In 2015, the Canadian Council of Insurance Regulators (CCIR) established a working group to review and compare the regulation of Individual Variable Insurance Contracts (IVICs, better known as segregated funds) with those governing mutual funds. The group’s recent issues paper says that, in order to keep pace with disclosure practices in the investment business, segregated fund rules need to change.

The CCIR’s issues paper examines the way mutual funds and segregated funds handle disclosure and ensure the customer’s interests always come first. It includes twenty questions for interested parties to consider, and invites responses and comments to be submitted by July 15, 2016. The paper makes it clear that the status quo is not an option. “It is no longer a matter of when the disclosure requirements will change but how these requirements will change,” says the CCIR.

The CCIR has identified several areas where there are gaps in regulation between mutual funds and seg funds. The first item on the list: the disclosure of fees and compensation.

The working group notes that securities regulators have zeroed in on mutual funds commissions recently. In particular, studies conducted for the Canadian Securities Administrators (CSA) by the Brondesbury Group and by York University professor Douglas Cumming last year which found that commissions resulted in conflicts of interest and suggested that the use of deferred sales charges work to the detriment of investors. “Although the studies did not include segregated funds, the results might be extrapolated to sales of IVICs,” says the CCIR.

Embedded commissions for mutual funds could be banned entirely, but the CCIR admits there has been concern in the industry that this could result in higher costs for full-service advice, drive older advisors into retirement, and force lower income investors to use simplified robo-advice. However, the paper points to studies which suggest these concerns may be unwarranted.

Conflicted remuneration

When “conflicted remuneration” was banned in Australia in 2013, the CCIR says there was no exodus of financial advisors from the industry but there was a small overall increase in fixed fees for advice. In the United Kingdom, the CCIR points to a study conducted by the British Financial Conduct Authority (FCA) which found “no significant reduction in the availability of individuals providing advice” and that “commissions were no longer a driving factor in advisors’ recommendations and advisors were providing an increasingly professional service tailored to their clients’ individual needs.”

The CSA will release a policy direction on mutual fund fees later this year, and the insurance regulators plan to take a wait-and-see approach. The CCIR says it will review the stakeholder feedback that the CSA receives and the regulatory stance they take and then determine if the securities regulators’ approach to mutual funds would be suitable for segregated funds.

There will be even fewer similarities in how mutual funds and seg funds disclose compensation once the second phase of the Client Relationship Model (CRM2) is implemented.

“Some insurers currently provide clients with the actual dollar amounts and breakdown of fees for IVICs. A requirement for more detailed information on how the MER [management expense ratio] is calculated would assist consumers in understanding why these are typically higher for segregated fund products than for mutual funds,” says the CCIR. “To align with CRM2, all fees paid by the insurance account holder should be disclosed by the insurance company.”

What’s more, CRM2 will widen the gap in the way that mutual funds and segregated funds disclose performance. Under the new regulatory regime, mutual fund clients will receive an annual performance report that summarizes deposits into, and withdrawals from, the client’s account, as well as the change in value of the account. The annualized total percentage return using a dollar-weighted methodology for a 1, 3, 5 and 10-year period will have to be disclosed for mutual funds, as well as the rate of return since inception. Seg funds do not face these kinds of requirements.

“How should account performance reports for IVIC contract holders be harmonized with those on the mutual fund side? To what extent should the enhanced investment performance data requirements be harmonized with mutual fund rules?” asks the CCIR.

Sales incentives

Another important difference between mutual funds and seg funds is the way they address “soft dollar” compensation, which is when product providers offer advisors and firms benefits other than cash. For example, investment dealers may offer proprietary, in-house research in exchange for business. The CSA has ruled that investment intermediaries must disclose these kinds of soft dollar arrangements to the client before opening an account, but similar requirements do not exist for segregated funds.

“To address this gap, such measures on the IVICs side should be implemented, keeping in mind any differences in distribution models that might preclude imposing exactly the same requirements,” reads the issues paper. The CCIR is asking stakeholders to comment on how insurers can best disclose soft dollar arrangements and other sales incentives to clients so that they do not create conflicts of interest for insurance intermediaries.

There is also the question of sales oversight. In the mutual fund business, securities legislation makes the dealer responsible for the conduct of its sales force no matter whether they are employees or agents.

“In principle, the supervision requirements of insurers and dealers are similar, but complaint and examination files surveyed by the CCIR indicate that in some cases life insurers have not accepted responsibility for the sales conduct of licensed intermediaries selling their products,” reads the paper. As a result, the CCIR is asking what level of responsibility life insurance companies should have over seg fund sales.

While both securities and insurance regulations oblige advisors to know their clients’ needs and assess product suitability, the CCIR points to a survey conducted by Quebec’s Autorité des marchés financiers which found that about 80% of seg fund complaints were related to agent sales practices, specifically around suitability of the product. The insurance regulators note that Quebec has now made it mandatory for insurance intermediaries to prepare a written needs analysis when recommending a product. “To what standard of care should individuals who advise on and sell IVICs be held?” asks the CCIR. “Should the know your client / know your product standards as used in the securities sector apply to the sale of IVICs?”

Disclosure gaps

Although Canadian insurance regulators have been proactive about making sure that customers receive fair treatment when buying segregated funds, they are still concerned by the disclosure gaps between mutual funds and segregated funds which need to be addressed. “CCIR standards do align currently with international principles for insurance regulation and fair treatment of the customer, but it is a good time to consider what can be done to enhance this process even further,” concludes the paper.