Insurance and ending the debate over stepped versus level premiums

In this concluding article of his series on risk insurance, Robert Keavney explores the differences between churning insurance and churning investments, and proposes a new solution to the stepped versus level premium debate.

As mere mortals, we humans do not know the future. This poses the fundamental problem of portfolio construction: how should you invest to earn future returns when you don’t know what the future will be like?

This unavoidable uncertainty is the fundamental rationale for diversification of investments. Not knowing which assets will do best or worst over any given period of time, you spread your bets.

In this article we’ll explore whether the principle of diversification can be usefully applied to insurance advice.

Background

I have written several recent articles on the impact on risk advice of the willingness of the insurance industry to pay repeated initial commissions when cover is moved from one company to another.

I have made the point that advisers can’t really be blamed for taking advantage of this willingness, so long as clients’ interests are not compromised. It must be acknowledged that industry-wide premiums will be higher due to the cost of the repeated commissions.

However, the actions of one adviser won’t impact premium levels in the slightest, so individual advisers need not be concerned by this.

Further, when cover is moved there will often be a benefit for the client, either through a lower premium or to attain an enhancement in the new policy, so moving cover from company to company may be in a client’s interest.

Churning ain’t churning

The most extreme scenario would be where an adviser places a client’s cover with life company A and elects to take the maximum initial commission, which we will assume to be 110 per cent of the premium.

After a year there will be no commission clawback, so the policy can be moved to company B, leading to the adviser being paid another 110 per cent commission.

The next year the cover is moved to C, then D, et cetera. Let’s say this goes on for 20 years.

Note that this frequent churning may not have cost the client one cent, compared to being in one policy the whole time.

The client paid the appropriate premiums and had cover through the period.

This is quite different from churning in the world of investment. Most commission paying investments have entry or exit fees, which fund the commission.

If investors’ portfolios were frequently churned to maximise commission, this would cause a continual erosion of capital.

In the world of investment, if one client is churned, that client suffers.

Yet, if churning is widespread, overall pricing is not affected because each client pays their own transaction costs (ie, they effectively pay for their adviser’s commission.)

Conversely, in the world of insurance, if one client is churned it costs that client nothing. Yet if churning is widespread, it will lead to an increase in overall pricing (ie, higher premiums).

Once these differences are understood, the unique nature of remuneration in the insurance industry becomes clear.

Who loses?

The adviser who moves a client every year for two decades will be richly rewarded, receiving as commission everything the client paid in premiums (or actually slightly more) over the whole period. Yet the client may be no worse off.

It doesn’t take an actuary to work out that the losers are the life offices. Each undertook the risk of a claim for 12 months and retained nothing from the premium to pay for it.

This suggests that policies that stay on the books longer term must subsidise those that don’t.

When I joined financial services, commission clawback periods were usually two years, ensuring an insurer collected two years of premium (ie, more than was paid in initial commission). More recently, clawback periods have reduced to one year.

Presumably this was to ensure that insurers could compete to attract advisers who were likely to move a policy in just over 12 months.

Why insurers wanted to ensure they had their share of these policies on their books is not clear — it was certainly not to make a profit.

However, for the purposes of this article we will leave the insurers to look after themselves, and focus on the question of advice.

Level premiums

So far it would appear that both advisers and clients can benefit from churning. However, there is one other factor that should be considered.

Leaving aside, for the moment, the relative merits of level versus stepped premiums, let’s consider how they each impact adviser remuneration.

The fundamental rationale for recommending a level premium is the belief (justified or otherwise) that, over the long term, a level premium will prove cheapest for a client.

As level commission costs more initially than stepped commission, the savings can only be achieved if the policy is retained for many years. It follows that a decision to recommend a level premium is inconsistent with an intention to move the policy.

An adviser who recommends a level premium forgoes the possibility of collecting subsequent initial commissions

It is not unknown for peoples’ actions to be influenced by self-interest, so it is realistic to acknowledge that the attraction of obtaining multiple initial commissions from stepped premiums will bias some, but not all, advisers against level premiums.

Affordability approaching 65

Graph 1 shows the projected costs of a life and trauma policy for a 33-year-old, comparing stepped and level premiums.

While every quote will differ depending on the insurer, type of cover, individual circumstances, etc, the general shape of this graph will be familiar.

In the late 50s and 60s, the stepped premium becomes many times more expensive than the level premium. It is impossible to know whether, 30 years hence, this soaring cost might move insurance beyond the budget of a client.

This raises the risk of late age underinsurance, just as the likelihood of a claim increases. This is not a trivial consideration.

If level premiums are appropriate for a client, in most cases it is best to begin as soon as possible, in order to ‘lock in’ the lowest costs.

It would rarely seem to make sense to pay stepped premiums for 10 years with the intention of moving to a level premium later.

It follows that a recommendation of stepped premiums will often start along a course that makes it likely that a stepped premium would still be recommended for any cover for those clients in their 60s — when there is less certainty about the capacity to pay increased premiums.

This highlights the complexity and uncertainty involved in evaluating stepped versus level premiums.

It must be acknowledged that the argument for level premiums is weaker for those taking insurance at older ages.

There are other circumstances that clearly favour stepped: some individuals are known to have a limited use for insurance (eg, an international executive in Australia for a known period of time or where there is uncertainty about the need for future cover).

Some clients simply cannot afford or are not willing to pay more than the minimum starting premium.

There is also the reality of the sale process. Level premiums are harder to sell than the cheapest cost right now, and there will be cases where complicating the sale process by explaining the two options will result in no sale at all — hence no cover.

It is unknowable

In any case, what should work in theory often does not work in practice. Will the projected savings from level premiums be achieved in reality or prove to be ephemeral?

After all, level premiums are not guaranteed for the duration of the policy.

Level premiums are only suitable with an insurer whose product will remain competitive for the long term. It is not so easy to know whether a product offered by a given insurer will remain competitive over time.

However, some clues are available: the attitude of an insurer to including recent policy upgrades into in force policies; the likelihood of a product series being closed or remaining the flagship product; and so on.

The bottom line is this: it is impossible to be certain about which will prove cheapest or most appropriate for a given client over the long term.

Critics of level premiums sometimes assert that this uncertainty undermines the argument for level and thus justifies the use of stepped premiums.

This is akin to saying that it is impossible to know whether A or B is better, and concluding this justifies the use of B.

Premium projections for long-term cover suggest a substantial cost saving for level premiums.

While it must be acknowledged that the reality may or may not prove different from the projections, this is not an adequate argument for recommending only stepped premiums.

My background is in the world of investment.

As noted above, where investment outcomes are always uncertain, the practice of spreading risk by diversifying is well established. This approach could also be adopted in risk advice.

Where it is likely that cover will be required long-term, but an adviser is unsure whether stepped or level premiums will prove most appropriate, one approach to managing this uncertainty could be to split cover over two policies with different premium structures.

When a level premium is adopted, level commission is likely to provide the greatest remuneration for the adviser as the policy is expected to stay in place long-term.

Of course, this assumes an adviser who is willing to forgo regularly moving policies to obtain repeated initial commissions on part of the cover.

An adviser whose main focus is maximising commission would be unlikely to recommend level premiums at all.

This is an unfortunate outcome of existing commission structures.

Robert Keavney became a financial planner in 1982, and has played many roles since then, and still believes financial planning can be an honourable profession.