Recommendation 2016-R-04 on the marketing of life insurance contracts in units of account constituted by complex financial instruments

1 Online publication on the ACPR website on 19/12/2019 Recommendation 2016-R-04 of December 13, 2016 concerning the marketing of life insurance contracts in units of account constituted by complex financial instruments, modified on December 6, 2019

1. Context Faced with the information asymmetry that exists between non-professional investors and producers or distributors of structured UCITS and complex debt securities (notably EMTNs), the difficulty for a non-professional clientele in understanding these products, and the risk of non-compliance with their obligations by those marketing them, the AMF decided to make public a position regarding the direct marketing of these products1. The ACPR, responsible for protecting the clientele of insurance undertakings, examines these financial instruments as underlying assets for life insurance contracts. Consequently, the ACPR decided to adopt a recommendation on the use as units of account of these structured financial instruments that present a risk of mis-selling, in order to clarify the conditions under which insurance undertakings and intermediaries can comply with their legislative and regulatory obligations regarding information and advice. This recommendation:

• recalls the responsibility of insurance undertakings and insurance intermediaries in the information and advice provided to policyholders/members regarding the financial instruments serving as units of account;
• draws the attention of insurance undertakings and intermediaries to the objective criteria for the risk of mis-selling of life insurance contracts underwritten by complex financial instruments.

2. Scope of the recommendation 2.1. The units of account concerned Article L. 131-1 of the Insurance Code,2 second paragraph, provides: "In the matter of life insurance or capitalization operations, the guaranteed capital or annuity may be expressed in units of account constituted by securities or assets offering sufficient protection of the invested savings and listed on a list drawn up by decree in the Council of State." Article R. 131-13 sets out the list of assets that can serve as units of account and caps the portion of the premium that can be invested in certain of these assets. The ACPR's recommendation concerns units of account constituted by:

• French law "structured" UCITS (covered by Article R. 214-28 of the Monetary and Financial Code);
• equivalent foreign structured UCITS4;
• complex debt securities and equivalent financial instruments issued under foreign law, excluding simple warrants, the latter being defined as structured products in the form of listed options (continuously traded) on a regulated market or a multilateral trading system, giving the right (but not the obligation) to buy or sell a chosen asset, at a price fixed at issuance and for a specified period.

2.2. The persons concerned The ACPR's recommendation is addressed to persons who design or market life insurance and/or capitalization contracts in units of account on French territory. As such, it addresses insurance companies, mutual insurance companies, mutuals or unions under the Mutual Code, and provident institutions (the "insurance undertakings") and insurance intermediaries (including those providing services freely or establishing themselves freely, provided they market the relevant unit-linked contracts on French territory).

3. On the obligations of insurance undertakings and intermediaries in the marketing of the concerned contracts 3.1. Reminder of legislative and regulatory provisions In addition to the list of assets that can serve as units of account mentioned above, the regulation covers three points: sufficient protection of invested savings and guarantees fixed by the contract, and obligations regarding information and advice.

• Guarantees fixed by the contract and sufficient protection of invested savings In the matter of unit-linked contracts, Article L. 131-1, first paragraph5, provides that "the insured sums are fixed by the contract" and that the securities and assets serving as units of account must offer "sufficient protection of the invested savings".
• Information obligations According to the provisions of Article L. 132-5-26, the insurer must provide the policyholder with an information note containing the essential provisions of the contract specified by order, notably regarding guarantees expressed in units of account. Article A. 132-4 thus imposes that the insurer provide the policyholder with an "indication of the main characteristics" of each unit of account chosen. Article L. 132-277 provides that information on life insurance contracts and capitalization contracts must present "clear, accurate, and non-misleading content".

Furthermore, Article L. 132-288 imposes on insurance intermediaries the obligation to conclude an agreement with insurance or capitalization undertakings, specifying the conditions under which:

• the intermediary must submit to the insurance undertaking, prior to their distribution, advertising documents as well as information sheets;
• the insurance undertaking must make the necessary information available to the intermediary. Article R. 132-5-1 provides, unless exceptions9 apply, that this agreement must be in writing and specify the respective obligations of the insurance undertakings and intermediaries.
• Duty of advice and personalized recommendation service Article L. 522-5 provides for two levels of life insurance advice. Paragraph I of Article L. 522-510 provides that "the intermediary or the insurance or capitalization enterprise specifies in writing the requirements and needs expressed by the prospective policyholder or member, as well as the reasons justifying the appropriateness of the proposed contract. [...]. To this end, this intermediary or enterprise inquires with the policyholder or member about their financial situation and investment objectives, as well as their knowledge and experience in financial matters". These provisions describe the obligations incumbent on all intermediaries, insurance undertakings, and capitalization companies for the exercise of their duty of advice and the assessment of the appropriateness of life insurance and capitalization contracts. Without prejudice to the aforementioned provisions, Paragraph II of Article L. 522-5 provides that "when a personalized recommendation service is provided by the intermediary or the insurance or capitalization enterprise to the prospective policyholder or member, this service consists of explaining to them why, among different contracts or different investment options within a contract, one or more contracts or options are more adequate to their requirements and needs and in particular more suited to their risk tolerance and capacity to bear losses". These provisions introduce the possibility for an intermediary, insurance undertaking, or capitalization company to provide, in continuation of their obligation of advice and information, a personalized recommendation service. This service is based on a comparative analysis of different insurance solutions to recommend to the client those that best meet their requirements and needs. The provision of this service entails an assessment of the adequacy of the recommended contract(s) or option(s). Intermediaries, insurance undertakings, or capitalization companies that provide a personalized recommendation service within the meaning of Article L. 522-5 are subject to the provisions of Sections 1 and 3 of Chapter III of Delegated Regulation (EU) 2017/2359. For the application of the provisions of Section 1 of Chapter III of said regulation, the term "personalized recommendation service" should be understood where the term "advice" is mentioned in the regulation11. Intermediaries, insurance undertakings, or capitalization companies that do not provide a personalized recommendation service within the meaning of Article L. 522-5 are subject to the provisions of Sections 2 and 3 of Chapter III of Delegated Regulation (EU) 2017/2359. Furthermore, the second paragraph of Article L. 522-6 places on the intermediary, insurance enterprise, or capitalization enterprise a duty to warn, prior to the conclusion of the contract, if the policyholder or member does not provide the information mentioned above.

3.2. Obligations of insurance undertakings and intermediaries It is necessary to deduce the following consequences from the provisions recalled above:

• insurance undertakings must: choose securities or assets allowing for sufficient protection of invested savings; provide intermediaries who market the contract with the necessary information to assess all characteristics of the unit of account and the proposed contract; when marketing contracts directly, ensure that their own employees have the elements enabling them to provide clients with adapted information and appropriate advice or an adequate personalized recommendation service, deliver this information and advice or service to their clients, and, if the policyholder/member does not provide sufficient information, warn them;
• insurance intermediaries must deliver to their client appropriate information and advice or an adequate personalized recommendation service, and, if the policyholder/member does not provide sufficient information, warn them.

4. On the determination of objective criteria to assess the risk of mis-selling The ACPR defines, in line with the AMF's position on the marketing of complex financial instruments, four criteria to evaluate whether the units of account proposed within life insurance contracts present a risk of poor risk comprehension by the policyholder/member and unintelligibility of the contract. Furthermore, since the life insurance contract can be terminated by death at any time, capital loss risks must be assessed accordingly, and not only at the maturity date of the financial instrument, if it has one.

4.1. Risk of poor risk comprehension by the policyholder/member Criterion No. 1: Poor presentation of the risks and gain/loss profile of the financial instrument The risk of poor presentation is potentially high for units of account whose performance is sensitive to extreme scenarios (sudden market drops, modification of the economic environment...), even if their probability of occurrence is very low. This is the case notably when they are presented as combining capital protection and performance. The chances of gains are thus indicated as almost inevitable, and the scenarios envisaged in the documents sometimes reflect only the most favorable assumptions. The policyholder/member is likely to misapprehend a risk due to the presentation of a unit of account whose performance is sensitive to unfavorable extreme scenarios.

Criterion No. 2: Unusual nature for the policyholder/member of the financial instrument due to the underlying(s) used Some financial instruments use underlyings difficult to apprehend by policyholders/members and generally not individually observable on markets, such as, for example, the volatility of an asset or the correlation between several assets. Products built on these underlyings therefore present the risk of being misunderstood by policyholders/members, who, for underlyings with limited public availability, are also unable to track their evolution.

Example 1 Unit of account presenting a gain/loss profile of the type "fixed gain of 10% regardless of the index level if it is up compared to its initial level and capital loss equivalent to the index drop if the latter experiences a drop of more than 40%."

Criterion No. 3: Gain/loss profile subject to the simultaneous realization of several conditions on at least two asset classes Some units of account have a return linked to the realization of several simultaneous conditions on different asset classes (stocks, interest rate products, real estate...) making it difficult for a policyholder/member to reconstruct the market scenario they must anticipate.

Example 2 Quater Unit of account indexed on an index (whether systematic or non-systematic) whose selection and/or weighting and/or rebalancing of components is based on (i) the 50 most liquid values from the investment universe, then (ii) the 30 values offering the highest dividends among the 50 retained, then (iii) the 10 values presenting a Beta lower than X% among the 30 retained. The 10 final retained values are equally weighted and the composition of the index is reviewed on an annual basis.

Example 2 Unit of account whose performance is linked to the level of correlation observed over a certain period between the stock of an oil company and the level of a commodities index.

The investor must here anticipate the evolution of the correlation between the stock and the underlying index, which generally requires a high level of expertise.

Example 2 bis Unit of account indexed on the VSTOXX index which exposes the policyholder/member at maturity to a loss of 50% of the invested capital if the index drops by 50%.

The underlying of the unit of account, the EURO STOXX 50 volatility index, is difficult to apprehend by a policyholder/member.

