Executive Summary:

Insurers rely on various distribution channels to sell insurance products,

representing a crucial intangible asset. However, risks associated with these
channels, such as inappropriate marketing practices, pose conduct of business risks.
While these risks may not directly threaten financial sustainability, they can lead to
significant harm to an insurer's reputation, income, and brand value. Distribution
risks can impact a channel, an insurer's business, and its financial sustainability.
These risks resemble operational risks, being unpredictable yet carrying substantial
reputation and financial implications. Concerns about an insurer's sustainability or
brand can rapidly degrade its distribution system. Insurance market conduct
supervisors enforce consumer protection measures, including suitability standards
and disclosure requirements. Actuaries play a key role in assessing sales quality,
policy performance, and identifying distribution and conduct of business risks for
effective enterprise risk management.

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Introduction Summary:

Sales in the insurance industry are complex due to the nature of insurance
products, often sold rather than bought. Insurers rely on various distribution
channels, ultimately responsible for managing distribution risks. Effective sales are
crucial for insurers and their channels to operate as sustainable entities, catering to
individuals and commercial entities through agents or alternative methods like
websites or mobile apps. Compensation for sales often includes commissions,
incentives, or salaries with bonuses. Distribution methods vary by market,
technology, and historical context, with hybrid approaches common. Three primary
forms of distribution risk include risks to the channel itself, to policy quality or
volume, and to the insurer's future sales capacity. Supervisors oversee product
fairness, sustainability, and consumer protection. Marketing encompasses product
design, distribution channel management, and brand development. Risks may be
joint between insurers and channels, impacting both parties' trust and reputation.
Effective distribution channels not only drive ongoing business but also mitigate
other risks and foster positive market conduct.

Summary of Risks to the Distribution Channel:

Efficient distribution channels are critical for an insurer's future business and
existing profitability. Risks to these channels pose significant threats to insurers.
Examples include:

Deterioration of agent continuity due to aging sales force.

Skilled salespeople lacking managerial abilities.
Poor agent reputation from past inappropriate practices.
Emerging competition from mobile/Internet-based sales.
Increased competition within the same channel.
Ineffective sales management leading to uncompetitive pricing or support.
Overreliance on a single agent or customer.
Managing general agents prioritizing sales volume over quality.
Technological advancements reducing channel effectiveness.
Reputation risks to insurers can stem from various sources beyond agents, such as
adverse publicity from industry practices, bad claim practices, intense competition,
government actions, or media relations. Negative events affecting insurers can also
impact agents tied to them, leading to adverse publicity. For instance, a data breach
compromising customer privacy not only affects the insurer but also damages the
agent's relationship with the policyholder.

