Practice

The "Treating Customers Fairly" Principle in the insurance regulatory framework

December 2023

The “treating customers fairly” principle runs like a golden thread through the tapestry of the insurance regulatory framework.

Section 90 of the Insurance Ordinance and the Codes of Conduct expressly require licensed insurance intermediaries to treat customers fairly. Guideline on the Corporate Governance of Authorized Insurers (Guideline 10) provides that “fair treatment of customers is an important concept and should form an integral part of an authorized insurer’s business culture, business strategies and internal controls.” Since directors, controllers and key persons in control functions of insurers are responsible for the business culture and internal controls of the insurer, it is part of their responsibility to ensure the companies they work for treat customers fairly. The same goes for responsible officers of insurance agencies and insurance broker companies.

This is all well and good, but what exactly does “treating customers fairly” mean?

Search the Insurance Ordinance, the IA’s Guidelines and Codes and you will find no definition. But “treating customers fairly” is not just a soundbite or hyperbolic slogan. It is the very core objective of insurance regulation and the lens through which the IA considers virtually every conduct matter.

The "invisible hand" of the market

Insurance practitioners always talk about the “market”. Listen in to their discussions and you will catch snatches of conversation about where the market sits on premium rates (“hard” or “soft”), how it will respond to loss events, whether levels of capacity are expanding or shrinking and news and rumours about major new appointments and potential movements. This is the soundtrack of the Hong Kong insurance market, which is exactly that: a market in which sellers of insurance (insurers, insurance brokers and insurance agents) are matched with buyers of insurance (potential policyholders), through supply and demand.

The market mechanism of supply and demand sees price points responding and terms and conditions adjusting to the infinite insurance buying decisions constantly ongoing. Adam Smith, the 18^th century philosopher who founded the “market” concept, called this the “invisible hand” allocating resources in the most optimal manner, driving competition and stimulating innovation.

The market dynamic also spontaneously incentivizes suppliers to display good conduct to generate trust from buyers to purchase the services on offer, and to renew their purchases the following year.

No market is perfect

Why then is regulation needed, if the market already operates to allocate resources efficiently, stimulate innovation and spontaneously generate good conduct?

Because no market is perfect. Like the human beings who are the actors in it, a market is replete with imperfections and imbalances that if left unchecked could result in unfair outcomes for buyers. Regulation is needed to set parameters, standards and guardrails for suppliers to counteract these imperfections and imbalances and ensure fairness for customers. No one understood this more than Adam Smith himself who, as well as being a professor of moral philosophy served as the Commissioner of Customs for Edinburgh and was thereby, himself, a regulator.

Like all markets, the insurance market comes with inherent imperfections and imbalances.

Imbalance of knowledge and expertise: Insurance is a complex product dependent on actuarial risk evaluation, a subject within an insurer’s knowledge, but beyond that of an average customer.
Asymmetries of information: Whilst insurers may draw on vast pools of data and expertise, customers do not have this luxury or resource. This gives rise to asymmetries of information between sellers and buyers.
Imbalances in bargaining power: On the retail side, large insurers have more bargaining power than the consumers they serve.
Conflicts of interest: Commission levels can create economic conflicts of interest that may skew selling in favour of certain products that may not be optimal for a particular customer’s needs.
Imbalances in timing: The very nature of insurance means there is a significant time gap between the customer paying premium and the insurer having to perform its obligations (sometimes many years later) under the policy. This exposes customers to changes in strategy and management at the insurer over time, which can affect the quality of servicing of their policies.

If left unchecked, these imbalances and imperfections could result in an unlevel playing field resulting in unfair outcomes for policyholders. So there is a need to subject suppliers of insurance to regulation, to restore balance, ameliorate these market imperfections and ensure customers are treated fairly. That, in a nutshell, is the objective of regulation and the meaning of the “treating customers fairly” principle.

How "treating customers fairly" applies in practice

So wide-ranging and embedded is the “treating customers fairly” principle in the insurance regulatory framework – it is referenced over 80 times in the Insurance Ordinance, Guidelines and Codes of Conduct - it is impossible in the scope of a single article to identify all its applications. For the purposes of explaining it, and how the IA takes account of it in its conduct supervision work, however, we provide the following selected examples.

