Products have to provide customers with value for money. Distribution activities should be unencumbered by conflicts of interest. While that sounds rather obvious, these two statements sometimes seem questionable when it comes to life insurance savings products. For this reason, the Federal Financial Supervisory Authority (BaFin) launched a consultation on 31 October 2022 on a draft guidance notice on aspects of conduct of business supervision for savings products; following the consultation, on 8 May 2023, BaFin published a finalised text as Guidance Notice 01/2023 (VA). The guidance notice is addressed to life insurance companies in Germany and abroad that are supervised by BaFin, fall within the scope of the EU Insurance Distribution Directive (IDD) and provide savings products.

The focus of the guidance notice is the product approval process. This process requires insurers to ensure that their products provide value for money in view of the needs of the target market and to set up the processes prescribed by law for this purpose (section 23 (1a) to (1c) of the German Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG) and Delegated Regulation (EU) 2017/2358). The distribution remuneration requirements that are addressed in the guidance notice (section 48a of the VAG, Delegated Regulation (EU) 2017/2359) are designed to prevent inappropriate incentives in distribution: excessively high commissions, for example, may discourage providers from giving policyholders unbiased information and advice.

Proposition 1: For the target market, the value for money received in return for the premium paid is an essential supervisory category. It requires taking the entire contract term into account. Attractive products call for appropriate value for money.

The IDD introduced the product approval process as a supervisory requirement for life insurers. In this context, value for money, which is what the customer receives in return for the premium paid, has become a crucial supervisory category. Value for money has been added as a supervisory requirement to the traditional, familiar requirements of consumer protection, which are largely set out in the German Insurance Contract Act (Versicherungsvertragsgesetz – VVG) and the German Civil Code (Bürgerliches Gesetzbuch – BGB). Unlike the duties to provide information and advice at the point of sale (POS), which pertain to the sale of insurance to an individual customer, value for money in terms of the product approval process is not geared toward the individual customer, but toward all the customers that collectively constitute the target market of the product.

With regard to savings products, particularly unit-linked products, BaFin’s guidance notice requires life insurers, when assessing the value for money, to formulate return targets, taking into account the product features and external factors (such as capital market conditions); these targets must be in line with the expectations of the target market they have determined. In this context, they should also assess whether the members of the target market seek not only a positive return after costs, but also a positive return after costs and inflation. With such products, the customers in the target market would then, as a rule, seek at least a return that is equivalent, for example, to a reasonable inflation expectation (“real investment return”). First of all, it requires that the savings phase should run its regular course. With regard to the needs of the target market, however, it is also necessary to take into account those contracts that are prematurely surrendered during the savings phase. The higher the life insurers’ expectations for the percentage of customers that surrender their contract early, the more significant the question of how the early surrender of contracts affects value for money. The guidance notice provides further information in this regard.

Proposition 2: When it comes to private pension products, costs play a key role.

If the target is to achieve, with a sufficient degree of probability, a return after costs that exceeds a legitimate inflation expectation, then it is clear: the higher the costs of the product, the more difficult it will be to achieve such a real return. For this projection, it is necessary to recognise the reduction in yield (RIY) that reflects how the annual return is reduced by costs.

Proposition 3: In view of contracts that are surrendered early, insurers should carefully review the costs of distribution remuneration over time.

The RIY indicates the impact of the costs on the annual return. In fact, however, the costs are not distributed equally over the contract term; they are usually incurred in large part early on in the term of the contract. This is because life insurers typically pay their sales partners an initial commission as soon as a contract is concluded, in the amount of a percentage of the contractually agreed total premiums of the insurance policy – even though this total premium amount has not yet been paid in full by the customer. Life insurers are thus under pressure to “refinance” themselves through their customers’ premiums as quickly as possible.

In this regard, section 169 (3) of the VVG stipulates that where a contract is surrendered, the acquisition and distribution costs applied in the calculation of the surrender values must be distributed over at least the first five years (and may not be higher than 2.5 percent of the total premiums). In cases where a contract is surrendered within the first five years, this provision mitigates the effect in the customer’s favour, since acquisition and distribution costs are normally incurred at an early stage during the term of the contract. In respect of the requirements of the product approval process, however, this provision is not conclusive on the issue of value for money.

The following extreme example illustrates the situation: a life insurer has a product that is designed to have a long-term savings phase. For this product, the insurer anticipates that 100 percent of target market participants will prematurely surrender their contracts within the first five years. It is obvious that such a product, which cannot achieve a positive yield if the contract is surrendered after only five years due to the costs incurred early on in the term of the contract, would not provide any value for money, irrespective of whether section 169 (3) of the VVG is complied with or not.

Apart from that, from BaFin’s point of view, the requirements regarding value for money do not imply any legal obligation on the part of life insurers to exceed the requirements of section 169 (3) of the VVG in calculating the surrender value where a contract is surrendered prematurely. The guidance notice likewise does not provide for this sort of legal obligation. All the same, life insurers must review the cost burden of the product also over time and examine the impact on the value for money for the target market.

Proposition 4: Kickback payments from investment companies are very dubious in terms of value for money.

BaFin observed that for about 30 percent of the new business written for unit-linked life insurance in 2021, measured in terms of total premiums (of a total of nearly 69 billion euros), either life insurers were aware of kickbacks being paid by investment companies to their sales partners or they were unable to rule out the possibility of such payments. To BaFin’s knowledge, such repayments annually constitute up to one percent of the fund assets. These are additional costs for which the corresponding value for money is dubious. Kickbacks paid by investment companies directly to sales partners are paid in addition to the remuneration paid by the insurance companies. These payments tend to have a cost-driving effect and may, in some cases, act as inappropriate incentives.

BaFin’s aim for its guidance notice is to help to ensure that savings products offer customers appropriate value for money and to prevent conflicts of interest in the distribution of these products.