GDV 1 response. Call for Evidence Need for a coherent approach to product transparency and distribution requirements for substitute retail investment

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1 GDV 1 response Call for Evidence Need for a coherent approach to product transparency and distribution requirements for substitute retail investment products? GDV welcomes that the European Commission consults the relevant stakeholders on the topic of substitute retail investment products. We strongly hold the view that equal products should be equally regulated. Against this background, we would like to start with some preliminary remarks as to the scope of the Call for Evidence. I. Preliminary remarks as to the scope of the Call for Evidence 1. Under the category of substitutable retail investment products the following products are enumerated: UCITS funds, nationally regulated retail funds, exchange traded or listed funds, most unit-linked life insurance, retail tranches or structured notes, some annuities and some bank term deposits (section 1.2, p. 10). From our perspective, this scope of the call for evidence resp. the working definition of substitutable retail investments products is arbitrary, since no empirical evidence for the alleged substitutive relationship between these product types is available. There can be no doubt, of course, that these retail financial services compete for a share of the households budgets. 2 However, given the range of different saving motives (e.g. inheritance motive, precautionary motive, retirement saving motive, short term consumption motive ) this does not qualify them as substitutes or interchangeable products. Experience in bancassurance shows, however, that they are rather complements which are specialized to fulfill clearly defined consumer needs resp. saving motives. The fact that many consumers hold e.g. life insurance products as well as investment fund products in their portfolio can be taken as an indicator for this complementary relationship. 1 GDV is the umbrella organization of private insurers in Germany. Its 452 member companies with employees and trainees offer comprehensive risk protection and provision for both private households as well as for trade, industry and public institutions by means of 431 million insurance contracts. GDV pleads for a regulatory framework which allows insurers to fulfil their tasks in the best possible way. 2 The same holds true, by the way, also for certain wholesale financial services such as occupational pensions. Gesamtverband der Deutschen Versicherungswirtschaft e. V. Wilhelmstraße 43 / 43 G, Berlin Postfach , Berlin Tel.: Fax: , avenue de Cortenbergh B Brüssel Phone: Fax: Ansprechpartner: Dr. Wilhelm Ruprecht European Office w.ruprecht.de

2 2. That different saving motives have to be served by different product characteristics can be illustrated by the case of the retirement saving motive, i.e. pensions, which is prominently highlighted in the first paragraph of the Call for Evidence (p.3). The European Commission rightly points out that investors demand investment products that not only allow them to maximize returns over the contribution period, but also deliver a regular income during the benefit period (p.9). Indeed, the accumulation of funds can be only one element of retirement provision. However, it is not sufficient. All EU member states face, in principle, more or less similar challenges in this field: Due to the parallel developments of the continually increasing life expectancy on the one hand and of gradual reduction of replacement rates by the statutory pension systems on the other hand it becomes more and more important a) that there is actually a long term contribution period and b) that retirement benefits (including survivors and disability benefits) are offered on a foreseeable base. From a social policy perspective it is obvious that long term contracts with regular contributions which e. g. are typical for German life insurance products (including unit linked life products) are a crucial element of retirement provision: The sometimes praised flexibility with regard to an arbitrary variation and termination of contributions comes to the price of not getting the benefits of risk coverage (be it the disability risk, the survivor risk or the risk of premature consumption of assets) in a collective. For the insureds remaining in the collective a premature exit is detrimental since biometrical risks have been calculated in advance on the base of a given collective. If member states decide to set up specific tax regimes for pension products it would be not acceptable from the tax payers perspective if opportunities were for private individuals whereas the public is expected to bear the risks. Whereas some of the products enumerated as substitute retail investment products such as annuities and unit linked life insurance products in this respect certainly qualify as pension products others serve different, rather short-term oriented savings motives. We will outline in more detail the differences between unit linked life insurance products and annuity products on the one hand and (UCITS) investment funds in our response to question 3 of the Call for Evidence. 3. According to the Call for Evidence the present sectoral approach on disclosure and distribution regulation at EU level was inherited from a period when retail financial products were largely distributed through Seite 2

