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Acknowledgements
This report could not have been completed without the assistance of a number of organisations. The
Actuarial Profession would like to take this opportunity to express our thanks to the following lenders who
participated in our interview programme:

"       Abbey National

"       Barclays

"       Britannia Building Society

"       Cheltenham & Gloucester

"       HBOS

"       HSBC

"       Leeds & Holbeck Building Society

"       Mortgage Express

"       Nationwide Building Society

"       Principality Building Society

"       Yorkshire Building Society

In 2002, the combined market share of these lenders was 71.5% of new mortgages by value.

We would like to thank the following for their assistance in providing research material and assistance:

"       LIMRA

"       The Compliance Institute

"       The Journal of Insurance Regulation

"       Louise McCulloch – Standard Life Bank

We would also like to take this opportunity to thank the Council of Mortgage Lenders for the assistance they
provided in facilitating this report.

Finally, we are grateful to Watson Wyatt for its support.




The views expressed in the report are not necessarily those of the Actuarial Profession.
                                      FOREWORD




                                                                                                Staple
                                                          was first presented at a seminar at
I was very ple   ased to introduce this report when it
 Inn on 2nd July 2003.
                                                                          areas of expertise. In this
  It is always good to see our    profession step outside its traditional                      on the
                                                      lysis of the impact of sales regulation
   paper the  authors provide a comprehensive ana
                                                               the potentially wide-reaching
   life industry and  put this to great effect in identifying
                                           ry of pending regulation.
   implications for the mortgage indust
                                                                             e a vested interest in a
    As the market leader in the   UK mortgage industry, we at HBOS hav                            the
                                                         been active in working with many in
     healthy ma rketplace. Like many others we have
                                                              pare for regulation in 2004.
     industry to think through all the implications and pre
                                                                   contribution to this industry. It will
      This paper confirms  that the profession can make a real
                                             with more food for thought.
      provide both lenders and distributors




     JAMES CROSBY,
     Chief Executive, HBOS plc




                                                    i
ii
Contents


Section                                                                                Page


Foreword                                                                                  i


Executive summary                                                                        1


1      Introduction                                                                      3


2      History of regulation in the life insurance industry                              5


3      Impact of the introduction of sales regulation in the life insurance industry     10


4      Structure and changes to distribution channels in the life insurance industry     14


5      Overview of mortgage industry sales and distribution                              17


6      Regulatory changes affecting the mortgage industry                               19


7      Projected impact on the mortgage industry                                         23


8      Industry view of future developments                                             25


9      APR as part of the new regulations                                                29


Appendix A : Analysis of APR calculations                                                30




                                                        iii
Executive summary
FSA regulation of mortgage sales is scheduled to be introduced on 31 October 2004. The purpose of this
report, published in July 2003, some 15 months before the regulations come into effect, is to assess the likely
implications of this for the structure and shape of the mortgage industry, and highlight the strategic issues
that companies should be addressing now. The report draws heavily on experience and lessons learned in
the life industry where the introduction of sales regulation occurred in the 1980s and 1990s.

This report is not intended to review the benefits or otherwise of sales regulation, although it notes that the
companies interviewed as part of the investigation welcome it and believe the introduction of regulation will
improve sales processes. Hence, the report focuses solely on the practical impact of such a major change in
the financial services industry.

Because of its high relevance, the report initially goes into some detail in Section 2 about the life insurance
experience. As well as detailing the experience of another industry in similar circumstances, this section also
goes some way to putting the proposed changes in the mortgage industry into the context of previous
developments in the financial services industry as a whole. It shows that the introduction of sales regulation
in the life insurance industry has been a long and complex affair with a significant impact on the structure of
that industry. Interestingly, a huge amount of change has happened in the last 15 years after centuries of
relatively slow evolution. It also demonstrates that, in recent years, regulation has impacted on the number
and size of life offices operating in the industry, and has driven significant changes in distribution patterns.

Taking into account this experience in the life insurance industry along with the views of senior executives at
11 lenders, covering over 70% of the market, a number of issues and likely trends are highlighted. They are:

"   A significant change in distribution patterns
"   Higher than forecast compliance costs
"   Reduced numbers of lenders and distributors
"   Increased chances of mis-selling costs
"   Greater competition and thinner margins
"   Polarisation between simple products and complex advice
"   Possible disenfranchisement of some segments of the population
"   Greater use of expense and unit cost analysis
"   Consolidation of compliance regimes.

It is quite clear then that there are useful lessons to be learned from the experience of the life insurance
industry where the introduction of sales regulation was the catalyst for major change in the industry.
Increased complexity and cost of sales are the most direct results, but wider changes in the structure of
product providers and distribution can also be traced back to these changes. Although views on the exact
degree of expected change in the mortgage industry are not unanimous, it is clear from within the industry
that significant change is anticipated, and this experience from the life insurance industry should act as a
warning.

Based on the interviews undertaken with a cross section of lenders, and taking into account the forecast
changes resulting from the introduction of sales regulation, we have identified certain parts of the industry as
possible winners or losers. These are:

Winners:
" Big lenders - with their resources to manage change and ability to absorb any additional costs of regulation
" Lenders with compliance departments in place for dealing with investment business are considered to be
   much better placed to deal with the introduction of new regulations, compared to specialist lenders with no
   previous experience of FSA regulation
" Specialist lenders, providing the regulations do not stifle their creativity
" Face-to-face sales - because of the perceived need to provide and explain the key facts illustration (KFI)
" Aggregators (companies providing back office support to brokers) - because of the increased complexity
   and overheads for smaller intermediaries.



                                                        1
Losers:
" Small to middle size lenders, especially those with no unique selling point (for example, small high street
   lenders)
" Completely intermediated businesses, depending entirely on broker business, where the effects of a smaller
   broker market may have an impact and there will be less control over sales and hence a higher risk of mis-
   selling
" Small niche lenders with low margins and a low cost base, who may find it difficult to fund the necessary
   changes and absorb the ongoing increased costs
" Exceptions to the above are seen as:
   " Small lenders with a loyal customer base and personal contact
   " Small but specialist lenders with a clearly defined niche.

We hope that this paper will stimulate thought about actions which can be taken between now and October
2004 to maximise potential and protect against change arising from the new regulations. In the meantime,
we suggest a number of key strategic issues that mortgage lenders can address in advance of the
introduction of sales regulation:

" Develop a corporate view on likely changes to the structure of the industry and develop plans for a market
  position in the new framework.
" Understand the likely winners and losers in the market and develop plans accordingly.
" Identify possible gaps in the market if some lenders and distributors lose competitive advantage.
" Address the question of integrating investment and mortgage advice most efficiently.
" Understand the prospects for key intermediary accounts and develop plans to support them and underpin
  the relationship. There may be opportunities, as has been seen recently in the life insurance industry, to
  make strategic investments in key intermediaries.
" Consider opportunities for partnerships between larger and smaller lenders, including option of sharing
  expertise and/or systems.
" Protect the book from churning as it is likely that higher initial costs will cause higher losses on prepayment.
" Consider investing in aggregators, who may be well placed in the new marketplace.
" Develop detailed expense analysis and unit cost analysis in order to understand the relative costs of different
  products and distribution channels.




                                                        2
1     Introduction
      Background
1.1   Regulation of mortgage sales is scheduled to be introduced in October 2004. This is a major change
      for the mortgage industry and therefore, after discussions with the Council of Mortgage Lenders, this
      subject was chosen as a subject for investigation. The purpose of this report is to look, at this early
      stage, at the likely impact that sales regulation may have on the industry.

      In particular, it was felt that the Actuarial Profession could usefully draw on the parallel experience of
      the introduction of sales regulation in the life insurance industry in the early 1990s.

      At this early stage, 15 months before the proposed introduction of the new regulations and with the
      detailed rules only just published, this analysis is intended to take a high level strategic view of the
      implications for the industry and suggest the key issues of which providers and intermediaries should
      be aware.

      Intended audience
1.2   This investigation will be of interest to:
      " Executives at mortgage providers with an interest in strategic planning, compliance and sales
          management
      " Life insurance industry professionals with an interest in the wider development of regulation in
          financial services
      " Retail banks, with their distribution networks.

      Scope of this study
1.3   This investigation is based on published information regarding the introduction of sales regulation in
      the mortgage industry and views gained from interviews with senior executives at mortgage
      providers. In most respects, this study concentrates on the high level strategic implications for the
      industry. Analysis of the detailed proposals for mortgage regulations is not within the scope of this
      investigation, with the exception that an analysis of the method for the calculation of APR (annual
      percentage rate) has been carried out, as this was an area that was identified as being a particular
      issue.

      Overview of the report
1.4   The remainder of this report is organised into the following sections:

      " Section 2 details the history of sales regulation in the life insurance industry. It is intended to give
        readers in the mortgage industry an idea of the changes which the life insurance industry has faced,
        and which may provide some lessons for the mortgage industry in the coming years.

      " Section 3 gives an overview of the impact of the introduction of sales regulation in the life insurance
        industry, as detailed in Section 2. This covers the impact on the life industry in terms of expense
        ratios, compliance costs, mis-selling and subsequent fines.

      " Section 4 considers the impact of sales regulation on the pattern of distribution in the life insurance
        industry.

      " Section 5 provides an overview of the current position in the mortgage industry in terms of:
        " Distribution
        " Sales
        " Costs.

      " Section 6 gives an overview of the expected regulatory changes in the mortgage industry, including
        the expected timetable. This section also covers other relevant proposed regulations such as
        depolarisation and European Credit Directive.




                                                       3
" Section 7 summarises the likely impact on mortgage distribution channels and costs considering,
  in particular:
  " Parallels with the life insurance industry
  " Impact on expenses
  " Impact on distribution channels
  " Compliance costs and requirements
  " Risk of mis-selling costs and fines.

" Section 8 considers the expected impact on the mortgage industry based on interviews carried out
  with senior executives of the lenders. This section also considers the possible winners and losers
  in the industry.

" Section 9 considers the suitability of the existing APR formula in the context of regulated sales and
  considers whether there are any alternatives.




                                              4
2      History of regulation in the life insurance industry
Introduction
2.1    In compiling this section of the report, we are deeply indebted to the Journal of Insurance Regulation
       (JIR). Its Fall 2002 issue contained a paper entitled ‘The developing role of actuaries and auditors in
       UK supervision’ by Ian P Dewing and Peter O Russell. Dewing and Russell are senior lecturers in
       accounting and finance in the School of Management at the University of East Anglia.

2.2    While the main focus of the JIR paper is the role of actuaries and auditors, it does also contain an
       excellent summary and analysis of trends in the regulation of insurance in the UK from the earliest
       days of the industry right up to the Financial Services and Markets Act 2002.

2.3    It is difficult to do other than concur with the Dewing and Russell conclusion that ‘the history of
       financial regulation in the UK suggests that increases in regulation closely follow corporate failures’.

2.4    From the point of view of sales regulation, the same is arguably true. Instances of perceived mis-
       selling or other sales malpractice are frequently followed by regulatory adjustments to counter such
       activities or plug loopholes that they may have indicated.

2.5    The conclusion was to some extent corroborated on 15 April 2003 by John Tiner, managing director
       of the consumer division of the Financial Services Authority, who said on ‘Moneybox Investigates’ on
       the BBC ‘I suppose that there are times when one would wish that the process (of regulation) could
       lead to faster conclusions’.

2.6    The issue here is that the burden of regulation has been cumulative with more and more activity
       proscribed or prescribed. Much regulation, in that sense, has been retrospective, based on seeking
       to counter perceived undesirable practices. This has undoubtedly added to complexity and cost.

