Distributional risk

1. Executive Summary
Each insurer us es one or more dis tribution channels to sell its products —ins urance policies . These channels and their relationships with customers and potential cus tomers repres ent a significant intangible ass et of the insurer. Nevertheles s, risks as sociated with the distribution process , including inappropriate marketing practices , create conduct of busines s risks. From a prudential perspective, these practices can pos e a material risk to an insurer’s sus tainability, brand value, and income-generating potential. The objective of this chapter is to des cribe and as ses s the major s ources of these ris ks to which ins urers may be exposed and the proces ses used to address them.
The key mes sages of this chapter include:
1. Although financial s us tainability of an ins urer is not often threatened by risks ass ociated with its distribution s ys tem and marketing practices, these risks can lead to significant financial and reputational harm from lack of new bus iness or poor quality of busines s, which can in turn advers ely affect its income, brand value, and value as a going concern.
2. Distribution ris ks can res ult in ris ks to a dis tribution channel, to the ins urer’s bus iness , and ultimately to its financial s us tainability.
3. Some types of dis tribution ris ks are s imilar to operational ris ks , which are unpredictable in nature, but can represent significant reputation and financial risks to the ins urer.
4. Perceived concerns regarding s us tainability or brand impairment of an ins urer can result in a rapid deterioration of the s ize and effectiveness of the ins urer’s distribution s ys tem.
5. Insurance market conduct supervisors are charged with ens uring that s ales and s ervice of insurance policies are made in a manner that delivers acceptable value to the cons umer. Their policies and actions can include a range of cons umer protection requirements such as s uitability s tandards and dis closure requirements . In s ome countries, it is common for actuaries to s ign off on the accuracy of illustrations of new s ales/in-force ins urance policies that clearly explain the mechanics of complex or long-term products and provide advice on the suitability of sales to customers .
6. Because of the importance of this ris k, actuaries are involved in estimating the quality of sales , ass es sing policy performance in pricing ins urance products, and helping to identify and meas ure distribution and conduct of bus ines s risks as part of the ass es sment of overall enterprise risk management (ERM) for the effective management of these risks .
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2. Introduction
Although sales are important in every indus try, due to the complex nature of many insurance products and that in many cas es they are s old rather than bought, they are especially full of opportunities and ris ks . Dis tribution ris ks are ultimately the res pons ibility of the ins urer.
Effective new s ales to and continuation of coverage of an insurer’s cus tomers are vital in enhancing the value of both ins urers and their dis tribution channels, enabling them to operate s oundly as effective and sustainable going concerns. Their customers may include individuals and commercial companies. Ins urers conduct sales through one or more distribution channels (methods or process es of distributing an ins urer’s products), either (1) by agents1 that repres ent a s ingle or multiple insurers or (2) through other means , s uch as a website, mobile phone, or mail. Individuals involved in the selling process are often compens ated through commis sions and/or incentive rewards, often a percentage of the premiums paid or ass ets under management, or pre-set s alary, pos sibly supplemented by bonus es or other incentives.
Agents that sell longer-duration insurance policies, some of which are complex and involve savings accumulation, are often paid more during the first policy year to reward s ucces sful new s ales to customers or new policies to exis ting policyholders. There are als o s horter-duration ins urance policies, such as policies that provide group and s hort-term life ins urance, motor, property, and other cas ualty insurance. Insurance can als o be sold directly through partners (e.g., banks, micro-insurance institutions, and pos tal services) or other means (e.g., webs ites, phones, mail, or advertising).
There are many marketing methods used by insurers , nuances of which vary by market, coverage, country, technology available, and his torical development of the insurer. In addition, an ins urer can utilize multiple or hybrid forms of dis tribution methods. The appendix to this chapter provides a description of s ome of the mos t significant methods us ed in many countries .
1 This chapter us es the term “agent” in a broad s ense, including agents, brokers , and employees . In its Ins urance Core Principle (ICP) 18, the International Association of Ins urance Supervis ors (IAIS) identifies this category as “intermediaries”. They might also be distribution partners or spons ors that are responsible for or are involved in the distribution process , but whos e primary bus iness is not ins urance and may not be licens ed as an agent. They may be individuals or entities.
Differences between thes e types of agents can aris e because an agent may be viewed legally as repres enting only one of the parties , typically the insurer, while a broker may be viewed legally as more independent, poss ibly having s ome level of fiduciary responsibility to the potential cus tomer. ICP 18.0.9 indicates that (1) “where the intermediary acts primarily on behalf of the ins urer, the intermediary s ells products for and on behalf of one or more insurers , they are often referred to as ‘agent’ or ‘producer’. Intermediaries may act for a s ingle insurer (s ometimes referred to as ‘tied’) or represent several. The products they can offer may be res tricted by agency agreements with the insurer(s ) concerned. (2) Where the intermediary acts primarily on behalf of the cus tomer, the intermediary of the ins urer(s) whos e products he sells . Often referred to as a ‘broker’, or ‘independent financial adviser’, they are able to select products from those available across the market.” As a res ult, many jurisdictions differentiate between the requirements of intermediates defined in the supervisory framework as agents and
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There are three primary forms of “dis tribution risk”:

1. Risks to the distribution channel itself. The quality and sustainability of a distribution channel are s ubject to a range of ris ks , which in turn can affect the earnings and sustainability of relevant ins urers .
