Like the rest of the financial services industry, insurers are subject to increasingly complex and prescriptive regulations and standards. In the coming year, insurers will need to focus on the new U.S. Department of Labor fiduciary standard, which is likely to have a significant effect on how insurance products are sold. Moreover, global developments, especially those related to the developing International Capital Standard, will require insurers to closely monitor—and, ideally, contribute to—official discussions about how globally active insurers should manage capital.
DOL Fiduciary Standard
In 2015, the U.S. Department of Labor (DOL) proposed regulation on the way investment advisers and brokers are compensated. Under the proposal, recommendations to an employee retirement benefit plan or an individual retirement account (IRA) investor will be considered “fiduciary” investment advice, thus requiring the advice to be in the “best interest” of the client, rather than being merely “suitable.” As a result, insurance brokers and agents who provide investment advice will face limits on receiving commission-based (as opposed to flat-fee) compensation.
The proposed compensation limitation does not apply to general investment education. Furthermore, the proposal’s amended Prohibited Transaction Exemption 84-24 (PTE 84-24) allows commission-based compensation for the sale of certain insurance products. However, to continue receiving commissions for certain products (e.g., variable annuity (VA) sales to IRAs), insurance brokers would need to utilize a separate best interest contract (BIC) exemption.
In addition to compensation structure, the new fiduciary standard will have significant operational and strategic impacts, especially in technology, compliance, product pricing and development.
There are four main considerations for insurance company and broker-dealer (BD) compliance:
- The BIC allows certain forms of commission-based compensation, but there are enhanced disclosure and contract requirements, including that financial institutions will have to disclose to retirement investors the total projected cost of each new investment over holding periods of one, five and 10 years, before the execution of the transaction. This could potentially cause a delay in new transactions, especially if the company’s current technology does not store this cost information in a central location. In addition, insurers must wait for customers to acknowledge the projected costs before a transaction can be completed. There are new contractual BIC obligations, including the requirement to have a three-way written contact between the financial adviser/insurance agent, financial institution and investor indicating the fiduciary status of the adviser and describing the fiduciary compliance program.
- Insurance companies have the option of moving to an “advisory” model. This means a flat fee for advisory services, and sales incentives would need to be adjusted to address the move from commission-based to flat fee compensation. (Clients could resist paying a standard flat fee for what they consider to be minimal investment advice.)
- Insurance companies could also move to a self-directed/order taker model. This would allow insurers to maintain their current fee structure but rely on customers’ direct orders (i.e., requests for broker advice and assistance).
- The PTE 84-24 exemption would allow insurers to sell certain products to fund retirement plans and IRAs, but it: prohibits commission-based compensation for sales of VA contracts to fund IRAs vehicles; prohibits the payment of certain types of fees to insurance advisers; and requires that conflicts of interest be disclosed and that the insurer act in the “best interest” of the plan, plan participant or IRA.
All of the above will have a significant impact on insurance company profitability and the competitive landscape. Insurers will have to make investments in employee training and technological enhancements. If companies leverage the BIC exemption, they will need to enhance their systems to detect and block disallowed products.
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Because insurers often do not have a central repository of relevant fee and cost data, new user interface tools may be necessary to produce timely pre- and post-sale customer disclosures. This increased disclosure and communication burden could mean companies will reconsider the appropriateness of maintaining smaller client accounts. In addition, new market entrants—such as low-cost (often automated), fee-based service providers—could disrupt future business. Accordingly, for insurance companies to remain competitive in the middle market, they may need to develop a new class of simple, low-cost products.
Making the transition from the suitability standard to the “best interest” standard will also be significant for insurance-affiliated broker dealers and their agents/registered representatives because of restrictions on providing investment advice to prospective clients. Agents will need to enhance their client profiling to refresh and verify clients’ objectives on a continuing basis to determine what is in clients' best interests. Retail financial advisers and non-affiliated broker dealers also will experience adjustments to compensation structures and will be subject to training that ensures registered representatives know which product recommendations will subject them to the new fiduciary standard.
Policy riders that could have prevented or delayed the standard's promulgation were not in the final draft of the omnibus appropriations bill that Congress passed in December 2015. The White House is pushing for the rule to be issued as early as March 2016, with a 2017 compliance deadline.
International Capital Standard (ICS)
The proposed International Capital Standard (ICS) is intended to be a consistent capital measure for globally active insurers. The ICS’s advocates promote it as a solution for groupwide supervisors to have a better understanding of how insurers manage capital allocation in an international business.
