Consumer Council Submission to the Financial Services and the Treasury Bureau on the Proposed Establishment of a Policyholders' Protection Fund

24 June 2011
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1.    The Consumer Council (the Council) is pleased to submit its response to the Financial Services and the Treasury Bureau (FSTB) regarding the consultation paper on the proposed establishment of a Policyholders' Protection Fund (PPF) in Hong Kong.

2.    This paper sets out the Council's response to the recommendations made in the consultation paper in respect of the key aspects of the proposed PPF, including its coverage and level of compensation, funding mechanism and governance arrangements.

The Establishment of a PPF

3.    The Council welcomes the establishment of a PPF in Hong Kong for reasons that it will act as a 'safety net' for better protection of policyholders' interest in the event of insurer insolvency and enhance public confidence in the insurance industry.

4.    As protection schemes are already in place for other financial sectors in Hong Kong, the Council considers it equally important that policyholders' funds should have similar protection, given that they could represent a major source of liquidity for many consumers.

5.    Having said that, the Council has concern over the issue of cost shifting to policyholders under the proposal of collecting levies for the PPF from insurers. The Council is of the view that there should be safeguards in place to ensure that the cost would not be directly passed on to policyholders.

6. The Council also urges that the regulatory standards and requirements for supervision of insurers should not be in any way relaxed notwithstanding the establishment of the PPF in Hong Kong.

Key Features of the PPF Scheme

7.    The following sets out the Council's response to the recommendations as to the proposed PPF that have direct implications on consumer interests.

Coverage

Individual and SME policyholders

8.    The Council fully supports focusing the coverage of the PPF on individual and SME policyholders who are generally less capable of protecting their own interests in respect of insurance. This proposal also matches a policy objective of protecting vulnerable policyholders which is also adopted for some overseas protection schemes.

Life and Non-life schemes

9.    As regards the form of participation, the Council considers that mandatory participation of all authorized life and non-life insurers in the PPF is crucial. A voluntary system is unlikely to provide universal protection to policyholders. Rather, it may give rise to the undesirable scenario whereby insurers will refrain from joining the PPF to reduce the costs associated with the levy, hence leaving the vulnerable insured at risk of loss upon insurer insolvency. The Council therefore fully supports the proposal of making it a mandatory requirement for all insurers to participate in the PPF.

10.    The consultation paper also proposes that the PPF will accept claims in respect of all life and non-life policies, with exceptions for policies in respect of reinsurers, wholesale retirement schemes, captive insurers, and those that are already covered by the Employees Compensation Insurer Insolvency Scheme and the Motor Insurers' Bureau's Insolvency Fund Scheme. The Council has no objection to this arrangement provided that there are some safeguards to ensure that correct representation regarding PPF membership and coverage can be ensured.

11.    In addition to the proposed exceptions, the Council wonders whether exemption from the PPF would be provided, for instance, where an overseas insurer is already subject to similar protection scheme in another jurisdiction. The Council considers it important for the Government to clarify this and provide detailed information on the basis for granting such exemption (for example, circumstances under which an overseas insurer can apply for exemption from participation in the PPF).

12.    Another issue the Council would like to raise is related to the proposal that the PPF will cover all life and non-life policies written in Hong Kong, which would exclude offshore policies from the scope of the PPF. As the consultation paper lacks information on the amount of offshore policies in Hong Kong, the Council suggests the Government to explore if the exclusion would substantially lessen the level of policyholder protection.

13.    In any case, consumers should be made aware of whether insurers they are dealing with or policies concerning them are eligible for protection. The Council considers that for insurers (or policies) not covered in the PPF, there should be some safeguards to ensure that consumers are not led into believing that protection exists when it does not. Moreover, rules should be made to require scheme members' disclosure of the nature and extent of PPF protection applicable to their policyholders, and such information should be made available to existing and potential policyholders.

14.    As to the setting up of two separate and independent schemes (i.e. the Life Scheme and Non-life Scheme) under the PPF, the Council supports this proposal given the different nature of life and non-life policies.

