1. The Consumer Council is pleased to submit its response to the Office of the Commissioner of Insurance (OCI) regarding the consultation paper on the feasibility of establishing Policyholders' Protection Funds (PPF) in Hong Kong. The OCI's consultation paper raises the issue of (i) whether a PPF should be introduced in Hong Kong, and (ii) if so, what the design features of the PPF should be. The Council's views are set out in the following.
The Introduction of a PPF (paragraphs 9.1 & 9.2 of the consultation paper)
2. The Council supports the introduction of a PPF in Hong Kong for the reason that it will act as a 'safety net' for customers of insurance companies. The PPF should cover both life insurance and non-life insurance. The Council considers that introduction of a PPF would best serve the interests of consumers in the following ways:
(a) a PPF scheme would instill confidence in the insurance industry and policyholders, particularly private individuals, may be less panicky towards insurer insolvency;
(b) in the event of an insurer failure, a PPF scheme would ensure that policyholders are guaranteed compensation (in that they would not have to worry about a failed insurer having insufficient assets to meet their claims); and
(c) having a PPF scheme is consistent with giving protection similar to that already in place for investors in the securities market, and the proposed depositor insurance scheme under the Deposit Protection Bill. It could be argued that it is equally if not more important that policyholders should have similar protection, given that insurance could represent life protection and a major source of liquidity for many consumers in time of critical needs.
Main Design Features of the PPF Scheme
3. Given the Council's support of a PPF scheme, this submission addresses some of the questions raised in the OCI's consultation paper that are related to consumer protection. They are:
- compensation coverage & limit (paragraphs 9.3 - 9.4, 9.6, 9.9);
- administration framework (paragraph 9.11);
- funding approach (paragraph 9.12); and
- levy framework (paragraphs 9.13 - 9.15).
Compensation coverage & limit
4. The consultation paper proposes two PPF options:
(a) a broader scheme that pays compensation based on 90% of the value of the policy for all types of polices; and
(b) a limited scheme that pays compensation up to a fixed dollar limit for certain protection-type claims only.
5. As to how a scheme should operate, the Council is in favour of an even broader option which provides full compensation to all policyholders, instead of the proposed 90%. From the perspective of consumer interests, a higher level of compensation will make available a higher protection to policyholders to cover their needs.
6. Notwithstanding the above, recognizing that a higher cap may incur extra costs and funding, the Council suggests that an impact analysis could be conducted to assess the cost implication and the percentage of policyholders to benefit under different overages and compensation limits.
7. In order to ensure continued full protection to policyholders, the Council supports the proposal that the PPF scheme should facilitate transfer of policy to another insurance company in the event of insurer insolvency. But criteria should be set beforehand on how the PPF scheme will exercise this power.
8. The consultation paper also raises the question of how "investment-linked products" should be treated under the PPF scheme. For example, whether these products should be subject to lower compensation limits or not covered at all. The Council proposes that surveys should be done to gauge the extent of the presence of investment-linked products in Hong Kong prior to making any exclusion decision.
9. Another issue of concern is whether policyholders are fully aware that the insurance products they have bought are "investment-linked products". The Council therefore suggests that a clear definition of "investment-linked products" should be provided, regardless of whether the products will or will not be included within the scope of the PPF scheme. Making this definition transparent and easily understood not only gives certainty to policyholders but also reduces the prospect of unnecessary appeals against PPF scheme decision regarding coverage and limit.
Administration framework of the scheme
10. The Council considers that a PPF should be publicly administered, the reason being that the public may perceive a PPF without government participation as a less credible form of assurance. Another justification is related to difficulties arising from assessing and indicating the level of insurance levy (if a risk-based approach is adopted). There will be a concern with the collection of such sensitive information by the private sector and such a concern, whether substantiated or not, may put the integrity of the insurance industry at stake.
11. Given the relatively small size of the Hong Kong market and the comparative rarity of insurer insolvencies, the Council suggests that the size of the PPF administration should be kept at a minimal level in order to save costs.
12. As regards the management of funds held under the PPF scheme, the Council suggests that an independent body should be created to administer the PPF. It is noted that international best practice also seems to be in favour of a degree of separation in terms of governance between the PPF and the supervisory authority. Such an arrangement could avoid potential conflicts of interest, and allow for direct consumer representation, in addition to that of insurance and government interests, on the management board. This provides greater accountability and transparency to the public. In the case of Hong Kong, it is important for the governance to be independent of the Government, e.g. an independent board while the regulatory authority may appoint staff to serve as secretariat. Reference can be made to the Travel Industry Compensation Fund which is a statutory fund administered by an independent board.
13. The Council also suggests that the management of the PPF scheme should have a role to promote public awareness of the PPF, such as making clear what rules and procedures will be used when the PPF is being applied in case of an insurer insolvency. It is important to make the information available to the public to reassure policyholders that in case of an insurer insolvency, the PPF will be able to effect a speedy and systematic payout to lessen the burden on policyholders; and to provide information on what procedures policyholders should follow in such event.
Funding approach
14. The Council notes that the PPF schemes in the sample of jurisdictions studied by the consultancy do not adopt a uniform pre-funded or post-funded approach. On the other hand, in Hong Kong in relation to motor insurance and employees compensation schemes, and in the securities and banking sectors, the pre-event funding approach is applied.
