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The FCA has become increasingly concerned that firms’ use of cross-subsidies or price discrimination (also known as differential or dual pricing) may lead to unfair outcomes for certain groups of consumers who, as a result of these pricing practices, end up paying higher prices. The FCA’s scrutiny of these practices was explored in our recent paper, “Cross-subsidies in the crosshairs.”

With the aim of establishing whether general insurance pricing practices are leading to unfair outcomes or consumer harm, and of setting out a wider framework for how it will assess pricing practices more generally, the FCA has now published the following documents:

  1. A Thematic Review into pricing practices in the household insurance market (TR18/4),
  2. The terms of reference for a General Insurance Pricing Practices Market Study (MS12/1.1),
  3. A Dear CEO letter making clear the FCA’s expectations around insurance pricing practices; and
  4. A Discussion Paper exploring Fair Pricing in Financial Services (DP18/09)

This blog explores the FCA’s findings, highlights the key issues they raise for firms across all financial services sectors, and outlines actions firms might consider in response. More detail on the FCA’s findings and conclusions is provided in the Annex.

What has the FCA’s work found so far?

The Thematic Review of home insurance pricing practices identified a number of concerns, specifically:

Pricing strategy, governance and control - The FCA identified concerns around the governance, control and oversight of firms’ pricing practices and activities. In some cases, the FCA found that firms did not have pricing strategies in place, while in many firms pricing decisions focused primarily on achieving business plan or financial objectives, rather than considering the impact on customers.

Consumers who renewed legacy products on older systems often failed to benefit from the same level of pricing governance and scrutiny as customers whose products were on more modern systems. Newer products were found to have more dynamic and competitive pricing models and were subject to greater levels of management oversight.

Some firms lacked appropriate management information (MI) to help senior managers review the impact of pricing decisions.

While all the firms reviewed had vulnerable consumer strategies in place, many did not factor vulnerability into their pricing strategies.

Differential pricing - The FCA’s research found widespread evidence of differential pricing. Long standing customers who continually renewed with their existing provider tended to pay materially higher prices than newer customers. This echoes the concerns of Citizens Advice’s recent super complaint, which claimed that long standing customers often pay a “loyalty premium” if they fail to switch products regularly.

As shown in the table below, newer customers are often able to buy policies priced up to 30% below the cost to supply, while pricing for longstanding “back book” customers who have held the same product for over 10 years often incorporate margins close to 40%:

Table1

Source: FCA, Pricing practices in the retail general insurance sector: household insurance (TR18/4), October 2018, p13

Notably, the Thematic Review found that these pricing differentials led to extensive cross-subsidisation between different cohorts of consumers”, with longstanding “back book” customers cross-subsidising loss leading insurance provided to new customers.

The FCA identified the types of consumers who are likely to be “winners” and “losers” from this cross-subsidy. The “winners” (those who renew often and switch providers) tended to include private renters with children, consumers with low credit scores, and unemployed renters. “Losers” (longstanding customers) tended to include those over 65 years old, those who pay monthly, those who auto-renew, and those who have made previous claims. Notably, consumers who may be vulnerable fall into both the “winners” and “losers” categories, which may make it difficult for the FCA to determine the overall impact on vulnerability.

Discrimination against protected characteristics - The FCA also voiced concerns about the potential for discrimination through pricing based on protected characteristics, principally race or ethnicity. While the FCA found no evidence of firms engaging in direct discrimination, it did find that firms were using datasets (including those purchased from third parties) within their pricing models that “may contain factors that could implicitly or potentially explicitly relate to race or ethnicity.”

The FCA also found that where firms used third party data in their pricing models, they did not always undertake the necessary due diligence to ensure that the data did not include factors that might lead to discrimination based on protected characteristics.

The Market Study on General Insurance Pricing Practices

Given its above findings, the FCA has concluded that a market study (MS) on general insurance pricing practices is required. The MS will examine whether pricing practices used across the home and motor insurance markets leads to consumer harm and which consumers are affected.

