The End of Upfront Commissions?

Commissions are under fire again; this time in the life insurance market. A number of recent inquiries have highlighted issues the industry may need to resolve, including how advisers are remunerated for their advice. In this article we consider the arguments for and against life insurance commissions, with a focus on ‘upfronts’, and look through a crystal ball at one future for advisers…

A brief history of the spotlight on commissions

While some of the following examples don’t relate directly to life insurance commissions, it’s not hard to see why the word ‘commission’ has negative connotations within the mind of the consumer…

Compare the pair

In 2005, the Industry Super Network (now Industry Super Australia), released a series of television commercials which promoted the value of investing in an industry superannuation fund. Timed to coincide with the new ‘choice of superannuation fund’ legislation, the commercials compared the superannuation balance of two everyday Australians. The customer invested in a retail super fund was portrayed as being worse off for a range of reasons, including the fact that their fund paid commissions to financial advisers.

While these commercials were labelled as misleading by the retail super sector, the seed was sown in consumers’ minds that commissions are bad. These commercials are widely regarded as one of the most successful advertising campaigns in the sector, and the ISA continues to run with the ‘compare the pair’ theme in its ads, some 10 years later.

Ripoll and FoFA

Commissions were further vilified when they were identified as having played a role in the mis-selling of financial products, which culminated in the high-profile collapses of Storm Financial, Opes Prime and Westpoint. A 2009 inquiry into financial products and services, chaired by Labor MLA Bernie Ripoll, recommended the Government seek to remove product commissions from the market, because they created a conflict of interest for financial advisers.

In April 2010, the then Minister for Financial Services and Superannuation, Chris Bowen, announced an overhaul of financial advice, designed to address conflicts of interest, amongst other key issues impacting consumers. Known as the Future of Financial Advice (FoFA) reforms, the package proposed a ban on commissions and volume based payments in relation to the distribution of retail investment products. Life insurance advice was exempted from the ban on commissions, because of the complexities of the product, the nature of the advice delivered, and the adverse impact on an already serious underinsurance dilemma.

The Labor Government consulted widely on the FoFA reforms, and during this process a number of consumer advocacy groups rallied behind the changes, declaring that commissions were ‘bad news’ for consumers. When the FoFA reforms were finally made law, risk advice commissions remained, but for reasons which were possibly not clear or easily understood by the average Australian.

In 2013, the new Coalition Government proceeded to deliver on its promise to roll-back some of the FoFA reforms. This move was met with anger by consumer advocacy groups, who led a public media campaign arguing that some of the measures represented a ‘back-door’ opportunity to reintroduce commissions. Regardless of the accuracy of the detail contained within this campaign, consumers once again heard the message from politicians and other stakeholders that commissions posed a threat.

Sustainability and the ‘churn’ debate

While the FoFA debate was building momentum, the life insurance industry was facing another major issue in the form of falling profits and ongoing sustainability. In 2011, the Australian Prudential Regulation Authority (APRA) reported a 10% fall in profit on the previous year. Higher than expected claims and lapse rates were blamed for the issue, as the industry struggled to find ways to deliver ‘sustainable’ products and services. In looking for a solution, ‘churn’ was identified as a problem the industry needed to address.

Insurance churn, or churning, is widely understood to mean the process by which an adviser moves a client from one insurance policy to another for the purpose of obtaining additional remuneration, with little-to-no regard for what is in the client’s best interests.

In August 2011, the Financial Services Council (FSC) announced new reform measures designed to manage churn. The proposals included the removal of takeover terms for policies transferred by an adviser between insurers, and the establishment of a mandatory two-year responsibility period.

After consulting with industry, the FSC revisited its proposals in March 2012, recommending a restriction on upfront commission for replacement business. A further three-month consultation period ensued, during which the majority of financial advisers expressed concerns over the FSC’s proposals. The FSC membership failed to reach a consensus and in early 2013 the Council’s initiative was abandoned.

ASIC investigation

In October 2012, the Australian Securities and Investments Commission (ASIC) flagged its intention to undertake a review of life insurance advice, citing ‘churn’ as the primary cause for concern. ASIC’s Deputy Chairman, Peter Kell, told attendees at the 2012 Association of Financial Advisers (AFA) National Conference that “…in the course of recent ASIC investigations and surveillance work we have seen some inappropriate switching out of life insurance policies, resulting in detriment to consumers”.