2. Risks to the quality or volume of the insurer’s ins urance policies caus ed by actions of the distribution channel.
3. Risks to the insurer as a company and to its future s ales capacity caused by the actions of the distribution channel. Thes e can include decreased volume and quality of busines s, miss elling (i.e., selling an insurance policy inappropriate for the policyholder’s situation), and moving books of busines s in a way that may be inconsistent with the policyholders’ interests .
Insurance supervisors are also concerned with the effect an insurer and the dis tribution of its products has on the citizens of their juris diction. Distribution risks (such as inappropriate agent behaviour) and marketing risks (such as inaccurate marketing materials) are referred to together in this chapter as “distribution risks”. The dis tribution channel provides the connection between the ins urer and its cus tomers, with its attendant risks of unacceptable sales and marketing practice, especially with respect to thos e who are not financially or ins urance s avvy. Insurance s upervisors are usually charged with oversight of appropriate product des ign and rates , including ensuring that insurance policies s atisfy the needs intended and treat the ins urers ’ customers fairly. This is in addition to ens uring the s us tainability of the insurance s ystem and the insurers that make up that s ys tem. The complex nature and perceived lack of transparency of many insurance products, as well as the relative lack of knowledge regarding insurance risks and policy features , have resulted in the need for cons umer protection, especially relating to s ales of ins urance to individuals . These cons umer concerns have led, among other requirements , to the licensing of ins urance agents , ins urance rate regulation, and in some cas es regulatory review of ins urance products prior to their sale.
In some insurers, the marketing proces s is viewed as encompas sing all elements of the development, maintenance, and management of new busines s and continuation of exis ting bus iness of an insurer, from des igning and rating its insurance products; growing, managing, and providing incentives for the ins urer’s distribution channel(s); and communicating with and educating its agents and its customers, as applicable. In contras t, in other ins urers the marketing function is dis tinct from the sales function, which has a s eparate organizational structure devoted to overseeing operations relating to the insurer’s dis tribution channels . In either cas e, marketing is involved with, if not responsible for, the development and management of its brand through s uch approaches as partnering, advertising, sales promotion, and s ponsors hips.
Some risks are joint ris ks between the ins urer and its distribution channels, es pecially in the cas e of agents who are tied to a single insurer, whether as independents or as employees. For example, adverse events or publicity can affect both the ins urer and the dis tribution channel, either directly as a res ult of data ris ks (s uch as cyber-ris ks or customer file hacking, or inadvertent incorrectly recorded transactions, not uncommon when the Internet or phone is
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involved) or in the extreme through criminal activity (such as fraud). If trus t in the indus try is adversely affected, both the ins urer and the ins urance distribution channel are negatively affected as well.
Although the emphasis of this chapter is focus ed on the risks as sociated with an insurer’s dis tribution channel(s ), it is important to note that the benefits of an effective dis tribution channel are quite significant to the s uccess of the insurer. Thes e ris ks can be ass es sed on a qualitative as well as a quantitative manner. Not only does the dis tribution channel(s ) cons titute the s ource of ongoing bus iness and in some cases base from which policyholder s ervices are provided, it can also serve as an effective mitigation tool against other busines s risks, including field underwriting, communicating the value of the ins urer’s brand, a pos itive relationship between the insurer and its customers , and positive influences with respect to market conduct.
3. Risks to the Distribution Channel
Given that effective and efficient dis tribution channels are of crucial importance to the generation of the future bus ines s of an ins urer (including in s ome cas es the continued profitability of existing business), risks to one of the insurer’s dis tribution channels can in turn represent a s ubstantial source of ris k to the ins urer.
Examples of such ris ks include a deterioration of agent continuity resulting from an aging sales force (for ins tance, in s ome developed countries a concentration of post-World War II baby boomers who are currently retiring); skilled sales people who may not be skilled at being managers of field relations hips and operations but have been placed or are chosen to s erve as such managers ; a poor reputation of its agents due to past inappropriate or fraudulent sales practices ; new s ources of competition to agents including mobile/Internet-bas ed sales; more intens e competition in the same type of dis tribution channel; poor sales management as evidenced by uncompetitive pricing, compens ation, or support services; overconcentration of sales in a single agent or cus tomer; managing general agents that are more focused on generating high sales volume than on generating quality or profitable (to the ins urer) s ales ; and more modern technology that diminis hes the relative effectiveness or efficiency of the current distribution channel.