2.7    It will be interesting to see whether the Financial Services Authority’s risk-based approach to
       regulation will have any impact on this. The proposed depolarisation of the sales infrastructure does
       provide some opportunity for the rationalisation of sales regulation by the FSA. Hitherto, any
       rationalisation that has been possible has been the consequence of compliance practitioners learning
       to work smarter within the framework established by the FSA and its various regulatory
       predecessors.

       Regulation prior to the Life Insurance Companies Act 1870
2.8    In the early 19th century, there was relatively little regulation of business in general and many
       businesses, including some in the insurance sector, were established for dubious reasons. The Life
       Insurance Companies Act 1870 was introduced as a response to the failure of Albert Insurance,
       which was itself the result of a number of mergers and amalgamations. The Act included provisions
       that required underwriters:
       " To maintain a separate fund and accounts for life business
       " To present separate accounts for each class of business
       " To submit to actuarial review at least once every five years for new companies or once every ten
            years for companies that existed prior to the Act
       " To deposit an abstract of the accounts at the Board of Trade.

       Statements and valuations had to be deposited with the Board of Trade which was required to
       present these individually on an annual basis to Parliament.

2.9    There was no specific requirement at this time to regulate sales and marketing activities of insurance
       companies or their agents or brokers.

       Regulation from 1871 until 1971
2.10   A variety of different acts of Parliament reinforced the regulation of the insurance industry between
       1871 and 1971:
       " Assurance Companies Act (1909) – inter alia requiring insurers to maintain distinct funds for each
           class of business and to keep separate revenue accounts


                                                       5
       "   Statutory rules and orders from the Board of Trade (1910)
       "   Industrial Assurance Act (1923)
       "   Road Traffic Act (1930)
       "   Assurance Companies Act (1946) which extended regulation to marine and aviation insurance
       "   Insurance Companies Act (1958) consolidated previous acts of Parliament.

       Additionally, regulations were strengthened by the Companies Act 1929 (covering winding up in case
       of insolvency) and the Companies Act 1948 which introduced the concept of mandatory auditing.

2.11   The Companies Act (1967) led to significant tightening of the legislation governing insurance in the
       UK. For the first time, responsibility for insurance supervision was assigned to a specific government
       department (the Board of Trade).

2.12   Through this Act, the Board of Trade gained:
       " The power to refuse authorisation
       " Ability to impose conditions on operation
       " Requirement to ensure adequate reinsurance arrangements
       " Power to request information from companies
       " Authority to prevent control of companies deemed unfit and
       " The power to prevent a company from accepting new business.

2.13   The failure of Vehicle & General Insurance Company in 1971 (due to low premium rates and
       inadequate provision for claims) suggested the framework was not yet sufficiently robust.

2.14   At no point before this date was the sale of insurance products subject to specific legislation but over
       the next twenty years, issues began to emerge and remedial action was developed (again arguably in
       response to, rather than in anticipation of, issues).

       Regulation from 1971 until 1986
2.15   Following the collapse of V&G, the powers of the Board of Trade were strengthened (especially in the
       context of broking firms owned by insurers – the first time at which issues relating to distribution were
       specifically targeted).

2.16   There were further insurance company acts in 1974, 1980 and 1981 (primarily driven by the
       incorporation into UK law of various EU directives).

2.17   These various acts were then consolidated into the Insurance Companies Act 1982. Additional
       regulation was subsequently introduced to protect consumers’ interests in long term investment
       funds. In addition to consolidating previous law, the 1982 Act also reinforced the powers of the
       Secretary of State for Trade and Industry (which department had by now replaced the Board of Trade)
       to intervene in insurance industry matters and investigate specific issues.

2.18   Under Professor Gower, the Government also undertook a review of investor protection (1982). This
       review led directly to the Financial Services Act of 1986. The Act introduced a new regulatory regime
       for the companies involved in investment business which was rightly defined to include investment
       and savings classes of life insurance business.

       Regulation from 1986 to date
2.19   The Financial Services Act 1986 was the first specifically to address issues relating to the marketing
       and promotion of investment products. This issue had risen to the surface over the preceding 15
       years almost directly as a consequence of the introduction into the UK of unit-linked insurance
       business, which was sold by a new breed of commission-based sales forces in a more aggressive
       fashion than had previously been the case for sales forces and brokers involved in selling traditional
       participating insurance business.




                                                       6
2.20   The Act (which only came fully into force in April 1988) created the concept of polarisation with advice
       either being based on products from a single company (tied advice) or being based on selecting from
       the whole market (independent advice). It focused on investment business and therefore excluded,
       as non-regulated, a range of insurance-based products including:
       " Pure life assurance
       " Health insurance
       " Income protection and, of course,
       " Mortgages.

2.21   The Act crystallised the roles of intermediaries and those who had previously been selling life
       insurance and collective investments. The division was crystallised between:
       " Direct sales forces (DSF) and tied agents representing a single company
       " Independent financial advisers (IFAs)

2.22   The Act also introduced the concept of best advice; intermediaries (tied or independent) had to be
       able to demonstrate that they had based their recommendations on the products most suitable to
       address the needs of their clients. This requirement led directly to the need to set up an audit trail
       from first contact with a prospective client through to final sale (and service). The requirement for an
       audit trail was responsible for the creation of the list of regulated activities included in the sales
       process that is discussed in the next section of this report.

2.23   The 1986 Act introduced the concept of self-regulation and caused the establishment of a number of
       organisations charged with regulation of, and orderly conduct of, business by those involved in the
       manufacture, marketing and distribution of investment and savings business. These self-regulatory
       organisations (SROs) were overseen and ultimately accountable to the Securities and Investment
       Board (SIB). Their role was to oversee the conduct of business of their member organisations.
       Prudential regulation was undertaken separately under the 1982 Insurance Companies Act. This
       means that the regulation of insurance business was divided into four areas:
       " Regulation of freedom to conduct business
       " Regulation of the marketing and selling of insurance products
       " Regulation of brokers in general insurance
       " Complaint handling.

2.24   The main SROs of relevance to the insurance industry included:
       " LAUTRO (Life Assurance and Unit Trust Regulatory Organisation); to this day the LAUTRO scale is
          the acknowledged criterion for the development of commission scales for insurance products
       " FIMBRA (Financial Intermediaries Managers and Brokers Regulatory Association)
       " IMRO (Investment Managers Regulatory Organisation)

2.25   Prior to 1994, the DTI was responsible for overseeing the regulation of the industry. In 1994
       responsibility transferred to the Treasury (though at that time it was initially delegated straight back to
       SIB) and the long process of reuniting and co-ordinating the various regulatory strands began. This
       process was to result in the Financial Services and Markets Act of 2000 (FSMA).

2.26   This particular seismic shift can be traced back to the report of the Director General of the Office of
       Fair Trading in March 1993. The OFT’s main aim is to ensure that competition is fostered in all
       consumer markets. Its report identified the life and pensions market as being particularly non-price
       competitive. The report concluded that greater disclosure would be likely to lead to a more
       competitive situation with consumer benefit flowing from transparent and therefore probably lower
       policy charges. It also believed that commission disclosure would lead to consumers seeking
       rebates and negotiating their financial arrangements with their advisers.

2.27   The Treasury, too, was interested in achieving greater disclosure but its focus was somewhat
       different. It was concerned about commissions creating bias between providers and/or between the
       products recommended.




                                                        7
2.28   As a result of the collision of these two tectonic plates, the earthquake of disclosure was generated in
       1994. The new regulations required product manufacturers to provide to potential policyholders:
       " Tables showing the likely effects on returns of expense and benefit charge deductions (the so-called
           reduction in yield tables)
       " A statement in cash terms of the timing and amount of commissions and other forms of adviser
           remuneration
       " A key features document describing the product being recommended
       " A ‘reason why’ letter setting out why each particular product recommendation had been made.

       As the following section of this report indicates, this created a sharp upward shift in the expense ratios
       of very many life insurance companies as they grappled to comply with the much increased
       regulatory and compliance requirements.

       The present situation
2.29   The Financial Services and Markets Act came into force in 2000. Its main effect has been to bring
       together in one body:
       " The Financial Services Authority (which assumed responsibilities from SIB)
       " The functions of a range of existing financial services regulators including the Personal Investment
          Authority but still excluding occupational pensions.

       The FSA has responsibility for both prudential and conduct of business regulation for insurers but it
       also has responsibility for:
       " Investment businesses
       " Banks
       " Building societies
       " Recognised investment exchanges and clearing houses
       " Lloyds
       " Professional firms offering certain types of service
       " Friendly societies
       " Credit unions
       " Mortgage lenders.

       The proposal to regulate the conduct of business of mortgage lenders – the subject matter of this
       paper – is being driven by the desire to ensure consistent regulatory approaches across all classes of
       financial services business.

2.30   Under the FSMA 2000, the Financial Services Authority has been instructed to fulfil four regulatory
       objectives:
       " Market confidence
       " Public awareness
       " Protection of consumers and
       " Reduction of financial crime.

2.31   The FSA has adopted a risk-based approach to supervision whereby each individual firm is risk
       assessed based on the potential impact if a regulatory risk were to arise and the likelihood of that risk
       occurring. Greater resources are devoted to supervision of those companies that have the highest
       assessed risk profiles.

2.32   No sooner had the FSA assumed responsibility for the conduct of business of insurance and
       investment organisations than it raised a challenge to the merits and perceived advantages (or
       otherwise) of the polarised sales regime that had been in place for the previous 14 years. It has
       acknowledged that one unforeseen consequence of point of sale regulation has been the effective
       disenfranchisement of mid- to lower-income consumers. These consumers have traditionally relied
       for advice and guidance on the old direct sales forces and home service companies. These are the
       organisations whose numbers have been severely diminished by the breakdown of the distribution
       model, largely driven by the costs and burden of regulatory compliance.

2.33   The FSA’s view, bearing in mind this incidental increase in the level of financial exclusion, was that
       polarisation had not materially worked to the benefit of consumers. Because of the introduction of



                                                       8
       disclosure in 1994, the regulatory environment established by the Financial Services Act 1986 has
       changed substantially and the FSA view was now that ‘polarisation is too blunt an instrument to serve
       the interests of consumer protection’. Its view was that customer detriment can arise through failure
       to make adequate financial provision at least as much as through the purchase of inappropriate
       products or the products of one organisation as opposed to those of another. The move towards
       increased product regulation (for example, stakeholder pensions) reinforces the reduced need for
       close regulation of the conduct of business.

2.34   As a result the FSA developed new proposals for a depolarised regime which it is hoping will increase
       rather than reduce customer choice. The proposals effectively identify and ‘unbundle’ advice as a
       product in its own right.

2.35   As noted above, this approach fits well with the development of a simplified suite of products
       modelled on the existing approach to stakeholder pensions which are designed to address the
       relatively simple financial needs of low to middle income consumers, and to have reduced advice
       requirements.

2.36   As at June 2003, development of the new regime is still under way but the likely outcome is the
       abolition of polarised advice, as a result of which:
       " IFAs may continue much as is the case today
       " Providers with tied sales forces may augment their product ranges with products bought in from
           organisations with the relevant product expertise
       " Some organisations may ‘multi-tie’ though the benefits of this approach are moot
       " Partnerships between product specialists and distribution specialists may increase in importance.




                                                     9
3     Impact of the introduction of sales regulation in the life
      insurance industry
      Sales regulation has reshaped the life insurance industry
3.1   The revolution that has transformed the life insurance industry and the long term savings and
      investment market since the Financial Services Act of 1986 undoubtedly has its roots in sales
      regulation and the various measures taken since then.

3.2   Historically, the life insurance industry has been characterised by vertical integration with the insurer
      delivering all elements of the insurance value chain, by stable earnings, by generous margins and by
      being more focused on developing products than meeting clients’ needs, with products that were
      ‘sold’ as opposed to being ‘bought’.

