consumer choices, and choices made in a poor consumer environment.
Market participants should expect behavioural economics to drive ASIC's criticism of products, particularly add-on insurance products and payment protection insurance, where much of the work has been done by their UK peers. A big hurdle for ASIC is to convince policy makers that the proposed increase in regulation will be offset by a reduction of regulation elsewhere, given the Government's clear direction to cut red tape and reduce the regulatory burden. To this end ASIC has suggested that the regulation of disclosure may be "peeled back", but no real detail has been provided to date.
There is little doubt that if ASIC is given the regulatory "toolkit" it wants, add-on insurance products will be among the first to be put in the vice. Insurers and intermediaries should keep an eye on developments in the UK as an indicator for what may be in store in Australia.