By FintechOS · September 03, 2021
7 minute read

Advice gap: how insurance regulators inadvertently created a problem

How insurance regulators inadvertently created a problem

Financial regulators have to balance their ideals on consumer education and protection; wider national and market strategy; and industry realities. How can the insurance industry reconcile these competing needs when it comes to the ‘advice gap’? We need to look at the long-term intentions behind the regulator’s rules and guidance,

says David Punter, Product Owner, Digital Insurance at FintechOS

Why are so many consumers falling into the ‘advice gap’ and not getting the right financial advice – or, indeed, not getting any advice at all? It’s a critical question for insurers and regulators, and the UK’s Financial Conduct Authority (FCA), is on a long-standing mission to improve the situation.

The latest FCA report shows the extent of the problem. In 2020, only 28% of UK adults had received information or guidance relating to investments and pensions in the previous 12 months. This was almost unchanged from 2017. That’s three years of no progress.

Even at the very top echelon, the data is unimpressive. Only 39% of adults with more than £250,000 to invest received regulated advice. Of the less affluent, those with £10,000 to £20,000, the figure falls to 7%.

Of course, not all people would feel they need professional advice to pick financial products and make key financial decisions. However, there’s clearly a risk that advice gap consumers are not adequately educated and supported. This is especially the case where decisions are more complex and risky.

For less-wealthy people, there’s a combination of a lack of financial experience, higher impact from bad decisions, and impracticality of paying for professional advice. This has led to both regulators and the industry highlighting the persistent advice gap.

So, what’s going wrong? Two things:

1 Regulation

The Retail Distribution Review (RDR) reforms of 2006 – which came into force at the end of 2012 –  removed established sales incentives for financial advisors, partly to reduce the risk of biased recommendations.

This created unintended consequences of reducing the amount of financial advice of all kinds since consumers (unsurprisingly in hindsight) were not prepared to pay up-front for pure advice services.

2 Software

Advisors and insurers struggled to build the automated guidance services that were originally expected to plug the advice gap, to a sufficient degree of quality and commercial viability to satisfy both consumer and financial institutions. I’ll look at this issue in the second article in this series.

Both of the issues contributing to a financial advice gap must be addressed within the insurance industry, by understanding where the regulator is coming from and aligning digital and product strategies to satisfy everyone’s needs.

Moving beyond commission-based sales

Pre-2006, consumers would need to be skeptical about the advice they received about financial products. Those selling insurance, pensions, and other financial products were often poorly qualified – sometimes not qualified at all. Worse, they were incentivized to endorse certain products without a requirement to put the individual’s circumstances, knowledge, and risk-appetite first.

Advisors got a payment depending on the type and volume of products they sold. Consumers could be paying nothing up front for advice, but the commission structure made many people blind to the possibility of truly disinterested professional advice.

Too often, customers were mis-sold products by advisors who either wanted to generate maximum fees for themselves or were unwittingly driven by the incentives set up by investment or insurance providers who knew how to game the system. Perhaps just as worrying for the regulators, it was hard to assess how widespread these problems were, or even to agree on an objective definition of ‘mis-sold’.

Costs both recurring and hidden

Disadvantages for customers might not only be one-offs. Passing hidden costs of commissions on to consumers within product fees meant many got stung a second time. When their advisors moved between firms, they might move with them, and be subject to a new set of fees as a result, without having any say in the matter.

Thankfully, commission disclosure was introduced to ensure that the consumer could see how much their advisor was being remunerated for the provision of advice services related to the policy they have purchased. Even so, the direct link between that remuneration, and the fees being deducted from the premiums being paid and invested was not always that transparent.

So, in 2006 the Financial Services Authority, as the FCA was then known, launched the Retail Distribution Review. It came into force in 2012, on December 31st.  It’s no exaggeration to say that this changed everything.

Commissions went out. Transparent fees came in. Advisors would now have to be neutral, with no incentive to recommend one product over another, other than merit and suitability for the individual customer.

The new rules also introduced a new level of professionalism. Regulators wanted to see financial advisors on an equal footing with solicitors and accountants, in as much as they had to be authorized, take exams, and undergo continuous training in order to give advice. The more sophisticated and risky the financial products advised on were, the more training and qualifications needed.

Lots of former advisors exited the market, and so consumers faced a compounding effect of fewer experienced advisors. There was a new expectation that they should pay for advice as part of financial decisions that hadn’t needed this before – or at least had not made these charges obvious.

Reviewing progress on closing the advice gap

In 2015, the FCA launched a new enquiry. Had the measures worked? Were consumers being well served by the new model? How could improvements be made? The Financial Advice Market Review appeared in March 2016.

It made 28 recommendations aimed at closing the advice gap between the well-off and lower-income consumers. It hoped to achieve, “a real improvement in the affordability and accessibility of advice and guidance to people at all stages of their lives”.

Lord Bates, a government minister, said the review “proposed remedies to improve supply of affordable advice in the market”. These included setting up an FCA advice unit to provide firms developing large-scale automated advice models with regulatory support to help bring these to the market more quickly.

The regulator viewed technology as the answer to many problems of access to advice. Lord Bates said, “automated advice has the potential to provide affordable advice to the mass market, with some existing models charging a fixed fee of below £500.”

In retrospect, proven technology didn’t exist. Regulators weren’t able to explain exactly what good looked like, and any costs higher than ‘free’ would continue to be very off-putting for ordinary consumers.

The advice gap is actually getting wider

So, what were the results? When the evaluation was completed in 2020, it shockingly showed that the regulator’s measures had only widened the financial advice gap.

The billing model was to blame. Financial advisors and distributors of financial products tended to use models of charging and providing advice that were designed for wealthy individuals and families, which are attractive, but numerically small, sections of the market.

Expensive advice did not make sense for everyone else. The mass consumer market is composed of people who are used to going without advice in the first place and couldn’t afford it in any case.

This is the situation we find ourselves in. In the UK and other developed markets around the world, both regulators and financial institutions are understandably looking to digital innovators to come up with a second generation of automated guidance tools that can start to address the persistent advice gap more successfully.

These automated guidance solutions need to satisfy regulators that they’re just as good as human advice within certain well-defined contexts. They should reduce or eliminate fees for customers and improve efficiency and accuracy for the managers and distributors of financial products.

In our next article on this topic, we’ll look at what the industry has learned from first-generation ‘robo-advice’. What improvements do firms need to implement to satisfy both the regulator and their customers?

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