Reputation risk to the ins urer can, of course, arise from many s ources in addition to the insurer’s agents. For example, it can also arise from advers e publicity generated by agents of other ins urers (the indus try), bad claim practices , intens e competition, government actions , or bad media relations .
Es pecially if the agent is tied to a single ins urer, a negative reputation event will als o likely lead to adverse publicity to the agent. A related example is that if an insurer’s client data file is hacked, not only will there be a loss of customer privacy and pos sible adverse cons equences to the policyholder, but the agent’s relation with the policyholder may also be negatively affected.
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4. Risks to the Quality or Volume of the Insurer’s Policies Caused by the Distribution Channel
The dis tribution channel(s ) and target market(s ) of the insurer can significantly influence the type of ins ureds an insurer will provide ins urance to, which consequentially res ults in different levels of expected insurance cost. Field underwriting2 may influence the nature and type of expos ures to ris k that the insurer will be subject to. Examples of concerns include quality of ins urance risks covered in relation to what is anticipated in the ins urer’s pricing as sumptions and policyholder behaviour (e.g., applications not placed, policyholder terminations prior to the policy’s expiry) and move busines s away from the insurer.
1. Risk s election. Often, but not always, agents directly or indirectly participate in the ris k s election proces s through identification of cus tomers and field underwriting, which may res ult in experience incons is tent with pricing as sumptions due to potential anti-selection, policyholder moral hazard, or even fraud by applicants. Agents can be more focus ed on maximizing their personal revenue than maximizing profitable sales —particularly a concern with managing general agents who have been given s ignificant autonomy with respect to the field underwriting and management of their individual agents. If an independent agent splits its bus ines s between more than one ins urer, the busines s directed to a particular insurer might be of worse quality, representing adverse risk selection against that insurer. In addition, if an agent gathers incorrect or incomplete information regarding the quality of the risk, the ins urer may as a result make incorrect underwriting decisions.
2. Policyholder behaviour. Although often thought of solely in relation to premature voluntary policy terminations and nonpayment of premiums relative to pricing expectations , policyholder behaviour also can res ult in moral hazard with res pect to the expected amount of claims or in fraud. Agents can als o influence inappropriate exercis e of policy options —for instance, the exchange of one policy for another, es pecially one of another ins urer, is often referred to as replacement. Such a replacement may not be in the bes t financial interest of the policyholder, as it might be the result of an agent more incented by large front-end commiss ions on long-term ins urance policies or by a bonus for block-transfers of a book of short-duration insurance policies s uch as automobile or personal property ins urance, than by the bes t interes t of the policyholder. In fact, a replacement can indicate a situation in which a conflict of interes t3 or miss elling may be pres ent. In s ome cas es it may not be evident who “owns ” the ins urance policyholder relations hip—

2 Selection of potential insured risks by agents in the field, either judgmentally or in accordance with rules set by the ins urer, often confirmed by an insurer’s underwriter.
3 A conflict of interest can aris e where compensation is paid by the insurer for a sale of an ins urance policy by an agent. Such compens ation may incent an agent to steer a s ale toward a product that provides a larger amount of compensation. It may especially aris e where it is not clear whether the agent is working primarily on behalf of the insurer or the insured. This has led in s ome jurisdictions to a greater us e of fees payable by the cus tomer for the service of the agent or of required dis closures of the amount of compens ation To s ubmit comments about this paper or to report any problems with the webs ite, please send an email dir ectly to ris [email protected]
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this may res ult in alternative service responsibilities and movement of insureds between companies. In s ummary, agents can influence policy laps e or non-continuation behaviour counter to the bes t interes t of the policyholders , which at the same time can impair the recovery of acquis ition expenses or increase anti-selection against the insurer.
3. Policyholder interfaces . A lack of effective and convenient cus tomer interface, whether via technology (website, mobile phone, or toll-free call-in number) can caus e s ignificant brand (and even indus try) damage for an insurer and its dis tribution channels.
Actuaries regularly monitor policy experience and develop expectations regarding policy performance and policyholder behaviour, indicated by s uch experience as high policy lapse and low policy continuation; agent retention; and claim approval rates, changes in s ales volume, and expense margins , which are incorporated in premium rates and valuation ass umptions. Whether through internally tracked or external customer complaint sources (e.g., s ponsored by regulators, independent firm or s ocial network), complaint res olution metrics (by type, resolution percent, and timeliness ) can provide us eful feedback information to the insurer and s upervis or. Thes e are sugges tive of distribution iss ues needing immediate ins urer attention. As deviations from these expectations emerge, the insurer as sess es whether its expectations need to be revised or corrective action is needed with res pect to the insurer’s dis tribution channel or underwriting.