Example 3 Unit of account which at maturity proposes the average performance of the CAC 40 over a 5-year period increased or decreased by an annual coupon conditioned by the evolution of the bond market: (i) Each year, if the 10-year CMS rate is higher than the 2-year CMS rate by more than 55bp, and the CAC 40 is up, a coupon of 4% is acquired at maturity. (ii) Each year, if the 10-year CMS rate is higher than the 2-year CMS rate by less than 20bp, and the CAC 40 is down, the final performance is decreased by an amount of 1%.

Two asset classes condition the final performance of the unit of account: stocks and rates. It is delicate, even impossible, for the policyholder/member to reconstruct the macro-economic market scenario they must anticipate.

4.2. Risk of unintelligibility of the unit of account Criterion No. 4: Number of mechanisms included in the gain or loss calculation formula of the unit of account Understanding the risk taken requires a good appreciation of the calculation steps of the product and the mechanisms of realization of the formula or the nature of the underlying asset class. However, when there are more than three different calculation mechanisms to determine the overall return of the product, directly or through a structured underlying index, it is delicate, even impossible, for the policyholder/member to reconstruct the "bet" they are taking, i.e., to understand the mechanisms leading to the realization of a loss or gain depending on a market scenario.

Indicative non-exhaustive list of strategies that can be counted as a formula mechanism:

• an underlying calculation algorithm of a proprietary strategy index;
• an averaged performance;
• a cap/floor effect;
• a protection deactivated upon breaching a downward threshold;
• a "memory" effect;
• a crystallization of gains.

Example 4 Unit of account which at maturity proposes the following gain/loss profile: (i) The average quarterly performance over 5 years of a strategy index that overweights the 20 best-performing CAC 40 values over the past month and underweights the 20 worst-performing stocks. (ii) If at a quarterly observation date, the index experiences a rise greater than 10% compared to the previous quarter, a coupon or bonus of 6% will be acquired at the product's maturity. (iii) If at a quarterly observation date, the index experiences a drop greater than 30% compared to its initial level, then the product is dissolved (or terminated in advance) and the holder is reimbursed in advance. Their initial capital is then reduced by the entire drop of the index and potentially increased by the bonuses acquired during previous quarters.

High risk of unintelligibility. Four different mechanisms enter into the calculation of the final performance: an averaging effect, a strategy intrinsic to the underlying index, a bonus in case of breaching an upward barrier, and a loss in case of breaching a downward barrier.

Example 4 bis (Example of use of particular underlyings allowing to count several additional calculation mechanisms) Unit of account indexed on an equally weighted index (whether systematic or non-systematic) which includes several selection and/or rebalancing criteria for its components, one of which is based on a selection of the 60 least volatile stocks over the last 6 months. The index is "dividends reinvested" but deducts a fixed annual amount/percentage.

5. Recommendation Life insurance contracts in units of account may present, given their nature, risks of poor comprehension by policyholders/members of the potential losses to which they are exposed, or even unintelligibility. In particular, life insurance contracts whose units of account constituted by structured UCITS or complex debt securities that meet at least one of the criteria defined above present a high risk of non-compliance with the legislative and regulatory obligations applicable to their marketing. Due to the characteristics of these financial instruments, insurance undertakings and intermediaries might thus not be able to comply with the aforementioned provisions. For these financial instruments serving as underlying for units of account and not offering capital protection of at least 90% of the invested capital over the lifespan of the financial instrument, the ACPR recommends, in accordance with point 3° of II of Article L. 612-1 of the Monetary and Financial Code, to insurance undertakings and intermediaries:

5.1. Regarding financial instruments whose performance is sensitive to extreme scenarios: 5.1.1. To expose, including in commercial documents, in a manner understandable to a policyholder/member, the information that must allow them to reasonably understand the nature of the underlying proposed as a unit of account, as well as the associated risks, and in particular: 5.1.1.1. To present the unit of account as a risky investment, and not as a unit of account offering attractive and safe yields except upon realization of an extreme scenario whose probability of occurrence would be almost null; 5.1.1.2. To clearly expose the situations in which the maximum risk occurs without minimizing the possibility of its occurrence; 5.1.1.3. To present the maximum risk scenario in clear comparison with the favorable scenario of potential gains; 5.1.1.4. To indicate in a manner understandable to a policyholder/member, prior to the choice of the underlying, the consequences on the amount of invested capital, in case of surrender of the contract before its term, termination by death before the maturity date of the financial instrument (when it has one), or at the end of the contract in the event of occurrence of unfavorable scenarios and the extreme scenario. 5.1.2. To describe, in a comprehensible manner, in the document formalizing the advice or personalized recommendation provided for in Article L. 522-5, the information delivered to the policyholder/member. 5.1.3. To be in a position to justify to the ACPR the means implemented (regarding continuous training, provided for in Article L. 511-2, II, a specific training device for personnel specific to the complexity of the products) so that policyholders/members are able to understand that the proposed financial instrument constitutes a risky investment and to know the situations in which the maximum risk occurs as well as the consequences on the amount of invested capital, in case of surrender of their contract before its term, termination by death before the maturity date of the financial instrument (when the contract has one), or at the end of the contract in the event of occurrence of unfavorable scenarios and