At the time, ASIC said it was happy to let the industry pursue self-regulation in the form of the FSC’s proposals. However, when these were shelved in early 2013, ASIC decided to conduct a formal, year-long investigation into insurance advice, which commenced in June 2013.

ASIC’s Review of Retail Life Insurance Advice report was released in October 2014. According to the regulator, its findings showed a clear correlation between high upfront commissions and ‘inappropriate switching advice’.

In response, the FSC and AFA joined forces to address the findings, convening the joint Life Insurance Advice Working Group (LIAWG), led by independent chair, John Trowbridge. Following a period of industry consultation, Trowbridge issued an interim report, which contemplated whether the industry should continue with its current, high-upfront commission model.

In December 2014, the Financial Systems Inquiry, chaired by David Murray, released its report, drawing attention to ASIC’s report on retail life insurance advice. The Murray Report recommended that a level commission structure be implemented through legislation, requiring that upfront commissions should be no greater than ongoing commissions.

What are the issues with upfront commissions?

A number of viewpoints have been put forward in the current debate, which argue that upfront commissions distort the advice market…

ASIC

In its Review of Retail Life Insurance Advice, ASIC found more than one-third (37%) of the advice files it reviewed failed to comply with the rules governing appropriate and compliant advice. Of these ‘failed’ advice files, 96% were delivered using an upfront commission model. ASIC argued this confirmed that commission structures affect the quality of life insurance advice.

The issues ASIC observed in its sample of poor advice files included:

  • Poor documentation
  • Poor needs analyses or lack of reasonable basis for the advice
  • Advice that did not comply with the best interests duty and related obligations, and which failed to leave the client in a ‘better position’
  • Advice that recommended clients take out cover they could not reasonably be expected to afford, both inside and outside superannuation

product churn by financial advisers in light of the attraction of very high up-front commission rates for new business has contributed to lapse rates

ASIC also found advice outcomes utilising an upfront commission model were more likely to lapse than those written on hybrid on level commissions. This points, in part, to the extent of the churning problem ASIC originally sought to quantify with its investigation. The regulator also suggested higher lapses may result from utilising the upfront model because the adviser only receives a small trailing commission, which does not motivate them to review (or possibly even contact) their client, leading to retention issues.

ASIC made other observations about upfront commissions within its report:

  • The actual dollar amount received via an upfront commission was generally higher than the estimated cost of a comprehensive financial plan
  • The upfront commission model requires the insurer to make a significant outlay at the beginning of the policy, and costs are not generally recouped for five to seven years. Because high upfronts correlate to high lapse rates, where insurers lose existing business to competitors, it would seem that the upfront model is not commercially sustainable.
  • Clawback mechanisms designed to provide a disincentive to advisers to rewrite cover are a ‘blunt instrument’ because they usually only apply for the first 12 months of a policy
  • While upfronts recognise the amount of work required of an adviser at the commencement of the policy is higher than that required once the policy is inforce, there is no correlation between the complexity of the advice and the amount of commission – commission is calculated on the value of the business to the insurer

(It should be noted that ASIC did not recommend the industry should ban commissions. Instead, the regulator suggested that appropriate checks and balances need to be imposed to ensure remuneration and incentive structures do not undermine good quality, compliant advice.)

Consumer advocates

Responding to the Trowbridge Interim Report for the LIAWG, The Consumer Action Law Centre, Financial Rights Legal Centre, Choice and Maurice Blackburn Lawyers issued a joint submission which called for the removal of upfront commissions for life insurance advice.

In fact, the submission went one step further, arguing that commissions of any kind are unnecessary in the sale of life insurance advice, and that the challenge of moving away from commissions is a problem with the culture of advisers, not necessarily a problem with consumers.

The arguments against commissions put forward by the advocacy groups included:

  • Commissions create an incentive for advisers to recommend a client replace existing cover, exposing the client to the risk of a failed claim through innocent non-disclosure. The risk arises from the client failing to disclose any pre-existing condition to the new insurer.
  • Commissions create a dis-incentive to provide quality advice, because advisers are only paid when they sell a product. Under a commission model, advisers are technically required to work for free whenever they provide strategic advice, recommend a client retains or reduces their cover, or recommend that a client take up group life cover through a superannuation fund.
  • Commissions are not transparent, and it is difficult for consumers to calculate the cost of advice (as opposed to product implementation) and compare different offers before buying. The amount the client pays is determined by the sum insured they take up, not by the length of time taken to deliver the advice and implement the solution.

