It is an accepted part of the investment process that even investments subject to the best standards of selection and monitoring can under-perform. Notwithstanding this, the introduction of the Prudent Person Principe (PPP) may have the unintended consequence of making it easier for customers to successfully sue insurers for compensation for some types of investment losses on unit-linked business.
One just needs to consider the types of investment losses experienced during the financial crisis (misunderstood credit risks and credit spreads, losses on financial shares, falls in property valuations, effect of leverage, etc.) to see that there could be potential grounds for customers to successfully sue for breaches of the Identify, Measure, Monitor, Manage, Control and Report (IMMMCR) requirements in a Solvency II world.
In the unit-linked business, these breaches might include the following:
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Whilst the insurer might have operated in good faith, there may have been an inadequate appreciation of the investment risks at the outset. Potential litigants could claim a breach of obligation under a failure to ‘identify’ risks as part of due diligence.
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Whilst a particular risk might have been identified, the magnitude of the risk may not have been appropriately understood. Potential litigants could claim a breach of obligation under a failure to ‘measure and control’ risks
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Whilst appropriate due diligence might have been carried out at the outset, the nature of the risk might have changed over time.
Potential litigants would claim a breach of obligation under a failure to ‘manage, measure and control’ risks
The litigation risk arises primarily in the context of national primary legislation that prescribes either:
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Powers conferred on the regulator to direct a regulated financial service provider to provide redress to customers on losses arising due to failure in systems or controls; or
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That a failure by a regulated financial service provider to comply with any obligations under financial services legislation is actionable by customers who suffer loss or damage as a result.
Section 5 of the Explanatory Text of the EIOPA Final Guidelines on the System of Governance draws specific attention to the litigation risk on unit-linked business viz paragraph 2.136 (d), which emphasises that legal risk and operational risk resulting from a lack of care may impair an insurer’s solvency, especially in the unit-linked business. Therefore insurers need to deploy appropriate risk mitigation tools to manage such litigation risks, because otherwise significant additional regulatory capital will be required under Solvency II to cover the risks.
Pre-Solvency II, the litigation risk on unit-linked business was primarily centred on whether or not there was appropriate disclosure and communication of risk. However in the Solvency II world, the regulatory obligations have broadened with the requirement to apply the Prudent Person Principle (PPP). This means that failure by an insurer to meet PPP standards could result in compensation becoming payable to customers who suffer investment losses on unit-linked business.
Where large losses arise on investment business, there is likely to be a post-mortem carried out by either regulators or customers with the first line of enquiry being whether or not there was a failure of the insurer to follow the PPP. Consequently insurers that fail to meet best PPP standards will potentially expose themselves to the downside risk, particularly the tail downside risk on unit-linked business.
EIOPA has stated that it would be premature to provide extensive guidelines on the Prudent Person Principle at this point in time.
Accordingly, the Guidelines on the prudent person principle have been limited to very basic minimum requirements reminding insurers that greater flexibility for investments is linked with firm responsibilities on the governance around the investment activities, and that the level of prudence required is not diminished under Solvency II.
However without extensive guidelines, the risk to insurers of customers successfully suing in the future for compensation for investment losses on unit-linked business in scenarios where compensation might not have been payable in such circumstances in the past is now significant. Insurers urgently need to deploy appropriate risk mitigation tools to manage these litigation risks.
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