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 Inquiry’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 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 GFC and the payment protection insurance “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 (ICA) 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 payment protection insurance, Mr Kell noted how badly things can go wrong with add-on products, highlighting that the enormous capital return on Payment Protection Insurance (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.