Other significant consumer issues
It is important that consumers have access to products that help them meet their financial needs, including managing their risk. General insurance assists consumers to protect their assets and provides a safety net in the event of loss. Life insurance and income protection insurance help protect consumers and their dependants if they are unable to earn an income, whether due to death, critical illness, or temporary or permanent disablement.
The decision to insure is a personal choice, meaning there will always be a level of non-insurance or underinsurance. However, insurance can mitigate the risk of significant loss and financial hardship for consumers. In addition to the negative effect of non-insurance or underinsurance on the consumer where they suffer loss, costs can be passed on to Government and the non-government organisation sector, particularly in the case of natural disasters.
More granular risk-based pricing of insurance may make it less affordable for some, but can also play an important risk-mitigation role, providing incentives for consumers to implement measures that reduce their risk.
Technological developments have the potential to reduce insurance pooling. This will reduce premiums for some consumers; however others will face increased premiums, or be excluded from access to insurance. Underinsurance may occur for a number of reasons including personal choice, behavioural biases, affordability, and lack of adequate information or advice on the level of insurance needed.
Submissions have raised the issue of underinsurance in both the general and life insurance sectors. A number of industry submissions raise the issue of affordability, with a focus on the affordability of flood and cyclone cover for those in high-risk locations. Many consumer group submissions focus on availability and affordability for particular segments.
Because underinsurance often only becomes apparent after a loss, and often in a large-scale natural disaster, it is difficult to measure the exact level of underinsurance. One difficulty in measuring underinsurance is that, following a natural disaster, building costs often rise, meaning that a consumer who was adequately insured in normal circumstances may become underinsured in a subsequent natural disaster situation.
In 2013, Quantum Market Research estimated that only 4 per cent of homeowners do not have building insurance, but that 63 per cent of renters do not have contents insurance. However, Quantum also estimated that 83 per cent of homeowners and renters view that they would be worse off in a total loss situation.43 This non-insurance or underinsurance may be due to one or more of four issues:
- A lack of understanding about the amount of cover required. In most cases, buildings and contents are insured according to the consumer’s evaluations. Further, consumers do not regularly update their sum insured to cover increasing value or new items.
- Deliberate self-insuring for the whole or only a proportion of the value, sometimes driven by a desire for lower premiums.44 Alternatively, consumers may not see value in holding insurance, because they have few valuables to insure, they are not risk averse or they are sufficiently wealthy that a potential loss would not be significant.
A lack of affordability of suitable cover. People may not insure due to the high cost of insurance relative to their financial circumstances.45
Behavioural factors, which may influence consumers’ decision to insure, or the extent to which they adequately insure.46
On the issue of affordability, the overall cost of comprehensive motor vehicle insurance and home contents insurance has remained broadly static as a proportion of annual income since 1997. However, the cost of home building insurance has increased significantly since 2008 (Chart 6.1). This reflects the increasing incidence of natural disasters and greater number of claims insurers have incurred as a result (Chart 6.2).
Chart 6.1: Insurance cost as a proportion of annual income
Source: Insurance Statistics Australia, ABS Catalogue 6302.0: Average Weekly Earnings.47
Chart 6.2: Cost of claims due to catastrophes (2013 values)
Source: ICA and Risk Frontiers.48
Submissions argue that insurance affordability is a problem for low-income consumers, who require low-value insurance, such as contents insurance of $10,000. These types of policies are proportionately more expensive, because there are fixed costs that do not decrease in proportion to the policy’s value. The second area of concern is locations with a high risk of natural disasters such as floods or cyclones. Submissions also raise concerns about the impact of state taxes that apply to insurance, raising the cost of insurance premiums.49
Superannuation funds now play an important role in providing life insurance to members through group insurance policies. Latest estimates indicate more than 90 per cent of the working age population now has some life insurance.50 Introducing default insurance into many superannuation funds has extended the number of people holding life insurance; however, submissions question the adequacy of this coverage. Some submissions put forward the view that underinsurance for life and disability is significant, requiring policy measures to close the ‘underinsurance gap’. Rice Warner estimates that current life insurance cover is 64 per cent of the amount needed, with disability insurance much lower again.51
Submissions argue that underinsurance and non-insurance are likely to become more acute as insurers use data and technology to price individual risk more accurately. Increased risk-based pricing has the potential to advantage some consumers by reducing costs, but disadvantage others through increasing costs — potentially to the point of unaffordability. In addition, increased risk-based pricing may mean some consumers are not offered insurance at all. This issue arose in relation to riverine flood insurance following the 2011 Brisbane floods, with residents of flood-prone areas experiencing significantly higher premiums for cover, or finding none available.52
The trend towards individualised risk-based pricing is growing, as firms access larger data sets, including data from outside their own businesses, and develop more sophisticated analytical techniques. For example, the Insurance Australia Group now prices at the household or address level for personal building, home and contents insurance for flood and cyclone risk. Its NRMA brand also prices at the household level for risks such as theft and domestic house fires.53 Product issuers who fail to use better information to differentiate risk will be exposed to adverse selection. They will be more likely to acquire higher risks, while more sophisticated competitors will attract lower risks at lower prices.