3.3   There was, as indicated in section 2, a broadly benign regulatory and fiscal environment. Product
      constructions were complex and opaque. Charging structures were concealed and cross-
      subsidisation between the various components of products that bundled savings and protection
      objectives was commonplace. The with-profits endowment policy is a good example of the sort of
      product that prevailed. It was extremely difficult or even impossible to understand product design,
      pricing, charges, returns on investment and likely maturity values. It was often at the discretion of the
      provider or the intermediary to settle on a set of projections and then seek to justify them in a way that
      would expedite the sale of the product. Consequently, the cost structures themselves were often
      built around the commission needs of the distribution channel, backed by people-based
      administration processes with high intervention levels and resulting costs, and so a need to drive big
      volume sales.

3.4   There were fixed boundaries between the different types of financial institution and the products they
      offered. Few consumers, other than those who could afford the on-going services from a
      professional adviser, were able to benefit from comprehensive advice about their overall finances.

3.5   At present, the industry is in transition from the old product and provider-centric structure to the new
      market-driven and customer-centric model. Regulation is the driver and its effects are being felt
      widely:
      " Margins, already thin, are being driven further downwards
      " Products are being simplified and disaggregated
      " The aim is to make consumers better informed and able to make positive purchasing decisions.

      These effects are having some profound consequences:
      " There is a need for operational scale, except in niche markets, to maximise cost efficiency
      " Areas of operational weakness are being exposed to scrutiny with increasing transparency and
         reduced ability to ‘hide’ costs and allow cross-subsidisation
      " Advice is emerging as a ‘product’ in its own right, confirming a value-adding role in the industry’s
         value chain for genuine advisers, while marginalising the efforts of the salesman or product pusher.

      As a result there has been massive rationalisation, restructuring and consolidation in the financial
      services industry (not just in the life insurance sector). While bancassurance has not been perceived
      to have been a success in the UK (relative to France and Spain, for example), there no longer seems
      to be much doubt that the UK financial services industry is being reconfigured to include:
      " A small number of integrated financial services providers; these would typically include banking
          and deposit-taking capability, asset management capability, access to insurance-based solutions
          (life and non-life) whether through ownership or strategic alliance and a range of advice propositions
          from independent to tied
      " A small number of large scale specialist manufacturers eg asset managers and insurers, benefiting
          from the economies of scale
      " A small number of niche providers benefiting from their knowledge, reputation and experience base
      " An advice-based distribution sector.




                                                      10
       Survival of the fittest
3.6    The transition process from the old model to the new one is approaching maturity and it is only the
       fittest organisations that have been able to adapt. It is difficult to identify any organisation that has not
       had to change or make compromises on the route.

3.7    There has been no one single strategy for success. Different companies have adopted different
       methods to ensure their survival – acquisition, rationalisation, focus on perceived areas of strength
       and withdrawal from areas of weakness – or even withdrawal from the market as a whole.

3.8    In most cases, however, response to regulation has been one of the main catalysts for change. This
       can be demonstrated by reference to some of the major considerations that have driven the
       evolution.

3.9    The simple fact is that profitable operation in the life insurance industry has become an increasing
       challenge for more companies over time. It is claimed that the cost of regulation and compliance has
       been a major factor in this. In 1995, the industry was hit by the costs of moving to product and
       commission disclosure. At the same time, there was a fall in sales volumes which one may surmise
       was partly as a result of the new compliance regime. The effect of this on the industry’s total expense
       ratio is clearly demonstrated by the following chart.

       Chart 1 – Total expense ratio 1985-2001

                                                 120                                                                                                                            70%
         Number of Companies included in total




                                                                                                                                                                                60%
                                                 100


                                                                                                                                                                                50%




                                                                                                                                                                                      Total Expense Ratio %
                                                 80

                                                                                                                                                                                40%
                                                 60
                                                                                                                                                                                30%

                                                 40
                                                                                                                                                                                20%


                                                 20
                                                                                                                                                                                10%


                                                  0                                                                                                                             0%
                                                                                                                                                                  2000


                                                                                                                                                                         2001
                                                       1985

                                                              1986

                                                                     1987


                                                                            1988

                                                                                   1989

                                                                                          1990

                                                                                                 1991


                                                                                                        1992

                                                                                                               1993


                                                                                                                      1994

                                                                                                                               1995

                                                                                                                                      1996


                                                                                                                                             1997

                                                                                                                                                    1998

                                                                                                                                                           1999




                                                                                           Number of Companies               Expense Ratio


       Note: The expense ratios in charts 1 and 2 are defined as [management expenses in connection with
       acquisition of business (FSA form 14, line 43) / new business (AP+SP/10 from FSA form 47)]

3.10   The chart also shows the steadily rising total expense ratio over the period from 1987 immediately
       before the Financial Services Act, right through to 1994. Even the modest acceleration that
       accompanied abolition of the minimum commission agreement in 1991 can be seen. However, the
       main point to note is the peak in the total expense ratio in 1995, following the introduction of greater
       product and commission disclosure, and the subsequent decline in the number of companies
       operating and the reduction in the overall expense ratio as the least profitable (or perhaps most
       unprofitable) companies withdrew from the market or were taken over. This period also coincides
       with the most rapid decline in the incidence of ownership of tied sales forces.

3.11   Even the largest companies were not immune to the peaking of the total expense ratio in 1995. The
       following chart shows the same data for the top 25 life offices by new business in 1994.




                                                                                                               11
       Chart 2 – Expense ratios for top 25 companies

                                                 30                                                                                                                            60%

         Number of Companies included in total
                                                 25                                                                                                                            50%




                                                                                                                                                                                     Total Expense Ratio %
                                                 20                                                                                                                            40%



                                                 15                                                                                                                            30%



                                                 10                                                                                                                            20%



                                                 5                                                                                                                             10%



                                                 0                                                                                                                             0%




                                                                                                                                                                 2000


                                                                                                                                                                        2001
                                                      1985

                                                             1986

                                                                    1987


                                                                           1988

                                                                                  1989

                                                                                         1990

                                                                                                1991


                                                                                                       1992

                                                                                                              1993


                                                                                                                     1994

                                                                                                                              1995

                                                                                                                                     1996


                                                                                                                                            1997

                                                                                                                                                   1998

                                                                                                                                                          1999
                                                                                          Number of Companies               Expense Ratio



3.12   Overall, contemporaneous sources estimated that compliance with the disclosure regime may have
       cost the industry up to £250 million. A survey by Mercantile & General Re (subsequently to be bought
       by Swiss Re) suggested that life offices, on average, spent around £2.5 million each in seeking to
       comply with the new disclosure rules – and this estimate excludes the costs of necessary new
       product development. The ABI had earlier estimated an industry cost of ‘more than £100 million’.

       Mis-selling costs and fines
3.13   Mis-selling reviews and the threat of mis-selling reviews have become a fact of life in the market since
       the inappropriate sale of personal pensions to consumers who had previously had access to
       satisfactory occupational pension arrangements first came to light in the early 1990s. Every
       suspicion of consumer disadvantage is now greeted with the suggestion that it might be the latest
       mis-selling scandal. Mis-selling (and now mis-buying) scandals are even intimated for products
       before they hit the market; Sandler stakeholder products are the latest targets for a possible mis-
       buying scandal.

3.14   The industry has had to learn to live with this threat and the impact it has on consumer confidence
       and trust whilst, at the same time, paying the price of actual mis-selling behaviour in the past.

3.15   The costs of potentially lost business cannot be quantified but the costs of some of the earlier
       experiences are now a matter of public record.
       " Under the pensions and FSAVC reviews, a total of 1.7 million consumers had their cases reviewed
          and they received compensation of £11.8 billion; furthermore, the FSA has identified administrative
          costs of more than £2 billion for the pensions review and £80 million for the FSAVC review and, from
          the beginning of the pensions review to January 2002, the FSA had taken disciplinary action against
          35 firms and levied fines of over £9.5 million.
       " Mortgage endowment failings have been treated in similar fashion though there has been no formal
          review. In June 2002, Howard Davies, chairman of the FSA, wrote to the Consumers’ Association
          confirming that 20 firms had agreed proactively to compensate policyholders who were mis-sold
          their endowment policies. The action involved around 218,000 policies and total compensation of
          £315 million. Subsequently, between December 2002 and March 2003, a number of high profile
          fines were announced relating to mortgage endowment mis-selling:
          " Abbey Life was fined £1 million primarily for mortgage endowment mis-selling; total
              compensation due is expected to be between £120 million and £160 million
          " Scottish Amicable was fined £750,000 for mortgage endowment failings; £11 million was set
              aside for redress
          " Royal & SunAlliance was fined £950,000 for the same reason; in addition £11 million was set
              aside for redress.


                                                                                                              12
       Compliance costs and staff numbers
3.16   There is no public domain information on the overall costs of compliance and there is no simple
       method to identify the actual numbers of personnel involved in the compliance function. As the
       following section demonstrates, the number of regulated steps in the sales process is extremely
       large. On this basis, a significant number of personnel over and above any that may have formal
       responsibility for the compliance function are actually involved in the work. The more fully a
       compliance culture is instilled at the operational level, the less is the need for an extensive compliance
       function. The FSA has explored ways in which the costs of compliance in total could be measured
       but this has not yet been undertaken because of competing pressures on FSA resources.

3.17   However, the FSA has undertaken some work on developing indicators of the costs of regulation itself
       (ie the cost of the regulatory superstructure). It has compared the UK to a number of different
       regulatory regimes and the results are reported at Appendix 10 of its annual report for 2001/02.

3.18   Looking solely at the central cost of regulation of financial advice/advisers and of the selling and
       marketing of retail financial products (excluding occupational pensions), it has identified the following
       annual costs:
       " Financial Services Authority £66 million
       " Financial Ombudsman Scheme £25 million
       " Financial Services Compensation Scheme £11 million.

       Regulation of the sales process
3.19   One of the key drivers of the proposal to abolish polarisation and to develop a range of simpler
       ‘commodity’ products that would address the basic needs of the majority of mass market financial
       services consumers was the recognition that regulation of the sales process has become increasingly
       burdensome, costly, intrusive and debilitating since the Financial Services Act of 1986.

3.20   Compliance departments have sometimes been referred to by frustrated advisers as ‘business
       prevention units’ on the basis of the hoops that have to be navigated to make a compliant sale. The
       regulators have been known to counter this challenge by observing that, out of caution, some
       providers have taken an even more conservative approach to compliance than the regulator originally
       intended.

3.21   The move to risk-based regulation under the new regime may well help expedite sales processes. If
       this happens it is to be welcomed because, although the current regime has clearly reduced mis-
       selling and led to better informed customers, compliance/regulatory considerations are currently
       complex and impact separately on each of the following 16 key steps in the insurance/investment
       sales process:
       " The role and practice of business introducers
       " Prospecting/lead generation
       " Marketing and sales management
       " Issue of terms of business and status disclosure
       " Money laundering precautions
       " Fact find (know your customer)
       " Needs analysis
       " Issue and delivery of pre-sale key features document
       " Structure and content of illustrations
       " Commission disclosure
       " Presentation and recommendations
       " Suitability letter
       " Cooling off period
       " Supervision and compliance auditing and checking
       " Compliance training and CPD requirements
       " Post sale key features




                                                      13
4     Structure and changes to distribution channels in the life
      insurance industry
4.1   Since the introduction of regulation of the sales process relating to investment business in the UK,
      there have been profound changes to the nature of insurance and financial services distribution.

4.2   Prior to the Financial Services Act of 1986, the insurance market was dominated by direct sales
      forces. This domination dated right back to the 19th century when the industrial branch business
      delivered by home service sales forces dominated the mass market for low cost, low value but high
      volume protection (funeral plans and other life cover) and basic savings products. These early sales
      forces were viable because of the economies of access to large numbers of clients in a concentrated
      location literally on a door to door basis. Their viability was reinforced by virtue of the fact that,
      although there may have been incentives for sales achieved, there was also a fixed element to sales
      force remuneration as a result of the agents’ role in collecting premiums and servicing claims. Thus
      the business of home service providers was (and for the very few surviving major UK practitioners
      remains) relationship-based.