5. Risks to the Insurer Caused by Distribution Channel Activities
The characteris tics and quality of a dis tribution channel, or the effects of management decis ions relating to a distribution channel, can also expose the insurer to direct damage in s everal ways .
Risks res ulting from the operation of a dis tribution channel can include:
1. Concentration risk—that is, overreliance on a s ingle distribution channel, a few agents , or a few ins ureds . In the extreme, this can be the result of over-dependence on the ins urer on a s ingle agent or relationship that could (1) adversely influence corporate policy, pricing levels or underwriting decisions; (2) adversely affect profitability; or (3) terminate a s ignificant amount of bus iness from the ins urer if corporate decis ions don’t go its way. Alternatively, if, for example, a large portion of an insurer’s s ales are from agents located in a particular retail chain (such as a bank or department s tore), a decis ion by that retail chain to end the relations hip may materially impact the insurer’s financial position.
2. Outs ourcing ris k. If the management of a dis tribution channel has been outs ourced to an intermediary (e.g., to a managing general agent) or to a partner (s ee partnering ris k below), the insurer us ually has les s control of the channel and its bus ines s. Although this can res ult in high acquisition costs because of relatively high commiss ions /fees, this may be offset by the functions and services provided that the insurer no longer has to fund directly. The outsourced entity may be able to provide immediate scale or recruit more agents more quickly through which higher
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volume might be able to be achieved and access to new markets might be obtained, although the arrangement might at the same time contribute to increas ed concentration risk. Careful ongoing oversight may be required to overcome the direct loss of control.
3. Partnering ris k. This can result from partners hip with other firms , pos sibly with a bank (Bancas surance), a retail network, or micro-finance institution, with the res ponsibility for various functions , including dis tribution, s plit between the parties —the relationship involved is usually s imilar to the outs ourcing situation. It s hould be noted that the more parties involved in the acquisition and servicing proces ses, the greater the likelihood of inadvertent or intended risks . In addition to the obvious risk of the partner becoming bankrupt, misaligned motivation and incentives , ineffective coordination, and a lack of an exit strategy may harm the insurer. In fact, the partner may be more involved with promoting its elf than the s ucces s/profitability of the ins urance co-venture; if, for example, a repres entative of the partner s its on the board of the insurer, that repres entative might influence the decis ions of the insurer to favor the partner (as a result, many juris dictions forbid agency firms to be on the insurer’s board). In the case of a bank partner that acted as a corporate agent, the partner could exert undue press ure and influence on the bank’s customers to purchase ins urance policies pass ed off as investment products. If inadequately monitored and managed, a potential for mis selling and fraud exis ts , which is bad for bus iness both in the s hort and long term, representing brand and reputation ris k for the insurer.

If the partner is respons ible for collecting premiums, the insurer needs to monitor the delivery of premium payments directly to the agent or other intermediary, because they might never reach the insurer, resulting in los s of coverage by the policyholder and ultimately a loss of reputation by the ins urer. This could als o lead to s ignificant increases in internal and external cos t, including litigation costs . This type of ris k, which may be wides pread among insurers across a particular marketplace or is olated to a particular ins urer, is similar to other types of operational risks, leading to los s of future new busines s. This risk can be exacerbated if the insurer delegates control and inadequately monitors the actions of the agents or managing general agent, as applicable. See Section 6 for further dis cussion of these risks and related iss ues of s upervis ory concern.
4. Cos t vers us control. The choice of a particular type of dis tribution channel requires an as ses sment of the ris k of higher compensation, support cost, and effective oversight. Sudden changes in the cost, quality, or number of agents , es pecially involving a particular product or s ector, have to be monitored on a regular basis. Indicators of s uch a change include unexpected changes in new bus iness , not placement or lapse/continuation rates , outs ourcer fees, or bankruptcy of outs ourced agents . In any case, the actuary is sens itive to the level of expens es involved in the ins urer’s operations, including the cost of acquisition—to ass es s relative competitiveness and the cos t and success of agent recruitment—and care is needed to ensure that the agent does not benefit more than the policyholders .
