Institute of Actuaries of Australia Submission to Treasury on Product Rationalisation in the Financial Services Industry September 2007 [19 September 2007]
1 Introduction The Institute of Actuaries of Australia ( the Institute ) welcomes the release of the product rationalisation issues paper by Treasury. This is a complex area with many obstacles where suitable reform will generate significant benefits for all stakeholders, including consumers. It is pleasing to see that Treasury are looking to develop new legislation to simplify the rationalisation process whilst ensuring that the interests of consumers are fully protected. The Institute represents a profession with a significant interest in this field and would like to assist in developing a practical and sound rationalisation solution for all affected parties, so that consumer interest and reasonable benefit expectations are appropriately protected. Many actuaries work in the financial services industry and have significant existing experience in product design, restructure and the equitable treatment of consumers, that is directly relevant to this topic. The Institute has established a task force to consider the current operating and legislative environment with respect to the equitable management of legacy financial products and what simplifications are required to improve this environment. The task force has focused on operation of the mechanism rather than on the legislative changes required. It has developed a model that is consistent with the key principles put forward in our submission to the Commonwealth Government in November 2006: Consistency Simplicity Consumer Safeguards Practical Equitable and fair Transparent Tax neutral Facilitate rationalisation Certainty of outcome This paper shares this thinking and provides responses to the points raised in the Treasury issues paper on product rationalisation. 2 Overview The Institute agrees that there is a case for government intervention with regard to product rationalisation. The introduction of a mechanism for rationalising legacy financial products would generate long-term economic benefits for both product providers and consumers. 2
However any extension of powers to product providers (and issuers) to rationalise products needs to be balanced with sufficient protection to adequately safeguard the interests and reasonable expectations of consumers. The introduction of a test for equivalent rights and benefits before and after the rationalisation is welcomed and the Institute believes that a principle based approach should be used. The test or assessment should focus on whether the rationalisation outcomes are equitable and fair rather than ensuring a replication of all rights and benefits after the rationalisation as the latter would negate the benefits of product rationalisation. The Institute recognises that financial products in each of the three sectors: Managed Investment Products, Superannuation Products and Life Insurance Products are written under a number of different legislation environments and governed by different parts of the law. That being said, the new mechanism should be applied consistently across the different sectors. There is much overlap between the sectors and separate development for each sector would lead to anomalous outcomes. Reforms are required to ensure that rationalisation is treated as a continuation of the existing arrangements for the payment of tax and other duties. The rationalisation and transfer of beneficiaries should not, of itself, change the liability for tax or other duties. The Institute has developed a model, not dissimilar to Option 5 in the issues paper, but with less legal formality and associated costs than an independent tribunal. It has been designed to be a practical process with product rationalisation driven by the product provider (or product issuer). Consumer safeguards are based on independence and transparency through disclosure. Central to this model is the independent arbiter, whose role is to consider and approve (or reject) the proposal, based on the assessment made by independent experts. The operation of this model and the tests of equity and fairness are covered in the next section. 3 Institute s Model The Institute proposes a model which focuses on ensuring a fair and equitable result for consumers whilst being practical and cost-effective so that providers rationalise their products releasing the benefits to all stakeholders. 3.1 The main steps in the process would be: The product provider (or issuer) is responsible for developing and bringing forward any rationalisation proposals. The provider is responsible for the administration of the legacy product and will be most aware of any issues that may exist. The product provider would take the finalised proposal to the arbiter for approval. In practice there would be the opportunity for informal discussions before the finalised proposal is put forward. Independent expert(s) would be required to advise the arbiter on the impacts of the proposal. 3
