Time to do away with the insurance industry's remuneration structures

The insurance industry carries legacy remuneration structures from the days of tied agents. Robert Keavney argues that they reduce industry profitability, contribute to underinsurance and create ethical conflicts for advisers. He is calling for change.

Imagine an industry that paid people to do something that systematically worked against its profitability. It’s hard to believe that such an industry could exist, if it wasn’t for the reality of life insurance companies.

In recent months, I have met a number of life office executives who are intelligent individuals of good character, with a real desire to create a sustainable industry that serves its clients. There may be exceptions to this, but I did not meet them.

Similarly, the body of risk advisers broadly consists of individuals who wish to serve their clients well. Yet there is an element in the legacy remuneration structures of the risk industry that creates ethical dilemmas for advisers.

The industry would be more robust, less prone to criticism and, ultimately, more profitable without this practice. Before we explore this, let’s consider the economics of risk advisers’ businesses.

Building a quality business

When one begins a business, the need for immediate cash flow is usually the highest priority. However, a sound long-term business strategy should be focused on building recurrent earnings.

This not only maximises business value but it builds capacity to cope with fluctuations in new sales.

Insurers usually offer three commission options, broadly similar to those in the table below.

For simplicity I will refer to these as initial, hybrid and level commission.

Let’s consider the long-term impact on a business of initial versus level commission — the two extremes.

Note that all examples used are simplified to maximise clarity of the illustrations (ie, all sales are assumed to be $100 of premium in the first and subsequent years).

Clearly this is unlikely as inflation indexing of cover would see premiums rising, even with level premium rates. If premiums are stepped, it is certain that they will rise over time.

If the examples reflected the reality that premiums do rise over time, it would not alter the broad conclusions drawn in the table below.

Level commission is a far better basis on which to grow a sound risk advice business than initial commission. If a policy is in place for an industry average of seven years, level commission will deliver 24 per cent more aggregate income (30 initial plus 180 [6 x 30] renewal totals 210; versus 110 initial plus 60 [6 x 10] renewal totals 170).

However, this is not the whole story, as it ignores any capital value of the business. Calculating this is very simple.

Receiving 30 per cent renewal commission versus 10 per cent will produce exactly three times as much recurrent income, tripling the sale value of your business. This would make a substantial difference to your financial position at such a time as advisers exit the industry.

Growing the business

Now let’s compare two businesses, each of which makes one $100 premium sale each year for seven years. Business A makes all sales under the initial commission option. Business B always selects level commission.

In its seventh year business A would have revenue of $170. B’s revenue would be $210 (ie, 24 per cent greater). B will have earned less in the first four years but will maintain greater revenue for all future years (note that the figures are identical to those above. If you work through the arithmetic you will see this is correct).

Analysing the position in the seventh year shows that business A will earn $110 initial commission on the sale made that year plus $60 recurrent commission ($10 on each policy put in place in the previous six years).

By contrast, business B will make $30 from the sale in year seven, plus $180 in recurrent (ie, 6 x $30 from previous sales).

Business B could have earned more money in year seven than A, even if it had decided to stop selling. By contrast, new sales still represent two thirds of A’s revenue. B is a far more financially robust business.

Of course, not all policies last exactly seven years.

A risk adviser will be able to identify some cases where a policy is likely to be in place for less than an average period of life versus those where it could have a longer than average life (a 60-year-old and a 30-year-old are obvious examples).

The former may be more suited to initial commission and the latter to level. If an adviser is able to identify clients whose need for cover is likely to be long term and select level commission for them, the economic benefits will compound for longer.

It follows that, for advisers who service clients with long-term insurance needs, the adoption of level commission is likely to maximise business income and value and reduce the need to rely on new sales (note this ignores any risk that commission could ever be banned).

Unfortunately, this is not true.

What a pity that everything just written might be false.

