24 Feb 2010
Speech by Peter Smith, Head of Investments Policy, Conduct Policy Division, FSA
European Life Settlement Association, London
Good morning ladies and gentlemen. Thank you for inviting me to speak today on regulatory priorities for the life settlement industry.
I would like to start with some thoughts about the FSA’s general approach to regulation, in particular of the retail investment market. I will then give some background on the FSA’s interest in investments backed by life settlements, talk about some of the risks and issues that we see around such products, and offer our views on disclosure and advice issues. I’ll conclude by setting out some of our expectations for product providers and for distributors.
Many of you will have seen our Chairman, Adair Turner, quoted in the press as describing much of the City’s activities in recent years as “socially useless”. Clearly this makes good headlines, but there is – as you would expect - an important point underlying it. Historically, the FSA has tended to take a benign, if not positive, view of innovation in financial services. Adair’s point is that we should be far more sceptical in considering whether innovation is in every case a net benefit, or whether benefits accrue to the innovators at the expense of everyone else.
The FSA’s approach has also been to focus on the disclosure and sales elements of the value chain in the retail investment market. Our Chief Executive, Hector Sants said in a speech at Bloomberg in November 2009 that we will increasingly need to focus on problems that have their origins higher in the value chain, and on indentifying these problems before consumer detriment occurs. So where in the past we might have concentrated on sales practices to try to ensure good outcomes for consumers, we will now intervene earlier, in product design and the marketing by providers of those products to distribution firms.
Many of you will have read that the FSA is taking a more intrusive and intensive approach to its supervision. This will apply to activities in the retail investment market as much as to activities elsewhere.
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I would like to cover the FSA’s position on the inherent risks and issues of Traded Life Policy Investments (TLPIs). We use TLPI as a collective term for any products that invest in Traded Life Policies, Senior Life Settlements or Viatical Settlements.
The FSA views TLPIs as complex products with a number of inherent risks. We do not see them as mainstream products. I was interested to note – from your Agenda – an expectation that it should be “sophisticated investors” who are entering this market – we would not disagree with this. From our supervisory work we do have some significant concerns in the way these products are brought to the market at present. We have had to take action with a number of firms already and so we would be very concerned to see a rapid increase in the size of this market.
I am aware from your Agenda that you had a session this morning that looked at ways of mitigating the risks that are involved in the products. There was quite a long list of risks:
- life expectancies;
- portfolio valuation;
- carrier solvency;
- credit;
- premiums;
- mortality;
- reputation;
- moral hazard, and
- others.
I hope that you had a productive discussion, but would like to focus on a few of these risks; they are both real and significant.
Longevity risk
An accurate estimation of life expectancy is the single most important factor in assessing the price of each underlying policy in a TLPI. Based on this, the primary risk is that the underlying policyholders live longer than expected. Medical advances can, and do, prolong life and undermine longevity assumptions. We have already seen this risk crystallise in the long-term care insurance market, where rapid advances in medical knowledge meant underwriters had mispriced the inherent longevity risk. Premiums were revised upwards dramatically, destroying the market. The profile of those policyholders most likely to sell their life policies in the US secondary market means that these are the very people whose life expectancy is likely to change significantly with medical advances.
Let us be frank here: accurate assessment of longevity risk is difficult. The largest insurers and life insurers in the world struggle with this. We have seen defined benefit pension schemes sell their longevity risk to investment banks, including Goldman Sachs and Deutsche Bank, because the pension schemes are too uncertain about their ability properly to assess and manage longevity risk.
I would not want people in this room to think that this is straightforward.
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Volatility of returns
Assuming there is sufficient diversification in the fund and actuarial calculations on longevity are accurate, volatility in terms of performance should be low. However, experience has shown that there is a real risk of a lack of diversification of policies. Many of you will be familiar with the Shepherds Select Fund. This was the first in the UK to invest in this asset class, but the fund’s management team was not able to buy enough whole policies to gain a sufficient risk spread. The fund collapsed in May 2005 and left UK investors facing losses of approximately £22 million.