Notably, the FCA has signalled its clear willingness to intervene where it finds material harm; potential remedies it may consider include:

  • Changes to the way that firms price insurance
  • Contractual changes, such as limiting auto-renewal
  • Limits on differences in prices between different groups of consumers

The FCA also states that, when considering remedies, it will explore whether technology-based and innovative solutions could lead to better pricing outcomes for consumers; if so, it will look to encourage and facilitate these.

Dear CEO Letter

Based on the findings of its home insurance pricing work, the FCA wrote to the CEOs of all general insurers and a number of GI intermediaries who undertake pricing activity. The letter sets out the FCA’s clear expectation that firms address the issues identified in its Thematic Review and reiterates the FCA’s existing expectations of firms, namely that:

  • Firms must have appropriate systems and controls which deliver the fair treatment of customers when determining prices and selling products. 
  • All firms are required to assess whether their pricing practices result in their customers being treated fairly, and be able to demonstrate to the FCA how they have arrived at this conclusion. 
  • Firms’ should have in place governance and control structures that are underpinned by clear lines of accountability and responsibility, as set out in the SM&CR. It says that there should be clear ownership and responsibility “for pricing decisions and their impact for customers.

The letter also highlights the Insurance Distribution Directive’s requirements to act honestly, fairly and professionally in accordance with the best interests of their customers.

Fair Pricing in Financial Services

The FCA has also published a wider Discussion Paper on fair pricing in financial services. Here, the FCA discusses the principles underpinning its approach to firms’ pricing practices, and explores how many of these issues covered in its insurance papers may apply to other financial sectors.

Importantly, the DP draws attention to the FCA’s six evidential questions to determine the fairness of price discrimination, previously published as parts of its Research Note, “Price discrimination in financial services: How should we deal with questions of fairness”:

Table 2

Source: FCA, Fair Pricing in Financial Services (DP18/09), October 2018, p16

Implications for firms

These documents provide important insights into the FCA’s thinking on, and developing approach towards, pricing issues across all financial sectors. In sum, the FCA is signalling a sharply increased willingness to act robustly where it considers that pricing, including differential pricing between consumer groups, is leading to unfair outcomes and/or harm. In line with its approach in markets such as cash savings and high cost credit, we expect any cases of differential pricing or cross-subsidisation which the FCA finds unacceptable to be targeted in the remedies that emerge from the market study. So far as the general insurance market is concerned, any regulatory limits or restrictions on auto-renewal or differential pricing between customer groups could have a very significant impact on firms’ business models, especially for those firms with large numbers of “back-book” customers and/or legacy insurance products.

Below we set out our thoughts on the wider issues arising from the FCA’s review that firms across all sectors will need to consider:

Governance, MI and vulnerable customers

Firms will need to ensure they have a comprehensive and documented pricing strategy, which evidences consideration of the impact that pricing will have on their consumers. Firms should also consider reviewing their MI to ensure it provides the Board and senior managers with adequate information on pricing and margins, and that it highlights clearly where action is needed. The FCA will also expect firms to incorporate consideration of vulnerable consumers in their pricing strategies, and will be particularly alert to any pricing structures that take advantage, inadvertently or otherwise, of these customers or their circumstances.

Differential pricing and cross-subsidies

Firms should consider reviewing the levels of differential pricing they have adopted, particularly where there is a risk of poor outcomes for certain groups of customers, for example “back-book ” consumers who may pay higher prices than new consumers. This will require firms to put in place strong oversight and pricing governance for their legacy products.

Importantly, firms should also look to see if their pricing practices are likely to raise any of the fairness concerns highlighted by the FCA as part of the six questions published in its DP, as summarised above. The FCA states that it is more likely to intervene in markets where it finds high levels of harm to large numbers of consumers who are more likely to be vulnerable, and so will be particularly interested in mass market financial products.

