Time for a level risk commission playing field

The proposed disclosure requirement for commission paid on risk products contained in the Financial Services Reform Bill has reignited the debate on commission disclosure.

This issue was hotly debated in 1993 during the then Trade Practices Commissioninquiry into sales practices in the life insurance industry. The outcome was that commission disclosure was required for all products except risk. These were excluded on the basis that there was no investment component and therefore commission payable did not impact on the 'value' received by the consumer.

However since 1994 several major risk companies have introduced products with variable premiums. Premium discounts can be applied by the agent, with corresponding reductions in new business and renewal commission. Premium discounts of up to 50 percent in the first year are now available if an agent selects zero first year commission. Ongoing discounts of up to 25 percent each year are common where dial down commission is offered. Commission discount facilities are now widespread. Sales by companies offering products with commission based premium discounts represented more than 30 percent of total disability new business in the twelve months to June 2000.

There is a now substantial amount of new business being sold where the level of commission selected by the agent can have a significant impact on the price paid by the client. The widespread adoption of commission discounting has ended any validity to the argument that consumers are not directly affected by commissions paid to agents.

If commission is to be disclosed, then the amount of commission paid also becomes an issue. When commission disclosure was introduced for annual premium superannuation and savings products the then ubiquitous high upfront commission structure disappeared within a year. However the front end loaded commission system remains for risk products. Ironically commissions payable on risk business have increased since the introduction of commission disclosure for life insurance, superannuation and savings products in 1994.

The introduction of commission disclosure did not rule out continuation of the existing up-front commission system. Life company concerns over community reaction to disclosure of the amount of up-front commissions lead to the abandonment of front end loaded commission structures. No company was prepared to disclose that initial commission payable could exceed 100 per cent of the first year's premium.

It is unlikely that consumer reaction would be any different today to the disclosure of first year commissions of 50 to 100 percent of the premium, excluding over-riders etc. that are currently paid on risk products.

The Australian Security and Investment Commission (ASIC) recently undertook an investigation into advice and sales practices in the disability market. The recently released report documenting the findings of this investigation notes that is common practice for some agents to claim more than 50 percent of their sales are made without the provision of advice. The ASIC report notes however that commission terms are identical irrespective of whether or not advice is provided. There may be other reasons for the high level of sales being recorded as made without advice however the practice brings into focus the issue over the level of reward an agent should receive where no advice is given. Should companies/licensees introduce a two tier commission structure with a lower level of commission for sales made where the adviser claim states that no advice was provided?

Since 1994 there has been sweeping change in the life industry due to the high level of de-mutualisation and merger and acquisition activity. Four prominent risk companies, Legal & General, Prudential, FAI Life and Tyndall have disappeared. In the last year both National and Commonwealth Banks, through the acquisition of MLC and Colonial, have become major forces in the agent/adviser market.

Those companies who remain in the risk market are seeking an adequate return on their investment. Achieving this rate of return with risk products is not going to be easy when the following is considered:

- new business expenses of more than 100 percent of the first year's premium;

- twelve month responsibility periods;

- continuing high levels of discontinuances (the disability discontinuance rate was 65% at June 2000); and

- a substantial deterioration in disability claims experience over the past three years.

The front end loaded commission basis results in the interests of shareholders and agents/advisers being diametrically opposed, the agent derives the highest income by regularly recommending replacement but the shareholders derive the greatest benefit if the policy stays in force for at least five to seven years.

There are few companies that are still chasing growth and market share at the expense of profitability. The focus is now clearly on writing profitable business. High front end commissions coupled with short responsibility periods no longer sit comfortably with this objective.

Commission disclosure on risk business is not the only issue agents will need to address. The adoption of licensee/authorised representative model for all intermediaries will bring the concept of agency to an end. Financial planners already operate under this model, and if they comply with the Financial Planning Association (FPA) best practice codes, currently disclose commission.

Agents will therefore face the greatest challenge as these reforms are implemented. The existing commission structure has survived for so long because it provides a strong incentive for new sales. Risk products fall into the category of goods that consumers need but do necessarily want. The vast majority of risk products are sold because of the agent's skill in identifying a need and motivating the client to solve it now. People who can successfully do this remain in short supply. Therefore it is critical that the majority of the existing agents successfully make the transition into the new world of risk.

The extent to which life companies assist with this transition will play an important part determining the outcome.

Given the reasons for excluding commission are no longer valid, shareholder companies are unlikely to embrace structures that encourage frequent replacement and adverse community reaction to disclosure of current terms, what are the other options?

Level commission rates are currently in the vicinity of 25 to 30 percent of premiums. Few agents currently choose level commission where it is available. Whether the current rate of level commission will prove acceptable to the wider community or be viewed as excessive is unknown. We do however know that these are these are the maximum levels that current premium rates will support.

Level commissions substantially reduce the financial incentive for advisers to recommend replacement. Level commissions fit comfortably with a twelve-month responsibility period and when commission is paid as premiums are received there is no need for any responsibility period.

All agents will have the opportunity to use a level commission basis to build an agency with substantial ongoing value. Acceptance of level commission structures will be made easier if life offices offer transitional terms before, rather than after, disclosure becomes mandatory. The greatest barrier to smooth transition to this new regime is the willingness of agents to adapt to this new income model.

Mark Kachor is the executive director of Rice Kachor Research