The provider would write to all affected consumers setting out the proposal and what this means for consumers. This would be sent prior to the formal submission of the proposal to the arbiter. The provider would also inform the relevant regulator(s) of the details of the rationalisation proposal. The regulator(s) would have the right to ask for further information and provide feedback to the arbiter. The arbiter would assess the fairness and equity of the proposal taking into account, consumer feedback and objections, regulator input and advice from independent experts on the impacts of the proposal. The assessment would consider all consumers, those that remain in associated products and funds, transferring beneficiaries and those that are in the receiving product or fund. The arbiter would be independent of the product provider and the regulator(s). The arbiter would be of high professional integrity and status and would not have any (actual or perceived) conflict of interest. The trustees of a superannuation scheme could act as the arbiter where superannuation products are being rationalised. So as not to add a significant delay to the product rationalisation process the time taken to approve a proposal should be limited. We feel that three months would be appropriate for the standard process, with the right to extend a further three months where the proposal needs to be amended. This means that there would also be a limit on the period during which consumers, regulators and other parties could raise objections. Once approved by the arbiter all beneficiaries would be compulsorily transferred to the new product. A complaints process would be included to deal with any subsequent complaints. Complaints would be handled by the provider and only if they cannot be satisfactorily resolved would they be forwarded to the arbiter or complaints body. The arbiter or complaints body could award additional compensation (above that included in the rationalisation proposal to cover expected losses). All compensation would be funded by the provider. We envisage that the arbiter would deal with complaints for the first 6 months after a proposal is approved and the complaints body would deal with later complaints. We do not believe that it is practical for an arbiter to deal with all future complaints, but we think that it is appropriate for the arbiter to be involved initially as early complaints could highlight a previously unidentified shortcoming of the rationalisation which could result in an amendment to the compensation element of the rationalisation. We envisage that it would only be in the most unusual and remote circumstances that a consumer complaint could lead to a major restructuring of a proposal as the basic process set out above is designed to reduce the likelihood of any major shortcomings arising. 3.2 A rationalisation proposal would have to meet a number of principles: Consumers in similar circumstances should be treated similarly, or given similar options. 4
There is no detriment to any consumer in normal circumstances. This allows an existing benefit to be replaced by one offering better value, but potentially with some differences in product design. As some benefits may be dependent on external factors or contingent outcomes, there may be a probabilistic element in this assessment. Consider the example if a legacy product with an expensive charging structure containing a flat dollar fee is replaced by a new product with an asset based percentage charging structure. Although the new product may give rise to lower charges in normal circumstances this may not be the case if investment markets performed significantly better than expected. Normal circumstances would be defined so that there was a low probability of an adverse outcome. The fair value of all rights and benefits when aggregated across all impacted beneficiaries after rationalisation has to be at least as good as the fair value before rationalisation. Any expected net loss of rights or benefits resulting from the transfer to the new product would be compensated as part of the proposal. It should not be required that any additional benefits of a rationalisation be distributed equally to all consumers. Some consumers should be able to benefit more than others. In particular, processes of levelling up should be facilitated. The costs of rationalisation would be met by the provider. 4 Discussion Points 4.1 Should product rationalisation be limited to a one-off opportunity? No. Legacy products have arisen as a result of changing legislation, technical change, competition and market innovation. This is an ongoing process and the environment can be expected to continue to change in the future. Therefore the product rationalisation mechanism should not have a limited lifespan. Whilst a rationalisation mechanism will affect the rights and benefits of consumers, the proposed tests for equivalence would ensure that there is no net detriment to the consumer. 4.2 Should there be threshold requirements limiting which products may be rationalised? Threshold requirements could become outdated over time which would mean that legislation would need to be regularly revisited. We do not believe this would be an efficient outcome. However, we recognise that if the scope of the new mechanism is not defined it could be possible for it to be applied inappropriately. We believe that to ensure a fair outcome for the consumer the most effective solution is to require that all proposals meet a set of legislated principles for consumer protection. However, a reasonable limitation to the scope would be to restrict the application of the mechanism to legacy products (defined as no longer being open to new applicants) _. 5
