The proposed changes to commissions for selling life insurance may just tip the system back in favour of the customer. For years paying life insurance advisers by commission was not seen as a conflict of interest, even when it incentivised bad advice and continuous changing of policies.
The changes will reduce the incentives for upfront commissions and allow better monitoring of the cost of the policy relative to the commission, however there is still no legislative cap on total commissions payable.
Problems with the current system
Life insurance covers death, illness, injury and disability. The consumer pays the insurer for their policy and then the insurer pays the adviser who gets a proportion of the premium as a commission.
Up-front commissions can be up to 130% of the first year’s premium followed by 10% of subsequent premiums. “Hybrid” commissions (which sit between upfront and “level” commissions) usually amount to 80% of the first year premium and 20% of subsequent premiums. Level commissions are about 30% of each year’s premium.
The upfront commission is an incentive for advisers to switch clients from one life insurance policy to another in order to keep collecting the high commission. They may churn clients from a suitable life insurance policy, to one that may let them down when they most need it.
Sometimes the policy life insurers recommend is not in the best interests of the client. Some advisers act outside the law.
ASIC has found a high correlation between high commissions and lapsed life insurance policies.
People are holding the same life insurance policy for fewer years and ASIC also found more than a third of life insurance advice didn’t comply with the law ensuring its quality.
Advocates arguethat commissions are about preserving the value of the business, not guarding against under-insurance and the risk to the client.
There are rules to protect consumers from conflicts of interest and conflicted remuneration. However the life insurance industry was successful in securing exemptions from the conflicted remuneration rules in the Future of Financial Advice reforms.
The exception to the exemption from the ban, is a group life policy for a superannuation fund or an individual policy for a member of a default superannuation fund.
How the government plans to fix this
At the time of these reforms the parliament recommended monitoring life insurance and subsequent ASIC studies identified problems. This led to an industry commissioned report.pdf) which put forward concrete measures to minimise conflicts of interest such as a fee for service model and competitive approved product lists.
The (Murray) Financial System Inquiry recommended level commissions, that is, the same commissions on each year’s premium, arguing that the upfront style commission should not be greater than an ongoing commission. In its response to the Murray Inquiry, the Government said it would address this by the end of 2015.
The current bill, which was before parliament prior to the election, removes the exemption of life insurance commissions from the definition of conflicted remuneration, effectively banning these commissions. But it then reinstates these commissions in two circumstances.
Commissions can be paid if the benefit and the cost of the policy is the same for each year, that is, level. It changes the timing of the commission, putting a cap on upfront commissions and evening out payments over the life of the product.
In another circumstance, if the first year plus subsequent years commissions are less than an ASIC determined fair ratio between the commission and the cost of the policy, more commissions can be paid. In fact there is an obligation to repay it if the policy is cancelled or if the cost of the policy is reduced.
The claw back applies only if the insurer gives the adviser an upfront commission. It’s designed to prevent the incentive for switching or churning through policies.
ASIC will have the power to determine an acceptable fair ratio and extra commission, effectively setting the allowed amount of commissions.
The Trowbridge Report.pdf) proposed an initial capped payment for advice that could be paid, only once every five years, plus level commissions capped at 20% of premiums.
There is ongoing debate about fee for service payment for product advice and whether consumers are prepared to pay. The problem is how much does it really cost to prepare advice and how much is it really worth?
The proposed bill gives the life insurance industry further time to reform itself. However the industry has been on notice from at least 2012 that it needs to change and the question is whether it has now been given too much time.
The ASIC review in 2018 could recommend banning all life insurance commissions.
Authors: Gail Pearson, Professor, Business School, University of Sydney