4.3   Through the same period, Equitable Life had also relied on its own sales force but one which worked
      to a different model. Its advisers were salaried and were also relationship-based. The company
      always prided itself on not paying commissions (although there was also a significant variable element
      to the pay of its advisers). Its advisers sought to develop relationships with higher net worth
      individuals with more complex needs and its focus was very much on the delivery of advice.

4.4   The dominance of tied sales forces was reinforced in the late 1960s and early 1970s by the arrival in
      the UK of commission-driven sales forces selling the new breed of unit-linked life-based regular and
      single premium products. These sales forces were very transaction, rather than relationship,
      oriented. The focus was on a formulaic approach to activity management. Sales personnel were
      expected to make a certain number of contacts with new clients. On the basis of experience,
      providers were able mathematically to project contacts into appointments into sales and adjust
      recruitment and retention strategy and reward levels to drive the required market activity. Because of
      the focus on sales, there was high attrition of both sales personnel and of policy holdings. Focus on
      sales rather than advice to the clients and the resulting possible detriment to clients were major
      catalysts leading to the development of point of sale regulation.

4.5   Prior to the Financial Services Act, a relatively small element of individual financial services distribution
      was in the hands of insurance brokers and general financial advisers ranging from stockbrokers
      through to accountants and solicitors. These forerunners of IFA distribution fell into two camps (as do
      the IFAs of today). Some were very much transaction-focused (e.g. specialists in mortgage advice).
      They, like the transaction-based sales forces, were more focused on the sale and the resulting
      commission. Others were relationship-based and, like Equitable Life, tended to target higher net
      worth individuals and owners of small businesses whose own finances were often inextricably linked
      with those of their companies.

4.6   At the peak of the insurance distribution business towards the end of the 1980s and into the 1990s,
      though estimates vary (because no-one had a complete grasp of who was actually involved in the
      business), there were, conservatively, over 250,000 individuals involved in selling insurance. The
      great majority of these were members of direct sales forces. Issues in pinning down a precise
      number for the intermediary population include:
      " The sheer size
      " Complexity of field management structures and
      " High turnover rates for sales personnel.

4.7   By the beginning of the 1990s, the Financial Services Act was beginning to change the distribution
      landscape. Banks and building societies had become important players and had remodelled the
      sales process by operating from warm leads generated from existing customer bases. Compliance
      costs and training and competence costs were beginning to take their toll on the viability of



                                                       14
       transaction-based sales forces and the role of independent advice was being increasingly recognised
       as a valued component of the insurance sales process.

4.8    The real watershed probably came in 1994 with the transfer of responsibility for insurance regulation
       to the Treasury and the subsequent establishment of the Personal Investment Authority. At this time
       status and commission disclosure were introduced and the world changed.

       Recent history of financial services distribution from 1995 to date
4.9    The market has evolved to the extent that tied advice accounted for less than one third of all new
       individual business written in 2002. IFAs increased their overall market share to over 60% for the first
       time. Between 2001 and 2002, the IFA channel made notable progress increasing its market share
       by almost ten percentage points against the background of overall market stability: total new
       business rose by just 1% in terms of APE (annual premium equivalent – new annual premiums plus
       10% of new single premiums) between 2001 and 2002. Growth was achieved at the expense of tied
       channels whose collective market share fell from around 38% to less than 30%. Alternative channels
       [direct mail, telephone and internet, for example] have increasingly become part of the distribution mix
       offered by life and investment companies but, despite considerable hype, have made little impact.

4.10   As recently as 1997, direct sales forces and tied agents accounted for over 50% of sales and IFAs for
       just 44%. Chart 3 shows new business trends by channel between 1997 and 2002.

       Chart 3 – Distribution trends 1997-2002
                       70.0%



                       60.0%



                       50.0%
        Market Share
        (AP + SP/10)




                       40.0%



                       30.0%



                       20.0%



                       10.0%



                       0.0%
                               IFA           DSF                 Tied Agents            Direct         Other
                                                                                 Marketing/Telesales
                                                   1997   1998   1999   2000   2001   2002

       Notes:
       "   Based on ABI data.
       "   From 2002, the ABI no longer measured Tied Agents as a separate category and included them in the DSF category.

4.11   The success of IFAs in gaining market share should not be taken just as a ringing endorsement of the
       positive attractions of this channel. There have been a whole range of different factors at work –
       some positive about IFAs and some negative about other channels:
       " Scale and industry consolidation have favoured larger organisations and, as far as insurers are
          concerned, the majority of larger providers are focused on the IFA market. This focus has been
          reinforced by the withdrawal of some of these players from their owned distribution systems since
          1995 – many have made the strategic decision that their greatest competitive advantage is in
          manufacturing or asset management and that they should simply outsource distribution.
       " The introduction of products with a 1% charge cap has undoubtedly reinforced this trend; scale and
          efficiency of manufacturing, fund management and administration have become increasingly
          important requirements.



                                                            15
       " Post disclosure - given the overall levels of and rises in the costs of regulation, compliance, training
         and competence and marketing and communications - the economics of the direct sales force
         business model have been fatally undermined for all but a small handful of providers who can make
         exceptional business cases for continuing with this distribution strategy. As a generalisation, direct
         sales forces are seen as a much more expensive distribution option than independent financial
         advisers.
       " The relative and absolute boost to IFA business in 2002 owes much to the disappearance of
         Equitable Life from the ranks of active writers of new business, the subsequent transfer of existing
         pensions business to other providers and the realignment of many of its former clients with the IFA
         channel. This major influence was echoed by the withdrawal of a number of other direct sales forces
         during that time – in the early 21st century a whole host of companies with large customer bases
         withdrew from, or substantially reduced, their tied face-to-face advice capability – for example,
         Prudential and Britannic.
       " Changes in the mix of business undertaken have also favoured an increased role for IFAs; there has
         been a sustained shift away from regular premium products towards single premium (investment-
         based) products, where advice and wide market access are desirable components of the purchase
         decision. The move towards pension business and retirement income planning also favour IFAs at
         the expense of direct sales forces. Sales forces have also come under pressure from commoditised
         product lines like term assurance, from direct marketing initiatives and from newer distributors like
         food retailers.
       " Consumerist pressures have generally favoured independent advice perceiving it (rightly or wrongly)
         to be less prone to high pressure selling techniques and commission bias.
       " Fashion, too, has played a part. Direct sales forces are out of favour and have borne the brunt of
         the adverse publicity stemming from the various mis-selling scandals that have hit the industry.

       Direct sales forces have been fatally undermined by regulation – or have they?
4.12   The old direct sales force model has proved unsustainable as a result of the combination of regulatory
       costs and the other factors just discussed, but the principle of owned distribution continues to have
       appeal. There are indications that owned distribution will survive and flourish in the post-polarisation
       world that will follow the introduction of the principles outlined in Consultation Paper 166 though it
       may look very different from previous DSF incarnations represented by home service companies,
       unit-linked offices or Equitable Life:
       " Some providers have acquired IFA capability and can expect to benefit from the abolition of the
           current ‘better than best’ advice requirements that, in effect, prevent such advisers selling the
           products of their parent company. Advisers in this camp may well be seen as maintaining their
           independence and there are proposals in the new regulatory regime that should ensure this. These
           proposals will not, however, prevent the parent companies from accessing their owned IFAs as a
           route to market.
       " Organisations able to develop an advice-based proposition relying on their own products
           augmented by best of breed providers in specialist or niche sectors may have a continuing role; non-
           life products or mortgages may be expected to play a significant part in their activity.
       " Organisations specialising in selling protection and retirement savings products through the
           workplace (again with an advisory role) may succeed.
       " Distributors with access to large customer bases may well be able to benefit from a ‘lighter touch’
           regulatory regime in making use of face-to-face advice to sell CAT-standard stakeholder products
           as suggested by the Sandler Review of long term savings. It is hoped such organisations will begin
           to fill the advice void left by the effects of polarisation on direct sales force and home service
           providers serving the needs of middle to lower income consumers who have been forced out of the
           market on the grounds of cost.
       " Note that some organisations are well placed to play in any or all of these competitive spaces.

       The key in all cases is the added value delivered by the provision of education and advice. The high
       pressure product salesman probably has been consigned to history but the financial adviser (whether
       truly independent or not) has been given a new lease of life.




                                                      16
5     Overview of mortgage industry sales and distribution
5.1   For the benefit of readers who do not work in the mortgage industry, some key statistics regarding the
      existing structure of the mortgage industry are shown below.

5.2   The industry consists of approximately120 lenders with total outstanding balances of £671 billion at
      the end of 2002.

5.3   The total number of mortgages in force at the end of 2001 was over 11 million and the table below
      shows how this has steadily increased since 1969.

      Chart 4 – Growth in mortgage market
                     12,000,000


                     11,000,000


                     10,000,000


                     9,000,000


                     8,000,000


                     7,000,000


                     6,000,000


                     5,000,000


                     4,000,000


                     3,000,000


                     2,000,000
                                  1969          1974                 1979              1984           1989          1994           1999


      Source: CML Survey of Mortgage Lenders

      Split by type of lender, outstanding balances at the end of 2001 were:
      " Banks                                   71%
      " Building societies                      19%
      " Specialist mortgage lenders             10%

      Source: CML Market Briefing, October 2002

      The table below shows gross advances by type of lender from 1990 to 2001 and demonstrates that
      there has been a rapid increase in gross advances since 1995, led mainly by the banking sector,
      although this is influenced by the change of status of a number of building societies to banks. In
      addition, since 1995, we have seen the emergence of the specialist lenders to claim 10% of the market.

      Chart 5 – Mortgage lending by type of lender
                     £ million
                     120,000




                     100,000                    Building societies
                                                Banks
                                                Other specialist mortgage lenders

                      80,000




                      60,000




                      40,000




                      20,000




                           0
                                  1990   1991    1992       1993        1994        1995      1996   1997    1998    1999   2000     2001



      Sources: Department of Trade & Industry, Bank of England, Office for National Statistics, Office of the Deputy Prime Minister



                                                                                    17
5.4   The industry is dominated by a number of large lenders with, in 2001:
      " Top 5 lenders making 71.2% of total gross advances; and
      " Top 10 lenders making 91.7% of total gross advances.

5.5   Distribution is through three main channels:
      " Branch networks
      " Intermediaries
      " Direct (telephone, internet).

5.6   The split of new business by distribution channel in the first half of 2000, measured by value of loan
      was:
                                                                                                         %

      Branch network                                                                                 48.6
      Intermediary                                                                                   40.2
      Telephone/postal                                                                                7.6
      Internet                                                                                        0.3
      Other                                                                                           3.3

                                                                                                   100.0
      Source: Sources of Mortgage Business - CML, November 2000

5.7   Over the period 1996 to 2000, the percentage of mortgages arranged through branch networks fell
      from 65% to 48% as shown in Table 3.

      Chart 6 – Mortgage distribution by branch networks

       70%



       60%



       50%



       40%



       30%



       20%



       10%



        0%
                   1996             1997              1998              1999             2000




      Source: CML Annual Housing Finance Surveys 1996-2000, MORI

5.8   The intermediary sector consists of approximately 14,000 firms with 46,000 advisers.

5.9   At present, the sales process is not formally regulated but it is covered by a voluntary code,
      ‘The Mortgage Code’, which is self regulated by the Mortgage Code Compliance Board (MCCB).




                                                     18
6      Regulatory changes affecting the mortgage industry
Introduction
6.1    This section gives a high level overview of the different regulatory changes facing the mortgage
       industry, from the FSA’s proposals through to EU directives.