4.3 Which parties should have the right to bring forward proposals? The most logical and practical conclusion is that it is only the product provider that has the right to bring forward a proposal. The provider is responsible for running and maintaining the product and is best placed to assess whether there are any benefits from rationalising the product range. Other parties could, in theory, put forward proposals, but it would be unlikely that they would have sufficient resources to fund the rationalisation. 4.4 Should beneficiaries have the right to object to proposals? Yes. The beneficiary should have the right to air objections. In the Institute s model the arbiter would consider and assess objections and would have the power to reject a provider s proposal if it did not adequately address valid objections. 4.5 Should compulsory transfer of beneficiaries be a part of a product rationalisation process? Yes. Compulsory transfer should be a feature of the new mechanism as otherwise the benefits of rationalisation will not be achieved. Experience shows that many consumers and beneficiaries do not actively participate or respond. Often this non-participation can be quite high. 4.7 Should the legislation itself contain a detailed test? No. Including the detail of the test in the legislation would lead to more certainty on how the test would be applied, but would be cumbersome in practice as there are many types of product in the market place and specific types could be missed. In addition detailed rules in the legislation could become outdated. Certainty on the adequacy of an assessment can be achieved through independent external scrutiny of any proposal with regulatory involvement. 4.8 What high level principles should be included in legislation? The Institute believes that the test of equivalent rights and benefits should consider whether a rationalisation proposal is fair and equitable. It should be possible to replace existing rights and benefits with ones of similar or better overall value. Rationalisation will be stifled if equivalent rights and benefits is interpreted as replicating the rights and benefits from the old product into the new product. For example many new products have fundamentally different charging structures from those under legacy products. Replicating such old structures would be prohibitively expensive and not in the consumers interest where the new structures often offer better overall value. Our proposed high level principles are set out in section 3.2 and the Institute s task force has developed a more detailed operating model for discussion at a later date. 6
4.9 How should the test be applied to beneficiaries? Do you think it is feasible to require analysis of each beneficiary and their circumstances? This is discussed in section 3. Sufficient analysis should be undertaken to assess the impact on all beneficiaries. Analytical techniques exist to model and assess the impact on groups without necessarily physically testing each individual separately. These types of assessments are regularly conducted by actuaries when advising on Part IX schemes under the Life Insurance Act or transfers of members between superannuation schemes. 4.10 Which entity should be responsible for applying the equivalent rights test? There should be independent approval of the rationalisation proposal and therefore an independent assessment of the fairness of the proposal. The Institute s model proposes the role of the independent arbiter. We think that commercial entities (independent of the providers) would be able to fill the role of arbiter and they would be better resourced than a tribunal to deal with the potential volume of proposals. We also believe that the trustees of a superannuation scheme who have a fiduciary duty to act in the interests of their beneficiaries should be able to act as an arbiter where their beneficiaries are impacted. However, directors of life companies and of the responsible entity for a managed investment scheme should not be considered for the role of an arbiter. This is recommended because they have dual responsibilities and do not solely consider the interests of members or beneficiaries. 4.11 What rules should apply to the procedures of the approving entity? There should not be any specific rules or procedures. However, the legislation should include the principles for the product provider to follow. 4.12 Should the regulators have a special role in the approval process? Yes. We believe the regulators should be informed of a proposed rationalisation in a timely manner and the regulators should have: The right to ask for further information; The right to provide feedback to the arbiter; and An ability to object to a proposal. 4.13 Can there be a single process covering all types of products? Although there are different legislative environments for the different product types we believe that the principles and processes can be applied consistently across each of them. If consistent principles and processes are not applied, inconsistent outcomes for the different product types could ensue. 7