APRA

In January 2015, APRA released its annual Insight Report. It highlighted that lapse rates had continued to rise in the previous 12 months, and there was no sign of this trend reversing. In its report, APRA made the following statement:

‘It is also possible that consumers are recognising that the life insurance cover they hold may no longer meet their changing needs, and that product churn by financial advisers in light of the attraction of very high up-front commission rates for new business has contributed to lapse rates.’

This statement is consistent with similar messages the regulator issued last year, when it argued that the flow-through impact of upfront costs borne by insurers when establishing contracts is not sustainable.

‘Historically, life insurers have paid more regard to business acquisition than business retention and APRA would expect some rebalancing of focus in this regard,’ APRA said in its 2014 Insight Report.

If you only measure upfront commission on a completed case basis you are not measuring the overall activity, and therefore costs, of the adviser

The regulator also warned that ‘…increasing lapses may reflect an increase in the anti-selection effect, in which case the impact on profitability is even worse’.

The argument for commissions

There are numerous arguments for the retention of upfront commissions, many of which have been expressed by practitioners and other stakeholders in their submissions to the Trowbridge-led LIAWG…

Fair remuneration for risk advice

Responding to an article in riskinfo earlier this year, industry veteran, Guy Mankey, had this to say about the true nature of commissions:

“Am I paid ‘sales commission’ when I spend hours finding an interested prospect, uncover their needs, suggest astute solutions, encourage action and walk them through the underwriting minefield?

“No, because payment is not related in any manner to any of the above.

“The payment I receive relates to one thing and one thing only: business placement and acceptance. The product providers don’t pay me if I don’t place business with them no matter how much other work I do throughout the process.

“I am paid a ‘Placement Brokerage’ and importantly, it is paid by the insurer, NOT the client. This is just one of a large number of expenses met from the ongoing premiums the client agreed to pay. These include wages for the provider’s management and staff, costs for product design and marketing, advertising, printing, education and training as well as putting money into the claim pool and lots of other costs associated with running an insurance company.”

Wayne Handley, Founder and Managing Director of risk-specialist licensee Bombora, told riskinfo that the need for upfront commissions is, in the majority of cases, linked to the cost of risk advice. He explained that because advisers are only remunerated when a policy completes, there are situations in which the adviser’s business incurs costs which are not reimbursed; for example, when a policy is declined in underwriting, or if the client decides not to proceed with the application.

the FSA said it did not believe continuing to receive commission on pure protection sales was of material detriment to consumers

“If you only measure upfront commission on a completed case basis you are not measuring the overall activity, and therefore costs, of the adviser,” he said.

Reviews and switching

Nick Hatherly, Managing Director of Australian Financial Risk Management, also highlighted the importance of being paid fairly for undertaking a review of a client’s policy:

“For the purpose of the client’s best interest, there are many reasons that a policy still needs to be changed. Many of these reasons are caused by the insurer themselves.

“The insurers as product manufacturers have a right to put out whatever they like to the market. They must however be cognisant of the need for advisers to act in the best interest of their clients and that may mean they lose that policy. This is not an adviser problem; this is an insurer problem.”

Claims support

Many advisers have told us claims support is perhaps the most important role they play in a client’s insurance journey, and the current upfront commission model supports this critical service by ensuring the client does not have to pay for advice at a time when it is needed the most.

According to Elixir Consulting’s Sue Viskovic, claims is arguably the moment that the adviser demonstrates their true value:

“Unfortunately, assisting a client with a claim is a time consuming process, and most advisers do not charge a fee for this service – rather they consider it as being an obligation, for the ongoing commission they receive from all of their clients, that is costed on an averaged basis (ie: whilst the ongoing commission for that client may not cover much of the time spent assisting with their claim, the adviser may only ever receive a claim from a small percentage of their client-base).”

Viability of risk-only advice practices

Risk-specialist licensee, Synchron, asked the LIAWG to consider the impact the removal of upfront commissions would have on independent advisers.

Using modelling based on practices within the Synchron network, the group’s submission argued risk advisers experience significant operating expenses, particularly when placing client business. Synchron suggested that a move to level-only commissions would mean the cost of acquisition would be far greater than the revenue generated, driving many advisers to exit the market.

Synchron’s submission said this move would be especially challenging for new, independent risk advisers who don’t have the benefit of an established book of business or vertically integrated parent company to offset the operating costs in the first few years:

‘It would be a pity if younger consumers or those wishing to purchase smaller policies had no access to advice, or only access to restricted advice from vertically integrated suppliers who have the opportunity to cross subsidise their costs.’