15. The Council favours a pre-funded approach, which entails the creation of up-front funds or cash reserves against contingent liabilities, as this will provide certainty to policyholders that there will be funding available to compensate them in the event of insurer insolvency. The Council is concerned that if a post-funded approach is adopted, it might not be practicable to collect enough funding if a large insurer failed.
16. In the late 1980's when the Government started to look at regulation of travel agents, the setting up of a compensation fund through imposition of $2,000 per registered agent was proposed at that time. The amount was regardless of the size of operation and business volume of travel agents. The Council had grave reservation of the flat rate contribution on the one hand and the small amount on the other. The Government held the view that should there be inadequacies, the travel agents would be called upon to pay more to the compensation fund. This was immediately put to test as two big travel agents collapsed soon after each had over $10 million dollars outstanding debts owed to consumers. All other travel agents refused to make up the deficit as prescribed by the Travel Agents' Ordinance. Finally, the Government had to revamp the entire compensation fund arrangement and introduced a levy on outbound travels instead. Such an episode in history well illustrates the problem of a post-funded approach.
17. It is noted the consultation paper proposal that the cost of the PPF be borne by all insurers. The Council supports this. In a pre-funded approach, it is essential to avoid the possibility that consumers may be compelled to bear the levy calculated with reference to and as an addition to the insurance premium. The Council considers that a built-in approach should be adopted, that the levy should have been taken into account in coming up with an insurance premium, and that consumers should only be required to pay the insurance premium and no more. Again, this is similar to the levy on outbound packaged tours, motor insurance and employees compensation schemes.
Levy framework
18. The consultation paper discusses the calculation of PPF levies on insurers taking into account their relative financial strength either using a simple formula discount method or using objective information regarding the insurers.
19. The Council is of the view that using a differential levy system based on risk to calculate levy for individual insurers would be fair for all participating insurers. The calculation of levy for a PPF based on relative risk will reduce moral hazard and avoid implicit cross-subsidies among insurers.
20. Regardless of which method to adopt, the Council suggests that a system should be set up to review and adjust the annual levy so as to check whether it remains appropriate, or whether the levy needs to be reduced or suspended. This is important to ensure the PPF has sufficient resources to meet expected demands; and that the levy is not excessive as to result in financial burden on insurers which, notwithstanding the degree of competition between insurers, might ultimately be passed on to policyholders.
Other Comments
Moral hazard & cross subsidization
21. The consultation paper points out some arguments against introducing the PPF scheme. Some insurers are concerned that establishing a PPF might promote moral hazard in that lower rated insurers might be forced to undertake businesses with higher risks in order to recover the higher cost involved, and that consumers have less reason to discriminate between insurers on grounds of risk. It is also noted that prudent insurers might claim they are subsidizing riskier insurers in the sense that the prudent insures are helping to pay for a system which they themselves do not need and are unlikely to use. Also, there are concerns that the costs of the PPF scheme will be directly passed on to consumers.
22. The Council notes the resurgence of such arguments prior to the setting up of the Travel Industry Compensation Fund, Deposit Protection Scheme and Investors Compensation Fund. The Council considers that the answer to the issue of moral hazard is competent regulatory supervision. The Council notes the good work of the OCI and believes that the system of prudential regulation would not be in any way relaxed in spite of the implementation of the PPF in Hong Kong.
23. With regard to the arguments of cross-subsidization, an element of subsidy is inherent in any form of insurance, particularly mandatory insurance. It is considered that PPF would help promote competition in the market concerning insurance products, and that strong competition between insurers will play its part in reducing the extent of costs being passed on to consumers.
24. The Council is also of the view that the introduction of a PPF would improve the competitive position of smaller insurers by increasing confidence on the part of consumers to utilise those smaller institutions' services. In turn, a stronger market position by those smaller institutions could diminish any incentive by them to take higher risks in order to gain market share.
Participation in the PPF
25. The Council considers that mandatory participation in a PPF is crucial. The Council considers that a voluntary system will not provide universal protection to policyholders and may give rise to adverse selection whereby only riskier insurers will choose to join the scheme.
26. With regard to disclosure of PPF membership, the Council suggests that there should be some safeguards to ensure that any misrepresentation regarding PPF membership and policy coverage is generally addressed.
27. From a consumer's perspective, they should be made aware of whom they are dealing with and what forms of insurance policies are eligible for protection. Along with this, the Council suggests that the management of the PPF should make rules to require scheme members' disclosure of the nature and extent of the PPF protection applicable to their customers, and make copies of such information available to customers.
Appeal system
28. There could be some instances in which the PPF scheme cannot pay compensation, or may not be able to compensate policyholders fully for their losses. Since these policyholders may be unhappy with the scheme decision on their claims, the Council considers that a mechanism should be set up to allow policyholders to appeal against the scheme decision on compensation payment or refusal to make payment.
29. The Council suggests that the procedures and rulings under the mechanism should be documented and made transparent to the public and consumer representation on the mechanism should be allowed.
Conclusion
30. The Council pledges its full support for introducing a PPF in Hong Kong. Hong Kong policyholders should have a protection scheme that will advance the limited protection in Hong Kong, and bring Hong Kong into line with the world's best practice.
31. Given the vast implication of a PPF scheme, the Council considers that the OCI should further consult the public on the detailed arrangements on how a PPF scheme should be structured in a separate consultation exercise.
