In this article, we take a deep dive into the ‘fair value’ outcome of the Consumer Duty, including a look at how firms might evaluate and evidence this outcome, and the skills and resources needed to do so.
Fair value is one of the four outcomes that the FCA is seeking through its Consumer Duty initiative and which it sees as forming the key elements of the firm-consumer relationship. It sits alongside the products and services, consumer understanding and consumer support outcomes.
Fair value — what does it mean?
In relation to the fair value outcome of the Consumer Duty, the FCA is looking for firms to assess whether the total price paid is reasonable in relation to the benefits. The FCA says that it wants to set out a clear and consistent expectation of how firms should assess whether the price of products and services offers fair value. However, it has not provided detailed guidance on the matter. It has simply indicated that firms can consider many factors, including costs, benefits, and utility to customers, as well as market rates for comparable products.
This leaves firms in the position of having to decide how best to assess fair value and what factors should be included in the assessment. Most firms are familiar with the concept of benchmarking prices to market rates of comparable products, but less so with assessing the reasonableness of prices in relation to the costs and benefits to consumers.
To understand more about the FCA’s proposals on fair value, it is worth bearing in mind that they originate from a long-running programme of work on fair pricing, which has most recently been applied in policy interventions in General Insurance and Funeral Plans1. The FCA’s 2019 Feedback Statement on Fair Pricing in Financial Services, noted the difficulty of issuing prescriptive rules around fair pricing:
‘Assessing whether a particular pricing practice is unfair can be complex and the issues can vary from market to market. So, there is no simple formula that determines whether a practice is unfair, and we will use our judgment to balance the considerations in specific context. This implies that prescriptive rules are unlikely to be sufficient to incorporate our thinking into a regulatory approach. We consider at this stage that a principles-based approach may be more effective in driving appropriate outcomes…’
In earlier work leading up to the Feedback Statement, the FCA notes that assessing whether pricing practices are harmful to consumers and competition requires a case-by-case assessment based on detailed data2 . There is no template or set of instructions or rules that can be applied. Nevertheless, the FCA's approach to the assessment of pricing practices in other cases has relevance. Further, the approach adopted by other industries and competition regulators can provide insights on how they asses prices and other consumer outcomes.
The Competition and Markets Authority (CMA), for example, often examines prices as a key outcome of how a given market is functioning3. Other outcomes include the extent to which the market meets consumers' needs in terms of product choice and innovation, and levels of product and service quality. A deterioration in one or more of these market outcomes can be a sign that the market is not functioning effectively and may motivate a market study or other regulatory review. In the language of competition economics, poor or deteriorating consumer outcomes are indicators that certain market features are preventing, distorting, or restricting competition in some way. And quantifying the extent to which actual market outcomes diverge from the objective of a well-functioning market4 can help authorities to assess the scale of the problem in terms of harm or `detriment' to consumers.
Fair value in context
Fair value needs to be evaluated on a market-by-market basis based on context-specific information. The examples below, chosen from different sectors, will not necessarily have a precise read-across to other retail product markets in financial services but do provide a starting point for firms to consider how to proceed and — importantly — to consider the types of skills that they will need to have in place to deliver these fair value assessments across their product sets.
Case study: GI add-ons and GI pricing practices
The FCA has been considering fair value in general insurance (GI) markets for several years. This has informed, and has been informed by, parallel work on price discrimination and fair pricing.
In its Market Study into General insurance add-ons, the FCA found that selling a product as an add-on often led to consumers purchasing products that were of poor value and not what they needed. These findings were underpinned by consumer research showing poor understanding of product cover and low pay-out ratios compared to some other stand-alone insurance products. The FCA conducted behavioural economics experiments to test consumer ability to compare product value.
The chart below shows pay-out ratios or proportion of premiums paid out in claims for home insurance, with add-ons broken out separately. The FCA has noted5 that it is particularly concerned about the value of personal accident and key cover based on this data, which shows that less than 20% of the value of premiums for these add-ons was paid out in claims, compared to over 30% for home emergency cover and over 50% for buildings and contents insurance. This is one example of how data can be used as an indicator of value.
