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At the end of May, the Financial Conduct Authority will make its final decision on whether or not to go ahead with its plans to ban the so-called “loyalty penalty” in home and car insurance.

In case you’re not familiar with the term, this is the practice of insurers offering you a cheap price as a new customer, only to slowly ratchet it up the longer you stay with them.

Multiple surveys have shown this is consumers’ number one bugbear with insurers. And a couple of years ago, Citizens Advice launched a super-complaint to the Competition and Markets Authority, urging it to call time on this practice — not just in insurance, but across all sectors where it exists. 

People want to be rewarded, not penalised, for sticking with the same insurer, broadband company, energy supplier — so why let firms profit from their apathy?

Sadly, regulating away this problem is not as simple as it might appear. The FCA’s plans — now going through the consultation stage — are to ban car and home insurers from offering different prices to new and existing customers from next year. But the impact of doing that will mean an immediate price increase for new customers. By the FCA’s own calculations, it will amount to as much as a one-off 38 per cent rise in home insurance premiums and a 12 per cent increase in motor insurance prices.

My organisation, the independent consumer group Fairer Finance, decided to do some research into how this might go down with customers, commissioning a poll of 2,000 UK home and motor insurance consumers in November 2020. Unsurprisingly, while people told us that they dislike the loyalty penalty, when asked how much more they would be willing to pay to eliminate it, 86 per cent said they would not want to pay any more than 5 per cent extra.

As with all pieces of heavy-handed supply-side regulation, the FCA rules will take from one group and give to another. Those who will lose out most are the active consumers who take the time to make the most of a competitive market by shopping around every year or two. The beneficiaries will be those who don’t shop around.

The FCA’s assumption is that most people who don’t shop around are involuntarily paying more than want for their insurance. But I don’t believe that’s the case. Among all those paying more is a significant chunk of people who are not particularly price sensitive and decide that the potential savings on offer from switching do not match the cost of their time (and potentially goodwill to their existing provider).

The FCA has some evidence of its own to back up my theory. A few years ago, it started forcing insurers to put last year’s price on their renewal letters, so customers could see how much more they were being asked to pay.

When they went to measure the impact of these new rules, they found that in the car insurance market — where the average price increase was £57 — the added disclosure led to more people switching.

But in home insurance, where the average price increase was only £16, the number of customers who switched actually fell. So when consumers saw that the potential savings from switching were not that great, they were happy to stick with their existing provider rather than invest the time in switching.

All of this leads to an interesting philosophical question around what you believe the role of regulation should be — and what constitutes market failure.

The FCA has been experimenting with more stringent interventions over the past few years, taking the view that a market is failing if a significant number of consumers are paying more than they would if they switched.

In the savings market, for example, the regulator got quite close to forcing banks to offer only one account into which they would roll all of a customer’s money once introductory or fixed rates had ended. Its concern was that many customers were coming in on high rates, but once the offer period had ended, banks would whittle down their rates to rock bottom, while setting up new products for new customers where they could repeat the same trick.

The regulator talked about levels of aggregate harm for customers running into the tens or hundreds of millions of pounds. But in reality, the benefit of this intervention would amount to a few pence extra a year in interest for those passive customers — and would reduce rates at the top end of the market for the rate chasers.

When the regulator’s new chief executive, Nikhil Rathi, arrived in October, one of the first things he decided to do was scrap this intervention. I hope he’ll do the same with these insurance proposals.

The loyalty penalty is an unnecessary evil of a competitive market. Those regular switchers are the grease that keeps the wheels of the market efficient. By banning the loyalty penalty, we’ll remove the incentive for those regular switchers to shop around — taking away one of the mechanisms that keep the market efficient. With a more passive customer base, insurers will focus on increasing margins by whittling away the quality of their products.

I believe the FCA’s priority should be to ensure that all customers have access to a competitive market and that they understand how much they could save by shopping around if they choose to access it. If those two conditions are met, then there’s no market failure to worry about — even if many customers choose to pay more than they need.

Of course it is essential that we come up with ways to protect vulnerable consumers who are being overcharged and who are unaware or unable to switch. But the FCA’s current proposals are an overbearing way of supporting that small minority of customers. And their intervention will have more serious unintended consequences.

James Daley is managing director of the consumer group and rating agency Fairer Finance

Letter in response to this article:

Churchill understood the limits of ‘the market’ / From Teresa Kennard, Milton Keynes, Buckinghamshire, UK

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