Embedded insurance products: regulatory considerations

This article was originally published in Practical Law, September 2023 and is reproduced with permission from the publisher.

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This article explains what embedded insurance products are and outlines key aspects of the applicable EU insurance regulatory framework. It includes a case study of a bicycle manufacturer offering customers an embedded insurance package.

The article also considers some of the benefits and challenges that arise for those involved in the offer and distribution of embedded insurance products.

 

Scope of this article

Have you ever bought or sold a product that was so valuable (such as a car, an (e-)bike or even a new phone), that the purchase agreement not only extended to the product itself but also to an agreement to cover the risk of, for instance, damages to, or theft of, that product? If so, you may have bought or sold an embedded insurance product.

In this article, we explain the regulatory framework for embedded insurance offerings from a European (and high-level) perspective. With 23 million bikes among a population of 17.5 million people in the Netherlands, it is only logical for us, as Dutch lawyers, to clarify the concept of embedded insurance with a case study of a bicycle manufacturer offering an embedded insurance package. We also outline some relevant developments in the insurance sector and identify the key opportunities and challenges related to embedded insurance offerings.

 

What is embedded insurance?

An “embedded” insurance product is an insurance product that has been integrated in the purchase of a product or service. While embedded insurance offerings could be offered in relation to virtually any product or service, it is most common to see these insurances embedded in credit card schemes, and in the purchase of cars and bicycles. With the rise of sales in e-bikes, for example, manufacturers, suppliers and retailers have increasingly been offering embedded insurance products to cover the costs of the loss of, or damage to, (costly) e-bikes. This often also includes a service extending the guarantee of the bike, covering the costs of reparation or even a promise to replace the bike in case of theft or loss, depending on which (embedded insurance) package had been purchased by the customer.

As explained in Regulatory framework, in general, a true embedded insurance product constitutes an insurance contract and is, therefore, in essence not different from a conventional or “normal” insurance product. This means that the offering of such a product is regulated, and its offeror needs to comply with the license obligation and ongoing conduct and prudential requirements set out in the EU insurance regulatory framework, provided no exemption can be applied (see Exemptions to the license requirement).

It may be argued that embedded insurance products improve customers’ access to insurance products, since it is no longer necessary for them to acquire a separate insurance contract to cover risks relating to their property or service, and it also improves the coverage “protection gap”. However, the embedded aspect also raises some challenges for compliance with certain regulatory requirements relating to the offer and distribution of insurance products.

 

Regulatory framework

Insurance contracts

According to the Final Report of the Commission Expert Group on European Insurance Contract Law (published in January 2014), there is a lack of a meaningful definition of an “insurance contract” at EU level. The definition of insurance may, for instance, depend on the assessment of the legal relationship between the involved parties (that is, the insurer, policyholder, insured and beneficiary), the technical process or the tax qualification. Few EU member states have adopted a statutory definition of insurance. The Netherlands is, however, one of the jurisdictions that has.

In general, an insurance contract means a contract under which one party, the insurer, promises another party, the 2 Practical Law policyholder, cover against a specified risk in exchange for a premium. In the Netherlands, (article 9:725, Dutch Civil Code (Burgerlijk Wetboek)) an insurance contract is defined as an agreement under which one of the parties (the insurer) engages itself towards its counterpart (the policyholder) to pay one or more insurance benefits in exchange for an insurance premium, while neither party, at the moment they enter into such an agreement, knows for certain if, when or what amount of insurance benefits have to be paid, or how long the agreed payment of insurance premiums will last. Other jurisdictions have adopted similar provisions.

Applying this definition means that certain guarantees and service contracts may also constitute an insurance contract, as we describe in more detail in the sections below.

License obligation: offering insurance contracts

Parties that offer contracts or arrangements meeting the definition of an insurance contract must, in most cases, apply for a license as a non-life insurance company, pursuant to the Solvency II framework (based on Directive 2009/138/EC). In Europe, insurance companies must adhere to conduct requirements (which ensure, among other things, fair treatment of customers and adequate information provision), and capital requirements (which ensure the insurer is able to fulfil its financial obligations). In Europe, in their capacity as regulated entities, insurers are subject to rather strict supervision by national competent authorities (NCAs).

For an overview of the regime under the Solvency II Directive, see Practice note, Solvency II: overview.