Governments sometimes limit the use of certain types of information for pricing and access decisions.54 In Australia, some protections exist in the form of anti-discrimination legislation, but usually with an exemption for insurance decisions based on actuarial or statistical data. The Financial Services Council standard on genetic testing, which has been in place since 2002, states that an insurer must not request genetic testing, but can access testing that has already been done.
Price signals are important in influencing people’s decisions about risky behaviour, such as whether to live in a location prone to cyclone, bushfire or flood, or whether to buy a particular car. Price signals may also be beneficial for efficiency and competition. Future developments, such as vehicle telematics, mean that technology and premium prices may directly influence behaviour and reduce the level of risk to the community.
Accessibility can be improved if insurers and lenders better understand the risks involved, especially where the risk is found to be less than previously assumed. However, the better understanding of risk can cause problems for people who are found to be a higher risk. They may face higher premiums or a loss of access. This is a particular problem where consumers are not able to change their risk profile or find it difficult to do so.
Policy options for consultation
The information available on the extent of underinsurance is limited, including no agreed measure of what level of insurance is desirable. Further evidence beyond that already in submissions would be welcomed.
The Inquiry seeks further information on the following areas:
- Does Australia have a problem with underinsurance that warrants some form of policy response? Specifically:
- How does Australia compare internationally on adequacy of insurance coverage?
- Has the issue of underinsurance been increasing over time?
- What evidence and data are available to support a conclusion about our level of underinsurance?
- What evidence and data are available to assess whether more granular risk-based pricing will lead to exclusion or further underinsurance?
- If warranted, what are possible approaches to lessen the existence of, or mitigate the impact of, underinsurance?
Access to credit
Submissions raise issues with access to fair and affordable credit for some consumer segments. Consumers require access to products and services that help them meet their individual financial needs, including credit products, which can smooth consumption. Low-income consumers, consumers with low financial literacy and those precluded from obtaining mainstream credit often use small amount loans to meet everyday expenses.
Submissions contend that such consumers are frequently unable to access suitable credit from mainstream lenders, as they do not meet the eligibility criteria. Instead, they use high-cost products, such as consumer leases, which are regulated differently to credit contracts under the NCCP Act. Or they rely on ‘fringe’ credit providers, such as payday lenders, where they may enter into loans on a recurring basis without being able to use the credit to improve their financial position.
Although lenders will make lending decisions on risk-based criteria and other commercial considerations, access to reasonably-priced small amount credit may have individual and societal benefits. Community organisations and financial institutions are seeking to address this issue with a growing number of joint microfinance initiatives, such as the No Interest Loan Scheme and the StepUP Low Interest Loan.55 However, these schemes provide a very small supply of reasonably priced fringe credit, compared with overall demand. Outstanding payday loans are currently estimated in excess of $380 million.56
Policy options for consideration
A 2013 report by NAB and the Centre for Social Impact on financial exclusion in Australia57 concluded the Government should explore ways of scaling up the supply of microfinance products to improve access to credit for low-income consumers. Microfinance initiatives are not-for-profit schemes that provide access to affordable credit for essential goods or savings programs, which aim to help consumers establish positive financial habits. They are designed to address issues of financial exclusion.
Submissions propose that Government and/or industry could facilitate further development of microfinance initiatives, in collaboration with the not-for-profit and community sector, to improve access to small amount credit. This option relies on both the voluntary participation of industry and Government funding. It will likely take time for microfinance initiatives to grow sufficiently to address the needs gap, or they may not be able to grow sufficiently to meet demand in this area.
The Inquiry seeks further information on the following area:
Is there a role for Government and/or industry to facilitate further development of microfinance initiatives, in collaboration with the not-for-profit and community sector? To what extent would this improve access to small amount credit?
Small business borrowing
Banks provide the majority of lending to small business.58 Access to credit helps small businesses meet their start-up, expansion or ongoing costs and manage their liquidity. Generally, small business lending is more risky than most consumer lending, which mainly consists of low-risk residential loans. This is discussed in the Funding chapter.