4.14 Do you agree with the [tax] issues as outlined? A requirement of the new mechanism should be that a product rationalisation should not increase or bring forward tax liabilities for any of the parties to the rationalisation. Tax neutrality should be a pre-requisite for a successful rationalisation mechanism. 4.15 Are there other tax issues that should be considered? An approach consistent with the above should also be required by the various state revenue offices. A product restructure should not give rise to material stamp duty or other state charges. 4.16 With respect to pre-rationalisation disclosure, what information would need to be given to beneficiaries? Should the disclosure documentation need approval, for example by the regulator? The disclosure should set out the full details of the proposed rationalisation and highlight the impact on beneficiaries and related consumers. This would include: The reasons for the proposed rationalisation; The proposed course of actions and timeline, and the rights of consumers including the right to raise objections; A summary of the experts assessment and advice; and The impact of the proposed rationalisation on consumers. The disclosure would require consideration and approval (by the arbiter under the Institute s model) to ensure it provided sufficient information to consumers. 4.17 If a right to object is included, how much time should beneficiaries be given to respond? Consumers should have the right to be heard and object to a proposal, but from a practical perspective there does need to be a time limit. We feel that it is reasonable to have a one to two month limit for any objections to be raised by consumers, their representatives and the regulators. This time limit needs to be consistent with the time limits on the approval process. 4.18 What procedures should apply in the case of lost beneficiaries? We do not see that there should be special treatment for lost beneficiaries. The tests of equity and fairness will be applied to all beneficiaries whether or not they are lost and so being lost will not impact the fairness of the proposal. Special treatment such as retaining the lost members in the old product would mean that much of the benefits from the rationalisation would be lost and lost members could end up in a worse position. 8
Additionally it is expected that any transfer under a product rationalisation proposal would not remove or alter any of the existing protections or processes that apply to lost beneficiaries or small accounts. The role of the arbiter would be to ensure the provider took reasonable and sufficient action to trace, contact and/or inform beneficiaries of the proposal and that the amount of non-contacted beneficiaries was not such as to call into question the general level of exposure the proposal has had with the beneficiaries as a whole. 4.19 As regards post rationalisation disclosure, should there be any special requirements other than notification of new allocations? Post rationalisation disclosures should confirm the rationalisation/transfer and what product and options the consumer is invested in and/or insured under. As there has already been initial disclosures then from a practical perspective it should be possible to make these confirmations as part of the regular communication cycle e.g. annual statement, member report etc. However, where there have been significant changes the disclosure should occur with the rationalisation. 4.20 Can one entity cover complaints and compensation regarding all products, or is more than one required? This covered in the following section. 4.21 What process and timeframes should apply to applications to this body? Should there be a time limit within which claims can be brought forward? We feel that initially the arbiter would be best placed to deal with a post approval complaint, but to avoid the difficulties with dealing with complaints many years after the rationalisation has occurred we believe that there should be a time limit within which claims can be brought forward to the arbiter. However it should provide sufficient time for consumers to consider the issues and we suggest 6 months would be appropriate. Once outside this time period complaints should go to the existing relevant industry complaints tribunal or process and this would be subject to the existing statutory limits. We would suggest that the relevant industry complaints tribunals would be appropriate. However, as a general matter we believe combining the various complaints bodies into one, to the extent practical, would simplify the process for both consumers and providers generally and for rationalisation matters particularly. Alternatively guidelines could be produced to ensure consistency of rationalisation complaints. 4.22 What is the appropriate scope of the claims and complaints the scheme may hear? Should it be limited to assessing claims for monetary compensation? If the scheme may determine compensation amounts, should it be subject to some sort of cap? If the scope of the mechanism were wider than monetary compensation, what types of remedies should the 9
scheme be able to impose? How long should the right to claim compensation endure after the product rationalisation has occurred? All beneficiaries should have the right to make complaints about any part of the product rationalisation proposal or transfer. However from a practical perspective these should first go to the product provider initiating the proposal and it is only if the complaint cannot be satisfactorily resolved that it should go on to the arbiter. For complaints made after the proposal has been approved the only recourse should be monetary compensation for economic loss (and reasonable costs of the complaint). However prior to approval it should be possible for an objection to result in a change to the proposal. The time limit for compensation should be consistent with that for customer complaints generally. 