License obligation: distributing insurance contracts

From a European perspective, the Insurance Distribution Directive ((EU) 2016/97) (IDD) contains standards on insurance distribution designed to:

• Create a level playing field for all market participants involved in the sale of insurance;
• Improve consumer protection;
• Promote a single market for financial services in Europe.

The IDD applies to reinsurers, insurers, advisers and intermediaries in insurance contracts, as well as (sub) authorised agents. However, there may be slight differences in implementation of the IDD in the EU member states.

In the Netherlands, parties involved in the distribution of an insurance contract require a license as an intermediary or (sub)authorised agent and, subsequently, must adhere to conduct requirements. Based on the definition of intermediation in insurance contracts, a supplier selling a product with embedded insurance may qualify as an insurance intermediary and, in principle, require a license.

Similar to insurers, companies in scope of the license obligation introduced by the IDD are subject to supervision by NCAs.

For an overview of the regime under the IDD, see Practice note, Insurance Distribution Directive (IDD).

 

Conduct considerations

Although embedded insurance contracts do not differ significantly from other insurance contracts, from a financial regulatory perspective, certain aspects are worth drawing attention to. These are outlined in the sections below.

Clear and transparent contracting

The offeror of, or intermediary in, an insurance contract must inform its customer in a correct, clear and nonmisleading way to enable the customer to make a well-informed decision on the purchase of the insurance product. This rule should allow customers to reflect on their insurance purchase (for example, whether the insurance offered is indeed the insurance needed or whether the price for the insurance is right). Within an embedded insurance context, there is a risk that either the manufacturer (or retailer) or the customer (or both) are unaware of the regulatory requirements that apply to insurance products and, consequently, do not comply with ((pre-)contractual) information requirements.

For more information on the IDD communication and disclosure provisions, see Practice note, Insurance Distribution Directive (IDD): Fair, clear and not misleading information (Article 17(2)) and Provision of general information (Article 18).

Cross-selling

The IDD introduced standards on cross-selling, which are relevant for the distribution of insurance contracts in addition to the purchase of a movable item or the provision of a service. An intermediary that offers an insurance contract in addition to the provision of a service or the purchase of a movable item (such as an e-bike), must also provide its customer with the opportunity to acquire that service or movable item without the insurance contract. Further to this requirement, the embedded insurance contract should always be optional, as the customer must have the opportunity to acquire the product or service without the (embedded) insurance.

For more information on the IDD cross-selling provisions, see Practice note, Insurance Distribution Directive (IDD): Cross-selling (Article 24).

Inducements

Insurance intermediaries must be transparent about inducements. A customer that purchases a product embedded with insurance from an intermediary must be made aware how the intermediary receives remuneration (which can be either an inducement received from an insurance company or a fee that is charged to the customer.

On a country-per-country basis, the exact rules in this regard may differ. In the Netherlands, for example, the rules on inducements are considered to be more stringent than the European standard set out in the IDD.

For more information on the IDD inducement provisions, see Practice note, Insurance Distribution Directive (IDD): Conflicts of interest and transparency (Article 19).

 

Exemptions to the license requirement

Where the contract is not insurance

Free insurance

Many embedded insurance schemes may fall within the definition of an insurance contract as described in Insurance contracts. To fall outside the regulatory regime, manufacturers, suppliers and retailers may argue that if no premium is being paid, the definition of an insurance contract is not met. As such, they may argue that the embedded insurance contract is actually free of charge, since the price of the insurance has been incorporated in the product or service and is paid for by the manufacturer or supplier out of its own sales margin. A supervisory authority would assess, however, whether this position is feasible, depending on local law and the actual circumstances, including whether the insurance is truly free of charge.

True service or guarantee

An embedded insurance contract often takes the form of a service agreement relating to maintenance and repair of the purchased product. Such an agreement does not necessarily qualify as an insurance contract. In the Netherlands, for example, the Dutch legislator has indicated that the concept of non-life insurance in the Dutch Civil Code is too broad in certain cases and that its limits must be determined in case law. The criterion in this assessment is whether the subscription, regardless of its name, is regarded as non-life insurance by society. A subscription for maintenance and repair is generally not considered an insurance contract if both of the following conditions are satisfied:

• The subscription is a subordinate part of the purchase agreement;
• It covers repairs of damages relating to the nature of the product and which are, therefore, not attributable to external causes and the duration of the subscription does not evidently exceed the lifetime that can reasonably be expected of the purchased product.