Data

Governance and oversight over the use data (including third party data) is a particular area highlighted by the FCA. Firms will also want to ensure they are meeting their obligations under the Equality Act 2010, and that their pricing models and data do not, either implicitly or potentially explicitly, lead to consumers from groups with protected characteristics paying more than others. The FCA noted that some firms were relying on the Equality Act’s provisions which allow for discrimination against people with protected characteristics so long as it is a “proportionate means of achieving a legitimate aim.” However, given the highly sensitive nature of this issue, Boards and senior managers will want to satisfy themselves on the legal and reputational risks of such an approach.

Annex

Thematic Review on “Pricing practices in the retail general insurance sector: Household insurance”, along with a Dear CEO letter on the FCA’s expectations of general insurance firms undertaking pricing activities, which reiterates sections of the thematic review.

The FCA identified the following issues with regards to current practices that present the most potential for significant harm and poor outcomes for consumers:

Some firms failed to have appropriate and effective strategies, governance, control and oversight over their pricing practices, and were consequently unable to evidence if they were treating their customers fairly.

  • Pricing strategy: In many firms, pricing decisions appeared to be focusing primarily on achieving business plan and financial objectives and there was little or no explicit consideration of the impact of the resultant pricing decisions on their customers. In some cases, though impact on the customer was a factor on the pricing decision document, the pricing staff involved in the operation of the pricing models and preparation of these pricing decision documents were not aware of this.
  • Governance: The FCA found that the Board and the Executive Committee were too distant from pricing decisions and/or were applying insufficient oversight over it. There was a lack of clarity in some firms over who was ultimately responsible for a range of pricing related decisions.
  • Legacy systems: Many firms had legacy home insurance products on legacy systems. They found it challenging (or impossible) to interface these with newer systems, or to compare the pricing of these products to that of their newer products. This meant that consumers who were renewing older legacy products supported on old systems were not benefitting from the same level of pricing governance and scrutiny as consumers purchasing new products.
  • MI: Some firms had not developed an appropriate suite of MI to consider the impact of pricing decision on their customers. The analysis of available MI was not performed consistently and was not appropriately considered by senior management. Issues relating to price and consumer outcomes were not identified and addressed through MI and other monitoring activities.
  • Vulnerability: All the firms included in the review had a vulnerable consumer strategy. However, these strategies were mainly used in the contact centre when interacting with customers on a personal basis and not for pricing decisions. This means that it is likely that many firms are not able to consistently and reliably take into consideration all their vulnerability factors in their pricing activities.

Differential pricing leading to some identifiable groups of consumers paying significantly higher prices than other identifiable groups of consumers with similar risk and cost to serve characteristics

  • Cross-subsidies: The FCA found widespread evidence of differential pricing occurring within home insurance pricing. This differential pricing appears to support extensive cross-subsidisation between different cohorts of consumers. In particular, in many firms there appears to be significant cross-subsidisation of new business consumers through higher margins from renewal consumers.
  • Long term renewal consumers: The greatest potential for harm identified by the FCA arose from the price differentiation relating to long term renewal consumers. Its work showed that cohorts of consumers who have renewed their home insurance with their insurer for many years are on average paying prices significantly above the cost of provision.

Risk of discriminating against consumers through using rating factors in pricing based (directly or indirectly) on data (including third party data) relating to or derived from protected characteristics

  • The FCA found no evidence of direct discrimination based on protected characteristics. However, it did find that firms were using datasets (including datasets purchased from third parties) within their pricing models which may contain factors that could implicitly or potentially explicitly relate to race or ethnicity.
  • Equality Act 2010: Many firms could not provide the assurance that the third-party data they used in pricing did not discriminate against certain customers based on any of the protected characteristics under the Equality Act 2010, without first contacting the third-party provider.
  • Due diligence: Where firms used external data within their pricing models, appropriate due diligence was not always undertaken to ensure that the data did not include factors that might have the potential to discriminate based on protected characteristics.