3 separate distribution channels. It should be noticed, however, that selling different products through identical distribution channels does not qualify them as substitutes. Moreover, it is incomplete from our perspective, to reduce the rationale behind the product-specific approach in this field to historical differences in the distribution practice. The existing vertical approach in this field must be likewise recognized and understood in the context of the corresponding supervisory regimes. As is mentioned on page 12 of the Call for Evidence the latter are equally product-specific. Against this background, it is surprising that the scope of the horizontal approach highlighted in the questions of the call for evidence (e.g. question 9) shall be limited only to selected regulatory elements. The three level 3 committees CESR, CEBS and CEIOPS which equally have set the issue of competing investment on the agenda of their mid term working program, in contrast, follow a broader approach by including also prudential rules into their analysis. Equally, the European Parliament includes prudential rules in its deliberation on level playing field issues between different financial products, in fact against the following background: In general, capital guarantees are valuable characteristics of pension products. Whereas the inherent value of capital guarantees offered by life insurance companies is ensured by stringent European solvency requirements the same is not true for capital guarantees offered by so called guarantee funds. Therefore, the European Parliament indicates in its recent report on Asset Management II a regulatory gap as regards to prudential rules for guarantee funds. Accordingly, it calls on the Commission to submit a proposal how the appropriate provisions such as capital requirements for these funds can be achieved. 3 Indeed, there are no reasons why capital guarantees issued by asset management companies should be less secure than capital guarantees issued by life insurance companies. In the light of the upcoming Solvency II directive which will determine own funds requirements for life insurance companies according to the modern risk management techniques it would be hardly acceptable if the supervisory principle same risk, same capital was ignored in the case of guarantee funds which are usually distributed across European borders. 4 3 EP Report on Asset Management II ( ), para We would like to point out that life insurance companies have to fulfill the capital requirements of the Solvency I regime which will be updated by the Solvency II directive, not the requirements of the Capital Requirements Directive (see. p. 37 of the Call for Evidence). Seite 3

4 II. Response to specific questions The important function of question 3 is to analyse whether the basic assumption (a substitutive relationship between the product types enumerated on page 10) can be taken for granted. Since the existence of such a substitutive relationship is the basic premise for the other questions raised in the Call for Evidence we only address question 3. Question 3. Is it appropriate to regard different retail investment products as substitutable regardless of the legal form in which they are placed on the market? Which of the products listed should be considered as substitute investment products? - UCITS funds yes no - nationally regulated retail funds yes no - exchange traded or listed funds yes no - unit-linked life insurance (especially which mortality risk level is small or nil) yes X no - retail tranches of structured notes yes no - some annuities; yes X no - some bank term deposits (e.g. with embedded optionality or structured deposits) yes no - others (please list and describe) yes no As an insurance association we focus a) on annuity products and b) on unit linked life insurance and outline in more detail that there is no such relationship to investment products. a) As to the relationship between annuities and investment products For the replacement of pensions financed on a pay-as-you-go basis investments in funds are by no means sufficient. Safe retirement provisioning normally means that benefits are offered on a foreseeable and life-long basis in order to prevent old people, in times of increasingly insecure prospects of statutory pay-as-you-go schemes, from prematurely consuming their assets and then living in poverty. An elderly person who has his or her saved-up capital paid out to him or her in a single amount or a person who chooses a withdrawal plan linked to a fixed terminal age implicitely makes a bet on a rather short life. That such a bet may easily be lost, results directly from statistics on the development of survival probabilities of men and women aged 65. The table in Annex 1 shows the large number of men and women who after their 65th year live longer, in Seite 4