4.23 Who should bear the costs associated with the operation of the entity and the compensation awards? Should it be the product providers, the schemes or funds, or should there be some measure of sharing, and if so what should it be? We believe that the product provider should bear the costs of rationalisation (i.e. producing the proposal, approval process, communication, implementation and compensation). Commercial entities are better placed to bear short term costs in return for longer term benefits. However for this to be reasonable the process should be efficient and not have a significant cost overhead and the provider should have first call on the efficiency benefits achieved 4.24 Which parties should bear or enjoy the costs and benefits arising out of product rationalisation transfers? This has been covered in section 4.23 above. 4.25 Should there be a special mechanism for resolving the problem of high exit fees? If so, what should it be? Exit fees should be addressed through the equivalence test on a case-by-case basis. For some legacy products it may be possible to replace exit fees with a more acceptable alternative, but on others the exit fees may need to be replicated under the new product. 4.26 Alternatively should exit fees be addressed as part of the equivalence test? Yes. This has been covered in the point above. 4.27 Do you think that regulatory action is required to achieve a reduction in the rate of creation of legacy products, and if so what specific measures would have to be adopted? 10
The financial service products that are the principal concern of this paper are those issued under a legal enforceable contract or deed, and where the provision of the insurance, investment and other services under that contract or deed span a number of years (potentially beyond 50 years in some cases). Legacy product issues arise where the environment in which those products were issued changes so that the original product is no longer suitable or attractive to consumers. Such environmental change can result from many circumstances: Many changes are a result of government reform of the legislative and regulatory environment. It would be short sighted to assume that these drivers will not exist in the future. Other changes arise from economic and technological developments. As with any industry, advances in product and delivery of financial services have occurred in the past and will continue in the future. The only practical, contractual way to deal with such change is for the provision of products with sufficient freedoms for providers to unilaterally change the product terms or migrate consumers out of the products as they become outdated. However, while this would overcome the legacy product problem, it would be the detriment to the economy and consumers. These new products would be inequitable and would not provide sufficient consumer protection as longer-term guarantees or undertakings to consumers have been effectively removed. If a provider can undo long term guarantees and undertakings at its option, then consumers and the economy effectively lose access to such guarantees. The best way to balance the desire for access to longer term guarantees and undertaking with a practical way to evolve the underlying contracts over time is a legal mechanism that: Allows long term contracts to be issued now in good faith, with clear promises and guarantees based on the current environment; but Allows those contracts to be steered over time, through the changing environment, via legislative permitted alteration of the contracts based on maintaining reasonable economic equivalence of terms and outcomes for the contract owners (the consumers). Such a structure reflects the product rationalisation mechanism proposed. 4.28 What action do you think that businesses could take to reduce the rate of creation of legacy products, thereby lessening the need for government intervention? What measures could be taken to encourage businesses to adopt such practices? As above. The only practical options are either to not provide the products that consumers need or to build the proposed legislative restructure mechanisms and controls into new products and contracts. However, this approach would have a number of risks, uncertainties, 11
complexities and inconsistencies from provider to providers and likely provide less overall consumer protection for no overall industry or economy economic gain. A well designed legislative rationalisation mechanism with adequate protection for consumers (which itself can be updated and enhanced over time) provides a good framework for product providers to provide the product with undertakings and guarantees that consumers and the economy want, while managing and reducing the volume of legacy products. 4.29 Do you think that beneficiaries of existing managed funds into which beneficiaries of legacy products are transferred require special protection measures? In the Institute s model the arbiter would consider the impact on all beneficiaries impacted by the proposal. This would include transferring beneficiaries and beneficiaries in the receiving fund. There will be products where the security of the beneficiaries in the receiving fund may be altered, but for others the impact may be minimal. We think that a holistic model that assesses the impact on all beneficiaries is sufficient and special protection is not required. 