FSA CP146 and CP186
6.2   The FSA’s proposals for mortgage regulation will encompass arranging and advising on mortgage
      contracts as well as lending and administering. The Government announced on 16 October 2001
      that mortgage and general insurance regulation would both come into force from October 2004,
      although this has since been delayed to January 2005 for general insurance to tie in with the required
      date for implementing the Insurance Mediation Directive.

6.3    CP146 “The FSA’s approach to regulating mortgage sales” was issued in August 2002. In May 2003
       CP186 “Draft conduct of business rules and feedback on CP146” was produced. The sections that
       follow outline the FSA’s proposals.

       What is a regulated mortgage?                                       What mortgage activities
                                                                           are regulated?
       The borrower is an individual or trustee

       The lender takes a first legal charge over
                                                                           Mortgage lending
       property in the UK
                                                                           Mortgage administration
       The property is at least 40% occupied by
       the borrower or by a member of his immediate family
                                                                           Advising on mortgages
       The mortgage definition does not cover buy-to-let
                                                                           Arranging mortgages
       mortgages (unless the tenant is immediate family),
       second charge loans or loans to limited companies.


6.4    The FSA has distinguished between the advised and non-advised sales process and proposes to use
       a number of “tools” to achieve the objectives of regulation. Comments on some of the regulatory
       tools are given below. In addition, the FSA propose a definition of “independent” to be consistent with
       the polarisation proposals. Therefore independent intermediaries will be those that can offer products
       from the whole of market, and also offer a fee option to borrowers.

6.5    Suitability - the FSA’s proposals regarding a suitability requirement comprise:
       " Assessing the affordability of the mortgage
       " Matching the different mortgage features
       " An obligation to recommend the most suitable mortgage out of the products identified.

       The suitability requirement does not place a requirement on firms to send customers suitability or
       “reasons why” type letters, although firms may still choose to do so. The FSA rationale is that
       consumers might read the suitability letter but then fail to read the disclosure information, which it
       considers more important.

6.6    Disclosure – consumers will be given product information, in a standard format.

       Initial disclosure – this refers to the information that a consumer will get from a lender or intermediary
       at the initial point of contact. An example document is enclosed in CP146, showing items such as:
       what service is provided, what lenders are dealt with, how the adviser is paid, refund of fees and
       optional items covering the adviser’s regulator and complaints procedure. In CP186 the FSA
       indicates it is looking to the possibility of a combined document for use by firms that provide services
       relating to different types of products, including general insurance and packaged investments.



                                                       19
       The pre-application illustration (termed Key Facts Illustration, KFI, in CP186) - as indicated in the
       definition, the KFI is supplied at the point before an application for a mortgage is submitted. Both
       CP146 and CP186 includes template KFI’s. It covers items such as: the service provided by the firm;
       what the consumer has informed the firm of; a description of the mortgage; the overall cost of the
       mortgage; what payments are needed; the fees to be paid; how payments may increase; and
       insurance.

       The offer stage - this basically requires information included in the KFI to be presented again, mainly
       so consumers can agree the mortgage applied for. The FSA propose some additional information is
       also included.

6.7    High, medium (standard) and low risk products – the FSA has described some general groups
       with a view to implementing higher or lower levels of regulation for certain products. Standard
       products refer to the normal types of mortgage. For the higher risk mortgages the FSA will vary the
       tools it uses i.e. whether an equity release product is suitable, additional disclosure etc. In CP146 the
       FSA had proposed a definition for lower risk mortgages, however the category was removed in
       CP186 and mortgages will therefore fall into either the standard or high risk category.

       High risk - Lifetime mortgages: the term “lifetime mortgages” describes what are commonly referred
       to as “equity release” or “home income plan” mortgages. This is in recognition of the higher level of
       risk posed by such products to the (older) consumers who are likely to buy them.

       Lower risk (since removed in CP186)
       " Mortgages where the term is limited to 12 months or less and where there is regular payment of
          interest
       " Mortgages for a limited amount (£10,000 or less is the recommended level).

6.8    Financial promotions - This relates to all advertising regarding either the availability of secured
       credit, or the advising or arranging of such credit. As such the rules will extend to non-regulated
       mortgages i.e. buy-to-let and second charge lending. Unauthorised firms will also be required to
       have the content of mortgage adverts approved by an authorised firm.

6.9    Filtering questions - In CP146 the FSA had proposed that a non-advised sales process using
       filtering questions could be used. Due to the risks of confusion between this sales process and that
       of advised or execution only, the FSA has in CP186 decided to remove this additional sales route.
       This means that, for all non-advised sales, firms will have to script questions that staff will use.

6.10   Training and competence (T&C) - All firms will be subject to the Commitments part of the FSA T&C
       Sourcebook. For advised sales firms will be subject to the full T&C requirements, which includes an
       examination. There will be additional examination requirements for advised lifetime mortgages.

6.11   Fair treatment of consumers - This covers rules to prevent excessive charges and high pressure
       selling and the refund of fees. From CP186 the responsible lending rule will apply to both advised and
       non-advised sales.

6.12   Business loans - This highlights that the regulations extend to sole traders and unincorporated
       partnerships with first charge on their property. For such sales the FSA will use the standard tools,
       but with variations to T&C and business loans will not be subject to comparative tables.

6.13   Variations to contracts - This applies to mortgages taken out after regulation comes into force,
       covering the regulated activities of making arrangements to vary and advising on the merits of varying
       a contract. CP186 indicates that a KFI will be required before the application for product switches,
       further advances, or the addition/removal of a party from a mortgage.

6.14   Complaints and compensation - Complaints relating to mortgages will fall under Financial
       Ombudsman Service. The FSA is also still considering whether mortgages will fall under Financial
       Services Compensation Scheme.



                                                      20
6.15   Regulatory processes - The authorisation approach is set out in Authorisation Manual of the FSA
       Handbook. Firms will needs to apply ahead of October 2004 (or apply for permission to vary if
       already authorised).

6.16   Territorial scope - Firstly, the definition of a regulated mortgage contract should be considered i.e. it
       needs to be secured over land in the UK. This being the case, in general all firms carrying out
       regulated activities to consumers normally resident in the UK will need authorisation.

6.17   Safeguarding client money - This was introduced in CP186 and relates to intermediaries that hold
       client money. The FSA is considering whether to use existing regulatory tools, such as capital
       requirements, the compensation scheme and the authorisation process, or whether to introduce
       client money segregation requirements.

6.18   Transitional provisions - CP186 discusses how mortgages sales that are under way when the FSA
       rules take effect are to be approached. For such sales firms will be required to meet the relevant set
       of requirements under the sourcebook for the stage of the sale. There are also certain allowances for
       items to be deferred until January 2005, the date at which general insurance regulation is expected.

Post-sale rules (feedback on CP98)

6.19   This was published by the FSA at the same time as CP146. The policy statement and near-final post-
       sale rules apply to mortgage lenders and administrators.

6.20   Before the first payment under a contract is made, certain information must be disclosed, such as:
       " Details of the first payment (and subsequent if it differs), including the method of payment and when
           payments will be collected.
       " Whether insurance or investments have been purchased through the firm in connection with the
           mortgage (and details of the premiums).
       " Whether the mortgage is repayment or interest-only. For interest-only mortgages the customer
           must be reminded to check that a repayment vehicle is in place.
       " What should be done if a customer falls into arrears.
       " Confirmation of any linked borrowing/deposits and whether the mortgage permits under/over
           payments.
       Firms must keep records of the information provided to customers and retain such records for a year
       from the date it was provided.

6.21   Once a year statements must be provided to customers. This must deal with the mortgage contract,
       any tied products, and any other linked contracts.

       The statement needs to cover:
       " The type of mortgage, including reminders regarding repayment vehicles for interest-only mortgages
       " Details of payments made and dates.
       " The rates of interest applying, dates of rate changes and the amounts of interest charged
       " Reminders for customers to contact the firm if they are unable to make payments
       " The amount owed and remaining term of the contract
       " The date when early repayment charges cease, and if applicable details of such charges (in
          monetary amounts)
       " The cost of redeeming the mortgage and other charges that may apply.

6.22   There is certain event driven information that must be provided that covers:
       " Notification of payment changes and other material changes to terms and conditions
       " Notification where the mortgage is sold, assigned, or transferred
       " Notification where additional borrowing is taken up.

6.23   There are separate requirements for lifetime mortgages. There is also a section covering charges,
       such as early repayment, arrears and exorbitant charges. Finally, there is specific guidance on dealing
       with arrears and repossessions.



                                                      21
Other UK developments

Review of Consumer Credit
6.24 From July 2001 the DTI has been undertaking a review of consumer credit with the aim of shaking-up
       consumer credit laws. Key areas being considered are:
       " Standardising the manner in which credit card APRs are calculated and presented
       " Changing the licensing regime to keep loan sharks out of the market
       " Increasing protection for consumers against extortionate credit
       " Regulating more credit agreements by increasing the Consumer Credit Act financial limit and
           reducing the number of exempt agreements
       " Giving consumers a fairer deal when they want to pay off a loan early by amending the early
           settlement regulations
       " Consulting on and responding to the European Commission’s proposals for amending the
           European Consumer Credit Directive.

European developments

Voluntary Code of Conduct on housing loans
6.25 This came into effect in September 2002, however although many UK institutions have registered,
       due to FSA proposals, they will not be implementing the Code until 2004. Its impact is particularly
       relevant on the KFI documentation. This has been recognised by the FSA, with firms having the
       option under the KFI to include an illustrative amortisation table for the mortgage. In CP186, the FSA
       state that they believe the proposed KFI delivers the requirements of the European Standardised
       Information Sheet (ESIS).

European Consumer Credit Directive
6.26 The European Commission adopted a proposal for a new directive in September 2002. The main
      issues in the directive are:
      " Defining the scope such that almost all consumer credit is included, however, mortgages used for
          acquiring or improving property will be excluded
      " Improved harmonisation of the calculation of APR
      " Improved circulation of solvency data
      " Introducing a 14 day right to withdrawal.

6.27   Although the directive is not specifically aimed at mortgages, and excludes mortgages used for
       acquiring or improving property, there will be some mortgages covered by the directive that do fall
       under the FSA regulatory umbrella. For example, the directive refers to “mortgaged consumer credit”
       being included. This term refers to credit secured by a mortgage on a property but used for
       consumption such as car purchase, holidays etc. If such credit is secured as a first charge on a
       property then it would fall under FSA regulation. Under the current proposals equity release loans
       could also be caught by both the FSA and EU regulations.

       Hence, the directive will have an impact. Any changes to APR calculations are also likely to have an
       effect. What is not as clear is how the directive will affect some of the more flexible mortgages that are
       available in the UK, particular those that offer offsetting.

       In CP186, the FSA state that it is a key objective of the UK regulators to remove reference to all
       mortgages from this regulation.




                                                      22
7     Projected impact on the mortgage industry
7.1   Based on experience in the life insurance industry as set out in sections 3 and 4, one may expect the
      following trends to emerge in the mortgage industry.

      A significant shift in distribution patterns
7.2   In the life insurance industry, the increased costs of selling, in particular the very onerous compliance
      costs involved in running a direct sales force, led to a shift from direct sales to IFA sales which were a
      more efficient option for most life offices. Logically, one may expect the same pressures to apply in
      the mortgage industry, but there is one very important difference. Direct sales in the life insurance
      industry were made by sales forces which incurred high lead generation costs. In the mortgage
      industry, direct sales generally arise from the branch network which has a lower marginal cost to the
      lender than selling through a broker. Therefore, if anything, there is likely to be a swing towards
      branch business where that option is available. This trend is likely to be reinforced by the fact that
      many brokers may find it hard to adapt to the new regulated world and will not make this transition.
      Branch business is considered better quality business because it has lower churn and offers the
      opportunity of cross-selling. However, the same fundamentals apply as in the life insurance industry -
      that for small scale operations, the overall cost of compliance could make branch sales inefficient.