Policies that pre-dated the PPF

15.    The Council supports the proposed coverage of the PPF to include all in-force policies as at the date of the introduction of the PPF as well as new policies issued thereafter.

Conditions for activating the PPF

16.    In relation to the proposed conditions for triggering the activation of the PPF, the Council supports laying down specific circumstances under which the PPF may be triggered in the event of insurer insolvency. The Council would welcome disclosure of such information to the public to enhance general awareness.

Eligible claims

17.    The Council welcomes the proposal of not setting any cut-off date for the submission of claims, to provide better protection for policyholders.

Level of Compensation and Application

Compensation limit

18.    It is proposed in the consultation paper that a 100% compensation cover for the first HK$100,000 and 80% of the balance, with a maximum limit of HK$1 million for an eligible claim, be adopted.

19.    A question regarding the above proposed percentages and cap on the level of compensation is whether policyholders should bear a share of any loss or whether 100% cover should be provided for a claimant. The Council has concern if the compensation limit of HK$1 million would provide adequate policyholder protection, and views that a scheme providing 100% compensation could give full protection to policyholders and promote market confidence.

20.    Notwithstanding that, the Council recognizes that a higher cap could increase the costs of participation in the PPF which might be passed on to policyholders. Considering the Government estimation that the proposed coverage would meet over 90% of the claims, the Council has no objection to the proposed tapering method (i.e. claim of a certain amount met in full and remaining balance met to a lesser extent) with a compensation cap of HK$1 million for claiming the PPF at an introductory stage.

21.    The Council also suggests that a review of the full payment amount, the percentage for the balance and the compensation cap be conducted at a later stage, to ensure they will remain effective in protecting the interest of policyholders in Hong Kong.

Basis of compensation

22.    The consultation paper proposes that compensation should be applied on a 'per-policy' basis for life insurance policies and a 'per-claim' basis for non-life insurance policies. The Council supports the proposed approach as this would be simpler to administer and could provide certainty to policyholders.

Arrangements in the event of insurer insolvency

23.    For continuity of protection in the event of insurer insolvency, the Council supports the proposals that the PPF should be able to transfer a policy to a replacement insurer wherever possible, and pay to affected policyholders an "ex-gratia" payment having regard to the losses arising from premature surrender of the policy concerned or procuring a similar policy from another insurer.

24.    In allowing consumer choice, the PPF Board should make clear to affected policyholders that they can choose to terminate the policy concerned or accept transfer of policy to another insurer. The Council urges the PPF Board to ensure that information to facilitate policyholders' decision making will be properly and effectively brought to their attention.

Funding Mechanism

Funding model

25.    In the consultation paper, a progressive funding approach for the PPF is proposed for consideration, i.e. a combination of the pre-funding and the post-funding models, with an initial moderate levy rate complemented by a stepped-up levy rate upon occurrence of insolvency. The consultation paper remarks that the progressive funding model is a more pragmatic approach.

26.    The Council is disposed to favour a pre-funding approach as this will provide certainty to policyholders that funds are already available to compensate them in the event of insurer insolvency.

27.    However, the Council notes the major drawback of the pre-funding approach of locking up a huge amount of levy the initial accumulation of which may in turn put pressure on the premium levels. Moreover, the Government has indicated that back-up funding would be provided under the progressive funding approach to bridge the liquidity gap to ensure the prompt reimbursement of policyholders' claims in case funds are not sufficient to meet liabilities in the event of insurer insolvency. The Council therefore accepts the progressive funding approach.

28.    Apart from the provision of back-up funding, the Council suggests that there should be a mechanism for triggering reinstatement or suspension of the levies when the PPF falls below a minimum prudent level or exceeds the self-funding level. A similar mechanism can be found with the Deposit Protection Scheme in which a target range with upper and lower limits is set up to provide an adequate buffer to the scheme.

29.    From the perspective of policyholder protection, the Council considers that a re-instatement mechanism is of particular importance in ensuring that there is no significant reduction in the funding level below what is required to provide sufficient protection to policyholders.