As a result, when banks lend to small businesses they tightly control lending decisions, providing limited flexibility, and often with detailed and paper-based assessment procedures. Following the GFC, banks have become more selective in determining eligibility. Some banks are reducing their exposure to small- and medium-sized enterprise (SME) borrowers, and lowering loan-to-valuation ratios to reduce their credit exposure.59
Yet individual borrowers and small business borrowers often face similar issues.
Some submissions are concerned about finance for small business, particularly about the restrictive covenants in small business loan contracts. Non-price covenants of loan contracts can make bank loans unattractive to some small businesses. Some submissions label non-price terms on small business loans ‘very restrictive’ and ‘vague’, with concerns that the way some of these terms have been applied has not been transparent. Small businesses are also concerned about the onerous nature of the loan application processes employed by some lenders. To some extent, this can reflect the quantity and quality of information that some small businesses provide to lenders.
The regulatory regime that currently applies to credit only regulates credit provided to individuals or strata corporations for personal, domestic or household purposes, or in relation to residential investment. As part of the credit reforms process, a proposal to introduce targeted reforms to small business lending was consulted on in the context of the draft National Consumer Credit Protection Amendment (Credit Reform Phase 2) Bill. The Bill proposed mandatory external dispute resolution, product and services cost disclosure by lenders and brokers, and a specific remedy to address practices by some lenders in unfairly refinancing small businesses in financial distress. The reforms were part of the COAG National Partnership Agreement to Deliver a Seamless National Economy. However, the agreement wound up on 30 June 2013, before the reforms were complete and the Bill was never passed.
Similarly, when the unfair contracts provisions now present in the ASIC Act were first announced in 2008, they were initially intended to apply to all standard form contracts, including business-to-business contracts. However, the legislation was restricted to consumer contracts, in response to criticism by the business community that such laws might create uncertainty.
A balance needs to be struck between facilitating access to credit on equitable terms and allowing lenders to effectively manage their risk and price accordingly. Regulating business credit more intensively may reduce access to or the affordability of credit for small business.
The Inquiry notes that Treasury is undertaking a consultation process on behalf of Consumer Affairs Australia and New Zealand on extending unfair contract term protections to small business. A consultation paper was released on 23 May 2014.60 The Inquiry will continue to monitor this consultation process until the Final Report is issued.
Consumer loss and compensation
Consumers require access to remedies and redress in the financial system where they may have been subject to misconduct. When investing, some consumers have suffered significant, uncompensated losses when non-prudentially regulated institutions have collapsed and/or where there has been misconduct on the part of financial services providers. A number of collapses have led to significant consumer losses, including Storm Financial, Trio Capital, Opes Prime, Westpoint and Commonwealth Financial Planning. In some cases, consumers received partial compensation; however, a significant proportion of losses remain uncompensated. Although the system is not designed to eliminate all risk of loss, submissions raise a number of issues relating to consumer loss and compensation, including the:
- Adequacy of the regulatory framework for managed investment schemes
- Appropriateness of compensation mechanisms
Adequacy of framework
Consumers have experienced significant losses from investing in the managed investment sector, although these losses are small compared to the overall size of the sector. Major sources of loss include failed agricultural schemes, mortgage and direct property schemes, and unlisted mortgage common enterprise schemes.61 Although some losses reflect poor underlying asset investments, or market price declines, others reflect poor business models, poor advice or fraud.
This raises the issue of whether the framework for regulating managed investment schemes adequately safeguards the rights of investors, especially compared with companies.
In a recent report, the Corporations and Markets Advisory Committee made a range of recommendations and proposals, which included to:
- Change the ‘trustee like’ obligations of responsible entities
- Review the structural requirements of managed investment schemes
- Prohibit common enterprise schemes
- Amend the definition of what can be called a liquid asset
- Clarify what is meant by ‘scheme property’ and how the client money provisions are applied to monies held by responsible entities
- Improve the external administration framework for failed managed investment schemes62
Policy options for consultation
Given recent financial collapses, submissions question the adequacy of the regulatory framework for managed investment schemes to protect the interests of their investors.
The Inquiry would value views on the costs, benefits and trade-offs of the following policy options:
- No change to current arrangements.
- Amend the existing regulatory framework for managed investment schemes.
Overall, stakeholders have said that dispute resolution systems are working well.63 Despite this, some stakeholders consider that current compensation arrangements may not be adequate to provide redress to consumers who have suffered financial loss. This is evidenced by the Financial Ombudsman Service (FOS) submission, which reports significant unpaid determinations and uncompensated loss. Since 1 January 2010, 19 financial services providers have been unable to comply with 105 determinations exceeding $8.3 million.64 According to FOS, the level of unpaid determinations as at 31 December 2013 is approximately 33 per cent of all determinations made in its investments jurisdiction.