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5. Up-front compens ation. Insurers in many countries pay significantly greater compensation (to those generating the s ales or those who are compens ated by additional sales ) at policy origination than at the time of renewal, e.g., long-duration life insurance sold to individuals . On the one hand this can align the interests of the agent and the insurer because in both cases a profitable product can create long-term capital/value for the ins urer while providing capital to the agent to build and inves t in the bus ines s of the agent. On the other hand, it can negatively affect the sustainability of agents as they can become dependent on new sales for cas h flows and do not build up a continuing s tream of income. In addition, it is important to recognize that this can create a conflict of interes t as a result of an over-emphasis on placing new bus iness by agents and on moving (replacing) blocks of busines s between insurers or between products of the s ame insurer, a reduced ability to recover acquis ition expens e, moral hazard, and, in the extreme cas es , fraud. Whereas the ins urer has an interes t in retaining policies and policyholders to ensure recovery of its up-front cos ts, up-front compensation reduces the incentive for the agent to keep a policy in force, increasing the incentives for s elling policies with higher compensation and for churning (replacing) the policy that may not be in the policyholder’s best interest. Excess ive compens ation can prove to be a long-term detriment to cons umers, es pecially for policies with a heavy inves tment component, e.g., privatized pension products previously s old in Latin America.
6. Expens e recovery ris ks . Both greater expenses and inadequate new or total busines s volume relative to pricing ass umptions can lead to a reduction in profitability. Although potentially caus ed by inaccurate actuarial es timates , this ris k can also be caus ed by a sudden adverse change in distribution channel quality or effectiveness . This impaired expense recovery res ults from fixed or non-variable expens es or lack of new busines s or greater than expected policy lapse or non-renewal rates. Larger unit expens es are typically included as part of a stres s tes t to as sess the magnitude of its poss ible impact.
7. Rogue agents. In certain cas es , an individual agent could act in a manner incons istent with an insurer’s policies and rules, or collude with a third party to take advantage of the ins urer, another party, or society. The action might be illegal, such as modifying an insurance policy without the consent of the ins urer, charging unauthorized fees, or acting in a fraudulent manner. Such action, once identified and reported to the supervisor or communicated to the public, can cause irreparable harm to the ins urer’s brand/reputation and cos t the ins urer a great amount of resources . This can be identified through monitoring of individual agents’ busines s for early lapses, poor placement rates , or mis sold policies. An ins urer can als o inquire of peer companies or an applicable supervisor whether a pros pective agent has been terminated with caus e.
8. Tax payments. In some countries , the tax status of agents might change retroactively (e.g., from being an independent contractor to an employee), pos sibly res ulting in considerable tax payments or penalties for the insurer and res tructuring of its dis tribution strategy.
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9. Technology/regulations . New technology or new regulations can make the current distribution process irrelevant or overly expens ive. An example of the us e of new technology includes mobile phone apps us ed to purchas e or pay premiums for insurance. For ins tance, new regulations may require additional continuing education requirements or fiduciary responsibilities , which may result in increas ed cost or inability to recover previous sunk cost.
10. Uncollected chargebacks. In some cases, commis sion will be charged back to an agent out of future commis sions if long-duration policies lapse in their firs t policy year. However, if an agent severs its relationship with the insurer, the chargeback may become uncollectable.
11. Multi-level marketing. Ponzi, or pyramid schemes, where agents are compensated upon recruitment of additional agents , might arise, although rare in insurance. These situations , banned in s everal juris dictions , can benefit agents, but eventually run their cours e to the benefit of no one, other than the first few participants in the s cheme.
12. Political ris k. If the agent or sponsorship is provided by a government or governmental agency, if the head of that government or governmental agency changes or changes policy, or if fraud or kick-backs are proven, the relationship and business can be adversely affected, especially if a large part of the busines s of the insurer.
Poor management governance practices related to its distribution can als o weaken ins urer performance. These can include:
1. Ineffective or unsuitable distribution channel. A poorly designed or managed distribution channel can develop a low quantity or quality of insurance sales and create a poor public image for the ins urer. It can be uns uitable if it is not appropriate for the needs , knowledge, or culture of the target market. This may be as or more important than unsuitable products in providing quality products.
2. Management resource ris k. It is often a priority to maintain the loyalty of top agents. This may require considerable time by top management and its employees in agent relations hips to maintain their loyalty. Although this may be a consciously chosen bus iness priority, it als o might divert an inordinate amount of top management time from important s trategic iss ues and toward quantity rather than quality of bus iness .
a. Over-emphasis on gaining market share. In some cases, the emphasis of management can be so focused on gaining or defending market s hare that the quality of its dis tribution channel, agents, and insurance risks s uffers . This can arise when s taff in charge of sales or marketing emphas izes increas es in sales at the expense of quality of agents, sound underwriting practices , or premium adequacy. An early warning s ignal of this happening might be a surge in market share that cannot be explained by another factor. Regular discuss ions with agents can provide insight into the underlying reas ons for such a change, which can then lead to appropriate corrective actions .
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3. Inappropriate product and pricing governance. Mitigation efforts include the design of products suitable to the dis tribution channels us ed and target markets , and costs consis tent with des ired level of competition and ris k tolerance.