      Despite this analysis, broker and IFA business has been shown to be very resilient over the years and
      may well find ways to adapt to the new situation.

      Higher than forecast compliance costs
7.3   There will be a significant increase in compliance costs, both transition and ongoing. The experience
      of the life insurance industry is that this cost cuts across many functions and is not limited to pure
      compliance staff. For example, a lender can clearly expect increased costs in the sales, marketing, IT
      and admin departments. In addition, set-up costs may prove to be ‘never ending’ as, in the life
      industry, the regulations have seen regular changes and amendments, all of which require changes to
      IT, process and training. It is quite possible that the additional compliance cost to lenders, of £14m
      initially and £14m annually thereafter as estimated by Europe Economics for the FSA in 1999 (later
      updated to £83m initially and £28m annually thereafter by the NERA report in May 2003), has been
      underestimated, as it was originally in the life insurance industry.

      Consolidation of lenders
7.4   Experience in the life insurance industry suggests that changes in distribution patterns and increased
      costs will eventually lead to a consolidation in the industry, with those lenders least suited to the new
      landscape falling by the wayside. This may not happen immediately but combined with the effect of
      increased competition and implementation of the Basel II Accord, there is likely to be a consolidation
      and reduction in the number of lenders.

      Increased chance of mis-selling costs
7.5   Based on the experience of the life insurance industry, it does seem inevitable that some companies,
      if not the entire industry, will incur mis-selling fines and costs at some point in the future. The FSA
      does police regulations very rigorously and the experience of the life insurance industry is that,
      regardless of corporate culture and desire to comply, it is very hard to control all aspects of all
      operations, especially in a competitive sales culture. As has been seen in the life insurance industry,
      fear of mis-selling has led to, in some cases, an over emphasis on compliance above what was
      expected by the FSA.

      Greater competition and thinner margins
7.6   A knock on effect of further consolidation in the industry and the reinforcement of a market dominated
      by a small number of big players could be a further increase in competition for market share and
      subsequent lower profit margins. However, for whatever reason, ultimately the larger companies may
      not be prepared to accept very low margins as has been seen in the life insurance industry, with
      Norwich Union stating it will not be prepared to develop low cost “Sandler” products if the charge cap
      remains at 1% pa.



                                                     23
       In the Profession’s report ‘A Study of Mortgage Prepayment Risk’, it was shown that there is some
       tolerance for uncompetitive rates in an existing mortgage book. This indicates that lenders do not
       necessarily have to be drawn into a price war. However, failing to have competitive rates in a
       competitive market would clearly have a much greater impact on new business levels.

       Polarisation between simple products and complex advice
7.7    As has happened in the life insurance industry, regardless of regulatory polarisation or not, the
       introduction of sales regulation is likely to polarise distribution between the sales of high volumes of
       simple products with a lower regulatory risk and sales of more complex products with a greater
       degree of financial planning involved. In the life industry this split is, simplistically, between
       bancassurance and IFAs. In the mortgage industry a similar split may occur between branch
       networks and full advice brokers although, of course, some large lenders may be involved in both
       types of distribution.

       Possible disenfranchisement of some segments of the population
7.8    Financial exclusion is likely to prove less of an issue for mortgages than has been the case for life and
       savings business because of the income requirements for taking out a mortgage in the first place.
       However, it is worth noting that any regulation whose consequence is to restrict distribution - for
       example by making smaller scale operations uneconomic - is likely to have its greatest and most
       immediate impact among middle to lower income consumers.

       Greater use of expense analysis
7.9    The need to be more efficient in managing increased initial costs and the need to manage distribution
       more closely may lead to a greater use of expense analysis and unit cost analysis. Clearly, there are
       currently different practices throughout the industry, but much expense monitoring is carried out at a
       macro level, such as measuring trends in expenses per £100 of lending. More detailed expense
       analyses, as typically practised in the life insurance industry, would provide detailed information about
       the relative costs and profitability of individual product lines and distribution channels, allowing
       lenders to operate in the most cost-effective areas and ultimately bring down the average cost of
       sales.

       Consolidation of compliance regimes
7.10   Based on recent trends in moving towards a single regulator and, in the interest of avoiding confusion
       for customers, it is possible that there may eventually be a single set of sales regulations for
       mortgages and life insurance. This process may be accelerated if there is a trend towards distribution
       channels selling both products, a trend which is quite likely due to economic pressures forcing
       distributors to look at all possible products.




                                                       24
8      Industry view of future developments
       Background
8.1    In order to gather a view from its own practitioners of how the mortgage industry may develop, a
       number of interviews (11 in total) were carried out with senior executives in the industry. This section
       reflects a consensus of views about the impact that sales regulation may have on the industry.

       Overview
8.2    All companies are in favour of regulated sales in principle. It is seen as a good thing for borrowers,
       especially with the trend to more complex products. However, it is accepted that it will give an
       advantage to large companies that are more easily able to absorb the costs and where there is an
       existing infrastructure and capability for compliance as a result of existing investment activities. It is
       also expected to encourage good sales processes which ultimately benefit both lender and borrower.

8.3    It is seen as a positive thing to move towards one regulator for all products.

8.4    Although the introduction of sales regulation is generally seen as a good thing, it is not currently
       perceived as an opportunity for development or growing business, rather a compliance issue that has
       to be dealt with. However, without consciously taking advantage of it, some larger lenders would
       concede that a tougher regulatory culture may give them an advantage.

       Impact on lenders

       Expenses/costs
8.5    Although not true of all lenders, there is generally a lot less emphasis put on expense analysis and unit
       costs compared to the life insurance industry. However, many lenders are aware of the increasing
       need for this type of analysis and, in particular to be able to understand the relative costs of different
       products and distribution channels. Many lenders are planning to develop, or are already developing,
       this area of the business.

8.6    It is felt that the increased costs of regulation will lead to a drive for economies of scale and hence
       consolidation in the industry. Although it is expected to have more impact on intermediary firms than
       lenders, it is still expected that some small lenders will be affected. However, few large lenders are
       likely to see this as a big acquisition opportunity.

8.7    Increased costs are expected to come from a number of sources, including higher training and
       monitoring costs in the branches. Although not directly responsible for these costs at intermediaries,
       most lenders believe that the costs could ultimately be passed on to the lender through higher
       procuration fees. The ability to negotiate higher fees is expected to give an advantage to the large
       brokers and networks, as has already been seen to happen in the life insurance industry.

8.8    Another significant cost will be IT and systems implementation costs. At smaller lenders, this is seen
       as a major cost whereas at larger lenders, these costs can be easily absorbed in the normal IT
       budget.

8.9    It is felt that the cost of introducing legislation may be higher than estimated in the past as, although
       many procedures already exist as a result of the Mortgage Code, there will be a greater imperative to
       avoid errors under FSA regulation.

8.10   Ultimately customers may lose if the costs are passed on.

       Documentation
8.11   There is a concern that the KFI, as it is currently prescribed, may be too long, although the FSA, in
       CP186, say they expect it to be no more than 4 pages. There is a sense that too much information
       may be a bad thing as it could confuse the borrower and ultimately not be read. There is no evidence
       in the life industry that long key features documents are fully read or understood.



                                                      25
8.12   There is a widespread view that the APR calculation is not well understood by the borrower, although
       the new disclosure rules may help to make it clearer. It is also felt that there is a wide degree of
       interpretation used by different lenders in the calculation method, resulting in the measure not being
       consistent. This has been addressed in more detail in section 9 and Appendix A of this report.

8.13   Although not mandatory, a number of lenders said that they felt a ‘reason why’ letter is an important
       part of the process and will consider issuing one in any event.

       Other regulations
8.14   Many of the larger lenders consider that Basel II may ultimately have more impact on the business
       and is a higher priority.

8.15   There is general concern that the European Credit Directive (ECD) may de-rail the implementation of
       the UK legislation. The ECD is not due to be implemented until 2006, and it would not be welcome in
       the industry if further new regulations were introduced within 2 years of the FSA mortgage regulation
       in October 2004. To avoid this, it would be essential for the UK regulations to be already largely
       aligned with the ECD when they are introduced. This leads to a view by many lenders that they would
       not be surprised if the October 2004 implementation date was delayed. This may have implications
       regarding the implementation of the Insurance Mediation Directive. To comply with this, General
       Insurance regulation must be introduced by 15 January 2005, and if the introduction of Mortgage
       regulation slipped beyond this date, there would be a mis-alignment between these two new
       regulated activities, which the FSA hope to introduce at much the same time.

8.16   The UK mortgage industry currently operates self-regulation in the form of The Mortgage Code,
       which is controlled by the Mortgage Code Compliance Board (MCCB). This body is due to be
       replaced by the FSA when new regulation is introduced, and is accordingly winding down its
       operations. There is some concern in the industry that, if the new regulations are delayed, there may
       be a significant gap between the closing of the MCCB and commencement of the FSA’s activities.

8.17   The European Mortgage Code is a European wide voluntary code and there is a perception that the
       UK is not seen to be complying. In practice, there are differences between the UK and many other
       European states that make it difficult for the UK to appear to comply, but it is felt that this position may
       lead to greater pressure for the ECD to be enforced in the UK, leading to problems with the timing and
       content of the proposed UK regulations.

8.18   Depolarisation is less of an issue now than it once seemed it would be as, with the latest response to
       consultation, it appears that there will be less change in the industry than previously feared. One
       predicted outcome of depolarisation is that IFAs will tend towards giving a more complex, full financial
       planning service and bancassurers and direct sales forces will focus on a simpler range of products.
       This split could well be mirrored in the mortgage industry with some brokers/IFAs giving full advice
       and other branch networks largely using filtered questions to advise on straightforward mortgages.

8.19   It is clear that lenders are aware of these issues and the need for joined up thinking.

       Nature of advice
8.20   There are widely different views on the issue of full advice or filtered questions, and hence it is
       expected that a range of quite different models may be introduced. There is general agreement that
       filtered questions need to be used with caution as there is a risk that the customer may mistakenly
       think they have been given advice. The response to this ranges from only using the full advice model
       to using the filtered question model where considered appropriate but with procedures in place to
       protect the borrower. The filtered questions option was removed as a separate advice category in
       CP186 but could still be used in some form.

8.21   It is considered that these issues would be diminished if consumers were better educated about the
       mortgage market.




                                                       26
       Timetable
8.22   There is concern that there may be further slippage in the implementation date. This is considered to
       be as a result of general slippage and also the interaction with the European Credit Directive. There is
       some argument for delaying implementation until January 2005 to coincide with the introduction of
       general insurance sales regulation.

       Distribution trends
8.23   It is widely thought that the proportion of branch sales will increase, if only because branches will
       remain in place whereas there is expected to be some reduction in the number of intermediary firms.

8.24   Although large lenders will benefit from being more able to implement new regulations, those with
       very large branch networks will have the challenge of setting up efficient systems to cover the whole
       network with advisers cost-effectively, as it is unlikely to be efficient to have a fully qualified adviser in
       every branch. In addition, large lenders with the budget to train large numbers of staff will, in the short
       term, run the risk of losing these staff to smaller companies and intermediaries after training.

8.25   Some smaller lenders may take the opportunity to align their investment and mortgage sales. As they
       cannot be authorised for one and tied for another, lenders will need to either take over responsibility
       for investment sales and break any tie that exists or arrange for the existing tied relationship to take
       responsibility for their own mortgage sales. It seems likely that the former route will be more popular,
       as it will give freedom to advise on a wider range of products.

