High costs reduce the returns of insurance-based investment products and diminish their value for money. This can be a sign of shortcomings in product oversight and governance (POG). After a BaFin survey revealed indications of considerable deficiencies, the supervisor has, as part of its efforts to strengthen conduct of business supervision in the insurance sector, examined several providers in the insurance industry for whom there were particular indications of possible shortcomings.

In May 2023, BaFin published a Guidance Notice on Aspects of Conduct of Business Supervision for Savings Products, setting out its expectations towards insurance companies. Alongside solvency supervision, which focusses on insurers’ stability, BaFin’s conduct of business supervision is intended to ensure that insurers take adequate account of the value for money of their products.

The work of BaFin’s insurance supervision sector has already resulted in notable improvements for consumers: some products that do not provide appropriate value for money have already been removed from the market. There have also been cost reductions for existing customers, alongside retroactive compensation measures.

BaFin has already conducted detailed inspections of 13 life insurers, which make up more than 20% of the market. The inspections focussed on private pension products. These products are particularly significant, both for individual customers and for society as a whole.

They are predominantly sold with long accumulation phases, sometimes lasting decades. But not all customers are able to keep paying their premiums for the full term of their contract, meaning they terminate their policies early (see graph below). With a lapse rate of 3.14% over a 40-year accumulation phase, 70% of policyholders will decide to terminate their policies early.

Development of the customer portfolio for unit-linked life insurance products*

Source: BaFin

*The graph is based on an annual lapse rate of 3.14%, as was determined for unit-linked life insurance products in 2022, and assumes a constant lapse rate regardless of policyholder age or time elapsed since the policy was taken out.

Early surrenders increase the reduction in yield, i.e. the reduction in annual yield as a result of costs. One reason for this is the distribution of acquisition costs throughout the term of the policy. Since commissions for insurance distribution, which are paid at the beginning of the policy, make up a large part of acquisition costs, life insurance companies place a significant cost burden on their customers at the start of their policies. This means that providers retain a disproportionately high proportion of premiums in the first years of a life insurance contract in order to cover their costs, and these funds are therefore not counted towards the policy account value.

Furthermore, in the calculation of costs for unit-linked life insurance products, a portion of the costs is commonly incurred as a percentage of premiums, which also typically raises the reduction in yield when policies are terminated early. If the policyholder keeps their contract until the end of the planned accumulation phase, the higher costs in relation to the policy account value incurred in the first few years of the policy are offset by lower costs in later years. This effect is lost if the contract is surrendered early.

Formal shortcomings

BaFin’s examinations revealed formal shortcomings in product oversight and governance. Providers showed deficiencies in their product oversight and governance policies. Insurers must draw up such internal guidelines to set out the requirements for the product-specific product approval process. The product approval process itself was also affected. The process must be carried out for each new insurance product and each material change made to an existing product.

In February 2018, BaFin published an expert article on the contents of the “product oversight and governance policy” that product manufacturers are required to produce. Several of the life insurance companies BaFin has since examined have failed to comply with the guidance in this article. For example, issues were identified in the way companies define “material changes” to products, which trigger a product approval process.

In the cases in question, documentation of the product approval process contained only vague descriptions of the target market. There was little indication that the specific characteristics and needs of members of the target market had been given closer consideration. BaFin is investigating the shortcomings it has identified.

Products suitable for the target market?

A more serious shortcoming is the fact that life insurers, as product manufacturers, have as yet failed to meet the requirements of the Guidance Notice on Aspects of Conduct of Business Supervision for Savings Products.
Product manufacturers are required to determine a target market, and their products must meet the needs of customers, belonging to the target market. Only then do products provide appropriate value for money.

To offer appropriate value for money, a product does not necessarily have to provide a financial benefit for each individual customer. Value for money is instead assessed based on the value provided to the target market as a whole. Product manufacturers must set out return targets for the respective target markets. Their products must be sufficiently likely to achieve the return target.

In particular products with a long accumulation phase are increasingly being terminated early by customers. Product manufacturers must therefore set out their lapse expectations for the accumulation phase. At what point in time are half of the members of the target market expected to have surrendered their policies early?

The insurance-based investment product in question must provide appropriate value for money for all members of the target market that surrender their contract from this stage onwards. The product is otherwise not deemed suitable for the target market. If early termination of the contract reflects the needs of customers in the target market, which requires the company to raise its lapse expectations, the distribution of costs over time may also need adjusting.

Very high reduction in yield

For products offered by several of the companies reviewed, the reduction in yield at the relevant point in time equalled or considerably exceeded 4%. For customers to make a positive return, these costs must first be earned. In the current market environment, this seems very ambitious. Insurance companies must therefore carefully review whether the target return for the target market is sufficiently likely to be achieved.

As part of its inspections, BaFin also noted the very high lapse rates for products offered by certain insurers. In some cases, half of all customers had surrendered their contract within the first few years. Since most costs are incurred during the early phase of a policy, the products reviewed by BaFin resulted in high losses for the majority of customers. These products do not provide appropriate value for money.

Review of reimbursements

During its inspections, BaFin also focuses its attention on individual cost items. These too must be appropriate. For example: the reimbursements paid by investment companies to the insurance company’s sales partners in the case of unit-linked products. If these additional costs are not coupled with any added value for customers, then there is no appropriate value for money.

Distribution outside the target market

Within their system of governance, companies must ensure that their products are distributed to the identified target market. An elevated lapse rate can indicate that a product is not being distributed to the intended target market.

If the actual market targeted does not correspond to the target market identified as part of the product approval process, then the life insurer, as product manufacturer, must determine the reasons for this. Normally, they will be required to temporarily suspend sales of the product in question. They must then make adjustments to the definition of the target market, to their actual distribution practices or to the product itself, or withdraw the product from the market.

What constitutes an irregularity?

If a product does not provide appropriate value for money, or if it is sold outside of the target market, this constitutes an irregularity within the meaning of section 298 of the German Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG). BaFin may take any action in respect of a life insurance company, the members of such a company's management board or other members of the senior management that is appropriate and necessary to prevent or remedy irregularities (see section 298 (1) sentence 1 of the VAG).

BaFin can, for example, prohibit the life insurer from continuing to distribute certain products. BaFin can also order companies to cease using certain distribution channels or terminate their cooperation with specific insurance intermediaries.

In the case of unit-linked products that do not provide appropriate value for money, the companies in question may be required to offer their customers the opportunity to switch to lower cost funds (or share classes) with comparable investment strategies.

BaFin can issue warnings to managers

If BaFin identifies irregularities with regard to value for money, this may cast doubt on the qualifications of the life insurer’s management board members. In this case, BaFin may, for example, issue a warning (see section 303 of the VAG).

If the insurer in question is part of a group, then improvements should be made at the group level.

If, in the past, the insurer has sold products or investment options (funds as part of unit-linked products) that do not offer appropriate value for money, or if the insurer has distributed such products outside of the defined target market, then they must examine how they handle policies that have already been taken out and policies that have already been surrendered. BaFin will carefully monitor companies’ practices.

FAQs with answers to further questions about the Guidance Notice on Aspects of Conduct of Business Supervision for Savings Products can be found on the BaFin website.