The Consumer Duty: assessing fair value of products and services

Fair Value is one of the four outcomes that the FCA is seeking through its Consumer Duty initiative and which it sees as forming the key elements of the firm-consumer relationship. It sits alongside Products and Services, Consumer understanding and Consumer support outcomes.

Fair value – what does it mean?

In relation to the Fair Value outcome of the Consumer Duty, the FCA is looking for firms to assess whether the total price paid is reasonable in relation to the benefits. The FCA says that it wants to set out a clear and consistent expectation of how firms should assess whether the price of products and services offers fair value. However, it has not provided detailed guidance on the matter. It has simply indicated that firms can consider many factors, including costs, benefits, and utility to customers, as well as market rates for comparable products.

This leaves firms in the position of having to decide how best to assess fair value and what factors should be included in the assessment. Most firms are familiar with the concept of benchmarking prices to market rates of comparable products, but less so with assessing the reasonableness of prices in relation to the costs and benefits to consumers.

To understand more about the FCA’s proposals on fair value, it’s worth bearing in mind that the FCA’s proposals originate from a long-running programme of work on fair pricing, which has most recently been applied in policy interventions in General Insurance and Funeral Plans¹. In the FCA’s 2019 Feedback Statement on Fair Pricing in Financial Services, it noted the difficulty of issuing prescriptive rules around fair pricing:

In earlier work leading up to the Feedback Statement, the FCA notes that assessing whether pricing practices are harmful to consumers and competition requires a case-by-case assessment based on detailed data². There is no template or set of instructions or rules that can be applied. Nevertheless, the FCA’s approach to the assessment of pricing practices in other cases has read across. The same is true about the approach taken by other industries and competition regulators when assessing prices and other consumer outcomes in the context of other markets.

The Competition and Markets Authority (CMA), for example, often examines prices as a key outcome of how a given market is functioning³. Other outcomes include the extent to which the market meets consumers’ needs in terms of product choice and innovation, and levels of product and service quality. A deterioration in one or more of these market outcomes can be a sign that the market is not functioning effectively and may motivate a market study or other regulatory review. In the language of competition economics, poor or deteriorating consumer outcomes are indicators that certain market features are preventing, distorting, or restricting competition in some way. And quantifying the extent to which actual market outcomes diverge from the objective of a well-functioning market⁴ can help the authorities to assess the scale of the problem in terms of harm or ‘detriment’ to consumers.

Fair value in context

Fair value needs to be evaluated on a market-by-market basis based on context-specific information. The examples below, chosen from different sectors, won’t necessarily have a precise read-across to other retail product markets in financial services but do give a starting point for firms to consider how to proceed and - importantly – to consider the types of skills that firms will need to have in place to deliver these fair value assessments across their product sets.

Case study: GI add-ons and GI pricing practices

The FCA has been considering fair value in general insurance (GI) markets for several years. This has informed, and has been informed by, the FCA’s parallel work on price discrimination and fair pricing.

In its Market Study into General insurance add-ons, the FCA found that selling a product as an add-on often led to consumers purchasing products that were of poor value and not what they needed. These findings were underpinned by consumer research showing poor understanding of product cover and low pay-out ratios compared to some other stand-alone insurance products. The FCA conducted behavioural economics experiments to test consumer ability to compare product value.

The chart below shows pay-out ratios or proportion of premiums paid out in claims by type of insurance and whether sold as add-ons to other insurances. The FCA has noted⁵ it is particularly concerned about the value of personal accident and key cover based on this data, showing that less than 20% of the value of premiums for these add-ons was paid out in claims, compared to over 30% for home emergency cover and over 50% for buildings and contents insurance. This provides one example of how data can be used as an indicator of value.

In its subsequent Market Study into General Insurance Pricing Practices, the FCA found evidence that some firms were gradually increasing prices to customers who renewed with them year on year (so-called ‘price walking’). The FCA found that firms were using complex and opaque pricing techniques to identify consumers who were more likely to renew with them and then increasing prices to these customers, resulting in some loyal customers paying high prices. The FCA took issue with the practice of targeting customers with lower awareness of pricing, who are more likely to be vulnerable. It said that its findings suggested that some consumers are not getting fair value.

An example of the evidence underpinning the FCA’s conclusions is shown below. The chart shows the average margin on home and motor insurance policies by tenure. As can be seen, the margin increases on the first renewal and steadily climbs with each subsequent renewal.

 

In 2021, the FCA introduced rules including a ban on differential pricing between new and existing customers, meaning that insurers and distributors will have to offer the same price to new and renewing home and motor customers of equivalent risk. The focus of these rules was to ensure that firms deliver fair value for GI and pure protection products to customers and have strong governance and oversight arrangements in place to support this. They represented a fundamental change to the economics of many firms’ business models. The FCA also introduced new requirements for firms to report and publish value measures on policies, claims, and complaints across most types of general insurance products, including add-on products, and a requirement for firms to take value measures into consideration in product value reviews.

