EU insurers and structurers clash over Priips cost disclosure

Insurers back the reduction in yield approach, while structured product providers broadly prefer the total cost ratio method

Esma: One of the the European Supervisory Authorities behind the consultation

Europe's insurance and structured products industries disagree over the best way to disclose product costs under incoming regulation on packaged retail and insurance-based investment products, or Priips.

The European Supervisory Authorities (ESAs) published a consultation in June on a technical discussion paper describing the key information documents (KIDs) that Priips providers will have to produce for consumers once this regulation is in force. The consultation closed on August 17.

Two options for disclosing the products' costs have been proposed: the reduction in yield (RIY) approach, which is supported by insurers, and the total cost ratio (TCR) approach, which is favoured by the structured products industry.

In response to the consultation, trade association Insurance Europe highlighted a key advantage of the RIY method: it takes into account the timing of individual cost deductions, which reduce the value of the underlying assets and hence the interest they earn. Compounded over the lifetime of the product, the amount of interest foregone in this way can be significant and have a big impact on the final yield of the investment.

In contrast, the TCR method adds up the costs and deducts them from the average annual value of the underlying assets without taking into account "the interest rate effects resulting from the exact timing of cost deductions", the ESAs wrote in the consultation document.

"The more the benefit at maturity is decreased due to costs the higher the RIY is. This is not always true for the TCR approach. Therefore in this respect, the impact of costs on the benefit at maturity is shown more accurately by the RIY approach," they added, noting that the RIY method can produce a much higher cost figure for investments with high upfront costs. "This is very important especially for life insurance Priips where upfront costs are often huge."

Insurance Europe prefers the RIY approach because of its greater accuracy. It also says the method produces a result that can be easily understood by retail investors – the impact of costs on the final return they will receive.

Some European Union member states already use the RIY approach for life insurance products. It has been in use in Germany since January 1 this year. The German Insurance Association supports the method's adoption across the EU, writing in its response that it captures the costs of life insurance products appropriately and is "suitable, transparent, comprehensive and comparable". The method's consideration of the timing of costs makes it uniquely suitable for products with long maturities, it added.

Gary Dale, head of intermediary distribution at specialist bank Investec, suggests another reason why insurers prefer the RIY calculation. "A lot of life insurance products don't break even until year seven to year 10 of their term. For this reason and others, the RIY approach is preferred by insurance companies," he says, stressing the fact that the RIY expresses total costs as a deduction from a product's yield at maturity. Under the TCR method, the costs are deducted evenly from each year of the product's duration, which can potentially make fixed yearly costs more prominent in investors' minds than the final payout.

However, the structured products lobby is strongly opposed to the RIY approach. In its response, the European Structured Products Association (Eusipa) wrote that "the RIY concept is not suitable for structured products or funds" as it treats certain activities of the product manufacturer – such as hedging – as an opportunity cost, rather than something that adds value by protecting the customer from downside risk or providing a potentially higher return. The association said it "basically agrees" with the TCR.

Jeremy Jennings-Mares, partner at law firm Morrison Forrester, says: "If I were to bet on which of the two the ESAs will decide on, I would bet on the total cost ratio." The TCR is "very similar" to the so-called ongoing costs that have to be disclosed in the key investor information document of a Ucits fund, he adds. "Although Ucits are currently exempt from the Priips regulation, they may become subject to it after 2019. So you could conclude that this is the option that would meet the least resistance overall."

Investec's Dale does not believe it will be that simple, however. He suggests that neither method is entirely appropriate for the wide range of Priips: "This is not just about the life insurance industry versus structured products. It concerns every single packaged product and there are thousands of them. A collateralised debt obligation, for example, can be a packaged product. Can you imagine disclosing costs, risks and performance scenarios on that?"

Other organisations are lobbying for a completely different cost disclosure methodology. The German Derivatives Association (DDV), for instance, has a "strong preference" for the issuer estimated value (IEV) approach, says Christian Vollmuth, the association's managing director. This method expresses costs as the difference between the ticket price of a structured product and its fair value on the date of issue.

"The IEV concept is well-known in structured product markets, so we are in favour of this concept providing a transparent disclosure for Priips," he says, adding that DDV members already state the IEV of structured investment products in German product information sheets.

A final consultation paper on the Priips-KID is expected in the autumn. This will inform the regulatory technical standards that will be submitted to the European Commission for approval by March 31, 2016.