8.26   There is no reason to assume that demand for mortgages will change, so on balance there is
       expected to be a further shift of market share to the large lenders.

8.27   It is possible that there may be more of a relationship between small lenders and small intermediaries.
       If the larger lenders are not keen to deal with the smallest intermediaries, they may find a home with
       small lenders.

8.28   As a result of increased set up costs for lenders, there may be a trend towards more trail fees. This is
       supported by the view that if intermediaries are to be authorised and hence more professional, there
       may be a greater expectation of ongoing service from customers.

       Impact on intermediaries
8.29   Not surprisingly, life is expected to become tougher for intermediaries as they will need to do more
       work to earn fees. However, it is expected that some will be able to adapt better than others.

8.30   It is felt that the introduction of sales regulation will be positive for large intermediaries who will be able
       to absorb the additional cost more easily and may be in a position to negotiate higher procuration
       fees to compensate for their higher costs or even negotiate direct assistance with training. The result
       of this may be a system of dual fees.

8.31   Small brokers are expected to find it harder to succeed as they will find it difficult to find the money or
       resource to deal with training issues. In addition, large lenders may have concerns over using smaller
       intermediaries if they have doubts over competency. As a result, it is felt that there could be a high
       degree of consolidation among smaller brokers, with many joining networks.

8.32   Some small firms may wish to avoid authorisation completely and opt to become arrangers or play
       entirely in the unauthorised market (e.g. buy to let). Certainly, many seem to be unprepared for
       change.

8.33   The nature of advice given is expected to depend on the nature of the operation, with telephone and
       internet channels, smaller brokers, and advisers such as estate agents likely to use a filtered question
       approach. On the other hand, it is expected that large brokers and IFAs will adopt full advice. It is
       expected that there will be more demand for face-to-face advice, as products are becoming more
       complex and there is a wider choice. This is likely, therefore, to generate more business for large
       brokers and networks. It is felt that there could be a high level of competition between the large
       intermediaries, leading to a pressure on margins.


                                                         27
8.34   It is also possible that more IFAs will be active in the mortgage market to act as a gap filler for the
       current reduction in business in the investment market. In many ways, IFAs are ideally placed to enter
       this market as they are already authorised and just need to add another permission.

8.35   There may be a demand from brokers to set up ties with lenders to avoid the need for authorisation.
       However, it is not clear that lenders will look on this favourably as it will increase the risk for them. If
       there is an increase in tied agents, it is only likely to be with the best quality brokers. This attitude to
       risk also applies to the provision of KFIs with many large lenders only willing to permit the use of their
       own KFI documents. For large brokers, bespoke, branded KFIs may be made available but for small
       brokers, it may only be practical to use the services of an aggregator. It is expected that there will be
       an increased demand for this type of service, acting as a clearing house for lenders’ documentation.
       This will also, in effect, have a degree of policing and enforcing the regulations with smaller brokers.

       Winners and losers
8.36   To summarise the above views, the overall impression of possible winners and losers in the industry is
       as follows.

       Winners:
       " Big lenders - with their resources to manage change and ability to absorb any additional costs of
          regulation
       " Lenders with compliance departments in place for dealing with investment business are considered
          to be much better placed to deal with the introduction of new regulations compared to specialist
          lenders with no previous experience of FSA regulation
       " Specialist lenders, providing the regulations do not stifle their creativity
       " Face-to-face sales - because of the perceived need to provide and explain the key facts illustration
          (KFI)
       " Aggregators (companies that act as a clearing house between lenders and small brokers) - because
          of the increased need to provide back office support to smaller intermediaries.

       Losers:
       " Small to middle size lenders, especially those with no unique selling point. (For example, small high
          street lenders)
       " Completely intermediated businesses, depending entirely on broker business, where the effects of
          a smaller broker market may have an impact and there will be less control over sales and hence a
          higher risk of mis-selling
       " Small niche lenders with low margins and a low cost base who may find it difficult to fund the
          necessary changes and absorb the ongoing increased costs
       " Exceptions to the above are seen as:
          " Small lenders with a loyal customer base and personal contact
          " Small but specialist lenders with a clearly defined niche.




                                                        28
9     APR as part of the new regulations
      Introduction
9.1   A number of lenders suggested that APR was a less than satisfactory measure for comparing
      different mortgages as it does not fully take into account the actual experience of early redemption. It
      was also criticised for a perceived inconsistent application of the rules between lenders. As a result, it
      was decided to look more closely at APR calculations in this report.

      Analysis
9.2   An analysis of APR calculations has been carried out to determine if the method of calculation could
      be improved. In order to do this, variations of APR calculation were devised to calculate it over limited
      time periods, also allowing for a prescribed pattern of early redemption. There was also some
      consideration of whether the use of current short term rates in the variable rate APR calculation could
      lead to anomalies when comparing fixed rate and variable rate mortgages.

      Results
9.3   Although the results show some difference in results if allowance is made for expected experience,
      the differences are relatively insignificant and do not appear to be material to the borrower. Full results
      and details of the calculations are shown in Appendix A.

      In addition, it was concluded that there is some scope for introducing a calculation similar to the
      “reduction in yield” calculation in the life insurance industry – particularly for variable rate mortgages,
      where the future cost is at the discretion of the lender.

      Conclusion
9.4   Although it may be the case that there is inconsistency in interpreting the rules for carrying out the
      APR calculation, on the basis of this investigation, there does not seem to be a big flaw in the general
      formula used, perhaps just in enforcement of the methodology used. The analysis shows that the
      APR calculated does not significantly change if more realistic assumptions about future experience
      are used and hence suggests that the APR calculation, as it stands, acts as a satisfactory indicator
      for borrowers. The potential complexity and additional opportunity for interpreting the rules resulting
      from making the calculation more detailed may well outweigh any possible increase in accuracy. In
      addition, it may be felt that quoting APRs over expected terms may actually act as an encouragement
      to redeem early.

      This does not mean that there are not better measures than that currently used but the APR measure
      seems to give a fair reflection of what it attempts to show.

9.5   If long term fixed rate mortgages become common in the UK, then there may be a need to use a more
      accurate estimate of future interest rates (such as a swap rate) in variable mortgage APR calculations
      in order to allow a fairer comparison between the two.




                                                       29
Appendix A. Analysis of APR Calculations
    Background
1   The Consumer Credit Act defines a total charge for credit (TCC) and sets down how to calculate an
    APR, which expresses the TCC as a standard measure for borrowers to use in comparing credit
    charges between different deals.

2   In basic terms the APR is the rate of interest (expressed in annual terms) that equates the present
    value of loan advances to the present value of repayments and charges.

3   FSA CP146 adopts the use of the APR with the methodology being consistent with that defined
    under the Consumer Credit Act.

4   The APR is useful as a standard measure that can be used by consumers. However, there are
    concerns over its use. For example, it is not always clear what charges need to be included in the
    calculation. Furthermore, with many customers repaying mortgages early, the requirement in the
    APR to assess the calculation over the original contract term can lead to distortions.

    CP146 – charges included in the TCC
5   CP146 indicates that the following charges should be included in the TCC (and hence APR):
    " Any charges payable under the transaction by or on behalf of the customer
    " A premium under a contract of insurance where this is a condition of the agreement, including life
       insurance, invalidity, illness or unemployment
    " Any fees payable to intermediaries.

    It also states that the APR should not reflect the “value” of any cashback or incentive linked to the
    mortgage agreement.

6   Having provided these descriptions, it is still not entirely clear what charges should appear in the APR
    calculation. This is one of the most common themes suggested from discussions with firms
    regarding the APR.

    For example, should legal fees, costs of land searches etc be included? The safest option appears to
    be that if in doubt, include the cost. However, the concern is that this does not always create a level
    playing field.

    Example APR calculations
7   The following examples are provided to illustrate some of the potential issues with the use of APR.

    Example 1- Standard fixed term mortgage
8   We start with a standard mortgage for £100,000, having an interest rate of 4.5%, initial fees of £500
    (added to the mortgage), and a 25 year term. There is no initial discount rate and no early repayment
    penalties.
    " The normal APR calculation assumes that the mortgage remains in-force for the full 25 years. This
       produces an APR of 4.6% (the figure is 4.55% without the normal APR rounding).
    " If the APR calculation is repeated, but assuming that the mortgage only remains for 5, 7 or 10 years,
       the respective (unrounded) APR’s become 4.62%, 4.59% and 4.57% respectively. These are all
       slightly higher than the 25 year term, reflecting the fact that repayments to be made by the customer
       include allowance for initial expenses and that over shorter terms these allowance have more of an
       impact on the APR.

9   Another method of calculating APR could be to introduce an early repayment decrement in line with
    the characteristics of the firms’ portfolio (or perhaps in line with industry figures). The table below
    outlines (for illustration) some decrements that will produce an average mortgage term of
    approximately 7 years. These decrements represent the probabilities that a contract in-force (with a
    certain duration) will be repaid.



                                                   30
Period                                                                Early repayment decrement

1-5                                                                                                20%
6 - 10                                                                                             10%
11 +                                                                                                3%


The use of these decrements implies that for every 100 contracts taken out on a certain date, 20%
would repay in the first year, leaving 80 contracts at the end of the year. During the second year 20%
of the remaining 80 would repay i.e. 16, leaving 64 at the year end. The process then continues and
uses the revised decrements applying from period 6, and from period 11. The use of these
assumptions means that not all contracts are expected to complete the full mortgage term. By taking
the number of contracts that repay in each year, a weighted average mortgage term can be
calculated.

Using this decrement table the present value of mortgage repayments can be calculated. The APR is
the interest rate that solves the present value of the repayments to the present value of the loan
advances. For instance, if the loan advance is £100,000, and monthly repayments of £553.48 apply
(i.e. £6,642 annual and calculated to allow for the £500 initial charges), the expected payments under
a contract can be assessed in a manner described in the table below.

Period        Contracts          Contracts             Mortgage        Total payments        Present value
               in-force          repaying             outstanding        per in-force         at 4.62% pa
               (at start)          early                (at end)          contract

   (1)             (2)                (3)                 (4)                  (5)                  (6)

   1              1.00               0.20               £98,245             £26,291             £25,263
   2              0.80               0.16               £95,888             £20,656             £18,973
   3              0.64               0.13               £93,426             £16,209             £14,232

   6              0.33               0.03               £85,353              £4,973              £3,827

  10              0.21               0.02               £72,789              £2,993              £1,924
  11              0.19               0.01               £69,286              £1,687              £1,043

  25              0.13               0.13                 £0                  £839                £277


Under this method the APR is calculated as 4.62%. This is not very different from the APRs
mentioned above. It does however demonstrate that even though the characteristics of the early
repayment decrements produce an average term of 7 years, the APR is higher than that for the
calculation that assumed the mortgage remains in force until the end of the 7th year (i.e. 4.59%
above). The method will become more relevant when early repayment charges are built in. Before
doing this the following notes explain the working of the calculations shown in the table:
" Column (2) is the number of contracts in force at a particular point in time. As we are calculating the
    APR for one contract it starts at 1. For later durations the number in-force reduces below 1 due to
    the fact that it is assumed that a proportion of the contract is repaid early. Hence, for period 3, the
    proportion in-force of 0.64 is calculated as 0.80 less 0.16 (i.e. columns 2 and 3 for the previous time
    period).
" Column (3) represents the proportion of contracts repaying mortgages early in the time period. It is
    calculated using the early repayment decrements described earlier and the number of contracts in-
    force at the start of the period (i.e. column 2). For example, at period 6, 0.03 is 0.33 (number in force)
    multiplied by 10% (the decrement for time 6).
" Column (4) is the amount of mortgage outstanding at the end of the period (assuming that a full
    contract is in-force).




