Jonathan Hall, Legal & Regulatory Executive at AILO, highlights a current European regulatory development that has significant implications for unit-linked product providers and advisers.

The design and distribution of financial service products have been a focus for the EU Commission for many years.  Following lengthy consultation, the Commission has recently published proposals in its Retail Investment Package to harmonise and strengthen the regulations for retail investors.  The Commission’s aims are laudable: “to ensure that retail investors receive the same treatment and protection regardless of which investments products, marketing and distribution channels they choose.”  In this context the Commission has paid particular attention to Investment-based Insurance Products “IBIPs”, the product structure most closely associated with unit-linked providers and those who distribute them, including those operating on a cross-border basis, and have added further protections

The Commission also aims to increase retail participation in financial securities (shares, bonds, mutual funds and derivatives).  The current level of participation is only 17%, which is below other markets.  Following a number of years of a low interest environment the Commission recognise that investors will need to invest in such financial securities if they are to generate sufficient income for their retirement. It is more important than ever to ensure novice investors are protected.

Unfortunately, whilst the aims are incontrovertible, the methods are likely to cause significant problems for the manufacturers and distributors of IBIPs. Here are a few examples.

The Commission proposes that the promoters of multi-option products (“MOPs”) – those which can link to a wide range of underlying funds – must provide a Key Information Document (“KIDs”) which is more fund specific than is currently the case. Greater and more detail will be required on the overall costs, the environmental sustainability and the risks of each fund. How the provider of the MOP or the adviser are meant to achieve this is not entirely clear as they won’t necessarily have access to all the required information for the underlying fund.  This is likely to result in potential investors being presented with detailed information on possibly ten to twenty underlying funds, the composition of which may change almost immediately if fund switching takes place the day after the product has been issued.  Since the MOP itself is ESG neutral and carries no investment risk, would it not be better to present the KID at a product level which would allow a true comparison between the product providers?  Under this proposal it seems that the customer has to make two choices – which wrapper to hold the assets in and secondly which underlying funds it will contain.  Would it not be better to treat the two decisions as distinct without the second clouding the first?

A second example of this more prescriptive EU approach is the proposal to clarify the nature of the best interests of a potential customer. Advisers must “recommend the most cost-efficient insurance-based investment product”. Objectively, this appears to be addressing the issues through a very narrow lens. What about customers with complex financial planning needs who are happy to pay for an enhanced advice service?  What about those customers seeking a wider range of underlying funds? What happens to customers who have particular family wealth and succession planning needs and are prepared to pay extra for advice to structure their wealth?   All advisers should surely be at liberty to address the needs and requirements of the customers without such a bias towards cost.

The Commission is also moving towards a ban on “inducements”, including commission payments.  Although it proposes such payments will be tolerated in the short-term any adviser who receives a commission rather than a fee for an IBIP will no longer be able to describe their advice as “independent”.   Will this encourage an adviser recommending a product other than IBIP, where inducements are still allowed?

The Commission plans to revisit the question of inducements in three years’ time.  To help it make an informed decision in the interim it is requiring manufacturers and distributors to submit data on the distribution costs to their respective national regulators.

 Uniquely for IBIPs it is the product manufacturer that is required to provide all of the cost information even though it is unlikely to know the total distribution costs unless it has a tied or direct sales force.

And one final example of how the Commission is making it more difficult for IBIP manufacturers and distributors. The Commission plans to raise the bar for product manufacturers when they approve and review products that appear to go beyond the current requirements of the Insurance Distribution Directive.  It will be necessary to assess the risk of the features, costs and risks of the IBIP to ensure they won’t be misunderstood. Perhaps most the worrying aspect of this is a proposal that the products must be measured against a benchmark, which has yet to be defined, but is to be developed by the European insurance regulator EIOPA. A product manufacturer can depart from the benchmark but must then show the costs and charges are “justified and proportionate”.  How many companies will be prepared to take the risk of a local regulator ruling several years after launch that the costs cannot be justified?   The introduction of such a benchmark is likely to lead to products clustering within a narrow range around the benchmark, potentially stifling true innovation and competition.  On the face of it, this proposal appears unlikely to advance the Commission’s stated aim of encouraging greater retail investment in the capital markets.

In summary whilst the motives and aims of the Commission are to be supported its suggested methods, whether by design or as an unintended consequence, are likely to make compliance with the regulations more onerous and more costly for IBIP manufacturers and distributors, potentially reducing their attraction, and consumer choice in the process.

Jonathan Hall
AILO Legal & Regulatory Executive