Guideline on Scenario Analyses from a Customer Perspective

SUPERVISION GUIDELINE NOVEMBER 2024 Scenario Analyses from a Customer Perspective

In Short By carefully developing financial products, enterprises can prevent foreseeable disappointments for customers. An important component of the product development process (PARP) is scenario analysis, which takes customer interests into account. AFM PARP investigations show that enterprises are still searching for the right approach when applying scenario analyses. The AFM aims to provide guidance on the use of scenario analyses with this guideline. In addition, the guideline contains a number of examples of scenario analyses for different product groups.

Step 1 Start in the development phase. Step 3 Involve the right expertise. Step 4 Choose the right method. Step 7 Document the results and any follow-up steps, and verify their execution. Step 6 Check whether and where changes are needed based on scenario results. For example in the product, in the distribution method, or in the target group. Step 5 If necessary: investigate the interplay between scenarios. For example by using proxy customers. Step 2 Which scenarios are needed: quantitative or qualitative?

This is how scenario analyses are carried out carefully: Go directly to the corresponding chapter. §3.4 §3.2 §3.5 §3.2 and §3.3 §3.2 Ch4 §3.6

SUPERVISION GUIDELINE Contents

1. Introduction 3 1.1 Rationale for this guideline 3 1.2 Relevant legislation 4 1.3 Which enterprises must conduct scenario analyses? 5
2. Why are scenario analyses important? 6
3. How can an enterprise conduct scenario analyses? 7 3.1 How can an enterprise conduct scenario analyses in practice? 7 3.2 Which scenarios can an enterprise analyze? 8 3.3 Proportionality: depth of elaboration depends on product complexity and impact 10 3.4 At what point in the process are the scenario analyses conducted? 10 3.5 How can an enterprise ensure that scenario analyses are carried out carefully? 11 3.6 The importance of careful documentation 11
4. What do scenario analyses deliver? 12

Scenario Analyses from a Customer Perspective 3 SUPERVISION GUIDELINE

1. Introduction 1 PARP stands for Product Approval and Review Process, and is also referred to as product governance. 2 For distributors, there is no obligation under PARP to conduct scenario analyses. However, the distributor may carry out additional analyses for the purpose of its distribution strategy and (possibly) refining the target group. In that case, scenario analyses could serve as a tool. See paragraph 1.3. 3 Pension funds are not subject to the PARP standard, but are subject to the instruction confirmation standard. In that context, they must also conduct scenario analyses to make the effects of their pension scheme visible. You can find more information about this in the instruction confirmation guideline of July 2023: https://www.afm.nl/~/profmedia/files/wet-regelgeving/beleidsuitingen/leidraden/leidraad-opdrachtbevestiging.pdf.

By carefully developing and evaluating financial products, enterprises can prevent foreseeable disappointments for customers. This contributes on the one hand to better consumer protection and on the other hand to greater confidence in the financial sector. An important component of product development and evaluation is scenario analysis. In this guideline, the AFM provides guidance to financial enterprises on how to give substance to this.

1.1 Rationale for this guideline Through scenario analyses, an enterprise investigates the functioning of the product under different circumstances (scenarios). This gives the enterprise insight into how the product works and allows it to verify whether it (still) fits the objectives of the target group under certain circumstances. In this scenario thinking, it is crucial that the impact of different situations and market conditions on the target group (customers, clients, or beneficiaries) is investigated, and that the results of the analyses are used in the product development process (PARP).1 The results of the analyses can lead to adjustments to the target group or distribution strategy. It may also become clear from the scenario analysis that adjustments to the product or the management of the product are necessary. In the event of changing market conditions, it is especially important that enterprises have conducted relevant scenario analyses so that they can take timely action or evaluate their products if necessary. The AFM continuously pays attention to the design and execution of PARP by market parties. The AFM's investigations show that enterprises are still searching for the right approach when carefully designing and executing relevant scenario analyses. For example, enterprises struggle with shaping their scenario analyses and using the results of the analyses in the balanced interest assessment that must take place in the PARP. The AFM also observes that enterprises often approach scenario analyses from a corporate perspective, and to a lesser extent investigate the impact on the product's target group (the customer perspective). Enterprises benefit from a clear view of the customer perspective in the event of disappointing circumstances, as this reduces the risk of misselling. The AFM aims to provide guidance to developers and co-developers of financial products2 regarding scenario analyses within the framework of PARP. The guideline applies to developers of all types of products subject to the PARP standard. Where pension examples are included in this guideline, this applies to pension insurers and premium pension institutions. Pension funds are not subject to the PARP standard.3 The guideline contains a number of examples of scenario analyses for different product groups, but does not provide an exhaustive overview of all requirements regarding scenario analyses.

