Following the implementation of the Insurance Distribution Directive (IDD) this year, Chris Finney, a partner at law firm Cooley (UK) LLP, examines the directive and the next steps for the insurance market.
The IDD will apply to life insurers and life insurers' distributors and Finney says it is this section of the market where the directive is likely to have its biggest impact, at least from a UK perspective.
The Insurance Distribution Directive (IDD) came into force on 23 February 2016, and must be transposed into the national laws of the EU Member States by 23 February 2018.
The IDD gives the European Commission a power to adopt delegated acts on
- product oversight & governance;
- conflicts of interest
- and the assessment of suitability and appropriateness, and reporting
In late February 2016, the Commission asked the European Insurance & Occupational Pensions Authority (EIOPA) for its technical advice on each of these things, so that it could decide whether; and, if so, how, to exercise these powers. EIOPA has just published a "Consultation Paper on [its] Technical Advice …"
Product oversight & governance arrangements
- Article 25 of the IDD:
requires an insurer, and an intermediary that manufactures insurance products, to "maintain, operate and review a process for the approval of each … product … before it is marketed or distributed to customers" – this process must be "proportionate and appropriate to the nature of the … product"; and "specify an identified target market for each product, ensure that all relevant risks to [the] target market are assessed and that the intended distribution strategy is consistent with the … target market, and take reasonable steps to ensure that the insurance product is distributed to the … target market";
- requires an insurer to (a) "understand and regularly review the … products it offers or markets, taking into account any event that could materially affect the potential risk to the … target market, [(b)] assess … whether the product remains consistent with the needs of the … target market and [(c)] whether the intended distribution strategy remains appropriate" too;
- requires an insurer, and an intermediary that manufactures insurance products, to make available to distributors "all appropriate information on the … product and the product approval process, including the identified target market …"; and
- requires an insurance distributor that advises on products it doesn't manufacture to have "adequate arrangements to obtain the [product and product approval process] information … and to understand the characteristics and … target market of each … product".
EIOPA's technical advice
EIOPA's technical advice proposes extending these obligations, so that an insurer, and an intermediary that manufactures insurance products, are also obliged:
- to carry out appropriate product testing, to make sure they only bring a product to market if it's "in line with the [interests,] objectives [and characteristics of] the target market over the lifetime of the product";
- to carry out ongoing product monitoring, to ensure their products stay aligned with the interests, objectives, and characteristics of the target market; and, "Should the manufacturer identify, during the lifetime of a product, circumstances which are [product] related … and give rise to the risk of customer detriment, … take appropriate action to mitigate the situation and prevent the re-occurrence of detriment. If relevant, the manufacturer shall notify any remedial action promptly to the distributors involve and to customers"; and
- to ensure that the product information they provide to distributors is clear, precise and up to date, and sufficient for them to be able to understand and place the product properly on the target market, and to identify the customers the product is and is not suitable for.
For these purposes, an intermediary will "manufacture" an insurance product if it "plays a key role in designing and developing [a] product" by (for example) providing substantial input into coverage, premiums, risks, target market or compensation, and the guarantees that will be included in the product (if any).
Intermediary as manufacturer
When an intermediary acts as a manufacturer, the intermediary and insurer must also "define their collaboration and their respective roles in a written agreement".
EIOPA's technical advice also proposes extending the article 25 obligations, so that an intermediary that distributes insurance products is obliged:
- (if it sets up or follows a distribution strategy of its own), to ensure that its strategy doesn't contradict the strategy and target market identified by the product manufacturer; and
- to tell the manufacturer if it becomes aware that a product is not aligned with the interests, objectives and characteristics of the target market or of other product related circumstances increasing the risk of customer detriment.
- A manufacturer and its distributors must also have an appropriate written agreement in place to coordinate their reviews, and to commit the manufacturer to giving the distributor all of the information it needs to be able properly to understand and distribute the relevant product(s).