4. Sponsorship ris ks . Advertisements and s ales can be augmented through the endors ement or other use of sponsors and brand sales people, such as a celebrity. As with any marketing effort, a deterioration in the reputation of the sponsor, celebrity, or agent can result in a significant reduction in the marketing potential of the insurer, although that might prove temporary with timely action by the ins urer.
Because of the importance of these ris ks to the insurer, actuaries are involved in es timating the quality of s ales and policy performance in the pricing and valuation of insurance products, as well as in the ERM as ses sment of the effective management of these ris ks and dis tribution performance. Effectivenes s and accuracy of sales material, whether in sales brochures , pres entations, policy illustrations , website, or mobile phone apps, can be pre-screened or audited, as applicable and needed. Although not normally involved in agent training, actuaries can be involved in the development of educational material regarding the products and needs address ed by the products . This involvement not only enables ins urers to better identify thes e risks, but to also develop or enhance the mitigation tools that can reduce the incidence and management of the severity of these risks.
6. Consumer Protection/Selling Ris ks
Insurers owe their customers a duty of care, which goes beyond simple compliance with laws and regulations . Since either their agents or other contacts with customers are us ually provided indirectly through others or by means of technology, distribution and sales risks need to be soundly managed. As a result, the protection of cons umers agains t inappropriate market conduct risks is quite important and should be within the scope of an ins urer’s ERM. A culture of fair busines s conduct, responsible pricing, and claims management is a key element of this area of risk management—both top-down and bottom-up methods and emphasis are needed to properly fulfil this important function.
In addition to ass uring that contractual promises made by an insurer are kept by means of regulatory s tandards and supervis ion of thos e ins urers , insurance s upervisors are also often charged with ens uring that the customers of an insurer are treated fairly and are s old policies that meet their insurance needs. In some juris dictions this s upervis ion is conducted by the same s upervisory authority as the supervisor charged with ens uring the s olvency of insurers , while in others they are s eparate.
As a result, supervis ors may regulate and monitor certain as pects of rates, products , and agents. This can be done, for instance, in areas s uch as rate and policy form approvals , minimum standards for policy illustrations and disclos ure, remuneration limitations, and agent licensing.
It should be noted that certain regulatory rules des igned for agent-based distribution may not be s uitable for situations in which an agent is not involved. Supervis ors in s ome les s developed jurisdictions may not have adequate res ources, rules , or ability to as ses s penalties for noncompliance. In addition, the regulation of dis tribution of insurance sales or products
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may fall in the cracks between supervisors with s pecified responsibilities—for example, between different indus tries/products or solvency/dis tribution. In s ome cases, not all thos e involved in the s elling proces s may be required to satisfy minimum knowledge and experience in the insurance area.
Insurers are subject to conduct of busines s ris k.4 Effective management of this risk cons ists of both operational (process ) and strategic (determining the busines s model followed, including dis tribution and marketing objectives) elements. A key component of this management is early identification and avoidance of inappropriate market conduct, which can ultimately lead to or be sugges tive of future lack of s us tainability and s ound financial condition, which in turn represents a prudential solvency risk. In addition, they may be a s ymptom of ineffective governance and lack of internal controls over an ins urer’s distribution proces s.
Inappropriate market conduct and lack of cons umer protection can result partly from an as ymmetry of knowledge regarding ins urance and insurance policy features and practice that may be complex and include many technical as pects . This as ymmetry is presumed to be more pronounced where the buyer is an individual (such as in the purchase of individual life ins urance, micro-insurance, and personal automobile ins urance) rather than where the buyer/s pons or is a commercial enterprise (s uch as is the case for group ins urance, commercial liability, or reinsurance). This concern may als o aris e in les s developed markets and jurisdictions. More cons umer protection is needed where greater asymmetry exists.
Risks relating to a failure to adhere to regulatory-mandated or generally accepted behaviours, particularly if an ins urer or its dis tribution channels take advantage of this asymmetry to the detriment of customers , are referred to as conduct risks in many jurisdictions. In this century s ome financial s ervices companies , especially but not exclus ively banks, have incurred large fines due to inadequate management of conduct ris ks. In some cas es , conduct risks have been a s ignificant driver of operational risk losses.
Insurance market conduct s upervisors are charged with ens uring that s ales of ins urance policies are conducted in a manner that delivers acceptable value to the consumer, often res ulting in cons umer protection requirements , including relating to policy features and illustrations of new sales and in-force policies . In s ome jurisdictions the content of policy illustrations is highly regulated, while in others it is primarily self-policed.
In highly regulated juris dictions , actuaries are often involved in preparing the values and descriptions of the content of policy illustrations and may be subject to actuarial s tandards . In s elf-policed juris dictions it is especially important that objective advice be provided to thos e preparing the illustrations, particularly in juris dictions with les s developed ins urance markets , where actuarial involvement can be beneficial to help ensure that they are objectively and accurately prepared and are accompanied by understandable information and education, which should be conveniently access ible.