5 some cases significantly, than was to be expected from their statistical expectation of life. Therefore, a prudent client who wants to provide for his maintenance in his old age from an individual capital stock instead of an life annuity and at the same time prevent the risk of premature asset consumption, must establish a safety margin or a contingency reserve in addition to the necessary capital in case that his expectation of life exceeds the average. Then the client will have to save a higher amount for his retirement provision than would be necessary according to the sole expected value. For EU Member States the OECD has estimated this contingency reserve, depending on the individual risk preference, at a figure between 29% and 60% of the single premium to be paid for an annuity. 5 Therefore, by establishing risk collectives, life annuities are capable of providing a predetermined safety level with considerably less use of resources. Coverage of the counterparty risk of UCITS is in Germany much lower than this is the case with annuities, where this risk is covered by a multilayer life insurance guarantee scheme to 100%. For UCITS, compensation in the case of insolvency is limited to EUR. Within this limit only a 90% protection level is offered. The Federal Association of German Investment and Asset Management Companies BVI (Bundesverband Investment und Asset Management e.v.) denies the legitimacy of the insolvency scheme for investment funds ( Entschädigungseinrichtung für Wertpapierhandelsunternehmen ). b) As to the difference between (unit linked) life insurance and UCITS (Unit linked) life insurance and investments funds which are compared in Annex 2 of the Call for Evidence are different products serving different customer needs. In their recent White Paper on Asset Management the European Commission rightly points out that different product features and regulatory requirements make a comparison between (unit-linked) life insurance and different investment products similar to comparing apples and pears. 6 5 The impact of ageing on demand, factor markets and growth, OECD Woking Paper No. 420, Paris 2005 pp White Paper on enhancing the single market framework for investment funds, p.4. Seite 5

6 Life insurers, in general, provide their clients with a coverage of the elementary risks of life (biometrical risk coverage). Persons who trust only in savings or investment products run the risk to be in case of disability without income and without possibility to provide for old age, to jeopardise their family s financial situation in case of premature death of the main earner, to prematurely consume his or her assets in case of an unexpected long life (see the section on annuities above). A unit linked life insurance product is a long term insurance contract between a policyholder and an insurance company. In Germany, for example, the average contract duration for unit linked life insurance amounts to 45.8 years 7, the average contract duration of unit linked annuity insurance amounts to 33.9 years. 8 As such it falls under the definition of insurance in Art. 135 a of the Proposal for a COUNCIL DIRECTIVE amending Directive 2006/112/EC on the common system of value added tax, as regards the treatment of insurance and financial services. The insured makes a liable commitment to pay regular contributions and must constantly renounce consumption today in favour of what is needed in old age. It is true that the capital market risk is beared by the insureds. The insurance company invests the money on the policyholders behalf. The allegation that insurers pass this risk to their clients in a way that is unnoticed by the latter is, however, wrong. In Germany, supervisory authorities require for unit linked life policies an explicit pre-contractual information about this issue. Unit linked life insurance, therefore, is in fact a product alternative providing the potential clients with the option to choose the investment strategy themselves. The latter can but not necessarily has to include guarantees given by the insurers. 9 By coordinating the capital market risk and the biometrical risk which are independent from each other insurance companies offer an extra service to their clients: in order to minimize the 7 The very long contract duration for this type of product are due to the fact that contracts usually include flexibility with regard to the termination date in order relieve the insureds from the pressure to sell in adverse capital market situations. 8 The source of these contract related data is a sample of approx. 1.8 m contracts newly effected in 2005 (~30% of newly effected life insurance policies 2005). Group insurance contracts are not included in the sample. 9 By offering long term guarantees insurers can provide their clients with the service of bearing their capital market risk. Solvency requirements warrant that insurers are able to meet their clients expectations. Seite 6