Scenario Analyses from a Customer Perspective 4 SUPERVISION GUIDELINE The AFM answers three questions in this guideline: • Why are scenario analyses important? • How can an enterprise conduct scenario analyses? • What do scenario analyses deliver?

What is a guideline? A guideline is a written policy statement in which the AFM aims to provide direction and clarity to market parties. A guideline gives, for example, recommendations, guidance, or additional explanation. With a guideline, the AFM can also provide (behavioral) guidelines to the market. The purpose of a guideline is to inform a specific group of people or provide more insight into a particular subject. This guideline does not have the status of legislation. Market parties are themselves responsible for complying with legislation. This guideline serves as a tool in this regard.

1.2 Relevant legislation Since 2013, there have been legal requirements for the product development by financial enterprises and the manner in which they distribute products to the appropriate target group. This standard is laid down in Article 32 of the Decision on Conduct Supervision of Financial Enterprises Wft (BGfo). Enterprises are expected to carefully design and execute their product development process (PARP). 4 Delegated Regulation (EU) 2017/2358. 5 ESMA35-43-3448_Guidelines_on_product_governance_NL.pdf (europa.eu). 6 Guidelines on product oversight and governance arrangements for retail banking products | European Banking Authority (europa.eu). 7 EIOPA’s approach to the supervision of product oversight and governance - European Union (europa.eu). 8 EIOPA publishes guidance on integrating the customer’s sustainability preferences in the suitability assessment under the IDD - European Union (europa.eu). 9 As stipulated in Article 32, second paragraph, sub b, BGfo, Article 6 of Delegated Regulation (EU) 2017/2358 (IDD) and Article 9, tenth paragraph, of Delegated Directive (EU) 2017/593 (MiFID II).

After 2013, European sectoral PARP legislation was established for various financial products. This has been implemented in Dutch legislation in Articles 32, 32a, 32aa, 32ab, 32b, 32c, and 32e BGfo. For the insurance sector, the specific delegated IDD regulation applies.4 In addition, the various European sectoral supervisors (ESAs) have drawn up guidelines or other clarifications for PARP, such as the ESMA guidelines,5 the EBA guidelines,6 the EIOPA approach7 and the EIOPA guidance.8 An important component of developing and evaluating products is conducting scenario analyses. The importance of conducting scenario analyses is also emphasized in sectoral regulation.9 This guideline focuses on scenario analyses and provides direction on conducting scenarios, regardless of sector or product group. This does not mean that sectoral legislation does not impose additional product-specific requirements, such as mandating certain scenarios. This guideline is not intended to replace sectoral legislation. The AFM aims to provide direction and clarity on how scenario analyses can be designed across all sectors.

Scenario Analyses from a Customer Perspective 5 SUPERVISION GUIDELINE 1.3 Which enterprises must conduct scenario analyses? There are different PARP standards for developers and distributors of financial products. Developers are enterprises that offer, assemble, and make financial products available on the market. Distributors are the financial enterprises, such as financial service providers, that distribute and sell the products. Developers of financial products are obligated to conduct scenario analyses.10 It is also possible to be a co-developer of a financial product.11 This is the case when the enterprise is not the sole developer but still plays a role in decision-making regarding the design and development of a product. In that case, the (co-)developers must document their mutual agreements on product development in writing. Distributors are obligated to use the developer's information about the target group when determining their distribution strategy.12 The distributor decides whether it needs information about the scenario analyses conducted by the developer. If the distributor concludes that it needs this information, it is logical to request it from the developer. The manner in which the information exchange takes place is up to the developer and distributor. Based on the developer's information and information about its own clients, the distributor may refine the target group. The distributor must ensure that the financial products meet the needs, characteristics, and objectives of the target group and must ensure that the distribution strategy aligns with the respective target group. If the distributor concludes that the necessary information from the developer is insufficient for this, the distributor is free to conduct the relevant (scenario) analyses itself. It could also choose not to offer the product in such cases.