In its subsequent market study into General Insurance Pricing Practices , the FCA found evidence that some firms were gradually increasing prices for customers who renewed with them year on year (so-called `price walking'). The FCA found that firms were using complex and opaque pricing techniques to identify consumers who were more likely to renew with them and then increasing prices for these customers, resulting in some loyal customers paying more than they should. The FCA took issue with the practice of targeting customers with lower awareness of pricing, who are more likely to be vulnerable. The FCA's findings suggested that some consumers are not getting fair value.
An example of the evidence underpinning the FCA's conclusions is shown below. The chart shows the average margin on home and motor insurance policies by tenure. As can be seen, the margin increases on the first renewal and steadily climbs with each subsequent renewal.
In 2021, the FCA introduced rules including a ban on differential pricing between new and existing customers, meaning that insurers and distributors will have to offer the same price to new and renewing home and motor customers of equivalent risk. The focus of these rules was to ensure that firms deliver fair value for GI and pure protection products to customers and have strong governance and oversight arrangements in place to support this. They represented a fundamental change to the economics of many firms' business models. The FCA also introduced new requirements for firms to report and publish value measures on policies, claims, and complaints across most types of general insurance products, including add-on products, and a requirement for firms to take value measures into consideration in product value reviews.
Case study: Overdrafts and the High-Cost Credit Review
Fundamental reforms were introduced by the FCA following a review which revealed high prices for unarranged overdrafts, complex pricing structures, low consumer awareness, and repeated use of overdrafts. The FCA found that high prices for unarranged overdrafts were disproportionately impacting vulnerable consumers.
In its assessment of the market, the FCA considered a wide range of performance and financial metrics alongside other types of information to deepen its understanding of the value that consumers were getting from overdrafts. Analysis of this information showed that:
Overall price levels were relatively high based on:
- return on equity calculations using a range of cost allocation approaches, including incremental costs and fully allocated costs
- risk-adjusted margins on overdrafts and other short-term credit products
Disproportionate revenues were earned from unarranged overdrafts relative to lending balances, compared to revenues from arranged overdrafts.
There was insufficient evidence of any cost justification for higher prices on unarranged overdrafts.
The distribution of charges was skewed, with most fees and charges being concentrated on a small number of customers: customer level data showed that 50% of unarranged overdraft fees were paid by just 1.5% customers.
The distribution was regressive, with a link between unarranged overdraft usage and vulnerability measured by deprivation, using postcode data.
Product usage was often inappropriate: whilst overdrafts are designed to provide short term credit many consumers were using arranged overdrafts regularly over long periods and, for these customers, overdrafts might not be the best form of borrowing.
Evidence from behavioural experiments and consumer research showed that consumers found fees and charges complicated and difficult to understand.
The FCA found clear evidence of harm in this market — and comparable examples will exist in other sectors/product lines. Based on the range of evidence summarized above, the FCA judged charges to be high in absolute terms and it observed a harmful distribution and structuring of prices.
Case study: Asset management
In its asset management study:
The FCA found persistently high profit margins, but no clear relationship between charges but performance of actively managed retail funds.
- `…we consider that profitability represents a useful indicator of overall value for money. The persistently high levels of profit earned by asset management firms suggest that prices lie above competitive levels, which in turn indicates that on average investors may not be achieving value for money.'
The FCA found that investors' awareness of charges is often poor. This highlighted the importance of clear disclosure of what asset management services cost through the presentation of a single charge. The FCA conducted behavioural testing to understand how consumers can be helped to make more informed choices through the presentation of information.
The FCA’s 2018 policy statement noted that ‘The asset management market study and our supervisory work have shown that in general, AFMs have not considered robustly the value they offer to investors under our existing rules. We believe that this is leading to harm to investors through poor value products.’