4 Risks to cus tomers, insurers, the insurance indus try, or the ins urance market that arise from the conduct of ins urers and/or their distribution channels in developing and managing their bus iness in a manner that may not fairly treat their cus tomers. For further discuss ion, see the IAIS Iss ues Paper on “Conduct of Busines s Risk and its Management”: http://iaisweb.org/index.cfm?event=getPage&nodeId=25244.
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User-friendly educational information and clear and concise disclos ure s uitable to the market concerning the workings of insurance (not exces sive, as that will likely be ignored by mos t consumers), provided by insurers , agents , s upervis ors , s chools, or the media can help mitigate any asymmetry and enable cons umers to make more well-informed insurance decisions . The sophistication of dis closures s hould be tailored, where poss ible, to the knowledge of the us ers —this is valuable even when middle- and upper-income individuals have enhanced their knowledge through readings about insurance from the Internet or from price comparis on webs ites. Less complex and clearly written policies and policy features can help, especially in less developed markets and juris dictions . This is particularly important where inves tment risk is not transferred to the ins urer, where there are benefit deductibles and exclus ions and poss ible rate increas es , or where the policyholder may not understand all available benefits .
Fairnes s in treatment may include ensuring that rates charged are not unfairly dis criminatory among class es of cons umers and that the insurance policies offered adequately meet the needs of the cons umers and that they are not overcharged. Concerns over exces sive premium rates have aris en for products s uch as credit life/health insurance (where the consumer is more interes ted in the loan than in the ins urance, so may be subject to excess ive premiums in relation to the cos t of insurance) and extended warranty coverage, while als o for policy fine print, which are inconsistent with policyholder expectations and may affect benefits and claims . Such situations may res ult from ineffective competition at the cons umer level and a lack of informed choice.
Since the dis tribution s ys tem plays an important role in the effective delivery of insurance policies, ins urance supervis ors are concerned with the effectivenes s of the dis tribution s ys tem in s oliciting new customers and servicing existing customers . This has led to the licens ing of insurance agents to help ens ure that thes e agents have achieved and maintain an acceptable level of knowledge of insurance policies and insurance and financial needs—put in place to provide a framework for regulatory compliance and s upervis ory oversight.
In response to situations where insurance policies have been missold to cons umers (that is , they are not suitable to s atisfy the s pecific consumer needs for which the product was des igned), pos sibly due to the incentives that led to up-front compens ation to agents, supervis ors have enforced certain cons umer protection rules and, in extreme cases, redres s. Depending on the market, type of ins urance purchas ed, and individual involved, an ins urance consumer may not have sufficient knowledge to completely unders tand the insurance policy, including its benefits and obligations. In certain cas es , an agent or s ales information might suggest, through explicit or implicit means , an insurance policy or amount of ins urance that is inappropriate for a particular cons umer. In others, benefit/claim limitations or exclus ions are not clear. In some cases, a pattern of mis selling has resulted in s ubstantial fines of ins urers or compensation to consumers , which can also result in a s ignificant reduction in the ins urer’s brand value.
Examples of miss elling include: pension miss elling in the United Kingdom, credit and payment protection ins urance, selling a payout annuity to someone who is s eriously ill, inappropriate tax advice or use of a policy des igned to dodge a tax rule, the sale of a product des igned to help customers in a different income tax category, and inadequate dis closure of
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the need for a s eparate flood or earthquake policy to a cus tomer with material expos ure to s uch a hazard.
As mentioned above, his torically, compens ation provided by the ins urer to agents who s ell long-duration insurance policies , especially permanent life insurance, has been front-ended—that is , agent compens ation in the first year of the insurance policy is much larger than in s ubs equent years . This has generally reflected the s ignificantly larger inves tment of time needed to sell these policies than needed to service them. This can create a conflict of interes t that can incent the agent to churn the bus iness and has led to cases of mis selling, or even fraud.
In some juris dictions there has been a recent move toward increased dis closure of agent compensation and in some cas es has led to the use of fees charged to the insurer’s customer ins tead of compensation provided by the insurer. Advocates of this change have claimed that this will contribute to more objective advice. In s everal areas, some s upervisors have limited ins urer expenses—for example, the s tate of New York in the United States has limited the expens es of insurers in an attempt to provide more value to cons umers , while in the United Kingdom the insurance supervisor has conducted a review of " value for money" acros s numerous life and pension products . Due in part to concern with potential conflicts of interest, other s upervisors have capped agent commiss ions at a certain maximum percentage, poss ibly a function of s ervices provided, have banned or res tricted certain commissions or other incentives, or required disclos ure of commiss ions received.