The Dear CEO letter focuses on three areas where “firms’ pricing practices could cause significant harm and poor outcomes for consumers”. These relate to the three main concerns highlight by the TR, namely the failure to have appropriate governance and oversight over pricing, some groups of consumers paying significantly higher prices than others despite similar risks and costs to serve, and the potential for discrimination against consumers based on data related to protected characteristics.

The letter highlights the following expectations the FCA has for firms:

  • System and controls: Firms must have appropriate systems and controls which support the fair treatment of customers when determining prices and selling products. This reduces key risks such as exploiting vulnerable and less active consumers or providing misleading information to consumers.
  • MI: MI should enable senior management at all levels to understand the impact of pricing decisions not only on business performance but also on the firm’s customers. This should include MI that identifies, measures, manages and controls risks that relate to the fair treatment of the firm’s customers and thus the protection of consumers, effective competition and the integrity of the UK financial system.
  • Decision-making: Firms must clearly identify who is responsible for pricing decisions, as is required by the PRA’s SIMR and the revised Approved Persons Regime.
  • Third parties data: Firms must undertake appropriate due diligence where they use data from third parties in the pricing of GI products and to ensure that the use of data is appropriate. A firm must take reasonable steps to establish and maintain adequate internal controls.

Market Study terms of reference: General Insurance Pricing Practices

The FCA’s market study will examine whether pricing practices for home and motor insurance lead to consumer harm, who is affected, and, if required, what action is needed to improve the market.

The MS will explore many of the issues identified in the TR of household insurance, with the FCA looking to assess the fairness of firms’ pricing practices, including differential pricing. It says it will look at the impact that pricing practices may have on vulnerable consumers, and promises to “prioritise the needs of the most vulnerable and least resilient groups of consumers.” It also says that the MS will explore the concerns of Citizen Advice’s recent super-complaint to the CMA about excessive prices for disengaged consumers.

Scope of the study:

  • Home and motor insurance
  • Sellers and providers of insurance, and third parties such as brokers and digital comparison tools

Issues the FCA will investigate:

  • The differences between prices paid for insurance by different consumers compared to the cost of providing them with insurance.
  • How many consumers are affected by paying higher prices.
  • The characteristics of consumers paying higher prices, especially the extent to which these consumers may be vulnerable.
  • Why some consumers end up paying higher prices.
  • Pricing models and strategies adopted by firms and whether these lead them to take advantage of certain consumers.
  • Whether firms provide consumers with clear and accurate information when they renew insurance.
  • The impact of contractual terms, such as auto-renewal.
  • How firms address their responsibilities to treat customers, including vulnerable consumers, fairly.
  • Whether pricing practices increase or restrict consumers’ access to good quality insurance products.
  • Whether firms are making high profits from certain groups of consumers, especially from those who are vulnerable.
  • Whether the current nature of competition leads to higher or lower costs for consumers in purchasing and firms in supplying insurance products.
  • Whether firms entering the market have proved successful or faced barriers. The FCA will look at new and different business models that have developed and whether these deliver good outcomes for consumers or raise concerns. This will include looking at business models that involve the sale of add-on products.

Potential remedies:

  • Changes to the way that firms price insurance.
  • Contractual changes, such as limiting auto-renewal.
  • Limits on differences in prices between different groups of consumers.

Next steps:

The FCA has stated it will publish an interim report in Q3 2019, and a final report in Q4 2019

Discussion paper (DP) on Fair Pricing in Financial Services

The FCA has published its DP on fair pricing in order to launch a public debate on the fairness of certain pricing practices in financial services.

The DP focuses on price discrimination and explains why judging when price discrimination is fair it is not always straightforward.