In 2019, the FCA introduced rules requiring UK authorised fund managers (AFMs) to assess the overall value that their funds deliver to investors. The criteria set out by the FCA are based on three key elements: cost, performance against objectives, and quality of service. The FCA expects to see firms making rigorous and robust assessments of the value that their funds will deliver to investors, overseen by strong governance. It has conducted significant multi-firm review work since the introduction of the rules, to evaluate the processes used by firms when carrying out assessments of value, and has continued to find residual issues.
Implications for firms
What is clear from the above examples across different sectors, is that the FCA's expectations for fair value assessments are high: they should be data-driven, rigorous, and multi-dimensional, and are likely to require a range of skills to deliver them. Mirroring the skill set employed by regulators would include economists, data scientists, behavioural economists, and financial economists.
Firms will need to develop a framework for assessing fair value that is flexible enough to accommodate the specifics of different products and services, whilst also providing a degree of consistency. This will be important to avoid the possibility of cherry-picking methodologies to obtain favourable results for the firm and to enable comparisons to be made between products and services.
Firms will need to evaluate product-level economics
Firms will need to consider the pricing model for each element of their product/service portfolio, possibly to a much greater level of detail than is currently undertaken by the business. Assessing value may initially be challenging due to gaps in information as well as the subjectivity of the assessment.
Understanding the relationship between price and costs is a critical part of the fair value jigsaw. To produce an economically meaningful assessment, a range of issues will need to be considered such as:
- Cost allocation: what are the direct costs associated with providing the product or service? How should firms approach the allocation of common costs, which may be shared across several products and services and not be routinely allocated out in existing management information?
- Revenue allocation: for some products, for example current accounts and savings products, an account may be provided `free' on the face of it, but the customer may be paying a price in terms of interest foregone. Firms will need to consider whether the transfer prices attributed to such deposits in existing management information are fit for purpose for their fair value assessments.
- The cost of risk is also an intrinsic factor, and it is often necessary to consider relative capital intensity, or risk-weighted asset density, when considering product `value'. Indeed, the FCA considered such metrics in its recent evaluations of overdraft profitability as part of the High Cost Credit Review6 and in its Strategic Review of Retail Banking Business Models.7
- Existing economic value or profit models may be helpful but are unlikely to be calibrated at the level of detail envisaged by the FCA.
Cohort analysis will be required to evaluate outcomes for specific consumer groups
The value assessment also requires firms to consider value for specific customer groups. Relevant considerations under this heading include:
- How different consumer groups/target markets use the product and how this usage impacts the overall price that they pay. Are some consumer groups contributing a disproportionate amount of profitability and other customer groups contributing very little or being cross-subsidised?
- Price differentiation — how headline prices differ between different customers and whether there is an underlying cost rationale or other justification.
- Firms will need to understand how the operational costs vary across different consumer groups in order to understand relative economic value.
- Specifying and executing these types of assessment will likely require significant data analysis skills combined with financial and economics expertise.
Demand-side analysis of consumer experience will provide an important component
The FCA has said emphatically that it does not want to price regulate and that fair value is not just about the price-cost relationship. That implies that firms should also consider elements of value such as customer satisfaction, utility, and quality of service. A thorough fair value assessment needs to consider not only metrics of price and profitability but also demand-side information from customers, most likely in the form of customer surveys or other sources of customer feedback.
In addition, the FCA has indicated that it may expect firms to consider how their pricing structures impact the ability of consumers to make effective decisions and choices. Firms will need to consider whether they have the necessary expertise in behavioural economics and the ability to conduct behavioural experiments with consumers to explore this aspect of fair value.
An example of how fairness can be considered in the context of consumer markets is presented in the box below.
Transactional fairness
The approach often taken by regulators and competition authorities when considering firms' practices and whether they are harmful focuses on overall consumer welfare, or the sum of impacts across all consumer groups. However, this may fail to capture any price discrimination between `naïve' consumers who lack information and `savvy' consumers who have the information to switch between firms. For instance, loss-leading headline prices will benefit `savvy' consumers but to make normal profits, the firm takes advantage of `naïve' consumers' by charging them additional fees. This is intuitively viewed by consumers as “unfair”, yet it allows the firm to operate efficiently at normal profits.
