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Price discrimination and cross-subsidy in financial services

December 7, 2016

At the end of September the FCA published Occasional Paper 22 on price discrimination and cross-subsidy in financial services.

It is a good analysis of the subject and worth a read, particularly in the context of Brexit where some EU-driven restrictions may be abolished or replaced with UK-specific ones.

Price discrimination happens when a firm charges different prices to different consumers for the same product, or where all consumers are charged the same price but costs differ between consumers – so different consumers face different mark-ups.

Currently, there are four key ways of implementing price discrimination. First consumers with higher income or wealth may have a lower sensitivity to price.

They may see the value of switching suppliers to achieve small savings as less important. Second, consumers may prefer to stick with a particular supplier despite price differences with other suppliers. Third, consumers may have fewer options, for example those with a poor health record. Fourth, some consumers may be less ‘savvy’ about the way the market operates.

With the increasing availability of Big Data, firms may be able to refine their prices to more accurately reflect the value a given consumer places on the product. But if the data are very expensive to acquire or analyse, consumers may be able to buy at a lower price from less sophisticated rivals. The jury is out on how this will turn out in practice.

There are two types of cross-subsidy. One is where some consumers are charged below the cost of providing the product, which is paid for by the firm charging other consumers above the cost price.

The second is between products, where a firm’s profits from one product are used to provide another product at a loss. The pricing of PPI was an example of cross-subsidy between the loan market and insurance, as some consumers with low credit scores might have been unprofitable were it not for PPI income.

Price discrimination and cross-subsidy may be a concern if the high-price segments contain a high proportion of consumers in need of protection (‘vulnerable’ consumers), or a significant share of such consumers are excluded from important products, such as IP insurance.

Charging higher mark-ups to less price-sensitive consumers may be an alternative to uniform pricing. But concerns may be raised that those groups are paying more than a proportional share of those costs.

However, price discrimination is often a part of normal competitive practice and so does not necessarily warrant any intervention. And badly designed or inappropriate regulatory interventions can lead to undesired or unintended consequences for consumers and competition.

So what’s this got to do with Brexit? The EU Gender Directive prohibits using actuarial factors based on gender in the calculation of premiums. The effect of the prohibition has been to introduce uniform pricing.

Due to the different accident risks, health risks and life expectancy of men and women, which affect costs of supplying insurance, the effect is to require different mark-ups for the two groups – a form of price discrimination. Next year we expect to see ‘The Great Repeal Bill’.

One in the frame could be the Gender Directive.

What is particularly interesting about the economic analysis is that it shows the intention to reduce one form of discrimination has actually produced another version of it.

What the report does not cover is the ethics of this deliberate decision. Next year it is likely that we will see a repeat debate on such seemingly settled issues.

Written by Richard Walsh, SAMI Fellow and first published in Cover magazine, November 2016

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