Liquidity risk
Despite the size of the US traded-life policy market, as a tradable asset class the underlying investments are rather illiquid due to their specialised nature. The underlying policies –by definition- only yield reward over time. Many TLPIs run for fixed terms. TLPIs must also meet the ongoing premiums on the policies they hold. This must be planned for and money kept to meet this need.
Counterparty risk
As with structured products, there is an equivalent counterparty risk if the insurance company becomes insolvent and is unable to meet the death benefit claims.
Potential for loss
Should actuarial calculations on life expectancy be wrong, there is the potential for significant capital loss where expected returns are not paid on time. Should an investor require access to capital during the product term, this may lead to a loss of capital.
Finally, there is a very practical question over how well the process works to track the death of the life assured if the family no longer has an interest in the proceeds.
Already these risks mean that we have had to enter the market to take action. Firms are not achieving good customer outcomes on their own and we are concerned at the number of problems we are finding. Obviously, I cannot go into detail about these problems here, but I can say that we have identified major flaws in the marketing of the products. It is simply unacceptable to produce complicated products and downplay the risks to customers.
I’d like to move on to these disclosure and advice issues in more detail. This is an area the FSA has been monitoring closely.
As many of you are aware, there are six Treating Customers Fairly outcomes. The second consumer outcome is that products and services marketed and sold in the retail market are designed to meet the needs of identified consumer groups and are targeted accordingly.
The risks I have mentioned need to be taken into account in product design. TLPI providers are responsible for ensuring appropriate risk mitigation strategies are in place at the early stages of design. This includes performing due diligence on counterparties, ensuring robust controls are in place to track the underlying assets and that the maturity model is realistic in being able to achieve income or capital repayment at the stated time. Finally, provider firms know most about these risks and have a role to play in educating advisers.
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Provider firms must have systems and controls to ensure that their products are well designed. This leads to a number of questions. Who is the target market? How is the product stress tested? How do firms ensure their product is suitable for the end user? Are there any systems in place to check up on sales and to make sure that the target customers are the ones receiving the product? Are any high levels of execution-only sales being identified and investigated?
Put bluntly, if you can’t answer all of these questions properly, you shouldn’t be launching the product.
Some of you may be involved in the distribution of TLPIs in the UK market, promoting these products to the IFA market, who then advise their clients to invest. Treating Customers Fairly requires firms involved in the distribution of TLPIs to consider fully the impact on the end user, the consumer purchasing the product.
We have identified that the compliance regime in firms governing the distribution of these products has the potential to be weak. It is never enough to assume that it is the adviser’s responsibility alone for advising their clients and delivering compliant and suitable recommendations to invest in the products. Our work on the shared responsibilities of providers and distributors emphasises this. Both groups have responsibilities to the end customer.
We expect provider firms to gather and analyse management information tracking where its products are sold, together with indicators about its suitability for clients. Providers should be gathering, analysing and acting on appropriate management information regarding the way their products are distributed, to minimise the risk of products being missold, inadvertently or otherwise. Firms should also satisfy themselves - on an ongoing basis - that adviser firms have adequate systems and controls (for example, verifiably robust quality-of-advice checks) which enable them to demonstrate that products are being sold appropriately. Provider firms should also carry out analysis identifying which advisers do comparatively more business, so that they are able to manage efforts to monitor the extent to which TLPIs are being sold compliantly.
We would agree that providers are not responsible for another firm’s advice to the end customer, but they have a duty to help the distributor sell the product and achieve good customer outcomes. All firms must help ensure that the customer’s best interests are served. From a business point of view, firms that do not do this will be exposed to significant reputational and commercial risk if customers find that the product they hold does not work as promised.
Providers also have a responsibility to ensure that their products are explained to IFAs in a way that is fair, clear and not misleading. If this is not done, there is a possibility that advisers misunderstand or misrepresent the products to their clients, which in turn has the potential for consumer detriment. If we find this has happened, then this is a problem for the adviser, but we would also have concerns about the way the product is being presented to the adviser.
We are concerned that some providers are not proactively highlighting the particular risks with this type of investment to advisers, instead supplying them with only basic information and awaiting further questions. If individual complexities and risks are not being adequately explained to IFAs, there is a risk that important features of the products may not be relayed to customers.