Insurers, through a range of techniques , provide consumer protection that at the s ame time manages s ales risks. For instance, these controls can include initial agent screening, training and continuing education programs regarding product features and proper sales techniques and s ales process rules and requirements, agent compens ation and s ales targets that consider the implied incentives, agent discipline, periodic audit of s ales process es , legal review of all advertising and s ales promotional material, and consumer education programs . For dis tribution channels that do not involve agents , thes e include technology-efficient and cons umer-sens itive information. Various techniques are available to ensure high quality distribution process , including the use of sales audits, customer satis faction s urveys, and a responsive independent sales ombuds men function.
Thes e techniques not only provide consumer protection, but also protect the insurer from harm from dis tribution ris ks . In particular, they are managed and monitored by the ins urer’s sales management and on the whole as part of insurers ’ internal audit and ERM process es. Consumer recours e, redress , or cons equential adverse publicity, a full dis cuss ion of which is outside the s cope of this chapter, can be provided by many means , including through cons umer complaint services s uch as a s upervis ory or other consumer entity or reported on an Internet website s et up for this purpose.
Actuaries have also been involved in helping to control thes e ris ks. In some juris dictions thes e activities have included signing off on the accuracy of illus trations of new sales /in-force policies that clearly explain the mechanics of long-term products and provide advice on the suitability of sales to customers .
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7. Conclusion
Distribution- and marketing-related activities , although not often thought of as s erious s olvency risks, can represent significant financial ris ks to an ins urer, as well as to its cus tomers. In particular, inadequate management of an insurer’s dis tribution channel and agents can lead to s ituations with advers e consequences to an insurer’s sustainability, brand value, and income-generating potential. In addition, s upervis ors are concerned with inappropriate sales and s ervice, which require consumer protection and cons equential action against sales practices and ultimately affect the advisability of allowing the ins urer to operate as a going concern.
Sound management of dis tribution risks will enhance and maintain the value of and trust in the insurer as an ongoing concern. Thes e risks have to be protected against, us ing s uch elements as :
1. Key performance indicators of the performance of individual agents, intermediaries, and distribution channels address ing the number of cus tomer complaints by type, retention rates of written business , surges in sales not s een company-wide, and pos sible fraudulent red and yellow flags seen in new busines s;
2. Use of actuarial s tandards for s uitable policy illus trations of long-term products , where applicable;
3. Agent and consumer education as to s uitable consumer needs for the offered products ;
4. A poss ible independent, accountable function (such as ERM) including the monitoring of sales practices and suitability process es and their risks; and
5. Regulatory requirements that govern market conduct and sales practices, as well as reviews that can as sess the effectivenes s of the insurer with res pect to dis ciplining/educating/managing its distribution systems .
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Appendix—Types of Dis tribution Methods

There is a wide range of dis tribution methods in use by insurers, the relative importance of which depends upon the market, the coverage, available resources , technology, and his torical development. An insurer can utilize multiple channels , often one for each bus iness unit, although s ome busines s units als o utilize multiple distribution channels. Agents (see footnote 1) serve as intermediaries between the ins urer and the ultimate insurance cons umer, and can be an individual or take the form of an agency, a group of individuals. An agent can specialize in a particular type of ins urance product or s ell many types. In addition, an ins urer may use a combination of thes e methods in a particular market, e.g., through leads generated by direct or website contacts , followed up by contact from independent agents or ins urer employees.
A distribution channel may involve more than one distribution approach or a hybrid method, and that any categorization repres ents an overlap of approaches, e.g., a full-time career agent may be an employee of an ins urer or independent, and a sale may involve both website and agent. The following is one categorization of distribution channels:
1. Full-time (tied or captive) career agents . They can be employees or independent contractors who repres ent a single ins urer, primarily involved in selling that insurer’s products . The class ification as an employee or independent contractor can result from tradition or tax laws . A new agent can be subs idized for a period to allow for training and development of customer relations.
2. Salaried employees. They sell products directly to the cus tomers of the insurer. This approach is often us ed in sales to large accounts —for ins tance, s elling group life/health or commercial property/cas ualty insurance to large corporations , or direct insurers in the case of reins urers . Salaries can be fixed or can include incentives /bonus es as a reward for success ful s ales.
3. Independent agents. Thes e are not employees of the insurer. They can be brokers , who can represent multiple numbers of insurers, or those who only sell insurance provided by a single insurer. Their primary bus iness may or may not be to s ell insurance products.
4. Consultant-led agents. In some market segments , particularly ins titutional ones, clients employ s pecialis t consultants or advisers to help consumers select between competing providers. Regulatory trends tend to differentiate between agents remunerated solely by the client and the s orts of independent agents referred to above who may traditionally have been remunerated primarily by the insurer. Some insurers’ dis tribution risks diminish if the gatekeeper to the client is remunerated by the client rather than the insurer, but other ris ks increas e, such as