International perspectives

Within the current debate, much is made of the fact that no other jurisdiction has introduced a ban on risk commissions…

The United Kingdom

On 1 January 2013, the UK’s Retail Distribution Review (RDR) reforms were implemented by its regulator, the Financial Services Authority (FSA). The reforms followed nearly seven years of industry consultation, in response to a series of mis-selling scandals and long-standing concerns about the use of commissions in financial advice. The original RDR proposals called for a ban on all commissions, including for risk products.

The advice industry response to the proposals was scathing, with some analysts suggesting that one-third of advisers would leave the industry if the reforms were implemented.

Subsequent consultation with the industry led the FSA to determine that pure protection products – critical illness, income protection and non-investment life insurance – would not be subject to the ban on commissions. In 2009, the FSA said it did not believe continuing to receive commission on pure protection sales was of material detriment to consumers, and that remuneration structures were not a key driver of the problems it saw arising for consumers with pure protection sales.

By the time the RDR reforms took effect, the FSA and industry had agreed on additional disclosure requirements for advisers receiving a commission for pure protection products. At this time, higher professional standards and training requirements for financial advisers were also implemented, along with a new classification framework requiring advisers to be either ‘independent’ or ‘restricted’.

Following the implementation of the RDR, sales for pure protection products fell. Despite the fact that commission was still payable on these products, the UK Society of Actuaries observed that many such sales were previously made on the back of investment products. ‘On reorganizing their sales forces, protection product sales collapsed for many banks,’ the group said in a 2014 report on the insurance market.

However, the commencement of the RDR coincided with the introduction of the European Union Gender Directive, which required that all premium pricing be set gender neutral. Similarly, a new taxation system came into effect in the UK in 2013. Both of these factors are likely to have had an impact on life insurance sales, so the fall in the protection market cannot be solely attributed to the introduction of the RDR.

South Africa

While commissions remain for life risk advice in South Africa, alternative approaches to remuneration have been adopted.

In 2009, after suffering significant losses in both market share and profitability, South African Insurer, Liberty Life, decided to analyse why the money (and clients) were leaving, and developed a comprehensive management information system to address this situation.

“Once we built the management information system, it became clear that the real problem was not in the legacy books, or in the back-office processes, but in our adviser relationships, and the behaviour of our advisers, both tied and independent,” said Frank Schutte, Executive – Sales and Distribution for Liberty Life.

it became clear that the real problem was not in the legacy books, or in the back-office processes, but in our adviser relationships

Liberty Life’s new model works on the principle that if an adviser is generating profitable business for the company, they will receive differentiated service and improved offers for their clients. If the adviser is writing business that is ultimately unprofitable, for example policies that lapse within the first five years, Liberty Life withdraws the benefits afforded to them until they are ultimately terminated.

As a result of implementing the new model, Liberty Life has seen record levels of client (and adviser) retention. The group has increased its new business market share over the last three years from 22% to 27%, and the value of new business, which had fallen to R129 million in 2009, grew to R619 million in 2012.

The Netherlands

Contrary to popular belief, there are jurisdictions in which life insurance commissions have been removed. In an article written for the UK’s Cover Magazine, Rijn van der Linden, Head of Business Development and Marketing at RGA Netherlands, explained how Dutch regulators were able to introduce a ban on commissions for all financial services products at the start of 2013. The ban was the culmination of a 10-year journey, which commenced with the introduction of a new conduct regulator, the Netherlands Authority for Financial Markets (AFM).

According to van der Linden, the AFM introduced standardised policy documentation, improved educational standards and initially required commission disclosures. In addition, public authorities allowed advisers to ask if their clients wanted to pay a fee.

In 2008, following a mis-selling scandal, the Dutch Ministry of Finance introduced changes to the payable upfront and trail commission amounts. The rate gradually stepped down to 80:20, then 70:30, and finally 50:50. Van der Linden said this approach “…weaned advisers off large upfront payments and gradually forced a change in the adviser cash flow model”.

The process of banning any kind of inducements started in 2009. Van der Linden said rules are now so severe that insurers “…cannot even buy an adviser a drink, let alone pay marketing fees for panel positions or provide advisers with discounted best advice software”.

In 2011, the regulator announced its intention to completely ban commissions by the end of 2012.