Ancillary insurance intermediaries

A supplier or retailer offering an embedded insurance scheme typically does so ancillary to its normal business activities. Think of a bike shop owner that sells bikes with an embedded insurance contract. The shop owner’s insurance-related activities may qualify as intermediating in insurance contracts. Under the IDD, a natural person or legal entity qualifies as an ancillary insurance intermediary if the intermediary, for remuneration, takes up or pursues the activity of insurance distribution on an ancillary basis, provided that:

• The principal professional activity of that natural or legal person is something other than insurance distribution;
• The natural or legal person only distributes certain insurance products that are complementary to a good or service;
• The insurance products concerned do not cover life assurance or liability risks, unless that cover complements the good or service which the intermediary provides as its principal professional activity.

Under certain circumstances, an ancillary insurance intermediary, such as the bike shop owner, may rely on an exemption to the license obligation included in the IDD (known as the “connected contracts” exemption). To rely on this exemption, the insurance offered by the ancillary insurance intermediary must be complementary to the good or service supplied by the provider. Also, the risks covered must be limited to the risks set out in the IDD (in general, the risk of breakdown, loss or damage of the good or non-use of the service) and the premium paid for the insurance cannot exceed a certain amount (in general, EUR600 pro rata annually).

While the ancillary insurance intermediary is exempt from the license requirement, an adequate degree of consumer protection must nevertheless be ensured in relation to these insurance distribution activities. Certain basic customer protection requirements, therefore, remain applicable.

This IDD exemption is implemented throughout the EU and, as a consequence, the national legislation of each EU member state in this regard may differ slightly from the European rule set out in the IDD. In the Netherlands, for example, if an intermediary is able to rely on this exemption, it would still have to comply with certain conduct requirements, such as (pre-)contractual information requirements, a general duty of care and the cross-selling requirements as described in Conduct considerations.

For more information on the IDD exemption, see Practice note, Insurance Distribution Directive (IDD): Exemption from scope: connected contracts.

Group insurance structures

Embedded insurance schemes are often based on group insurance policies. Under a group insurance policy, an insurer covers the risks of multiple insureds, while engaging only one entity as the (group) policyholder. This policyholder adds customers to the policy who accept the existing terms and conditions and become an insured under the (group) policy only.

The benefit of this structure is that it will only result in one set of terms and conditions, one policy and one contracting party. It was assumed in many EU jurisdiction that the policyholder cannot be seen as an insurance intermediary, eliminating the need for a license as an insurance intermediary. It was also, in some jurisdictions, believed that insureds (not being policyholders) were not in scope of certain customer protection rules, easing the compliance burden with related ongoing requirements (such as the crossselling prohibition or information requirements). However, this set-up has come under scrutiny after a number of Court of Justice of the EU (ECJ) judgments relating to the qualification of such policyholders as intermediaries, insureds as policyholders and the need to inform insureds (see ECJ 24 February 2022, joined cases C-213/20 and C-143/20 (Polish ULIP) and ECJ 29 September 2022, case C-633/20 (Medical Air Ambulance Agency), as well as ECJ 20 September 2023, case C-263/22 (Ocidental – Companhia Portuguesa de Seguros de Vida, SA v. LP)).

 

Non-compliance risks

The license obligation and other ongoing requirements applicable to insurance (intermediary) activities are being enforced on a national member state level. In general, non-compliance with these rules are punishable, depending on the circumstances, with:

• Normative conversations. (These are discussions with a regulated entity, initiated by the supervisory authority, to tell the regulated business to resolve the issues identified. These discussions are less formal than a warning)
• Warnings;
• Administrative fines (in the Netherlands, a general maximum of EUR5 million or 10% of the annual turnover applies);
• Penalty payments;
• Dismissal of board members;
• Withdrawal of licenses;
• Referral to, and notification with, the Public Prosecution Service for possible personal prosecution of daily policymakers.

Sanctions can be imposed on the company as well as (at the same time) on the relevant individuals deemed responsible for the company’s lack of compliance.

In practice, we see that regulators organise “search days” to find non-compliant companies (for example, by searching the internet with key words). Also, the recent development of companies complaining to the regulators about their competitor’s non-compliance (urging the regulators to enforce the rules), does not go unnoticed.