10 As stipulated in Article 32, second paragraph, sub b, BGfo, Article 6 of Delegated Regulation (EU) 2017/2358 (IDD) and Article 9, paragraph 3, of Directive 2014/65/EU (MiFID II). 11 Legal standards for (co-)developers and distributors of insurance products (afm.nl). 12 As stipulated in Article 32ab, second paragraph, BGfo, Article 32b, sixth paragraph, BGfo, and Article 32e, second paragraph, BGfo.

Scenario Analyses from a Customer Perspective 6 SUPERVISION GUIDELINE 2. Why are scenario analyses important? 13 The elaboration of this can be found on the AFM website: Product development and distribution (afm.nl).

At its core, PARP revolves around a balanced assessment of different interests (such as those of the customer, the enterprise itself, or other stakeholders) in the development of financial products. A financial product must demonstrably be the result of this interest assessment. Only products that are in the customer's interest and are offered to a defined group of customers for whom the product is suitable (the target group) should be developed. It must be prevented that the financial product is sold outside the target group. When developing and evaluating products, it is important that enterprises test whether their product will meet the objective(s) of the target group under various scenarios. Changing circumstances can indeed influence how a product works for the target group. Market conditions, such as interest rates or house prices, but also the customer's personal situation, for example in the event of a divorce or the death of a partner, can change. Enterprises themselves map out which scenarios are relevant for the respective product. In this scenario thinking, it is crucial that relevant effects for the target group (consumers, clients, or beneficiaries) are investigated. To verify that the product does not detract from the objective(s) of the target group, the enterprise must document and weigh the interests of consumers, clients, or beneficiaries in the scenario analyses. A method that can be used here is applying the KNVB criteria.13 Scenario analysis is a powerful tool for the enterprise in determining how the product, target group, or distribution method should be designed. In addition, it helps verify whether the product, target group, and/or distribution method need to be adjusted. In this way, the enterprise can ensure that the product continues to meet the target group's objectives. The results of these scenario analyses must be used when designing the product's characteristics and defining the product's target group. The functioning of the product as a whole and its individual components under different scenarios can be determined using scenario analyses.

AFM Market View The AFM observes in practice that enterprises often approach scenario analyses from a corporate perspective, and to a lesser extent investigate the effects on the product's target group. An example of this is that enterprises map out the profitability (margins) of a product under various scenarios, but do not investigate the effect of the costs on the target group in these scenarios. Enterprises must take the target group's perspective into account when (continuing to) develop their products. If enterprises do not conduct adequate scenario analyses, there is a real chance that foreseeable disappointments will occur for customers with the product. In addition to significant damage to consumers, enterprises may have to carry out (costly) remedial actions in such cases, and their reputation may suffer. An enterprise thus also has an interest in testing its products well from the customer's perspective. In short: both the enterprise and the customer benefit from robust products.

Scenario Analyses from a Customer Perspective 7 SUPERVISION GUIDELINE 3. How can an enterprise conduct scenario analyses? 14 See Annex 2 of the Occasional Paper on repayment-free mortgages for an example of this. Figure 19 graphically illustrates the influence of, among other things, the mortgage interest rate, house prices, and the assessed income on the refinancability of repayment-free mortgages. 15 The Monte Carlo simulation is, for example, a statistical method in which the probability of different outcomes is modeled. Conducting a simulation involves repeating or duplicating the characteristics and behavior of a real system. The main goal of the Monte Carlo simulation is therefore to try to imitate the behavior of real variables to, as far as possible, analyze or predict how they will evolve. 16 Note: the prescribed analyses as in PRIIPs are intended for providing information to the customer, presented in the KID. As also indicated in EIOPA's explanation, these performance analyses can also be used for stress-testing the product and may correspond to the scenarios presented in the KID. However, the scenario analyses for testing the product from a PARP perspective have a broader scope than testing performance under various market scenarios.