To reflect public concerns of “unfairness”, a complementary approach can be used to build trust between firms and consumers in a market. Specifically, this `transactional fairness' approach requires firms to act in ways to ensure:
No Deception — consumers with normal expectations about pricing practices can understand the consequences of transacting with that firm.
No Hinderance — consumers are not hindered from terminating a relationship with the firm or from transacting with alternative firms.
Public Explanation — the firm can explain the rationale of its pricing practices and is willing to publicly provide this explanation.
Transactional unfairness can occur if a firm uses misleading information or hides obviously relevant information to entice consumers into a transaction. This includes where a firm remains quiet about the alternative tariffs it offers and for which the consumer is eligible, or not periodically informing existing customers about price changes or the absence of price changes when supply costs are falling. It is also transactionally unfair if a firm uses short timeframe offers or renewal date notifications that deter consumers from searching for competitors' offers or make it difficult for consumers to cancel a contract with default auto-renewals.
To avoid this, firms should ask themselves: In this transaction, are consumers allowed to enter voluntarily, knowing what to expect, and are they free to leave? Or more simply put, are we acting to deliver good customer outcomes?
Source: https://www.fca.org.uk/publications/policy-statements/ps19-16-high-credit-review-overdrafts
Rigorous and thorough assessment of fair value across the product suite will take time, and the FCA's implementation timetable is currently challenging.
One of the key issues facing firms is where to focus attention first. For large firms with multiple product areas and large numbers of individual products, it is a daunting prospect to have to collect the detailed qualitative and quantitative information on the entirety of the product suite needed to conduct an evidence-based assessment of fair value as described above. Even once the data is assembled, it will take time to make the necessary evaluations and judgements required to form a conclusion on the extent to which individual products meet the fair value standard. In cases where issues with fair value are identified, firms will also need to determine and enact meaningful actions to address the situation.
This will take some time, particularly for firms with complex product sets for which a 'one size fits all' approach is unlikely to work. However, firms will want to identify any problem areas quickly to avoid the risk of being in breach of the Consumer Duty when it is implemented.
Next steps for firms
Firms with large and complex product suites face a significant task in identifying and assembling the management information required to assess fair value in a data-driven and consistent way. This will take time and specialist economic and financial resources to get right. Whilst the detailed, data-driven, product-by-product level assessments described above are likely to be necessary and firms should certainly take steps to begin the task, they should also consider how to identify obvious high-risk areas early on in the process. This could give firms the opportunity to beta-test their fair-value evaluation approaches on a limited number of products or product areas before rolling them out more widely.
How can KPMG support?
The Consumer Duty is an opportunity for firms to review their product suites across the board to consider how they might improve value for their customers. In doing so, firms have an opportunity to improve customer engagement and trust and potentially business performance.
KPMG in the UK has a dedicated Competition Economics team which specialises in providing financial and economic advice for firms in their interactions with economic regulators like the FCA - across a wide range of projects/sectors and with specific financial sector experience. If you would like to discuss fair value generally or discuss our experience of designing and deploying our fair value framework, please get in touch with any of the team below.
1 The FCA was recently given powers to regulate pre-paid funeral plans. One of the new rules for the sector is that products must offer fair value for consumers. In its Consultation paper, the FCA says that firms will need to consider the relationship between the total price paid to the customer and the quality of the product when identifying whether a funeral plan product offers fair value.
2 https://www.fca.org.uk/publication/occasional-papers/op16-22.pdf
4 In market investigations this term is used in the sense of a market without the features causing the adverse effect on competition, rather than to denote an idealized, perfectly competitive market.
5 See FCA, 2020 General Insurance value measures
6 See for example High Cost Credit Review: Overdrafts consultation paper and policy statement: Technical Annex, December 2018
7 Strategic Review of Retail Banking Business Models – Final Report