Conflicts of interest
Articles 27 and 28 of the IDD require an insurer or intermediary that's distributing insurance-based investment products:
- to "take all appropriate steps to identify conflicts of interest between themselves … and their customers or between one customer and another, that arise in the course of carrying out any insurance distribution activities";
- to "maintain and operate [proportionate and] effective organisational and administrative arrangements with a view to taking all reasonable steps … to prevent conflicts of interest … from adversely affecting the interests of its customers";
- (where these arrangements are not sufficient to ensure, with reasonable confidence, that a customer's interests will not be adversely affected), to "clearly disclose to the customer the general nature or sources of the conflicts of interest, in good time before the conclusion of an insurance contract".
EIOPA's technical advice:
explains that, when a distributor seeks to identify the conflicts of interest that it will or may face, it should:
- "assess whether [it] … ha[s] an interest related to its insurance distribution activities which is distinct from the customer's interest, and which has the potential to influence the outcome of the services to the detriment of the customer"; and
- assume that a conflict of interest will exist it, or any of its employees:
- will make a gain, or avoid a loss, at a customer's expense;
- has an incentive to favour the interests of one customer over the interests of another;
- will receive, from a person other than the customer, a benefit, in relation to the insurance distribution activities provided to the customer;
- is involved in the management or development of the relevant insurance-based investment product;
- proposes requiring a distributor to establish, implement and maintain a proportionate and effective written conflicts of interest policy, which identifies the circumstances in which a conflict of interest will or may arise, and specifies the procedures to be followed to manage and prevent conflicts from adversely affecting customers' interests; and
- proposes making it clear that disclosure of a conflict of interest is to be regarded as a "step of last resort" to be used if the organisational and administrative measures established to prevent or manage conflicts of interest are not sufficient to ensure, with reasonable confidence, that the risk of damage to the customer's interests will be prevented.
Article 17(1) of the IDD provides that "insurance distributors [must] always act honestly, fairly and professionally in accordance with the best interests of their customers".
Article 29 of the IDD provides that:
- if an insurer or intermediary (a) pays or is paid a fee or commission; or (b) provides or is provided with a non-monetary benefit in connection with the distribution of an insurance-based investment product or an ancillary service, to or by any party other than the customer or a person acting on the customer's behalf, the insurer or intermediary will only meet its article 17(1) and conflicts of interest obligations, if "the payment or benefit: (a) does not have a detrimental impact on the quality of the relevant service to the customer; and (b) does not impair compliance with the [insurer or intermediary's] duty to act honestly, fairly and professionally in accordance with the best interests of its customers";
- "Member States may impose stricter requirements on distributors [if they wish]. In particular, Member States may additionally prohibit or further restrict the offer or acceptance of fees, commissions or non-monetary benefits from third parties in relation to the provision of insurance advice", require that any "fees, commissions or non-monetary benefits [are] returned to the client or offset against fees paid by the client"; or "make the provision of advice … mandatory for the sales of [some or all] insurance-based investment products".
EIOPA's technical advice:
- gives examples of fees, commissions and non-monetary benefits (inducements) that have a high risk of leading to a detrimental impact on the quality of the relevant service to the customer, such as:
- the inducement encourages the insurer or intermediary to offer or recommend a product or service when a different product or service exists that would better meet the customer's needs;
- the inducement is solely or predominantly based on quantitative commercial criteria;
- the value of the inducement is disproportionate or excessive when compared with the value of the product and service provided;
- the inducement is entirely or mainly paid upfront, when the product is sold;
- there's no provision for the refund of inducements that have been deducted from a customer's initial investment, if the product lapses or it's surrendered at an early stage;
- proposes imposing an obligation on insurers and intermediaries to maintain and operate organisational arrangements and procedure to assess at the outset and ensure that inducements and the structure of inducement schemes do not lead to a detrimental impact on the quality of the services provided to customers, and do not prevent the insurer or intermediary from complying with their obligation to act honestly, fairly and in accordance with the best interests of their customers.