                                                 31
     " Column (5) reflects the total payments that would be made over the period, taking into account the
       proportion of contracts in force, annual repayments, and early redemptions. For period 2 the figure
       of £20,656 is calculated as the annual repayments of £5,314 (i.e. £6,642 multiplied by 0.8 in-force)
       plus the early redemptions of £15,342 (i.e. £95,888 multiplied by 0.16 contracts repaying early).
     " Column (6) is the discounted value of the total payments in column 5. The APR is the rate of interest
       that equates the sum of column 6 to the amount borrowed.

     Example 2 – Mortgage with reduced interest rate in the early years plus early redemption penalties
10   The next example introduces some complications. There is an initial discounted interest rate of 4%
     for the first 6 years. Thereafter the interest rate reverts to the standard rate of 4.5%. Within the first 6
     years there are early repayment penalties equal to £100 plus 6 months interest.
     " The standard APR (assuming the 25 year term) shows 4.3% (without rounding this is 4.31%).
     " Calculating the APR’s, assuming the mortgage only remains for 5, 7 and 10 years, gives APR’s of
          4.31%, 4.15% and 4.23% respectively. The figures for periods 7 and 10 look better than for the
          standard rate. There are a number of factors at play that give rise to this. Although initial expenses
          have to be repaid over a shorter period (and would therefore be expected to produce higher APR’s,
          as in example 1), contracts that only remain in-force for shorter periods benefit from the lower initial
          interest rate. In the absence of any early repayment charges this lower interest rate acts to reduce
          the APR.

11   On the basis of monthly repayments of £526.52 for 6 years and £547.90 thereafter (i.e. annual of
     £6,318 and £6,575 respectively) introducing the early repayment decrements as described above,
     provides an APR of 4.41%.

     Period      Contracts       Contracts        Mortgage            Early          Total           Present
                  in-force       repaying        outstanding         penalty       payments          value at
                                   early                             charges                        4.43% pa

       (1)            (2)            (3)               (4)              (4a)            (5)             (6)

        1           1.00            0.20            £98,087           £1,065         £26,149         £25,166
        2           0.80            0.16            £95,577           £1,041         £20,513         £18,911
        3           0.64            0.13            £92,967           £1,015         £16,073         £14,193

        6           0.33            0.03            £84,493            £932          £4,870          £3,791

       10           0.21            0.02            £72,056              £0          £2,963          £1,943
       11           0.19            0.01            £68,589              £0          £1,670          £1,055

       25           0.13            0.13               £0                £0            £831           £288


     This table is similar to that in paragraph 9, with the addition of column (4a) which highlights the
     penalties that would apply to a contract that repays the mortgage early. The methodology works
     similarly to that in paragraph 9, with the penalty charges being incorporated as follows:
     " Again column (5) reflects the total payments that would be made over the period and for this
         example includes the early repayment charges. For period 6 the figure of £4,870 is approximately
         the annual repayments of £2,085 (i.e. £6,318 multiplied by 0.33 in-force) plus the early redemptions
         of £2,788 (i.e. £84,493 multiplied by 0.033 contracts repaying early), plus charges of £31 (i.e. £932
         multiplied by 0.033).

     This alternative method shows that although the average term of the mortgage in the example is
     around 7 years, the APR produced of 4.41% is different to that assuming the mortgage stays in force
     until the end of the 7th year, giving an APR of 4.15%. The reason for this is that the decrement
     method, by allowing for a proportion of contracts to be repaid at various times, introduces factors
     such as the early repayment charges. Hence, although both methods could be argued to represent a
     firm’s typical mortgage characteristics, the decrement method perhaps gives a more balanced
     picture.


                                                      32
     What do these examples indicate?
12   The examples show that if the APR was to be calculated over a period other than the mortgage term
     (as set at outset) then the alternative calculations could be open to much interpretation. It could be
     possible for firms to design products and use assumptions that presented the APR in a favourable
     light. In addition, there may be issues with the literature appearing to encourage early redemption, or
     at least suggest the possibility.

     Hence, the existing basis seems reasonable as it is open to fewer assumptions and interpretation.
     The problem with this is that it does not reflect the impact of early repayment penalties. Although
     these are quite often described in words in the literature, it is difficult for consumers to judge the
     financial implications.

     Although using a table of expected repayment profile is instructional for the lender, it does not really
     provide the borrower with the required indication of what will happen for one mortgage, and so is not
     a useful solution in practice.

     Perhaps if firms are to adopt an amortised table (such as that described in the European
     Standardised Information Sheet [ESIS]), an option would be to quote the APR for each time period in
     the table on the basis that the customer repays the mortgage early at the relevant time period. This
     could help give customers an idea of the charges that could apply in the shorter and longer terms,
     and, for instance, help appreciate the financial implications of early repayment charges.

     Having said this, the amount of information provided to customers needs to be considered, and it
     could be argued that providing customers with more information would only serve to confuse.

     One last issue that could be addressed is the practice of assuming that current short term interest
     rates continue unchanged for variable rate mortgage. It would be more realistic to use a swap rate to
     estimate a fixed rate equivalent to variable rates over the term of the mortgage. At present, this is not
     generally a major issue as most rates are only fixed for short periods, so comparison between fixed
     rate and variable rate mortgages is relatively straightforward. In addition, the introduction of using
     swap rates would add another complication and opportunity for interpretation of the rules. However,
     if we were to see the introduction in the UK of long term fixed rate mortgages as is common in other
     European countries and is now being investigated on behalf of the Treasury, then some adjustment of
     this type may be needed to ensure borrowers can make a fair comparison between, say, a 25 year
     fixed rate and a 25 year variable rate mortgage.

     EU proposals
13   One of the proposals in the EU Consumer Credit Directive appears to be the introduction of insurance
     and other optional services within the APR calculation. This has not been well received, mainly
     because APRs are generally disclosed in advance of decisions on such optional items being
     considered.

14   The EU commission also proposed the introduction of an additional interest rate, the “total lending
     rate” (TLR), to be disclosed to customers. It is calculated in a similar manner to the APR but reflects
     only the costs payable to the creditor. These costs include interest payable, administration charges
     etc, and exclude optional items. Again, this has not been well received as it is viewed as surplus to
     requirements in that it does not add much to the main APR calculation, and would act to confuse
     consumers.

15   The EU proposals for the TLR could be considered to be similar in a way to certain disclosure
     requirements in the life and investment markets (in the UK). Specifically, customers are given
     information with and without the effect of charges (such as administration charges) so that they can
     judge the financial impact of the charges to be levied by the provider and to aid comparisons between
     products/firms.




                                                    33
     Comparisons to the life and investment markets
16   In the retail investment arena one tool that is used to measure the cost associated with a product is
     the reduction in yield (RIY). This falls under the FSA regulations within the production of Key Features
     documents, which is the literature that needs to be provided to customers at the time of a sale (it is
     possible for some documents to be drawn up on a generic basis).

17   The RIY is designed to show the impact that charges levied under a contract have on a standard
     assumed future investment return. For example, if the standard investment return is 6% pa, but after
     allowing for charges the maturity proceeds under a contract are only projected to give a return of 4%
     pa, then the RIY is 2% pa.

     The lower the RIY, the better the value of the contract in terms of cost. Of course this does not have
     any implications for how well the contract could perform in investment terms. It could be possible for
     a contract with a higher RIY to show a better return than one with a lower RIY due to actual
     investment performance. Nevertheless, it provides a useful measure to consumers of the cost of
     various products.

18   In calculating the RIY, certain assumptions need to be made:
     " Charges - including, if relevant, assumptions regarding RPI etc
     " Investment performance of 6% per annum (7% for non taxable contracts)
     " Customers will keep the contract to maturity.

     The effect of the assumption that customers will stay to maturity generally results in the most
     favourable outcome for the RIY. This is because initial expenses associated with the contract are
     generally recouped over the lifetime of the plan. If such initial expenses include a substantial fixed
     amount (i.e. not necessarily relating to the term of the contract) then the longer the term for the
     calculation of the RIY, the less the impact such costs have.

     Perhaps this approach seems at odds with the standard calculation of the APR, where assuming that
     the mortgage remains in-force for the full term leads to a rate that is not as favourable as other
     possible rates.

19   It would be possible to undertake various APR calculations with and without the inclusion of certain
     charges to give customers an indication of the cost of charges on the product being considered. This
     could also help customers compare the cost of charges between various providers. However, the
     benefits of doing this do not seem obvious. Customers are likely to be concerned at the overall deal
     they will get, i.e. the APR, taking into account all charges. The fact that the effect of charges on the
     APR for a particular firm’s APR excluding charges is greater than that for another firm does not
     necessarily mean that the first firm will give a worse deal overall.

     An example could help illustrate this:
     " Assume that firm A offers a mortgage as in example 1 (Section 9 of this Appendix). The APR
        including the £500 initial charges was calculated as 4.6%. If the £500 is removed from the
        calculation the APR becomes 4.5%. Hence, the customer can see that under the contract he is
        effectively being charged 0.1% for charges associated with the mortgage
     " Suppose we have another firm B that offers a mortgage with an interest rate of 4.3% but initial
        charges of £2000 (higher as there are intermediary expenses/commissions). The APR’s calculated
        are 4.5% with charges and 4.3% excluding charges. Therefore, the effect of charges is 0.2% which
        is higher than the first firm
     " Should this matter to the customer as overall this firm is giving a better deal with an APR of 4.5%
        instead of 4.6% offered by the first firm?

     However, if the customer is planning at outset to repay the mortgage early then the information about
     expenses could prove useful. For instance, assuming no early repayment charges apply:
     " If the mortgage is repaid after 3 years, the APR’s would be 4.7% for firm A, and 5.1% for B
     " At 5 years the APR’s are 4.6% for both.




                                                     34
If the customer was made aware of the higher charges associated with firm B, then armed with this
information, he could perhaps appreciate that if he repays the mortgage early then (especially at
shorter durations) firm B could actually give a worse deal. However, it could be that the information
on expenses is provided in other formats, for example by firms quoting the monetary amounts and it
could be viewed that this information is just as useful (if not more transparent) than any adjusted APR
measures.




                                              35
NOTES




        36
NOTES




        37
Actuaries provide commercial, financial and prudential advice on the management of a business’s assets and liabilities,
especially where long term management and planning are critical to the success of a business venture. This expertise gives
the Actuarial Profession an unrivalled appreciation of financial risk management – one of the most fundamental, but poorly
understood, areas of business.

Being skilled mathematicians, actuaries are able to analyse past events, assess the present risks involved, and model what
could happen in the future. Actuaries may then forecast the long term financial implications of business decisions to assess
the most likely outcomes and the chances of more of less favourable outcomes occurring.

For example, life insurance and pension products are characterised by high acquisition costs and a high dependence on
customer retention over several years in order to ensure profitability. In recognition of these characteristics, actuaries have
over the years devised a number of techniques to help providers understand the economics of the products they offer. For
example, embedded value accounting is now used by most quoted UK life companies, not only to value portfolios of
existing and new business, but also to help inform their product design and pricing, and to target their customer acquisition
and retention efforts. The read across to the banking industry is clear, as demonstrated in this report.

With the distinction between the insurance and banking industries becoming increasingly blurred, actuaries have for some
time been expanding the use of their techniques from the life and general insurance industries into banks.




   For further information about the work of the Actuarial Profession’s activities in the banking industry, please contact:

            Pat Rustem
            Institute of Actuaries, Staple Inn Hall, High Holborn, London WC1V 7QJ
            Tel: 020 7632 2187 Fax: 020 7632 2131 Email: patr@actuaries.org.uk www.actuaries.org.uk

            Mark Symons
            Institute of Actuaries, Staple Inn Hall, High Holborn, London WC1V 7QJ
            Tel: 020 7632 2133 Fax: 020 7632 2131 Email: marks@actuaries.org.uk www.actuaries.org.uk
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