Evaluating an insurer’s corporate culture

Many of the specific rules prescribed in the insurance regulatory framework aim to implement the “treating customer’s fairly” principle in given situations. For example, the requirement for intermediaries to carry out a financial needs analysis to fairly identify the customer’s needs for life insurance before making any recommendation. As an overriding principle, however, “treating customers fairly” also serves as a behavioral ethic that must be constantly displayed by every individual practitioner across all dealings with customers (even if there is no specific rule that applies in a given situation). The principle must also be embedded in the culture of every insurer, broker company and agency and the market as a whole.

When the IA carries out a conduct inspection of an insurer, a key aspect it evaluates is the insurer’s corporate culture and the extent to which this is imbued with a “treating customers fairly” mindset.

Culture refers to the collective values, attitudes, and norms shared by the people working for and representing the insurer, including its licensed insurance agents. In assessing culture, the types of questions we consider are:

Does the insurer have a code of conduct or values statement setting out the values it expects all its employees and agents to display when dealing with customers and does this demand that customers be treated fairly?
Are these values set by the board of directors and senior management and cascaded down through regular communications?
Are the values reflected in the strategic decisions made by the board so it is setting the right “tone from the top” and not saying one thing but doing another? Is there evidence of the culture and customer fair treatment being discussed in the board minutes? Is there any board committee assigned specifically to consider, drive and monitor the corporate culture of the company?
Is culture monitored through conduct indicators such as complaints, persistency/renewal rates, claims rejection rates, post-sales call statistics, CPD attainment, turnover and disciplinary statistics? Are staff surveys or agency surveys carried out to assess culture?
Are the values reflected in the insurer’s remuneration structure and performance evaluation metrics?
How are values cascaded down through the agency hierarchy? Are there regular meetings between senior management of the insurer and senior agency leaders to assess culture within the agency districts and teams?
Does the insurer have in place an effective whistleblowing policy?

These items offer hard evidence of the state of an insurer’s culture. But perhaps more valuable in assessing culture are the open discussions we have with management, staff and selected agents from all different levels and also by being present on-site during the inspection for a period of time, so a full “feel” for the insurer’s culture can be obtained.

Product Development

Whilst major commercial customers will often play a full part in the negotiation of terms and conditions in their insurance policies (which will be bespoked for their needs), for retail customers (individuals and SMEs) the situation is different. Volume breeds standardization, such that customers at this end of the market are offered insurance products on set terms and conditions on a “take it or leave it” basis. These retail insurance products are formulated unilaterally by insurers through their product design processes with no direct customer participation. As a consequence, a potential imbalance in bargaining position exists.

The “treating customer fairly” principle addresses this by requiring the insurer to take full account of the customer’s viewpoint and reasonable expectations in its product design process. There are specific requirements for product design in Guideline on Underwriting Class C Business (GL15) and Guideline on Underwriting Long Term Insurance Business (other than Class C Business) (GL16) on long term products and Guideline on Medical Insurance Business (GL31) on medical insurance products, but many of these provisions are common sense requirements that should apply to the design of all retail insurance products.

During our conduct inspections, when reviewing the product design process, we look for the presence of robust challenge from the customer viewpoint in the process itself. Insurers are expected to take full account of policyholder reasonable expectations, which involves asking and answering the question: “What realistic expectations should a retail policyholder have with regards to the coverage and benefits provided by this insurance policy”?

After answering this, the insurer can (and should) ensure that its product brochures, marketing materials, illustrations, and training of its agents, are calibrated to communicate clearly and manage expectations with its customers from the outset. Insurers and their agents must be honest about the limits of the product, not overpromise, convey risks in an understandable manner, and place customers in a position where they can make informed decisions.

Clear, simple, non-technical wording of brochures, policies and all communications with customers is crucial in this respect. Knowledge and expertise is vital in the insurance industry, but viewing matters from the customer’s perspective involves putting this knowledge and expertise aside (and being careful not to subconsciously assume knowledge on the part of the customer). Insurers must look at the wording of the materials and illustrations from the perspective of a lay person and ask: Would this be understood and how would it be understood?

Practices such as collating lessons from complaints and customer feedback or taking soundings from customer focus groups can assist in guarding against assuming too much or too little knowledge on the part of customers and help the insurer calibrating “policy holder reasonable expectations” in the product design process. When asked: what are “policyholder reasonable expectations” with this product? The insurer should be able to articulate the answer.