 

Case study: the bicycle manufacturer

When applying the insurance regulatory framework outlined in Regulatory framework to our example of a bicycle manufacturer who anticipates selling coverage for theft and repairs to its customer together with or embedded within the sale of the bicycles, the regulatory assessment will, in short, look as follows.

(Please note that the example of R&A Bikes used in this case study is fictional).

First of all, the manufacturer (R&A Bikes) will have to assess what insurance coverage it is selling. A service contract or an extended warranty for expected services (such as the yearly maintenance check) is generally not considered to be an insurance contract. However, the coverage for unexpected events due to external circumstances, such as theft, is considered to be insurance.

For the theft coverage, it would then have to be assessed whether the bicycle manufacturer would be providing the coverage itself or whether a third party, such as an insurer, would be involved. If R&A Bikes provide the coverage itself, it would most likely qualify as an insurer and require a license, and be subject to the ongoing conduct and prudential rules.

Assuming an insurer will cover the risk of theft, it must be assessed how the manufacturer would be involved in the insurance distribution scheme. Either it becomes a party to the insurance contract itself (as a group policyholder adding insureds (the customers) to the group policy contract), or the manufacturer ensures that each customer obtains its own coverage. The latter would mean that R&A Bikes adopts a role in the insurance distribution chain. This role is often regulated as that of an insurance intermediary and is only exempted from the licence obligation under certain conditions. Based on the advertisement pictured, it could very well be that R&A Bikes would be able to rely on the exemption available to ancillary insurance intermediaries as described in Ancillary insurance intermediaries.

From the pictured advertisement, we can derive that R&A Bikes distributes (non-life) insurances for remuneration (sale price) while:

• Its principal professional activity is not insurance distribution (it is a bicycle manufacturer);
• The insurance products distributed are complementary to the goods provided and within the limited list and premium amount set out in the IDD (it is an insurance against theft of the bicycle being sold for an annual fee of EUR15).

As explained in Ancillary insurance intermediaries, even if R&A Bikes would be able to rely on an exemption to the license obligation, this does not mean that the manufacturer is completely exempt from other conduct rules. In the Netherlands, for example, R&A Bikes would still have to make sure that it informs its customers in a correct, clear and non-misleading way.

 

Considerations for the insurance sector

While embedded insurance offerings may seem like an easy and accessible way for the customer to obtain insurance coverage, structuring and designing these insurance offering is more challenging than “normal” insurance products.

The benefits of embedded insurance are generally acknowledged in the sector. Obtaining insurance has never been so easy for customers. Often, coverage is bought swiftly, within a few clicks, in accordance with the general shift towards digitalisation in the insurance sector.

These new insurance distribution models are seen as an opportunity to expedite insurance purchases and, as a result, close a potential coverage protection gap for customers. However, this trend does not eliminate insurance distributors’ responsibility to act ethically and prioritise customers’ interests. Obtaining insurance so easily may also mean that customers buy unnecessary insurances (for example, if they are already covered for the same risks under other insurances, such as their credit card schemes or their general property insurance). In this regard, the European Insurance and Occupational Pensions Authority (EIOPA) has recently discussed the possibility of an insurance dashboard for customers that would collect and show all insurance policies and related information at a glance, functioning as a central point of contact that aggregates and combines information from the various insurance companies and intermediaries each customer has business with (see EIOPA’s Discussion paper on Open Insurance: an exploratory use case in the insurance sector, published July 2023).

The risks and challenges outlined in this article could also possibly be mitigated by any or all of the following:

• Transparent contracting;
• Ensuring the customer takes a moment to reflect on the embedded insurance offered;
• Providing the customer with tailor-made advice.

A forthcoming review of the IDD framework is expected to take into consideration group insurance structures, after-sales conduct, and emerging distribution activities that might fall outside the IDD’s current scope. Also, the provisions on quality of advice and selling methods will most likely be refined, particularly in relation to transparent communication on product coverage, appropriately conducting “demands and needs” tests and a cooling-off period.

Accordingly, regulators and courts are currently putting more and more emphasis on customer protection and compliance with regulation (such as the IDD conflict of interest and product oversight and governance (POG) rules). From recent case law, it seems that courts protect customer’s interest by interpreting used exemptions narrowly (see Group insurance structures).