In the wake of the 2008 financial crisis, the Financial Stability Board directed regulators to improve the regulatory system—particularly capital standards—for all financial services. While the banking industry has received the majority of the attention, the insurance industry is subject to a call for wider change. Initiatives have included the development of methodologies to identify and determine accompanying capital requirements for global systemically important insurers (G-SIIs), as well as insurers that are active in multiple jurisdictions (internationally active insurance groups (IAIGs)) but are not necessarily globally systemically important. The ICS is intended to be a truly global group measure, unlike any current regulatory practice.
Many insurers are concerned the ICS could potentially force insurers to adopt “foreign” calculations that differ from current regulatory processes and conflict with existing capital practices. In addition, there has been considerable regulatory change in recent years, and the ICS is yet another initiative insurers would have to address. If the final ICS calculation is different from current practices, then all functional areas could be affected because of a knock-on effect on product portfolio, pricing and investment strategy.
Accordingly, as the ICS continues to develop, insurers should begin to consider the potential impact it may have on available capital reserves, required capital levels and capital management. Insurers should consider how new capital standards will interact with current regulatory capital requirements and should prepare to identify additional capital resources; understand changing stakeholder and investor reporting expectations; and assess the wider business impacts, such as insurance product pricing and risk appetite. Furthermore, insurers should already be taking an active role in influencing capital standards development, becoming involved in industry groups and forums and regularly communicating with stakeholders to manage expectations and ensure appropriate treatment of company-specific issues. Financial reporting teams should consider the need for updated or new capital disclosures, the communication of capital ratios and rating agency concerns.
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If enacted, the ICS also is likely to increase the need to adapt, modernize and enhance the efficiency of core operations. To prepare for this eventuality, insurance groups should complete readiness assessments and review their key systems, data flow, processes and internal controls to determine whether they need new systems and processes.
More specifically, insurers may need to develop and implement internal models and adjusted calculation methods, including incorporating new risk margin calculations and alternative methods of classifying available capital. The calculation of required capital could pose more granular technical issues in regimes where an economic capital assessment has not previously formed part of the regulatory framework or common ancillary metric. Compliance, risk management and finance functions will have to assess emerging changes in reporting requirements, determine their role and decide how to educate the business and how to monitor the impacts moving forward. Insurers will need their ERM functions to identify, measure, aggregate, report and manage risk exposures within predetermined tolerance levels, across all activities of the insurance group with clearly defined and documented structures, frameworks and procedures.
In relation to organizational structure, insurance holding groups will need to assess the potential impact of the ICS on the classification of their separate legal entities. They should review their legal entity organization charts and be prepared to assign and categorize the regulatory classification of each operating legal entity within the structure (as various capital frameworks across multiple jurisdictions could apply).
Overall, the ICS is only part of the overall regulatory framework for globally active insurers, called Comframe. Other aspects of Comframe—such as governance, risk management policies and ORSA—will also have a significant impact on many areas of an insurer's business, regardless of what becomes of the ICS. It’s too early to say for certain what the final ICS will look like, but even the regulators who question its necessity seem reconciled to the notion that a common standard will eventually become reality. The big debate is what the one true ICS should entail and what should be the nature of calculations supporting it.
DOL Fiduciary Standard
- The “best interest” standard is likely to restrict certain investment advice to prospective clients and will certainly have an impact on how insurers approach and conduct sales. In particular, insurers will need to distinguish what is considered investment advice and what is not. One related development to watch is if the fiduciary standard increases insurers’ implementation of robo-advice for routine transactions and research.
- There will be significant operational and strategic impacts, especially in the areas of technology, compliance, employee training, product pricing and development. Moreover, it appears that compliance with the standard will be mandatory as of next year, which means insurers, affiliated and independent brokers and agents have to address all of these considerations in a very short time.
- The ICS has the potential to affect the entire organization, not just risk and capital management. Product portfolio, pricing and investment strategy will all feel the standard’s effect, with resulting pressure to modernize and enhance core operations. To prepare, insurance groups should complete readiness assessments and review their key systems, data flow, processes and internal controls to determine whether they need new systems and processes.
- Because the ICS is still in the developmental stage, we strongly encourage insurers to take an active role in influencing capital standards development, become involved in industry groups and forums and to be in regular communication with stakeholders to manage expectations and ensure appropriate treatment of company specific issues.