Insurance Renewals: FCA Takes Aim At Loyalty Penalties

Remediation Options Cause A Stir

Although the report does offer softer options for remediation–such as improving disclosure regarding the pricing differentials between customers and strengthening governance requirements–it specifically states that remedies could be more “interventionist.” We consider that this represents a significant shift in the regulator’s language.

To date, the FCA has shied away from direct involvement in pricing in the insurance industry. Instead, it favored “nudging” consumer behavior through increasing information and awareness (see “Are U.K. Motor Insurers’ Changing Business Models Inviting Conduct Risk?” published Oct. 24, 2018). However, the potential remedies listed in the interim report include:

• Restricting or banning insurers from offering new customers that are likely to renew a low initial premium, and raising the cost in subsequent years; and
• Automatically switching consumers currently paying high prices to lower-priced products that provide equivalent cover.

It seems likely to us that the FCA will choose to intervene in the market, but will only restrict some of the worst pricing practices. We do not expect it to take the nuclear option of banning all differentials between new and renewing business. That said, the FCA faced criticism for its handling of the Woodford Funds Issues. Its newly appointed interim CEO, Christopher Woolard, may choose to take a harder line.

Controls Are Unlikely To Harm Profitability

The FCA has estimated that customers who have been overpaying for their car and home insurance could save a combined £1.2 billion a year. It also estimated that home and motor insurance markets are worth a total of about £18 billion. On a very simple basis, if £1.2 billion of premium were taken out of the market, the gross combined ratio across these two product lines would deteriorate by 6-7 percentage points. However, we do not anticipate that the FCA will ban differential pricing entirely.

In our view, it is more likely to restrict the size of the differential by capping the multiple paid by renewing customers, compared with new business customers. The industry is also likely to react to any restrictions on renewal pricing by increasing premium for all customers.

The motor market demonstrated this recently, with its rapid response to legal changes in the discount rate over the past three years. According to Consumer Intelligence, a consumer research group, after the Ogden rate fell in 2017, motor premium increased by nearly 16% (see “Hazard Warning: Lower U.K. Discount Rate Will Push Up The Cost Of Car Insurance,” published Feb. 16, 2017).

Most of the insurers affected by the FCA’s decisions will also have been modeling different outcomes to gauge their pricing response. As a result, we expect the implementation of controls to have a very limited impact on profitability across the entire market. That said, individual insurers could be hit harder.

Who will lose out?

• Insurers that rely heavily on significant back books of business with low attrition rates could see profit margins shrink significantly.
• Insurers that sell their products through distribution agreements with well-known household brands may suffer because the FCA’s research showed that customers who paid high margins typically put more faith in trusted brands and preferred not to buy their insurance online.
• Insurers that use sophisticated lifetime pricing models and have aggressively underpriced new business, intending to increase margins in future years, may find it harder to recoup the high cost of new business acquisition.

Not all insurers rely on renewals

Customers already tend to shop around for motor insurance more than they do for home insurance, favoring those whose books are more focused on motor than on home insurance. In particular, those competing at the higher-risk end of the market (typically younger drivers) are likely to be less affected–this part of the market suffers high attrition rates anyway. As none of our rated insurers have U.K. home or motor books that dominate their portfolios, we do not expect any FCA policy interventions to trigger any rating actions.

How Will Firms Respond?

New customer-friendly products could reduce the social risk

Some key market players had already responded to their social risk, ahead of the FCA’s interim report. Aviva introduced “Aviva Plus,” a product that guaranteed customers the same or a better price at renewal than a new Aviva Plus customer. The product also offers monthly payments at no extra cost, and no administration or cancellation fees. Saga, which targets customers over 50 years old, has also launched a product that has a three-year fixed price.

The initial price for both these products is likely to carry a higher-than-normal margin. However, they offer customers peace of mind over renewal quotes. Saga’s product will also increase underwriting risk slightly because it will be unable to increase rates in response to any significant inflation in claims costs. We expect more firms to start to offer these “loyalty friendly” products for customers who do not wish to shop around at renewal. That said, those who have the energy to test the market at renewal each year will likely still see a price benefit.