4. Risks to the Quality or Volume of the Insurer’s Policies Caused by the Distribution
Channel
The distribution channel(s) and target market(s) of the insurer can significantly
influence the type of insureds an insurer will provide insurance to, which
consequentially results in different levels of expected insurance cost. Field
underwriting2 may influence the nature and type of exposures to risk that the
insurer will be subject to. Examples of concerns include quality of insurance risks
covered in relation to what is anticipated in the insurer’s pricing assumptions and
policyholder behaviour (e.g., applications not placed, policyholder terminations prior
to the policy’s expiry) and move business away from the insurer.
1. Risk selection. Often, but not always, agents directly or indirectly participate in
the risk selection process through identification of customers and field underwriting,
which may result in experience inconsistent with pricing assumptions due to
potential anti-selection, policyholder moral hazard, or even fraud by applicants.
Agents can be more focused on maximizing their personal revenue than maximizing
profitable sales—particularly a concern with managing general agents who have
been given significant autonomy with respect to the field underwriting and
management of their individual agents. If an independent agent splits its business
between more than one insurer, the business directed to a particular insurer might
be of worse quality, representing adverse risk selection against that insurer. In
addition, if an agent gathers incorrect or incomplete information regarding the
quality of the risk, the insurer may as a result make incorrect underwriting
decisions.
2. Policyholder behaviour. Although often thought of solely in relation to premature
voluntary policy terminations and nonpayment of premiums relative to pricing
expectations, policyholder behaviour also can result in moral hazard with respect to
the expected amount of claims or in fraud. Agents can also influence inappropriate
exercise of policy options—for instance, the exchange of one policy for another,
especially one of another insurer, is often referred to as replacement. Such a
replacement may not be in the best financial interest of the policyholder, as it might
be the result of an agent more incented by large front-end commissions on long-
term insurance policies or by a bonus for block-transfers of a book of short-duration
insurance policies such as automobile or personal property insurance, than by the
best interest of the policyholder. In fact, a replacement can indicate a situation in
which a conflict of interest3 or misselling may be present. In some cases it may not
be evident who “owns” the insurance policyholder relationship—
2 Selection of potential insured risks by agents in the field, either judgmentally or in
accordance with rules set by the insurer, often confirmed by an insurer’s
underwriter.
3 A conflict of interest can arise where compensation is paid by the insurer for a
sale of an insurance policy by an agent. Such compensation may incent an agent to
steer a sale toward a product that provides a larger amount of compensation. It may
especially arise where it is not clear whether the agent is working primarily on
behalf of the insurer or the insured. This has led in some jurisdictions to a greater
use of fees payable by the customer for the service of the agent or of required
disclosures of the amount of compensation provided.
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this may result in alternative service responsibilities and movement of insureds
between companies. In summary, agents can influence policy lapse or non-
continuation behaviour counter to the best interest of the policyholders, which at
the same time can impair the recovery of acquisition expenses or increase anti-
selection against the insurer.
3. Policyholder interfaces. A lack of effective and convenient customer interface,
whether via technology (website, mobile phone, or toll-free call-in number) can
cause significant brand (and even industry) damage for an insurer and its
distribution channels.
Actuaries regularly monitor policy experience and develop expectations regarding
policy performance and policyholder behaviour, indicated by such experience as
high policy lapse and low policy continuation; agent retention; and claim approval
rates, changes in sales volume, and expense margins, which are incorporated in
premium rates and valuation assumptions. Whether through internally tracked or
external customer complaint sources (e.g., sponsored by regulators, independent
firm or social network), complaint resolution metrics (by type, resolution percent,
and timeliness) can provide useful feedback information to the insurer and
supervisor. These are suggestive of distribution issues needing immediate insurer
attention. As deviations from these expectations emerge, the insurer assesses
whether its expectations need to be revised or corrective action is needed with
respect to the insurer’s distribution channel or underwriting.