Case study: Overdrafts and the High-Cost Credit Review

Fundamental reforms were introduced by the FCA following a review which found high prices for unarranged overdrafts, complex pricing structures, low consumer awareness, and repeat use of overdrafts. The FCA found that high prices for unarranged overdrafts were disproportionately impacting vulnerable consumers.

In its assessment of the market, the FCA considered a wide range of performance and financial metrics alongside other types of information to deepen its understanding of the value that consumers were getting from overdrafts. Some key elements of this information matrix included:

• Overall levels of prices were assessed as relatively high based on:
• return on equity calculations using a range of cost allocation approaches, including incremental costs and fully allocated costs
• risk-adjusted margins on overdrafts and other short-term credit products
• Disproportionate revenues were earned from unarranged overdrafts relative to lending balances, compared to revenues from arranged overdrafts.
• There was insufficient evidence of any cost justification for higher prices on unarranged overdrafts.
• The distribution of charges was skewed, with most fees and charges being concentrated on a small number of customers: customer level data showed that 50% of unarranged overdraft fees were paid by just 1.5% customers.
• The distribution was regressive, with a link between unarranged overdraft usage and vulnerability measured by deprivation, using postcode data.
• Product usage was often inappropriate: whilst overdrafts are designed to provide short term credit many consumers were using arranged overdrafts regularly over long periods and for these customers overdrafts may not be the best form of borrowing.
• Evidence from behavioural experiments and consumer research showing that consumers find fees and charges complicated and difficult to understand.

The FCA found clear evidence of harm in this market – and comparable example will exist in other sectors/product lines. Based on the range of evidence summarized above, it found that charges were high in an absolute sense and saw a harmful distribution and structuring of prices.

Case study: Asset management

In 2019, following the asset management market study, the FCA introduced rules requiring UK authorised fund managers to assess the overall value that their authorised funds deliver to investors. The criteria set out by the FCA are based on three key elements: cost, performance against objectives, and quality of service. The FCA clearly expects to see firms making rigorous and robust assessments of the value that their funds will deliver to investors, overseen by strong governance, and has conducted significant multi-firm review work since the introduction of the rules to evaluate the processes used by firms when carrying out assessments of value and has continued to find residual issues.

The FCA said in its policy statement ‘The asset management market study and our supervisory work have shown that in general, AFMs have not considered robustly the value they offer to investors under our existing rules. We believe that this is leading to harm to investors through poor value products.’
In the market study:

• The FCA found persistently high levels of profitability in terms of profit margins, and no clear relationship between charges and performance of actively managed retail funds.

• The FCA found that investors’ awareness of charges is often poor. It highlighted the importance of clear disclosure of what asset management services cost through the presentation of a single charge. The FCA conducted behavioural testing to understand how consumers can be helped to make more informed choices through the presentation of information.

Implications for firms

What’s clear from the above examples across different sectors, is that the FCA’s expectations for fair value assessments are high: they are data-driven, rigorous, and multi-dimensional assessments, and are likely to require a range of skills to deliver them.

Firms will need to develop a framework for assessing fair value that is flexible enough to accommodate the specifics of different products and services, whilst also providing a degree of consistency. This will be important to avoid the possibility of cherry-picking methodologies to obtain favourable results for the firm as well as to enable comparisons to be made between products and services.

Firms will need to evaluate product-level economics

Firms will need to consider their pricing model for each element of their product/service portfolio, possibly to a much greater level of detail than is currently undertaken by the business. Assessing value may initially be challenging due to gaps in information as well as the subjectivity of the assessment.

Understanding the relationship between price and costs is a critical part of the fair value jigsaw. To produce an economically meaningful assessment, a range of issues will need to be considered such as:

• Cost allocation: what are the direct costs associated with providing the product or service? How does one approach the allocation of common costs, which may be shared across several products and services and may not be routinely allocated out in existing management information?
• Revenue allocation: for some products, for example current accounts and savings products, the account may be provided ‘free’ on the face of it, but the customer may be paying a price in terms of interest foregone. Firms will need to consider whether the transfer prices attributed to such deposits in existing management information are fit for purpose for their fair value assessments.
• The cost of risk is also an intrinsic factor, and it is often necessary to consider relative capital intensity, or risk-weighted asset density, when considering product ‘value’. Indeed, the FCA has considered such metrics in its recent evaluations of overdraft profitability as part of its High Cost Credit Review⁶ and in its Strategic Review of Retail Banking Business Models work⁷.
• Existing economic value or profit models may be helpful but are unlikely to be calibrated at the level of detail envisaged by the FCA.

