EU risk ratings for structured products divide issuers

Structured product issuers are at odds over how the risks of the investments they sell to retail clients should be disclosed under the European Union's forthcoming regulation on packaged retail and insurance-based investment products (Priips).

The European Supervisory Authorities (ESAs) received 68 responses to their consultation on key information documents (KIDs) for Priips, which closed on August 17. A KID is a short disclosure document, which must be a maximum of three sides of A4 in length, designed to explain to a prospective investor how the product they are interested in buying works and what its risks and costs are.

The consultation paper laid out four possible methods for assigning risk ratings to different Priips, which proved as divisive as its proposals for disclosing product costs.

"There are big differences between products of insurers and investment funds or banks," says a spokesperson for Deutsche Aktuarvereinigung, the German association of actuaries, which submitted a response to the consultation. "While life insurance is a long-term product, the traditional bank business is short term or medium term. Because of this, insurers and investment funds and banks have a different point of view on the definition of risks and kinds of risks."

Dividing lines

The first option proposed by the ESAs, a qualitative indicator, was backed by 11 respondents. Sixteen endorsed option two, a quantitative measure that separates market and credit risk in a way similar to the synthetic risk and reward indicator (SRRI) used by Ucits funds. Option three, another quantitative measure which is based on value-at-risk, received 11 declarations of support, and option four, a two-level indicator incorporating quantitative and qualitative measures, won two backers. The remaining 27 respondents indicated no clear preference or lobbied for a hybrid methodology incorporating different elements of the four options.

While life insurance is a long-term product, the traditional bank business is short term or medium term

The divisions lie along familiar fault lines. Banks and asset managers, along with their associated trade bodies, largely favour option two, as it would make Priips and Ucits funds easy to compare. Eight respondents out of the 24 classified as banking and asset management stakeholders by the ESAs favoured this approach outright, with a further six supporting a modified methodology based on the option.

BNP Paribas is one cheerleader for a quantitative approach. The bank wrote that the European Structured Investment Products Association (Eusipa) had tested options two and three on a sample of more than 140 different structured products, with both options producing similar results "in terms of dispersion of products on the risk scale". BNP Paribas prefers option two over option three, saying that it is easier to implement, including for smaller manufacturers, and "produces similar results as a VAR-based methodology with less complexity".

Eusipa also supports the quantitative options. The trade body criticised the qualitative option one, which slots products into one of six risk categories, writing that "there is no quantitative rationale in the [category] scale" and that "it is less a risk measure than a product classification, which does not bring clarity to the investor". The association also dislikes option four, writing that "a two-level risk indicator contradicts the idea behind a summary risk indicator as is requested under the Priips regulation."

The fund industry is also fond of option two. "It is the only one assessing market and credit risks separately, which is of paramount importance for distinguishing between different types of Priips. This option is also the closest approximation in terms of risk indicators to the existing Ucits SRRI," says Susanne Weismüller, senior legal adviser at the Association of the Luxembourg Fund Industry.

However, insurance and pension fund stakeholders – including Allianz SE and trade association Insurance Europe – rejected this methodology. Allianz said option two was based on linear extrapolation from short-term market risk and therefore gave meaningful results only for short-term products. "It does not work for long-term products, as market risk cannot be linearly approximated over longer periods of time," the insurer wrote.

Meanwhile, Insurance Europe wrote that none of the four proposals "appropriately cover every different type of product and in particular long-term products with guarantees". In total, only two out of 14 insurance and pension fund respondents favoured option two outright.

Practicality of a single rating questioned

The divide between bank issuers and asset managers on the one hand and insurers and pension fund representatives on the other brings into question whether a single summary risk indicator would work in practice for the whole universe of Priips.

"The inclusion of certain elements relevant to one group of products might be irrelevant for another set of products, and different methodologies should be used," says Olivia Fabry, policy adviser in the conduct of business department at Insurance Europe.

However, others note that the incentive to come up with a single risk-rating methodology is significant. "I don't think there will be different methodologies used for different products ... as that effectively destroys the idea [of] comparing apples with apples, which is the whole point of Priips [regulation]," says a source at a European structured products issuer. "Regulators will work very hard to find a single common approach that is the best fit."

The forthcoming regulation requires a single rating for all products. It is unclear whether Priips manufacturers will be allowed to include a more detailed explanation of the differences between products in the KID in addition to the rating.

Fans of options two and three are also divided over what method should be used to generate the forward-looking scenarios that inform the quantitative ratings. Eusipa favours the "what-if" scenarios proposed by the ESAs, as they "would enable the investor to easily see how the product would perform under a selection of key hypothetical market situations that directly impact the various product features". This is also an approach supported by BNP Paribas.

However, French dealer Credit Agricole says it would be better if manufacturers of structured funds, notes and deposits were allowed to choose the performance scenarios themselves, as is the case under French regulatory guidelines. For all other Priips, the bank suggests disclosing how they performed under different conditions in the past rather than using forward-looking scenarios.

David Stuff, chief executive of Cube Investing, a UK-based structured products distributor, also backs the use of past performance data, writing that forecasts are "inaccurate, subjective, non-standardised and easily manipulated".

A final consultation paper on the risk ratings and other elements of the Priips KID is expected in the autumn. This will inform the regulatory technical standards that will be submitted to the European Commission for approval by March 31, 2016.