5. Risks to the Insurer Caused by Distribution Channel Activities

The characteristics and quality of a distribution channel, or the effects of
management decisions relating to a distribution channel, can also expose the
insurer to direct damage in several ways.
Risks resulting from the operation of a distribution channel can include:
1. Concentration risk—that is, overreliance on a single distribution channel, a few
agents, or a few insureds. In the extreme, this can be the result of over-dependence
on the insurer on a single agent or relationship that could (1) adversely influence
corporate policy, pricing levels or underwriting decisions; (2) adversely affect
profitability; or (3) terminate a significant amount of business from the insurer if
corporate decisions don’t go its way. Alternatively, if, for example, a large portion of
an insurer’s sales are from agents located in a particular retail chain (such as a bank
or department store), a decision by that retail chain to end the relationship may
materially impact the insurer’s financial position.
2. Outsourcing risk. If the management of a distribution channel has been
outsourced to an intermediary (e.g., to a managing general agent) or to a partner
(see partnering risk below), the insurer usually has less control of the channel and
its business. Although this can result in high acquisition costs because of relatively
high commissions/fees, this may be offset by the functions and services provided
that the insurer no longer has to fund directly. The outsourced entity may be able to
provide immediate scale or recruit more agents more quickly through which higher
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volume might be able to be achieved and access to new markets might be obtained,
although the arrangement might at the same time contribute to increased
concentration risk. Careful ongoing oversight may be required to overcome the
direct loss of control.
3. Partnering risk. This can result from partnership with other firms, possibly with a
bank (Bancassurance), a retail network, or micro-finance institution, with the
responsibility for various functions, including distribution, split between the parties
—the relationship involved is usually similar to the outsourcing situation. It should
be noted that the more parties involved in the acquisition and servicing processes,
the greater the likelihood of inadvertent or intended risks. In addition to the obvious
risk of the partner becoming bankrupt, misaligned motivation and incentives,
ineffective coordination, and a lack of an exit strategy may harm the insurer. In fact,
the partner may be more involved with promoting itself than the
success/profitability of the insurance co-venture; if, for example, a representative of
the partner sits on the board of the insurer, that representative might influence the
decisions of the insurer to favor the partner (as a result, many jurisdictions forbid
agency firms to be on the insurer’s board). In the case of a bank partner that acted
as a corporate agent, the partner could exert undue pressure and influence on the
bank’s customers to purchase insurance policies passed off as investment products.
If inadequately monitored and managed, a potential for misselling and fraud exists,
which is bad for business both in the short and long term, representing brand and
reputation risk for the insurer.
If the partner is responsible for collecting premiums, the insurer needs to monitor
the delivery of premium payments directly to the agent or other intermediary,
because they might never reach the insurer, resulting in loss of coverage by the
policyholder and ultimately a loss of reputation by the insurer. This could also lead
to significant increases in internal and external cost, including litigation costs. This
type of risk, which may be widespread among insurers across a particular
marketplace or isolated to a particular insurer, is similar to other types of
operational risks, leading to loss of future new business. This risk can be
exacerbated if the insurer delegates control and inadequately monitors the actions
of the agents or managing general agent, as applicable. See Section 6 for further
discussion of these risks and related issues of supervisory concern.
4. Cost versus control. The choice of a particular type of distribution channel
requires an assessment of the risk of higher compensation, support cost, and
effective oversight. Sudden changes in the cost, quality, or number of agents,
especially involving a particular product or sector, have to be monitored on a
regular basis. Indicators of such a change include unexpected changes in new
business, not placement or lapse/continuation rates, outsourcer fees, or bankruptcy
of outsourced agents. In any case, the actuary is sensitive to the level of expenses
involved in the insurer’s operations, including the cost of acquisition—to assess
relative competitiveness and the cost and success of agent recruitment—and care is
needed to ensure that the agent does not benefit more than the policyholders.
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5. Up-front compensation. Insurers in many countries pay significantly greater
compensation (to those generating the sales or those who are compensated by
additional sales) at policy origination than at the time of renewal, e.g., long-duration
life insurance sold to individuals. On the one hand this can align the interests of the
agent and the insurer because in both cases a profitable product can create long-
term capital/value for the insurer while providing capital to the agent to build and
invest in the business of the agent. On the other hand, it can negatively affect the
sustainability of agents as they can become dependent on new sales for cash flows
and do not build up a continuing stream of income. In addition, it is important to
recognize that this can create a conflict of interest as a result of an over-emphasis
on placing new business by agents and on moving (replacing) blocks of business
between insurers or between products of the same insurer, a reduced ability to
recover acquisition expense, moral hazard, and, in the extreme cases, fraud.
Whereas the insurer has an interest in retaining policies and policyholders to ensure
recovery of its up-front costs, up-front compensation reduces the incentive for the
agent to keep a policy in force, increasing the incentives for selling policies with
higher compensation and for churning (replacing) the policy that may not be in the