Other submissions raise specific issues about the sufficiency of relying on professional indemnity (PI) insurance as a compensation mechanism. Submissions contend that PI insurance fails as a complete compensation mechanism because:
- Where there is significant consumer detriment, aggregate funds available under the policy may be insufficient to meet all claims.
- The policy may not cover conduct giving rise to the compensation.
- The amount of the award may be below the applicable excess under the policy.65
Policy options for consultation
Submissions are mixed on the need for any statutory compensation scheme. Some argue that any scheme would increase moral hazard risk and would ultimately come at a cost to consumers. Others argue that a simple capped default compensation scheme should be considered to promote consumer confidence and trust in the financial system.
The Wallis Inquiry recommended against statutory compensation schemes in the financial sector, including deposit insurance. A report released by Richard St John in 2012 also concluded that it would be inappropriate and possibly counterproductive to introduce a last-resort compensation scheme.66 The report concluded that a better measure would be to reduce the incidence of misconduct and loss in the first place through improved regulator surveillance and stronger PI insurance requirements. The main downside of a statutory compensation scheme is that the better participants in the industry are likely to subsidise other participants, who do not have high standards of compliance and conduct.
Another option, which could proactively reduce loss through misconduct, would be to increase ASIC’s resourcing and capability for proactive surveillance of its regulated population. This is discussed in further detail in the Regulatory architecture chapter.
The Inquiry seeks further information on the following area:
Given the limitations of professional indemnity insurance, what options, if any, exist for addressing the issue of consumer loss?
Product rationalisation of ‘legacy products’
A number of submissions raise concerns about the operational risks and costs associated with the ongoing operation of ‘legacy products’. These are often managed investment schemes or life insurance products that have become outdated and closed as a result of commercial and legislative changes.
In 2009, industry estimated that up to $220 billion of funds under management may be in legacy products, adding an industry-wide operational cost of between $120 million and $350 million per year.67 These costs represent an inefficiency drag on the funds management sector and, ultimately, a cost passed on to consumers.
Submissions are most concerned about the lack of a practical, cost-effective and consistent product rationalisation regulatory framework to enable the conversion or consolidation of legacy products into products with equivalent features and benefits. This issue creates a trade-off that needs to be balanced between the interests of consumers who hold legacy products and product issuers.
Policy options for consultation
Government consulted on proposals for a new product rationalisation framework in 2009.68 The paper also discussed proposals for designing relevant taxation relief where assets are transferred under product rationalisation. These proposals have not been acted on to date. Thus, the operational risks and costs to consumers relating to legacy product operation remain today. The Inquiry considers that taxation relief issues related to product rationalisation should be considered in the Tax White Paper process.
The Inquiry would value views on the costs, benefits and trade-offs of the following policy options or other alternatives:
- No change to current arrangements.
- Government to renew consideration of 2009 proposals on product rationalisation of legacy products.
The Inquiry seeks further information on the following areas:
- Are there elements of the consumer framework not covered in this chapter that require consideration?
- In addition to the current regulatory framework, what role can industry self-regulation play in improving consumer outcomes generally?
43 Quantum Market Research October 2013, The Understand Insurance Research Report, Melbourne. See also Australian Securities and Investments Commission (ASIC) 2005, Report 54: Getting Insurance Right, A Report on Home Building Underinsurance, ASIC, Sydney, where it was estimated that structures destroyed by the Canberra bushfires were underinsured by an average of between 27 and 40 percent of the building cost.
44 Of those who estimated their own building insurance level, 10 per cent deliberately underestimated the value to lower their premium. For contents insurance, the same figure is 9 per cent. See Quantum Market Research October 2013, The Understand Insurance Research Report, Melbourne.
45 Insurance Council of Australia 2007, The Non-Insured: Who, Why and Trends, report prepared by Tooth R, and Barker G, Sydney. This report reflects that people may also not insure because consumers find purchasing insurance a significant administrative burden. This is supported by the fact that consumers are more likely to take out contents insurance once they take out building insurance.
46 Consumers have a tendency to focus on short time horizons when comparing upfront costs which impact on low-probability, high-consequence events. For example, consumers may not buy flood insurance as they perceive the risk of damage as being extremely low. See Wharton Center for Risk Management and Decision Processes 2013, ‘Informed Decisions on Catastrophe Risk: Insurance and Behavioural Economics, Improving Decisions in the Most Misunderstood Industry’, Issue Brief, Winter 2013, University of Pennsylvania,Philadelphia.