The FCA says it wants to focus debate on the following practices:

  • Firms charging different prices to different consumers based solely on differences in consumers’ price sensitivity (also known as ‘price discrimination’)
  • Firms charging existing customers higher prices than new customers (sometimes referred to as ‘loyalty pricing’ or ‘inertia pricing’)

It has concerns that these pricing practices can potentially disadvantage some consumers significantly, in particular the most vulnerable and least resilient consumers.

The DB goes on explain what price discrimination is, how it occurs in financial services, and gives a case-by-case framework for assessing the fairness, and associated harm.

The FCA says it will use six evidential questions to help it assess concerns about fairness in price discrimination. These are:

  1. Who is harmed by price discrimination? Is it wealthier consumers or those who may be vulnerable?Who is harmed by price discrimination? Is it wealthier consumers or those who may be vulnerable?
  2. How much are these individuals harmed?
  3. How significant is the pool of people harmed? Is it a small or large number of consumers?
  4. How are firms price discriminating? Is it transparent and based on behaviour which consumers can change or is it based on hidden or intrinsic characteristics?
  5. Is the product/service essential?
  6. Would society view the price discrimination as egregious/socially unfair?

Finally, the DP considers what remedies the FCA might introduce if it thought it was appropriate to take action in the market, such as:

Demand-side remedies, such as:

  • raising awareness of firms’ pricing practices
  • reducing the costs of shopping around and switching
  • using reminders and nudges

Supply-side remedies, such as:

  • changing products’ default structure
  • breaking up product packaging
  • simplifying tariffs
  • a relative price cap between new and longstanding consumer groups
  • a complete or partial price discrimination ban

 

 

__________________________________________________________________________________________________________________

Andrew Bulley

Andrew Bulley - Partner, Centre for Regulatory Strategy

Andrew Bulley joined Deloitte in October 2016 from the Bank of England, where he was, most recently, the Director of Life Insurance Supervision.  Between 2014 and 2016 he was a UK voting member of the Board of Supervisors of the European Insurance and Occupational Pensions Authority (“EIOPA”).  In a career with the Bank of England and Financial Services Authority stretching over 27 years, Andrew has held senior roles in the supervision of life and general insurers, the London wholesale insurance underwriting and broking markets, retail and investment banks, asset managers, and IFAs.

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Cindy

Cindy Chan - Partner, Risk Advisory

Cindy Chan has over 20 years of financial services consulting and audit experience. She has extensive experience in the supporting firms with regulatory risk assurance reviews and conduct risk projects covering product development and governance, sales and suitability assurance, as well as Section 166 Skilled Person reviews and enforcement cases. Cindy also has wider experience within the mortgages and consumer lending sector, including affordability assessments and debt collection activity, vulnerable customers and complaints handling.

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Adam Knight5378

Adam Knight - Partner, Audit and Risk Advisory

Adam leads Deloitte’s General Insurance Regulatory and Strategy team. He has extensive experience in helping firms with internal audits, due diligence, section 166 reviews, control framework reviews (including risk, compliance, internal audit and governance) and other bespoke regulatory work, for example conflicts of interest reviews. His clients include brokers, general and life insurers, price comparison sites and Lloyd’s of London managing agents. Adam is also an audit partner for insurance brokers, MGAs and Lloyd's managing agents.

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Orla

Orla Hurst - Senior Manager, Centre for Regulatory Strategy

Orla is a Senior Manager in Deloitte’s Centre for Regulatory Strategy where she focuses on Conduct Regulation. She has extensive experience of working with financial services firms to help them understand the strategic and operational implications of changes to conduct regulation. She joined Deloitte in June 2017.

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Felix

Felix Bungay - Manager, Centre for Regulatory Strategy

Felix is a Manager within the EMEA Centre for Regulatory Strategy in Deloitte’s London office, where he focuses on conduct regulation across a range of financial services sectors. Prior to joining Deloitte, Felix worked at the FCA where he helped produce a wide range of the organisation's House and Sector Views, including those on Retail Banking and Lending, Retail Investments and Wholesale Capital Markets.

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