4.30 What are the specific problems posed by participating policies, and how should they be addressed? Participating policies do not require special treatment as the Institute s model is designed to cater for these policies. However they do require special consideration. Participating policyholders rights and benefits are complex and their reasonable expectations need to be considered. The Appointed Actuary would be required to advise on whether the transfer from a participating product is equitable and would also consider the impact on policyholders in the receiving fund. The Institute s model is structured so that the arbiter would assess the fairness and equity of the proposal for all beneficiaries, those that remain in associated products and funds, the transferring beneficiaries and those that are in the receiving fund. 4.31 Are there any other issues that need to be considered? How should they be addressed? In considering the operation of the model proposed in section 3. above, the Institute s task force has developed a detailed operating model for discussion. This focuses on guidance on the considerations when testing whether a proposal is fair and equitable. 5 Options In our submission to the Commonwealth Government in November 2006 we suggested that an independent arbiter should assess and approve the proposal. The arbiter should be able to 12
clearly show independence and be a recognised expert in assessing the effectiveness and fairness of such proposals against criteria and principles defined in the legislation. Experts would be appointed to advise the arbiter on the impacts of the proposal on affected consumers and beneficiaries. We feel that it is important that the entity assessing the proposal should be independent of the entity proposing the rationalisation, to ensure that the process and outcomes are reasonable and fairly protect consumers interests. We do not believe there is a need for the regulator(s) to explicitly approve a proposal if there are sufficient checks and balances in the process. However, we do believe that timely notification of the proposal to the relevant regulator(s) is appropriate to allow the regulator to comment before the proposal is approved. This approach is similar to that proposed in the Issues Paper under Option 5 in that there is a body which is qualified to assess the impacts on beneficiaries and assess whether the proposal is fair and equitable. We think that commercial entities (independent of the providers) would be able to fill the role of arbiter and they would be better resourced than a tribunal to deal with the potential volume of proposals. We also believe that the trustees of a superannuation scheme are sufficiently independent to act as an arbiter where their beneficiaries are impacted. However, directors of life companies and of the responsible entity for a managed investment scheme should not be considered for the role of an arbiter. This is because they have dual responsibilities and do not solely consider the interests of members or beneficiaries. For superannuation schemes, the trust deed of the fund imposes on the trustees the fiduciary duty to represent the members interests. For this reason, the trustee would appear to be a natural choice as the arbiter for its members. There could be potential conflicts if the trustee is not chosen as the arbiter as it is assumed that the trustees will still have to approve any changes that impact their members. If there is to be a wider group of entities or individuals who can act as arbiter, then from a practical perspective the choice of arbiter should lie with the product provider, subject to the regulators agreement. We do not feel that the regulator would want to drive the selection process as this could project the image that the regulator was responsible for the acts of the arbiter. For other products run by life insurance companies, managed investment schemes and other financial institutions where there is no trustee relationship to represent the customer interests we believe that an independent entity or person who is not associated with the product provider is required. The role of the arbiter is to receive the proposal from the product provider, obtain input from expert, evaluate these materials, assess fairness of the proposal and finally approve or reject the proposal. 13
In the process, the arbiter will grant the affected consumers the right to be heard prior to acceptance of the proposal. Any objections and submissions from consumers will be assessed and the arbiter will seek to agree with the product provider on a basis or mechanism to deal with these objections and comments as a condition for the approval of the rationalisation process. The arbiter is charged with approving the final proposal as a whole but will not have to secure the agreement of the individual consumers on a case by case basis. From the provider s perspective, the arbiter will approve the proposal. The consumers will have the right to make individual claims against the product provider within a reasonable timeframe even when the proposal is approved by the arbiter. The right to litigation against the product provider is not forgone by the consumers. By comparison, a Court process would grant consumers the rights to be heard before a proposal is endorsed by the Court but as a result, it offers no recourse for consumers. On the other hand, the existing trust process confers the decision to the trustees who is the representative of the members. In such cases, the members are generally not given the rights to be heard but members can sue the trustees. We feel that the proposed rationalisation approach is a more practical approach which falls somewhere between a more formal Court process and other existing processes. 14