Last 23^rd December 2016 the European Supervisory Authorities (ESAs) published their response to the European Commission (EC) on the amendments it proposed to the draft Regulatory Technical Standards (RTS) on the Key Information Documents (KIDs) for Package Retail and Insurance-based Investments Products (PRIIPs).

Given the time constraints linked to the entry into application of the PRIIPs regulation (already deferred till 31 December 2017) the outcome is puzzling: the ESAs are not in a position to provide an agreed opinion on the amended draft RTS, but they all agree that the changes proposed by the EC on the performance scenarios may be misleading.

Let us take a step back to the origin of the story:

• 26 November 2014 – the Regulation (EU) N. 1286/2014 of the European Parliament and of the Council sets the form and he content of the KID for PRIIP: a document the manufacturers are required to create and distribute to retail investors to help them in understanding the economic nature and risk of a product
• 6 April 2016 – the ESAs submit to the EC the draft RTS: a document that specifies the technical features concerning the methodology and format underpinning the writing of the KID
• 30 June 2016 – the EC endorses the draft by adopting the Commission Delegated Regulation
• 14 September 2016 – the European Parliament reject the specifications of the RTS
• 10 November 2016 – the EC sends a letter to the ESAs to inform them on the intention of amending the draft RTS to address the concerns expressed by the Parliament

Even though the EC considers the choices made by the ESAs a good step forward to allow comparability across different PRIIPs, with a significant improvements in terms of transparency, it invites the Authorities to

• develop a guidance on the practical application of the Credit Risk mitigation factors for insurers (without any mitigation factor, the Credit Risk quantified by the rating agencies would penalize Companies with a robust Solvency Ratio that belong to countries with a poor credit risk)
• review the draft RTS and re-submit it in form of a formal opinion to the Commission within six weeks on the basis of these amendments
  • multi-option products
    the EC proposes to allow the manufacturers to use, during the transitional period, the UCITS information document as an appropriate means of providing retail investors with detailed pre-contractual information when the multi-option PRIIPs offer investments in these types of securities

• performance scenarios
  in the draft version proposed by the ESAs, the expected future performance of the PRIIP is shown at the maturities (1, half-holding period and holding period) at three different quantiles of its distribution: 25%, 50% and 75%. The quantiles correspond to an unfavourable, moderate and favourable state of the world. The commission proposes to replace the mean of historical returns with 0 and to include an additional scenario (4th stress scenario) to show how the PRIIPs behave under an extreme market condition. The aim is to avoid any assumption made on the direction of the future market expectation and to reflect that retail investors may lose money. The stress scenario has to be identified through a stress-test analysis of the historical volatility, over a time span that considers the Recommended Holding Period (RHP) of the PRIIP and the frequency of price calculation

• comprehension alert
  the EC states that a detailed guidance should be provided to facilitate a consistent use of the alert: simple disclosures approaches are associated with a better comprehension of the KID. The criteria should be

– the PRIIP invests in underlying assets that are not commonly invested in by retail investors

– the PRIIP uses a number of different mechanisms to calculate the final return of the investment, creating a greater risk of misunderstanding

– the payoff is based on teaser rates followed by floating conditional rates

Furthermore, the Commission claims that the description of the administrative costs related to the biometric components of the PRIIPs is not clear and has to be reviewed to allow the investor in identifying what is invested and what is related to the insurance cost.

The ESAs have discussed the above-mentioned amendments and have presented an opinion to the three Boards of Supervisors. A qualified majority was reached in the EBA (European Banking Authority) and ESMA (European Securities and Markets Authority) Boards, but not in the EIOPA (European Insurance and Occupational Pensions Authority) one. All the three Authorities convey that replacing the historical mean with zero in the performance scenarios do not allow to reflect the performance of asset classes, costs and product features. They also say that, in case the EC still wishes to amend the RTS along the line proposed, it should consider at least the distribution of risk free returns, adjusted for dividend yields; this will anyway do not allow distinguishing between different asset classes.

I do agree with the doubts raised by the ESA. Let us make a trivial example, supposing that an investor has to choose between two products A and B, where the volatility compensates the expected return: A has a lower expected return and a lower volatility, while B has a higher expected return and a higher volatility. If the performance scenarios were only based on the volatility with an expected return that equals 0 or risk free yield, B would be probably less preferable, while it may be more appropriate for a certain customer with a certain utility function.