Van der Linden argued that, because of the stepped approach to a ban on commissions, advisers were mentally ready for the changes, and were increasingly comfortable with giving strategic advice, as opposed to product-driven advice. He added that the inducement ban has drawn a clear line between advisers and manufacturers, which is a positive change that both advisers and consumers have embraced.

It should be noted that the Dutch market is somewhat different from Australia, as people living in the Netherlands cannot take out a mortgage until they have a life insurance policy in place, creating an incentive that does not exist here.

What are the potential outcomes of banning upfront commissions?

If upfront commissions were removed for life insurance advice, current industry speculation would indicate that either a hybrid or level commission model would be the most likely alternative…

Hybrid commissions

In its Interim Report, the LIAWG set out five alternative remuneration models which could replace high upfront commissions. Of these five alternatives, a riskinfo poll on the topic suggested advisers were most supportive of retaining the current hybrid model.

Under this approach, the maximum commission rate for the first year of the policy being inforce is 80%, with level commission paid thereafter. The LIAWG suggested one key reason for favouring the hybrid commission model is that some degree of upfront payment is justified because of the high costs associated with arranging and implementing life insurance. The current norm of around 120% initial and 10% ongoing commission is considered by the John Trowbridge-led LIAWG to be distortive.

Some insurance companies, including AIA Australia, have actively promoted hybrid commissions in recent times, suggesting it to be a more sustainable business model.

“By moving to an AIA Australia hybrid structure, it is anticipated that advisers could increase the value of their business by as much as 71% by the start of the fourth year in the program, and by as much as 93% at the end of year ten,” said AIA Australia CEO, Damien Mu.

Research conducted by Forethought for AIA Australia in March 2014 found that nearly 50% of advisers believed they would be using hybrid risk commissions by 2015. However, the research also revealed that the cash flow gap that arises from transitioning to a hybrid model was viewed by advisers as an impediment to making the change. If the market was to switch to a hybrid-only model, appropriate transition measures would need to be put in place.

Level commissions

Exploring an alternative model, NMG’s Ashwin Field, suggested the following consequences could arise from a level commission approach to life insurance advice:

  • Flat commission reduces adviser focus on life insurance, particularly older clients and complex cases (assuming such clients aren’t disposed to writing a large cheque for advice delivery)
  • Over 30% of sales relate to people over 50, so less adviser focus on this demographic will hit volumes and non-commission acquisition costs
  • Flat commission at 20% implies a 5% or better reduction in pricing, plus some lapse and selection benefits; we should assume insurers price this through in an effort to gain market share and cover fixed costs.
  • With new business now 5–10% cheaper than inforce business, this will drive a wave of switching from old policies to new, and from 10% trail to 20% flat, unless advisers are somehow prevented from being able to secure new pricing for existing clients.
  • In practice impacts will vary enormously by book of business, ie: the impact of commission change will affect an old, mature book of business very differently to a relatively new one with lots of new business.

Our greatest concern where commission bans are implemented is the risk of unintended consequences

Field argued that, in the long run, flat commission implies slightly lower pricing for retail life customers, and potentially lower lapse rates for insurers if risk advice capacity contracts. “These are welcome improvements but essentially incremental, and not risk free,” he said.

“The transition will exacerbate existing challenges for insurers which are already under pressure, and may defer real and necessary reforms to benefits, premium patterns, and risk processes. If this is not sustainable, customer benefits will be fleeting.”

In a global thought leadership paper produced by Towers Watson in 2011, Jeremy Forty and Keith Walter warned that a complete ban on commission could lead to a reduction in life insurance advice. While the paper is now a few years old, the argument remains salient for today’s debate:

“Our greatest concern where commission bans are implemented is the risk of unintended consequences. The risk that customers will be sold products with adverse or poor performance needs to be weighed against the risk of other adverse outcomes. In particular, advisers are more likely to focus on affluent customers, where the economics and feasibility of fee-based remuneration are more favourable. Many advisers that are unable to do so may exit the industry. Less-affluent consumers will find it harder to access advice.”

Conclusion

As we go to print, Trowbridge is preparing to hand-down his final report for the LIAWG. If he remains true to his original position, it is likely there will be a recommendation that upfront commissions, in their current form, should be abolished. What is unclear is what would be the new model that would eventually be adopted by the industry should this occur, and how the transition would be managed.

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Emily Saint-Smith is riskinfo’s Senior Journalist.

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