Collection of levy

30.    The Council strongly supports that the cost of financing the PPF should be borne by insurers. The Council is of the view that industry participants should have the responsibility of contributing to the PPF in case of insurer default, instead of having compensation funded by policyholders.

31.    As for other protection schemes, the Council believes that the main intention of the PPF regulation should be to have insurers accountable for problems associated with their own industry. Insurers are experts in assessing risks and they should be knowledgeable to avoid undue risk-taking. On the other hand, raising levy directly from policyholders would not pose an incentive to or have any impact on reducing insurer default.

32.    The Council is aware that the source of compensation funding for similar local protection schemes is mainly industry-based. For example, funds under the Deposit Protection Scheme are collected from banking institutions.

33.    For an industry-funded compensation scheme, some may argue that the costs of the levies although initially borne by insurers, are likely to be passed on to policyholders through higher premiums. As a result, the benefits of not requiring direct payment from policyholders may be partially reduced through the transfer of costs by insurers.

34.    In this regard, the Council considers that the PPF Board has a role to play in monitoring the situation to prevent unreasonable cost transfer to policyholders upon the inception of the PPF, given that the impact on the premium levels would be minimal as remarked in the consultation paper.

35.    With regard to the method of levy assessment, the Council notes the Government proposal of using premiums as the calculation basis on which levy can be assessed.

36.    Under this assessment method, insurers make contribution in proportion to the amount of premiums they receive. The Council considers that imposing levy based on liabilities, instead of basing levy for PPF on premium, would be more reflective of the exposure of the PPF to each insurer as it is more directly linked to the amount of payouts that will need to be made by the PPF in the event of insurer default.

37.    In considering the method of levy assessment, the Council urges the Government to ensure that it is appropriately set and that the approach to be adopted will not materially affect the effectiveness of the PPF.

Initial target fund size

38.    The Council understands that there is no single answer to the question of what the appropriate initial target fund size should be, because a trade-off is involved. That is, too large a fund implies a higher levy rate which may affect the financial integrity of the insurance industry with cost implications to policyholders, whereas too small a fund may provide inadequate funding in meeting claims from policyholders in case of insurer default.

39.    The Council therefore considers that smaller starting fund sizes of HK$1.2 billion for the Life Scheme and HK$75 million for the Non-life Scheme, are acceptable in the early stage of development. However, it is necessary to regularly review the fund sizes in the light of market developments and the changes in the risk profiles of insurers.

40.    The Council is of the view that as a small target fund size is set on the assumption that the PPF would be able to recoup against the assets of insolvent insurers, it is important for the PPF Board to work closely with the regulatory authority to ensure that any insolvent insurers would be prohibited from transferring assets overseas (asset flight) in case of cessation of their business.

41.    The consultation paper has not provided supportive information or scenario analysis on how the Government has come up with the estimation of the target fund size and the fund build-up period which would be able to provide adequate protection to policyholders. The Council suggests that detailed information on such estimation should be disclosed to the public for the sake of transparency.

Levy rate

42.    The consultation paper suggests that the initial levy rates for both the Life Scheme and the Non-life Scheme should be 0.07% of the applicable premium. The Council accepts the proposed introduction of a levy rate of 0.07% at the early stage of the PPF, but an annual review should be conducted to check whether it remains appropriate, or whether the rate need to be increased or reduced. This is important to ensure the PPF has sufficient resources to meet claims; and that the levy is not excessive resulting in a financial burden for insurers which might ultimately be passed on to policyholders, notwithstanding the competition among insurers.

43.    In addition, the Council considers that a more sophisticated approach should be adopted at a later stage taking account of experience and the availability of the insurer's supervisory risk rating. The Council suggests that a risk-based levy system should be adopted to calculate levies for individual insurers. Using a risk-based approach would reduce moral hazard and avoid implicit cross-subsidization among insurers.

Financial arrangement to bridge liquidity gap

44.    Whilst accepting that the PPF should not be accumulating assets beyond the amounts it needs, the Council sees it crucial for policyholder protection to have a mechanism in place to bridge any liquidity gap so that the PPF will be able to effect immediate release of funds to affected policyholders at the time of an insurer failure. The availability of back-up funding is particularly important at time of failure as there will be confusion and alarm on the part of policyholders.

