knowledge | 21 September 2020 |
Differential Pricing – What the Central Bank Expects
The Central Bank of Ireland has been concerned about differential pricing in the motor and home insurance markets for some time and commenced a review of this issue in January 2020. Following its completion of Phase 1 of its review, the Central Bank has issued a letter to firms in the insurance sector (the “September 2020 Letter”), identifying a number of issues with the approach adopted to differential pricing. The Central Bank expects the Board and senior management of each firm to consider, and, if necessary, take measures to address the issues identified. The Central Bank has also published consumer FAQs on differential pricing.
Broadly, differential or dual pricing is the practice of differentiating between customers for reasons other than the expected cost of claims and expenses.1 On 21 November 2019, the Central Bank issued a “Dear CEO” letter (the “2019 Letter”) stating that it had identified the practice of differential pricing in the insurance industry as a potential risk to consumers and stating that insurers should ensure that their pricing practices conform to the Consumer Protection Code 2012 (the “Code”) requirements to:
- act honestly, fairly and professionally in the best interests of their customers and the integrity of the market;
- act with due skill, care and diligence in the best interests of their customers; and
- make full disclosure of all relevant material information, including all charges, in a way that seeks to inform their customers.
In the 2019 Letter, the Central Bank also states that it is conducting a review of differential pricing in the motor and home insurance industries to examine the extent to which the approach adopted by insurers is consistent with the Code. The review, which commenced in January 2020, is being conducted in three phases:
- Phase 1 – Market analysis;
- Phase 2 – Quantitative analysis and consumer insight; and
- Phase 3 – Conclusions and recommendations.
The 2020 Letter
The purpose of the September 2020 Letter is to outline the Central Bank’s initial observations from the conclusion of Phase 1 of its review, make clear its expectations of firms and outline its next steps.
Following its Phase 1 analysis, the Central Bank identified the following key issues with respect to differential pricing:
- Firms failing to recognise and/or acknowledge the use of differential pricing – according to the Central Bank, the majority of firms use differential pricing techniques such as price elasticity modelling, retention/lapse modelling, conversion rate modelling and the use of models that facilitate the flexing of sales remuneration. Each firm must ensure that it fully understands the impacts of its differential pricing practices on its customers, on the basis that a failure to recognise or acknowledge the use of such practices raises “significant concerns about a firm’s ability to assess those impacts”.
- Inadequate Governance and Controls – in many cases it was not evident that a firm’s Board of Directors had appropriately considered the impact of its differential pricing practices on its consumers. In addition, firms failed to have clearly documented controls in place to quantify or monitor the impact of differential pricing on consumer groupings in advance of pricing model implementation.
- Culture and Conduct – firms have not given sufficient consideration to customer interests when developing pricing policies. According to the 2020 Letter, this raises significant concerns in respect of the relevant firm’s culture.
The Central Bank requires the Board and senior management teams within all firms to consider the issues it has identified and develop and implement actions to address any gaps/weaknesses identified and to mitigate customer risk immediately. The Central Bank also expects each firm to have documented evidence showing that it has:
- assessed its pricing methodologies against the Central Bank’s definition of differential pricing and, if it does not consider its pricing practices to fall within this definition, clearly documenting the rationale for this and ensuring it is agreed by the Board;
- put in place a robust governance framework so that Board and management structures ensure the firm’s pricing practices are well-governed, controls operate effectively and appropriate oversight is in place, with roles and responsibilities for pricing activities clearly defined; and
- a fully embedded consumer protection risk framework in place to manage conduct risk and drive positive behaviours. This framework should be an integral part of the pricing process.
Each firm should also be able to demonstrate how its pricing practice adheres to the requirements of the Code.
The Central Bank has made various amendments to its original Terms of Reference. Among other things:
- the purpose of the review now explicitly includes assessing the governance and oversight of differential pricing;
- the specific issues to be examined in governance and culture include the extent to which firms consider outcomes when designing pricing models;
- the specific issues to be examined in consumer insight have been redrafted and now focus on:
- the extent of differential pricing in different consumer cohorts (i.e. which consumer groups are affected most and by how much);
- the relationship between differential pricing and characteristics of consumer vulnerability (e.g. income, wealth, financial experience and knowledge, behavioural characteristics, etc.).
In terms of methodology, Phase 2 of the review, which is underway, will assess the extend of differential pricing among private car and home insurance policy types and will involve an analysis of a policy level dataset provided by all insurance firms and intermediaries in scope of the Review. It will also include a parallel consumer insights exercise to further develop the Central Bank’s understanding of how consumers engage with insurance providers. The Central Bank will communicate findings and observations from the first two phases of the review via an interim report.
The 2020 Letter and the Consumer FAQs are available here.
- The Central Bank defines differential pricing in insurance services as “a circumstance or practice whereby customers with a similar risk and cost of service are charged different premiums, for reasons other than risk and cost of service. This includes the use of any modelling technique or the application of a non-risk adjustment during the pricing process which leads to customers with a similar risk profile and cost of service being charged differing premiums.”
This briefing is for general guidance only and should not be regarded as a substitute for professional advice. Such advice should always be taken before acting on any of the matters discussed.