47 Insurance Statistics Australia is a membership organisation for a number of insurers and has collected and disseminated statistics since 1994. The membership comprises the majority of the Australian market. The average premium per policy for domestic motor, home buildings and home contents is determined from the data provided. It is then normalised by Average Weekly Earnings as published by the ABS.
48 The Insurance Council collates from its members the cost of claims from declared catastrophe events. Risk Frontiers (part of Macquarie University) developed an index to bring the costs to current values based on changes in building density and building costs.
49 Refer also to the Australian Financial Centre Forum 2009, Australia as a Financial Centre: Building on our Strengths, Canberra; Intergovernmental Agreement on the Reform of Commonwealth-State Financial Relations, 1999; and Commonwealth of Australia 2009, Australia’s Future Tax System Review: Report to the Treasurer, Canberra.
50 Rice Warner 2013, Underinsurance in Australia, Rice Warner, Sydney. This refers to life risk only. The report also estimates that 68 per cent of the working age population holds lump sum disability insurance.
51 As income protection insurance is only available to a limited range of people in certain types of employment, it is not possible to judge the level of underinsurance.
52 However, 93 per cent of all home building and/or contents policies now have flood cover as a standard feature. See Insurance Council of Australia (ICA) 2013, Aggregated Flood Policy Data, ICA, Sydney.
53 Insurance Australia Group 2014, First round submission to the Financial System Inquiry.
54 In 2009, the US Federal Genetic Information Nondiscrimination Actwas implemented to provide protection from genetic discrimination in health insurance. In 2011, the European Court of Justice prohibited gender-based discrimination. Consequently, the cost of UK comprehensive car insurance for first-time female drivers increased by 104 per cent but fell 27 per cent for their male counterparts. See Insurance Australia Group 2014, First round submission to Financial System Inquiry.
55 Good Shepherd Microfinance 2013, An Outcomes Evaluation of the Good Shepherd Microfinance No Interest Loan Scheme (NILS), report prepared by Bennett, S. Georgouras, M, Hems, L, Marjolin, A and Wong, J, Centre for Social Impact, University of New South Wales, Sydney. According to the 2014 NILS evaluation, 42 per cent of respondents who had obtained fringe credit in the past stopped or reduced their use of fringe credit due to their NILS loan.
56 Estimated by ASIC based on previous studies into the industry and information from annual reports.
57 Centre for Social Impact for NAB, 2013, Measuring financial exclusion in Australia, Centre for Social Impact, Sydney.
58 RBA data for December 2013 shows the value of outstanding bank business loans for amounts under $2 million was $242.5 billion. See Reserve Bank of Australia (RBA) 2013, Statistical Table D7: Bank Lending to Business — Variable-rate Loans Outstanding by Size and by Interest Rate, RBA, Sydney. Note: this lending includes an unknown amount of loans provided to businesses that do not fall within the definition of a small business.
59 As observed in Treasury 2010, Regulatory Impact Statement: Small business credit’ (as part of the National Credit Reforms), Canberra.
60 Commonwealth of Australia 2014, Extending Unfair Contract Term Protections to Small Businesses, Consultation Paper, Canberra.
61 Common enterprise schemes are a kind of managed investment scheme that is generally structured as a series of agreements between the member, the responsible entity and various external parties. The ‘scheme’ in this case is not a pool of assets under management, but rather the common enterprise carried out in accordance with those agreements. See Corporations and Markets Advisory Committee (CAMAC) 2012, Managed Investment Schemes Report, CAMAC, Sydney.
62 Corporations and Markets Advisory Committee (CAMAC) 2012, Managed Investment Schemes Report, CAMAC, Sydney and Corporations and Capital Markets Advisory Committee (CAMAC) 2014, Managed Investment Schemes Discussion Paper: The establishment and operation of managed investment schemes, CAMAC, Sydney.
63 The requirement to have a dispute resolution system applies to AFSL holders and credit licence holders. It also applies to product issuers and product issuers that deal with retail clients but do not require an AFSL for various reasons (for example, a legislative licensing exemption).
64 Financial Ombudsman Service (FOS) 2014, Unpaid FOS determinations by financial services providers: An overview, FOS, Melbourne. Note that the Credit Ombudsman Service Limited has only reported three unpaid determinations, totalling about $227,000.
65 Financial Ombudsman Service 2014, First round submission to the Financial System Inquiry, page 22.
66 Commonwealth of Australia 2012, Compensation arrangements for consumers of financial services, prepared by St John, R, Canberra.
67 Treasury 2009, Product Rationalisation of Managed Investment Schemes and Life Insurance Products, Proposals Paper, Canberra.
68 Treasury 2009, Product Rationalisation of Managed Investment Schemes and Life Insurance Products, Consultation Paper, Canberra.