45.    In this regard, the Council supports the proposal that the PPF Board may resort to borrowing from a third party to bridge any liquidity gap, for purposes of protecting policyholders and maintaining public confidence in the insurance industry.

Governance Arrangements

Legal and organizational structure

46.    To safeguard the interest of the consuming public and the public at large, the Council supports that the PPF should be established by legislation and be administered by an independent statutory body to ensure transparency and accountability of its operation.

47.    With regard to the composition of the PPF Board, the Council supports having a majority of professionals from various sectors instead of industry participants, to ensure sufficient independence. The Council suggests that consumer representation be included on the PPF Board to speak for the wider community interest.

48.    Furthermore, the Council considers the two industry committees to be set up under the PPF Board should be of advisory nature and include professional members as appropriate.

Functions and powers of the PPF Board

49.    The Council suggests that the PPF Board should have the responsibility of promoting the PPF to the public.

50.    For instance, it should be made clear to the public what rules and procedures will be used when the PPF is applied in case of insurer insolvency to reassure policyholders that at the time of insurer insolvency, the PPF will be able to effect a speedy and accurate payout to lessen the burden on policyholders. The PPF Board will also need to give guidance to policyholders on how to file claims for reimbursements. This will be important in helping to avoid potential financial hardship for policyholders and maintain public confidence in the insurance industry.

Governance arrangements

51.    As regards the proposed governance arrangements of the PPF Board, the Council supports the proposals of having annual budgets submitted for the Financial Secretary's approval, publication of annual reports for vetting of the LegCo, and appointment of auditor to perform reviews on the PPF.

52.    However, the consultation paper has not mentioned any interface arrangement between the PPF Board and the supervisory authority. It is noted that international best practice seems to be in favour of a degree of separation in terms of governance between protection fund scheme and supervisory authority. The Council therefore suggests that the Government should explore the degree of separation in terms of governance between the PPF Board and the supervisory authority, with a view to avoiding conflict of interest and providing greater accountability and transparency to the public.

Daily operations

53.    Given the comparative rarity of insurer insolvencies in Hong Kong and the cost saving consideration, the Council supports that the PPF Board should maintain a small team of staff for carrying out the daily operations of the PPF.

Confidentiality

54.    The Government proposes in the consultation paper that confidentiality provisions would need to be written in the PPF legislation to ensure that the PPF Board including its staff should be duty bound to keep sensitive information obtained in carrying out their delegated functions confidential.

55.    The Council understands the rationale behind keeping sensitive information about insurers confidential because the disclosure of such sensitive information, substantiated or otherwise, may put market stability at stake. However, as a matter of general principle, consumers should have access to sufficient information in order to make an informed choice. The manner in which a balance is to be achieved in maintaining confidentiality and meeting the need for transparency is a matter that should be addressed by the Government.

56.    A searchable database accessible to consumers would assist them in tracing an insurer in order to determine its status as participating insurers, its financial situation and its position relative to other insurers. This may meet consumers' information needs. In this connection, the Council recommends that a database containing comparative financial and non-financial information on insurers should be provided.

Appeal mechanism

57.    The Council welcomes the proposed setting up of an Appeal Board to allow policyholders to appeal against the decisions made by the PPF Board, for instance, about compensation payment or refusal to make payment. The Council suggests that the procedures and rulings of the Appeal Board should be documented and made transparent to the public and consumer representation should be provided for in the mechanism.

Conclusion

58.    In regard to the proposed establishment of a PPF in Hong Kong, the Council's overall stance is that Hong Kong policyholders should have a protection scheme that will advance the limited protection currently available, and having such a scheme will bring Hong Kong in line with the world's best practice.

59.     The Council urges that the future PPF Board keeps under review the scope and level of coverage, the fund sizes and levy rates for the PPF, taking into account changes in the market and the expanding range of products developed by insurers.