3.1 How can an enterprise conduct scenario analyses in practice? First, an enterprise determines which scenarios must be included. For this, the enterprise must gain insight into which scenarios are relevant for the functioning of the product in relation to the target group. This relevance depends mainly on how decisive product characteristics and external factors viewed from the product (such as life events for the customer, longevity risk, and the macroeconomic and fiscal context) are for the functioning of the product. Enterprises can make this visible using sensitivity analyses. Here, product characteristics and applicable external factors are inventoried, and it is examined to what extent the functioning and/or performance of the product are sensitive to changes/variations thereof.14 Subsequently, an enterprise maps out the effects on the target group in the relevant scenarios. Here, the relevant characteristics of the product are taken into account, so that the enterprise can determine whether the product continues to meet the objective(s) of the target group. Certain (unique) characteristics of a product can have (significant) influence on how a product works, such as the compound interest effect in repayment-free mortgages or whether or not the macro longevity risk is co-insured in a variable pension payout. For insurance products, certain coverages and exclusions can be crucial for the target group. Such product characteristics will emerge as sensitive parameters and/or assumptions from the aforementioned sensitivity analyses. It is important to shape and vary the scenarios based on the most sensitive parameters/assumptions, while also taking into account the stacking of these parameters/assumptions and the interaction between them. In this way, it becomes clear not only what effect one scenario has, but also how scenarios interact and influence the functioning of the product. To map out the effects of certain scenarios, an enterprise can use proxy customers (hypothetical persons serving as examples). Using proxy customers helps to gain an image of the effects for the (sub)target group. There is a risk that an enterprise, by focusing too much on individual characteristics, loses sight of the broader picture of the effects. Enterprises must not only work out scenarios qualitatively for certain products, but also run the numbers. Whether quantifying scenarios is necessary depends on the nature of the product. The more complex and impactful a product is, the greater the importance of quantifying scenarios. This quantification of scenarios can, for example, be done through statistical analyses. For instance, a developer can calculate the effects of a product characteristic (such as costs) over the product's term under both constant and changing market conditions. Other examples include using (statistical) simulations15 or using performance scenarios according to the PRIIPs methodology.16

Scenario Analyses from a Customer Perspective 8 SUPERVISION GUIDELINE Note: the standards for product development do not prescribe exactly which methods a developer must use to conduct scenario analyses. It is up to enterprises to select appropriate methods and substantiate that choice. It may be necessary to use different methods for the same product: for an investment product, the PRIIPs methodology can provide insight into the expected return under various market conditions. In addition, a developer can take into account possible relevant life events that may occur during this (long) term.

Example of quantification: repayment-free mortgages A provider of repayment-free mortgages calculates what impact a sharply rising interest rate has on the objectives of the initially defined target group. Due to the compound interest effect of these products, costs can rise significantly, making the target group's objective potentially unattainable. This compound interest effect must be mapped out under both constant conditions over certain terms and under changing conditions such as a rising interest rate. A rising interest rate cannot be prevented, but with this analysis, a better estimate can be made of when customers no longer achieve their objective and/or when the costs no longer stand in proportion to the added value of the product. Using proxy customers in this analysis can help to map out the impact on different groups more sharply (for example, by defining a number of profiles that fall under the product's target group). 17 The product is cost-efficient from a customer perspective if it offers value for money. This concerns the added value for the customer, not the extent to which the provider operates cost-efficiently.

An enterprise must determine, based on the results of scenario analyses, whether the product, target group, and/or distribution method need to be adjusted. In doing so, it also considers whether the customer should be better informed about the possible risks. A provider of a repayment-free mortgage, for example, could adjust the maximum Loan-to-Value (LTV), because analyses have shown that an average interest rate increase can lead to a significant group of customers quickly withdrawing (consuming) the value from their home and therefore no longer having money to withdraw. In this example, it is therefore necessary to change the product. Sometimes an adjustment to the target group or distribution method is also necessary.

3.2 Which scenarios can an enterprise analyze? Enterprises must take into account the complexity, impact, and (unique) characteristics of the product when conducting scenario analyses. A fully standardized approach therefore does not exist. Examples of scenarios to consider include: • Functioning of the product under constant market conditions: Providers must make it clear how the product works and must map out relevant risks. How high are the costs, for example, in different customer situations? And how high do the costs rise over the term of the product? Do the costs align with the target group's objective? In other words: do the costs stand in proportion to the underlying value of the product? Some products can be cost-efficient17 from a customer perspective with a high contribution due to their (fixed) cost structure, but not with a low contribution. The provider can make the product more cost-efficient17 for the target group in this case by adjusting the cost structure and/or the minim