The life industry offers advisers a ‘better’ option. It is possible to obtain recurrent earnings by extracting multiple upfront commissions from a single client, by moving the policy every one year plus one day (when the commission write back period passes).

While level commission will only produce 30 per cent of annual premiums per year, churning will produce a new initial commission of 110 per cent per annum. Churning is 3.7 times more profitable than level commission.

Further, on retirement, the business can be sold to another adviser to continue to, shall we say, work the book hard. I believe this is an aspect of the industry’s remuneration model that does not look good under scrutiny.

Churning

An industry that is prepared to pay advisers more than the whole of its clients’ premiums every year — or even every second or third year — will need to be ready to explain its rationale. This cannot be profitable for the life office, and must increase average premium levels.

How widespread is churning? It is usually stated by participants in the insurance industry that the percentage of advisers who churn is small.

One might expect that the industry would have clear statistics on this subject, however, none of the companies I spoke to actually know what percentage of cover taken out with them is for previously uninsured individuals, or represents adjustments to in-place cover or cover being moved from other life offices — notwithstanding the standard question on applications about replacement cover (note: I am not suggesting that all replacement business is churning).

Nor have I been able to find a source of industry-wide data to support a claim that churning is limited — or to support an assertion that it is widespread.

It seems to me that an industry under potential attack ought to make some effort to marshal such facts about its operations.

Any defence of current practices is certain to include statements about the underinsurance problem in Australia.

At the very least, it would be useful to know how many previously uninsured people take out cover each year.

There are real difficulties in assessing churning as it would require an understanding of the individual motivation of thousands of advisers.

For example, what is the motivation where a client saves 10 per cent of premium from a policy being moved, but the adviser earns 110 per cent? Prima facie this might seem a happy coincidence of clients’ and advisers’ interest.

However, this forgets that clients’ premiums ultimately pay for commission. If there were fewer switches and fewer initial commissions paid, premiums could be lower.

It also ignores the fact that the potential ability to extract multiple initial commissions through moving policies may bias some advisers against level premiums.

While moving a policy achieves a saving for a client, it is impossible to deny that it is in the client’s interest (all else being equal).

As life companies are willing to pay advisers a new commission every time they move a policy, why wouldn’t a portion of advisers do so periodically, as long as there is no disadvantage to clients?

Here I am not speaking of systematic annual churning, just moving a client whenever a cost or definitional advantage becomes available.

Yet any claim that such advice is solely motivated by a wish to serve clients is complicated by the fact that the adviser earns more money than the client saves each time the policy moves.

Thus the willingness to pay multiple initial commissions on a single client’s cover raises an ethical cloud over advice in an essential industry.

The irony is that the most profitable policies to a life office are those that stay on its books for many years.

Yet, the life industry in aggregate engages in remuneration practices that encourage cover to be moved repeatedly.

This reduces the aggregate profitability of life offices and, in turn, increases the cost of insurance for all Australians.

Of course, all industries compete, reducing their aggregate profit — but no other industry is prepared, under any circumstances, to direct all the money it receives from clients to its sales force.

Heads are not in the sand

Many insurers understand the problem perfectly well — but they are afraid to speak up. They have two concerns:

• advisers who support them might react by moving their support elsewhere; and
• regulators might overreact and ban commission altogether.

The first concern should be overcome by a clear explanation. If the objective is to pay advisers less in aggregate, it would put an insurer at a competitive disadvantage in the current marketplace.

However, if the objective is not to reduce aggregate adviser remuneration but to reward advisers for different behaviours, a reasonable portion of advisers would be able to understand this and operate accordingly.

The second concern is real. There is a worldwide attack on commission. The Labor Government has announced a general ban on investment commissions and is contemplating a ban on insurance commission inside superannuation. Insurance has specifically been excluded from the general commission ban 'initially'.

This delay provides the industry with an opportunity to sort out its own issues, rather than have a solution imposed on it. It would be wise to use this opportunity.