policyholder’s best interest. Excessive compensation can prove to be a long-term
detriment to consumers, especially for policies with a heavy investment component,
e.g., privatized pension products previously sold in Latin America.
6. Expense recovery risks. Both greater expenses and inadequate new or total
business volume relative to pricing assumptions can lead to a reduction in
profitability. Although potentially caused by inaccurate actuarial estimates, this risk
can also be caused by a sudden adverse change in distribution channel quality or
effectiveness. This impaired expense recovery results from fixed or non-variable
expenses or lack of new business or greater than expected policy lapse or non-
renewal rates. Larger unit expenses are typically included as part of a stress test to
assess the magnitude of its possible impact.
7. Rogue agents. In certain cases, an individual agent could act in a manner
inconsistent with an insurer’s policies and rules, or collude with a third party to take
advantage of the insurer, another party, or society. The action might be illegal, such
as modifying an insurance policy without the consent of the insurer, charging
unauthorized fees, or acting in a fraudulent manner. Such action, once identified
and reported to the supervisor or communicated to the public, can cause
irreparable harm to the insurer’s brand/reputation and cost the insurer a great
amount of resources. This can be identified through monitoring of individual agents’
business for early lapses, poor placement rates, or missold policies. An insurer can
also inquire of peer companies or an applicable supervisor whether a prospective
agent has been terminated with cause.
8. Tax payments. In some countries, the tax status of agents might change
retroactively (e.g., from being an independent contractor to an employee), possibly
resulting in considerable tax payments or penalties for the insurer and restructuring
of its distribution strategy.
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9. Technology/regulations. New technology or new regulations can make the current
distribution process irrelevant or overly expensive. An example of the use of new
technology includes mobile phone apps used to purchase or pay premiums for
insurance. For instance, new regulations may require additional continuing
education requirements or fiduciary responsibilities, which may result in increased
cost or inability to recover previous sunk cost.
10. Uncollected chargebacks. In some cases, commission will be charged back to an
agent out of future commissions if long-duration policies lapse in their first policy
year. However, if an agent severs its relationship with the insurer, the chargeback
may become uncollectable.
11. Multi-level marketing. Ponzi, or pyramid schemes, where agents are
compensated upon recruitment of additional agents, might arise, although rare in
insurance. These situations, banned in several jurisdictions, can benefit agents, but
eventually run their course to the benefit of no one, other than the first few
participants in the scheme.
12. Political risk. If the agent or sponsorship is provided by a government or
governmental agency, if the head of that government or governmental agency
changes or changes policy, or if fraud or kick-backs are proven, the relationship and
business can be adversely affected, especially if a large part of the business of the
insurer.
Poor management governance practices related to its distribution can also weaken
insurer performance. These can include:
1. Ineffective or unsuitable distribution channel. A poorly designed or managed
distribution channel can develop a low quantity or quality of insurance sales and
create a poor public image for the insurer. It can be unsuitable if it is not appropriate
for the needs, knowledge, or culture of the target market. This may be as or more
important than unsuitable products in providing quality products.
2. Management resource risk. It is often a priority to maintain the loyalty of top
agents. This may require considerable time by top management and its employees
in agent relationships to maintain their loyalty. Although this may be a consciously
chosen business priority, it also might divert an inordinate amount of top
management time from important strategic issues and toward quantity rather than
quality of business.
a. Over-emphasis on gaining market share. In some cases, the emphasis of
management can be so focused on gaining or defending market share that the
quality of its distribution channel, agents, and insurance risks suffers. This can arise
when staff in charge of sales or marketing emphasizes increases in sales at the
expense of quality of agents, sound underwriting practices, or premium adequacy.
An early warning signal of this happening might be a surge in market share that
cannot be explained by another factor. Regular discussions with agents can provide
insight into the underlying reasons for such a change, which can then lead to
appropriate corrective actions.
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3. Inappropriate product and pricing governance. Mitigation efforts include the
design of products suitable to the distribution channels used and target markets,
and costs consistent with desired level of competition and risk tolerance.
4. Sponsorship risks. Advertisements and sales can be augmented through the
endorsement or other use of sponsors and brand salespeople, such as a celebrity.
As with any marketing effort, a deterioration in the reputation of the sponsor,
celebrity, or agent can result in a significant reduction in the marketing potential of
the insurer, although that might prove temporary with timely action by the insurer.
Because of the importance of these risks to the insurer, actuaries are involved in
estimating the quality of sales and policy performance in the pricing and valuation
of insurance products, as well as in the ERM assessment of the effective
management of these risks and distribution performance. Effectiveness and
accuracy of sales material, whether in sales brochures, presentations, policy
illustrations, website, or mobile phone apps, can be pre-screened or audited, as
applicable and needed. Although not normally involved in agent training, actuaries
can be involved in the development of educational material regarding the products
and needs addressed by the products. This involvement not only enables insurers to
better identify these risks, but to also develop or enhance the mitigation tools that
can reduce the incidence and management of the severity of these risks.