The IA’s complaints statistics indicate that insurers should pay particular attention to their participating insurance policies when it comes to policyholder reasonable expectations. These policies combine elements of protection and wealth accumulation. They have minimum guaranteed benefits that are supplemented by non-guaranteed benefits that enable policyholders to participate in the investment returns of the insurer. The value of the non-guaranteed benefits is dependent on (and can fluctuate based on) the insurer’s investment mix, application of expense and decisions on how to share these across its various participating policies. These are not simple policies to be understood and insurers should resist assuming knowledge on the part of the customer and using jargon in their communications. They must work out how best to convey how these policies work in an understandable manner, so that customers are positioned to make fully informed decisions, reasonable expectations are aligned, satisfaction is achieved and trust is built.

Claims

When it comes to claims, the “treating customers fairly” principle is reflected in the insurance regulatory framework through the requirement that insurers handle claims “fairly and promptly”, provide transparency to policyholders on how to make a claim, and keep claimants updated on the progress of their claims.

The IA’s expectations on these matters have been articulated in our Special Supplement on Claims Handling published with Conduct in Focus in May 2023. These expectations aim at addressing the inherent imbalance created by the time gap between premium being paid and the insurer fulfilling its obligations under the policy, by holding insurers accountable for treating policyholders fairly at the claims stage.

Insurers should always challenge their claims procedures from the policyholder perspective and consider what is convenient for the claimant, not just efficient for the company. Fairness must also be reflected in the insurer’s approach to handling the claim by striking a fair balance between the need to investigate to ascertain coverage and ensuring valid claims are promptly paid. When interpreting terms and conditions in insurance policies, insurers should benchmark their interpretation against the question: Is this what a reasonable policyholder would have expected this clause to mean based on the words used?

All these issues can be reflected upon when considering the insurer’s claims payment/rejection rates, an important barometer we look at when considering the “treating customers fairly” principle in operation in the claims process.

Commission structures

Insurance intermediaries owe duties to policyholders but are remunerated through commission paid by insurers which, depending on the circumstances, can give rise to potential conflicting economic pressures. The most suitable insurance policy to meet a policyholder’s interests may not be the one with the highest commission level. The temptation to focus time on generating new sales of policies may conflict with the duty to service existing ones. Since commission itself is “all or nothing” (you get paid it if you sell, but nothing if you don’t), the more sizable the commission, the higher the inherent stress to push a sale. Economic reality means that commission structures – if wrongly calibrated – can overly incentivize the intermediary (even subconsciously) to put his own interests above that of the customer, risking poor customer outcomes.

How does the regulatory framework and the “treating customers fairly” principle address this?

Primarily by imposing specific duties on intermediaries to act in the best interests of the customers and for this to override any personal interest. This is then underpinned by requiring the intermediary management control function of an insurer (and responsible officers of intermediaries) to implement controls that ensure compliance with this duty. Licensed insurance broker companies must also make certain standard disclosures on their commissions and there are more detailed commission disclosure requirements for both brokers and agents for ILAS policies. For long term policies, prohibitions on indemnity commission and requiring commission only to be paid on an earned basis, must be strictly complied with, as these serve as a basic minimum starting point towards fair customer treatment.

Beyond this, in our conduct inspections we also look at how insurers, when calibrating their commission structures, seek to align remuneration and commission levels with the objectives of long-term customer satisfaction and treating customers fairly. Focus on long term insurance products draws particular attention in this respect. Examples of the types of questions insurers can and should consider in the commission setting and structuring process are:

Is a reasonable balance between upfront and tail commission achieved, so as to incentivize continued quality servicing after the policy is purchased?
Does the upfront commission reflect the work done for producing and advising on the arrangement of the policy?
Does the remuneration structure incentivize policy persistency, ethical behavior and positive customer feedback as well as achievement of sales targets?
Are their mechanisms to discourage aggressive selling e.g. clawback or deferred commission structures tied to persistency and ethical standards of conduct?
Would a reasonable policyholder, being informed of the amount of commission consider it representative of the value of the service provided (assuming the reasonable policyholder is apprised of the full scope of work performed by the intermediary)?

By considering these issues, an insurer can seek to ensure alignment between its remuneration structures and the “treating customers fairly” principle so as to cultivate good standards and practices in the market, build trust and mitigate against the prospect of poor policyholder outcomes.

Concluding remarks

Treating customers fairly, therefore, is an ethical principle elevated to the status of a regulatory requirement to ensure the insurance market is founded on trust. By treating customers fairly and embedding this into the culture of each company and the mindset of each insurance practitioner, insurers and intermediaries can enhance policyholder satisfaction, manage expectations, build trust and maintain long-term and lasting relationships with their customers. In doing this, the insurance market can continue to serve its vital social purpose of ensuring the losses of the few are borne by the many and that the risks we face every day are properly managed and addressed.