Most will increase rates on all business

If the FCA squeezes the margins insurers make on renewing customers, we anticipate that the most likely response from insurers will be to raise premium across the board. For a long time, margins on core underwriting in the U.K. have been much smaller than those for continental peers. Largely, this reflects the role of price comparison websites (PCWs), which have increased the focus on price in the U.K.

The FCA estimates that in the U.K., the margin on an average motor insurance premium of £299 is just 0.7%; home insurers make just 3.4% on an average premium of £231. Given that the FCA seems to be clamping down on practices that produce poor customer outcomes, we believe it is likely that, over time, U.K. insurers will increase margins on new business, bringing combined ratios more in line with those of Western European peers.

Increasing income from other sources would be a risky choice

If the regulator decides to intervene by capping the differential between new and renewing business, insurers may be tempted to try to maintain current pricing levels by increasing other sources of income. Alternative income sources include:

• Charging extra when customers choose to pay by monthly installments, rather than in a lump sum;
• Add-on products like key cover and personal accident cover; and
• Administration fees for making changes to your policy such as adding a new driver or moving house.

The FCA have addressed all these potential sources of income in recent years, with a particular reference to the questionable value for money they offer consumers and in relation to treating customers fairly. Given the FCA’s focus on these areas and the social risks that come with exploiting these ancillary sources of income, we consider it a risky strategy to pursue.

Insurers could also try to strip down their core policies to the bare minimum in terms of coverage. Although this could help insurers limit price increases and so maintain market share, the FCA warned against this response in its interim report because of the poor outcome for consumers.

Fierce Competition Encourages Business Models That Raise Social Risk

Although U.K. home and motor insurance does not seem an obvious place to start looking for social risk, the sector’s business models have increasingly courted conduct risk. About 70% of new motor business is now generated from PCWs, and 50% of new home business.

As a result, the U.K. motor and home market is now highly commoditized and customers chiefly focus on the cost of cover. Insurers competing in this market aim to maintain low premium, as recorded on PCWs, and have used alternative income streams to make up for a lack of margin in their core product. In its interim report, the FCA estimates that motor insurers make £3-£110 per policy on premium financing. Research from Which?, a consumer research organization, shows that the annual percentage rates (APRs) charged by different insurers vary significantly (see chart 3).

Vulnerable consumers overpay the most

To a certain extent, these business models have become accepted in the market. Savvy customers know the importance of shopping around at renewal and opting out of additional sales. However, the FCA’s work on identifying those paying high or very high margins highlights further increased social risk for insurers. Its analysis makes uncomfortable reading for those investors considering social factors in their investment decisions.

Perhaps unsurprisingly, those paying higher margins tend to be older customers. That said, 17% of those paying high or very high margins are under 35 years, generally a more internet-savvy generation. When the FCA examined the cohort paying high or very high margins more closely, they found that 37% of those paying over the odds were considered vulnerable customers (or potentially vulnerable). These customers are those that have one of following four characteristics:

• Health conditions or illnesses that affect someone’s ability to carry out day to day tasks;
• Have suffered a major life event, such as bereavement or relationship breakdown;
• Low ability to withstand financial or emotional shocks; or
• Low knowledge of financial matters or low confidence in managing money.

In addition, consumer champions have pointed out that charging higher prices to those paying by installments unfairly burdens those who can least afford it. Lower-income households are less likely to be able to pay their car insurance as a lump sum. Paying via installments can often attract significant APRs (see chart 3).

A Nudge In The Right Direction

ESG is becoming a bigger issue for investors and boards and the public’s perception of a firm’s behaviors increasingly plays an important role in its sales strategy. Therefore, insurers may not need FCA action to be convinced of the benefits of a more customer-friendly approach.

Related Research

• Are U.K. Motor Insurers’ Changing Business Models Inviting Conduct Risk? Oct. 24, 2018
• Hazard Warning: Lower U.K. Discount Rate Will Push Up The Cost Of Car Insurance, Feb. 16, 2017
• European Motor Insurance Markets Are Not Swayed By The U.K. Price Comparison Revolution, Oct. 4, 2016