Assessing the appropriateness and suitability of insurance-based investment products, and reporting to customers
Article 30 of the IDD provides that:
- when providing advice on insurance-based investment products, the insurer or intermediary should obtain information about (a) the customer's knowledge and experience of buying / using the relevant type of product or service; (b) his financial situation, including his ability to bear losses; and (c) his investment objectives and risk tolerance, so that it can recommend suitable insurance-based investment products;
- (unless certain tests are met, and the relevant EU Member State chooses not to require this) when carrying out other insurance distribution activities, in circumstances where no advice is given, the insurer or intermediary should obtain information about the customer's knowledge and experience of buying / using the relevant type of product or service, so that it can assess whether the insurance service or product is appropriate; and, if it's not appropriate, the insurer or intermediary must warn the customer;
In its technical advice, EIOPA:
- requires the insurer or intermediary to "determine the extent of the information to be collected from customers in light of all the features of the advice to be provided", so that it can satisfy itself that the product it recommends is consistent with the customer's demands and needs; it understands "the essential facts about the customer, and [has] a reasonable basis for determining that [its] personal recommendation … (a) meets the customer's investment objectives … (b) meets the customer's financial situation … [and] (c) is such that the customer has the necessary knowledge and experience in the investment field relevant to the specific type of product or service";
- requires the insurer or intermediary to "inform customers, clearly and simply, that the reason for assessing suitability is to enable them to act in the customer's best interests";
- makes it clear that, when robo-advice is provided, the same standards apply, and responsibility for the suitability assessment will lie with the insurer or intermediary (as the case may be).
EIOPA's consultation is open until 18:00 CET on 3 October 2016. EIOPA will consider the responses it receives, and prepare a final Technical Advice, before submitting it to the Commission on or before 1 February 2017.
EIOPA's final Technical Advice to the Commission might be different to the draft Technical Advice EIOPA's just been published – but it's unlikely to be materially different.
It seems almost certain that the Commission will adopt a set of delegated acts after 1 February 2017.
If it does, those acts are likely to be in the form of European Regulations; and, if they are, they'll have direct effect in the UK unless and until Brexit occurs, and (in all probability) for a material period after that.
EIOPA may issue (so called) Level 3, comply or explain, guidelines in 2018 / 2019, if it regards it as necessary or desirable to do this, to make sure that insurers, intermediaries, distributors and their supervisory authorities are interpreting, applying and complying with the requirements of the IDD and delegated acts, in a consistent way, across the whole of the EU.
It's difficult to know how the FCA will respond to, and implement the options in, the IDD and the Commission's delegated acts (if the delegated acts are consistent with EIOPA's draft technical advice).
It's unlikely, for example, that it will undo its RDR reforms – but the delegated acts might enable or encourage it to go further than it's been prepared to go already.
The European direction of travel is therefore clear, and seasoned FCA watchers will be able to make sound educated guesses about how it's likely to respond to these challenges.
Result: substantive changes are on their way for insurers, manufacturers, and distributors of investment-based insurance products (at least).
From the moment of Brexit – the FCA could change or revoke its IDD implementing rules, and – unless the FCA or Parliament does something to avoid this result – the Commission's Regulations and EIOPA's guidelines will fall away immediately after Brexit occurs.
This would cause problems – the FCA is unlikely to have time to make IDD replacement rules before Brexit occurs.
The expectation is that Parliament and/or the FCA will make 'grandfathering' arrangements so that the FCA's rules and the Commission's regulation continue to apply – post Brexit, until the FCA has had an opportunity to consider how it will amend or replace the IDD rules (if it will), and then had an opportunity to follow the usual rule making consultation process.
Result: the IDD regime will be implemented in the UK, and retained, for several years. After that, the FCA might water things down – but in all probability it will tighten the rules still further to enhance consumer protection and reduce the risk of mis-selling.