Summary of Consumer Protection/Selling Risks:

Insurers are obligated to protect consumers beyond mere legal compliance,

necessitating sound management of distribution and sales risks. This includes
fostering a culture of fair business conduct, responsible pricing, and claims
management. Insurance supervisors oversee consumer protection, ensuring fair
treatment and suitable policies. Regulations may cover areas like rate approvals,
policy form standards, remuneration limitations, and agent licensing.

However, regulatory rules may not always be suitable for agent-free distribution,
and some jurisdictions lack resources or rules for effective oversight. Effective
management of conduct risks involves identifying and avoiding inappropriate
market conduct, which can signal future solvency risks and governance issues.

Consumer protection is crucial due to knowledge asymmetry regarding insurance,

particularly in individual purchases. Regulatory fines for misselling have occurred,
such as pension misselling in the UK or inadequate disclosure of flood policies.

Historically, front-ended agent compensation for long-duration policies has led to

conflicts of interest and cases of misselling. Recent trends include increased
disclosure of agent compensation and limits on insurer expenses or agent
commissions.

Insurers implement controls like agent screening, training, sales audits, and
consumer education to manage sales risks and ensure consumer protection.
Actuaries play a role in ensuring accurate policy illustrations and advising on sales
suitability. Consumer recourse mechanisms, including complaint services and
ombudsmen, provide avenues for redress.

Conclusion Summary:

Distribution and marketing activities, though not typically seen as solvency risks,
can pose significant financial risks to insurers and their customers if inadequately
managed. Poor management of distribution channels and agents can harm an
insurer's sustainability, brand value, and income potential, prompting regulatory
action.

Effective management of distribution risks is essential for maintaining the insurer's

value and trust as an ongoing concern. Strategies for protection include:

Monitoring key performance indicators like customer complaints, retention rates,

and sales anomalies.
Adhering to actuarial standards for policy illustrations.
Educating agents and consumers on product suitability.
Implementing independent, accountable functions like Enterprise Risk Management
(ERM) to monitor sales practices and risks.
Adhering to regulatory requirements governing market conduct and sales practices,
and undergoing periodic reviews to assess effectiveness in managing distribution
systems.

Conclusion Summary:

Distribution and marketing activities, although not typically considered solvency

risks, can pose significant financial risks to insurers and customers if not managed
properly. Inadequate management of distribution channels and agents can
jeopardize an insurer's sustainability, brand value, and revenue potential,
potentially leading to regulatory intervention.

Effective management of distribution risks is crucial for maintaining the insurer's

value and trust as a sustainable entity. This includes:

Monitoring key performance indicators such as customer complaints, retention

rates, and sales anomalies.
Ensuring compliance with actuarial standards for policy illustrations.
Providing education to agents and consumers about product suitability.
Establishing independent oversight functions like Enterprise Risk Management
(ERM) to monitor sales practices and associated risks.
Adhering to regulatory requirements governing market conduct and sales practices,
and undergoing periodic reviews to evaluate the effectiveness of distribution system
management.