Cohort analysis will be required to evaluate outcomes for specific consumer groups

The value assessment also requires firms to consider value for specific customer groups. Relevant considerations under this heading include:

• How different consumer groups/target markets use the product and how this usage impacts the overall price that they pay. Are some consumer groups contributing a disproportionate amount to
• Revenues and profits and other customer groups contributing very little or being cross-subsidised?
• Price differentiation and how headline prices differ between different customers and whether there is an underlying cost rationale or other justification for that.
• Firms will need to understand how the costs to serve vary across different consumer groups in order to understand relative economic value.
• Specifying and executing these types of assessment will likely require significant data analysis resource.

Demand-side analysis of consumer experience will provide an important complement

The FCA has said emphatically that it doesn’t want to price regulate and fair value isn’t just about the price-cost relationship. That implies that firms should also consider elements of value such as customer satisfaction, utility, and quality of service. A thorough fair value assessment needs to consider not only metrics of price and profitability but also demand-side information from customers, most likely in the form of customer surveys or other sources of customer feedback.

In addition, the FCA has indicated that it may expect firms to consider how their pricing structures impact the ability of consumers to make effective decisions and choices. Firms will need to consider whether they have the necessary expertise in behavioural economics and the ability to conduct behavioural experiments with consumers to explore this aspect of fair value.

An example of how fairness can be considered in the context of consumer markets is presented in the box below.

Transactional fairness The approach often taken by regulators and competition authorities when considering firms’ practices and whether they are harmful focuses on overall consumer welfare, or the sum of impacts across all consumer groups. However, this may fail to capture any price discrimination between ‘naïve’ consumers, who lack information, and ‘savvy’ consumers, who have the information to switch between firms. For instance, loss-leading headline prices will benefit ‘savvy’ consumers but to make normal profit, the firm takes advantage of ‘naïve’ consumers’ by charging them additional fees. This is intuitively viewed by consumers as “unfair”, yet it allows the firm to operate efficiently at normal profits. To reflect public concerns of “unfairness”, one option could be a complementary approach to build trust between firms and consumers in a market. Specifically, this ‘transactional fairness’ approach requires firms to act in ways to ensure: No Deception – Consumers with normal expectations about pricing practices can understand the consequences of transacting with that firm. No Hinderance – Consumers are not hindered from terminating a relationship with the firm or from transacting with alternative firms. Public Explanation - The firm can explain the rationale of its pricing practices and is willing to publicly provide this explanation. Transactional unfairness can occur if a firm uses misleading information or hides obviously relevant information to entice consumers into a transaction. This includes if a firm remains quiet about the alternative tariffs it offers, and the consumer is eligible for or not periodically informing existing customers about price changes or the absence of price changes when supply costs are falling. It is also transactionally unfair if a firm uses short timeframe offers or renewal date notifications that deter consumers from searching for competitors’ offers or making it difficult for consumers to cancel a contract with default auto-renewals. To avoid this, firms should ask themselves: In this transaction, are consumers allowed to enter voluntarily, knowing what to expect, and remain free to leave? Or more simply put, are we acting to deliver good customer outcomes?

Source: https://ueaeco.github.io/working-papers/papers/ccp/CCP-21-03.pdf

Rigorous and thorough assessment of fair value across the product suite will take time, and the FCA’s implementation timetable is currently challenging

One of the key issues facing firms is where to focus attention first. For large firms with multiple product areas and large numbers of individual products, it’s a daunting prospect to have to collect the detailed qualitative and quantitative information on the entirety of the product suite needed to conduct an evidence-based assessment of fair value of the type described above. Even once the data is assembled, it will take time to make the necessary evaluations and judgements required to form a conclusion on the extent to which individual products meet the fair value standard or not. In cases where issues with fair value are identified, firms will also need to determine and enact meaningful actions to address the situation.

This will take some time, particularly for firms with complex product sets for which a ‘one size fits all’ approach is unlikely to work. But firms will want to identify any problem areas quickly to avoid the risk of being in breach of the Consumer Duty when it is implemented.

Next steps for firms

The Consumer Duty is an opportunity for firms to review their product suites across the board to consider how they might improve value for their customers. In doing so, firms have an opportunity to improve customer engagement and trust and potentially business performance.

Firms with large and complex product suites have a significant task facing them to identify and assemble the management information required to assess fair value in a data-driven and consistent way. This will take time and specialist economic and financial resources to get right. Whilst detailed, data-driven, product-by-product level assessments described above are likely to be necessary and firms should certainly take steps to begin the task, firms should also consider how to identify obvious high-risk areas early on in the process. This could give firms an opportunity to beta-test their fair-value evaluation approaches on a limited number of products or product areas before rolling out more widely.

For further support and advice

This article has been reproduced from an article written by Lucy Beverley FCA, a Director in KPMG’s Economics team, and published on KPMG’s website earlier this year. If you would like to discuss fair value and our approach to implementing fair value assessments, or for advice on the Consumer Duty more generally, please contact Lucy Beverley, Director, Economics: lucy.beverley@kpmg.co.uk