Standard rates of commission

Some argue that all life companies should adopt standard commission rates to address the perception and reality of bias.

However, it is illegal for competitors to collude on pricing so this can never come about by mutual agreement. Others hope this could be brought about by legislation.

Modern governments are loathe to interfere in the workings of a competitive marketplace to impose price fixing. In any case, it is a short-sighted strategy to cede control of pricing to the Government.

The world will change in unpredictable ways and businesses require flexibility to adapt. Putting oneself in a position where legislation needed to be amended before one could alter distribution strategy is madness.

Moreover, if standardised commission rates entrenched the current practise of repeatedly paying initial commissions on replacement policies, it would retain the worst elements of current practices.

Underinsurance

Every article about commission on insurance includes the claim that it is important that nothing be done which exacerbates the underinsurance problem — and this is important.

The reference to underinsurance suggests an industry struggling faithfully to identify the underinsured and service their needs.

However, the fact that underinsurance remains widespread suggests that the insurance industry has not been overly effective in addressing it.

No doubt many people have been offered insurance but declined to take it. Some will be unable to afford the premiums to attain adequate insurance.

Some people claim they simply don’t believe in insurance. It would be quite unfair to hold the industry solely to blame for the lack of cover of the whole community, as it would surely benefit most of Australia to be insured.

However, some insiders acknowledge that current commission arrangements contribute to underinsurance.

While clear statistics are not available, it is widely acknowledged that a significant portion of policies written are being moved from one life office to another. As one industry executive put it: “We are largely in the business of stealing each other’s clients.”

While this is normal business behaviour, in aggregate it is an unproductive process in relation to the objective of addressing underinsurance — which the industry uses as its banner in defending itself against attack.

From an adviser’s point of view, it is easier to move a client and be paid another initial commission than to find a new client to earn the same reward.

Finding new clients is a rarer skill, which ought to be more highly rewarded, but the industry’s remuneration structure does not reflect this.

Another insurance executive suggested to me that the surest way to make inroads on the underinsurance problem is to only pay initial commissions on cover established for previously uninsured individuals.

The way forward

It is important to recognise that risk advisers are essential to meeting the insurance needs of the Australian community.

If commission was banned outright today, it would wipe out the insurance advice industry to the detriment of the community.

Until a significant body of pioneers can demonstrate that fee for service risk advice is viable — which will happen in due course — there is no alternative to commission.

However, the existing commission structure needs reworking. It is absurd that the activity that offers the greatest reward for advisers is to churn clients annually, or every two or three years.

Policies that stay on the books for the long term are most profitable for insurers. It would be consistent with this if commissions to advisers increased the longer a policy is retained — yet remuneration structures are mainly front-end loaded.

The most valuable and rarest sales skill an adviser can have is the ability to constantly find new clients. If many of these new clients had no insurance, this would be the most productive encroachment on underinsurance. Yet this is not rewarded more highly than churning existing clients.

I believe the ethical standards of the risk industry have risen greatly over recent decades. The definitions in most policies are now designed to provide meaningful cover for clients, rather than establishing loopholes to deny claims.

Many companies pay more than 90 per cent of claims. Increasingly, risk advisers are being seen as financial professionals, leaving behind the sleazy reputation they once bore. It is an important industry, which has become far more client focused.

Yet industry remuneration has not changed as the industry has evolved.

It still allows the practise of churning, affecting the reputation of all.

Change is overdue. The future will see life offices that support flexible, transparent remuneration models, allowing risk advisers flexibility in how they operate — but there are great challenges in the transition.

It would take great courage for one life office to go it alone on remuneration, collusion amongst competitors is illegal, and it is short sighted to call for legislated standardised commission. From where can change arise?

It would seem the only body able to carry this process forward is the Financial Services Council (FSC).

The FSC showed great industry leadership on the question of investment commission. It has the opportunity to do so again — unless its members prefer to risk the gentle caress of government.

Robert Keavney is an industry commentator.