I have mentioned stress testing of products. Providers need to understand in which circumstances the product will deliver as expected and, crucially, in which circumstances this does not hold true. They also need to take a realistic view of the likelihood of these different circumstances materialising.
I have heard a fund provider say that “the product was a good product, it was just that the market moved against us” as if the performance of underlying assets or markets should be seen as a surprise. The product provider also needs to make clear to any distributor their expectations of the situations in which the product will and will not deliver.
Linked to the previous point, many advisers will gain the majority of their product understanding from provider literature. Advisers rely on this material in order to be able to describe the products accurately to clients, as part of their obligation to recommend products that are suitable for their clients. We have seen instances where the financial promotions, marketing materials and other information designed and approved for use by IFAs and their clients have fallen well below the standards we require.
We also have concerns about the general quality of marketing literature from providers. We have seen examples of promotions that feature a description of the benefits of TLPIs and do not provide sufficient information on the risks. We have also seen promotions that feature risk warnings that lack prominence or were of insufficient detail. Finally, there is a risk of unrealistic performance illustrations due to fund managers manipulating valuations by using shorter life expectancy figures to calculate future payouts. This is an area we are monitoring closely.
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Some of you may be active in advising clients to invest in these products. As TLPIs target relatively high returns which are uncorrelated with other asset classes there is significant potential for marketability by intermediaries. However, there is - again - a risk that a lack of understanding by intermediaries may result in unsuitable sales. If you do not understand the product, you should not sell it. We have seen far too many market problems arising from advisers selling products they have not properly understood.
As I have said, we regard these products as complicated and facing specific risks. Advice to use these products must be in the best interests of customers and should take account of the product complexity and risks. Given the extra risks and complexity here, we would expect close analysis to make sure that the advice is truly suitable.
One of the features we have observed of structured product sales - more generally - is a tendency for too great a proportion of a client’s assets to be invested in such assets. This is a matter of great concern to us and we would not expect to see significant proportions of any client’s portfolio invested in TLPIs.
I’m sure that over the course of your discussions you have talked about the features of TLPIs that make them the right product for investors. The product should, it might be argued, stand or fall on its own merits.
So it is a matter of great concern to us that we see commission rates being offered to advisers which are well out of line with market norms.
I would ask the providers in the audience – if it’s such a good product, why do you need to pay people so much to sell it?
I would ask the advisers in the audience – can you be certain that what you are recommending is in your client’s best interests, given the amount you stand to gain from the transaction?
As you know, as part of our Retail Distribution Review we are proposing to ban the payment of commissions to advisers by product providers. We believe this is the right solution in the retail investment market, so seeing relatively new product types emerging paying significant commissions is a matter of great concern.
In the run-up to the introduction of the RDR, we are monitoring the use of high commission rates in the market more generally, but including for TLPIs. It is not long now until the RDR comes into force and we would expect advisers to be thinking about how they will change their business models to adapt to its proposals, including adviser charging. Taking high levels of commission from these products in the interim does not send us the right signals at all.
My concluding remark is that the TLPI market is one in which the FSA has particular interest. We do not see it as mainstream and our work to date has found significant problems in it.
We expect providers to be clear about the target market for their products, to understand when the product will and will not perform, to disclose and explain all of this clearly to distributors, and to monitor what actually happens. If you don’t know who your target market is, you shouldn’t be bringing a product to market.
We expect advisers to understand the risks inherent in TLPIs, to explain these fully to their clients, and to recognise that these products are unlikely to be suitable for many clients:
- those who have specific investment goals so should not be put at risk of substantial capital loss;
- those who may need to realise their investments quickly;
- those who do not already have a diversified portfolio;
- those who do not have a sophisticated investment approach;
the list goes on, but I’m sure you can see the point I am making here.
We are monitoring the provision, marketing and uptake of these products. Where we have discovered issues with the firms involved in the production or distribution of these products in the past they have been subject to supervisory actions and, where necessary, enforcement proceedings. This is an approach that we will continue to pursue in future.
Thank you for your time
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