7 costs of providing an individually predefined level of financial security the premium share that is devoted to the coverage of biometrical risks is adjusted to the funds value: When the value of the funds is high, the contribution share devoted to biometrical risk coverage is automatically reduced and vice versa. All other features of classical life insurance remain. Unitlinked life insurance policy holders benefit from the balance of risks within the collective of insureds and on emerging biometrical surpluses. In Germany, there is a strong trend towards unit linked annuity products: during the first nine months in 2007 the market share of unit linked annuities in Germany amounts to approx. 80% of new business in the segment of unit linked life insurance (number of contracts). A UCITS investor, by contrast, is the beneficial owner of an interest in a fund, represented by his/her unit or shareholding. UCITS do not provide coverage of biometrical risks. Fund products, moreover, are used for short- and medium-term asset investment as can be substantiated by empirical data: According to a survey conducted in 2004 on behalf of the Federal Association of German Investment and Asset Management Companies (BVI) 10 by the Gesellschaft für Konsumforschung (GfK) 11 no more than 20% of German fund shareholders hold their shares for more than ten years. 12 Investment into mutual funds is not only in Germany motivated by short term considerations: sales of funds that were launched in 2002 in the EU declined from approx m EUR (2002) to m EUR (2003), to m EUR (2004) and to m EUR (2005). 13 In view of numerous close-downs of investment funds over the last years it has to be emphasized, furthermore, that a unit-linked life contract cannot be unilaterally terminated. Finally, it should be noticed that the differences between UCITS and unit linked life insurance with regard to the regularity and duration of contributions induce a different exposure of clients as to the capital market risk. 10 Bundesverband Deutscher Investment- und Vermögensverwaltungs- Gesellschaften 11 Institute for Consumer Research. 12 Bundesverband Deutscher Investment- und Vermögensverwaltungs- Gesellschaften (2004): Grundlagenstudie Investmentfonds Data source: FERI Fund Market Information Ltd. Seite 7

8 Long term contracts with regular contributions provide an efficient mechanism to reduce the capital market risk: The regular payment of contributions during a long period of time provides protection against the risk of entering at the wrong moment or of missing the right moment for leaving ( timing risk ). That this timing risk is real is shown e.g. by the fact that in Germany in the investment years of 1999 and 2000 more money flowed into equity funds than in the remaining years between 1990 and today. Investments of this period may still have a negative rate of return. In contrast, in 2004 funds were withdrawn from equity funds so that the 30% yield which would have been possible from 2004 to 2005 was on average not realized (see Annex 2). The empirical economic research literature knows innumerable examples where such pro-cyclical or follow the crowd behaviour with regard to short-term investment is not the exception but the rule. These differences certainly have to be taken into account when it comes to disclosure of risks. When it comes to disclosure of costs, equally, the long-term character of (unit linked) life insurance contracts has to be taken into account. Sometimes it is argued that the cost burden with insurance companies is comparatively higher. Simulations show, however, that this is normally not the case, in particular not with regard to long term contracts. In case of long term contracts the main focus should be on the display of the impact of costs, i.e. benefits after deduction of costs. This approach can be exemplified by the information requirements of state-subsidized pension contracts in Germany, the so-called Riester pensions, which are offered by insurers both as regular with profit annuities and as unit-linked annuities. For these products information must, inter alia, be given on: the acquisition, management and transfer expenses included in the calculation and the development of the benefits, i.e. after the deduction of costs, during the first ten years on the basis of a two, four or six percent interest-rate. In addition to the consolidated life directive s provisions which are transposed by the national Insurance Supervisory Law, life insurance companies will be required to disclose the acquisition, management and transfer expenses included in the calculation for each insurance contract in absolute terms by the amended German Insurance Contract Law. Berlin, Seite 8

9 Annex 1 T hee probability o f life e a fterr thee a v era ge ex pe ectaa tion of life e is highh E x pe c tati o n o f li fe at 6 5 m al e E x p ec tati o n o f li fe a t 65 f em al e number of surviving individuals F em a le D A V nd ord er M al e D A V nd ord er ag e lo n g e v it y fu n c t ion s f or w o m e n a n d m e n a g e d 6 5 i n Seite 9

10 Annex Short term investment: It is hardly ever possible to choose the optimum time for entering and leaving a fund 0, ,40 New inflows in m ,20 0,00-0,20 Annual yield of the relevant investment cohort Year Net inflow s to German equity funds Annual Dax yield for investments made in the relevant years -0,40-0,60 Seite 10