The insurance industry has a chronically high cost structure, is structurally flawed, and carries a bias against level premium policies, writes Robert Keavney. However, recent announcements of fee-based insurance advice indicate the way of the future.
I want to discuss the charging of fees for insurance advice, along with a subject that, perhaps surprisingly, is related to it: the recommendation of level versus stepped premiums.
As an introduction, I wish to acknowledge that I have known risk advisers whose business practices are highly ethical.
I have seen a risk adviser recommend a product that paid thousands of dollars less in commission compared to another product of similar quality, simply because it was hundreds of dollars cheaper for the client.
In cases like this across the insurance industry, many advisers have proven that they genuinely seek to serve their clients’ interests.
Therefore, nothing in what follows is intended to be a damning generalisation about all risk advisers.
However, the life insurance industry is structurally flawed, resulting in a chronically expensive cost structure, which makes the cost of cover for all Australians higher than it ought to be.
The core of the problem is the payment of commissions and the widespread practice of churning that flows from it.
At the same time, the elimination of commissions would threaten the viability of the risk advice industry, so the problem is complex. But first, let’s explore level premium policies.
Level premiums
The fundamental purpose of insurance is to receive a payment when an adverse event occurs.
Therefore, a primary objective of insurance advice must be to ensure that there is insurance in place when a claim is most likely.
With life, income replacement and trauma insurance, the likelihood of a claim increases with age.
Therefore, it is vital that clients are not put into policies that are more likely to be cancelled the older they get.
This is the primary benefit of level premium policies — their cost does not accelerate over time. Level premiums generally also cost less in the long term, but this is only a secondary benefit.
This is not to suggest that level premiums are better for all clients under all circumstances.
There is no substitute for tailoring recommendations to individual circumstances. Any comments made in this article about the benefits of level premiums must be understood subject to this proviso.
Stepped premiums begin at a low level and increase each year as the risk of a claim increases, whereas level premiums are initially higher but remain flat (apart from any indexing, and recognising that insurers always reserve the right to increase premiums) over the term of the policy.
Stepped premiums increase because the proportion of, say, 65-year-olds who will die this year is higher than the proportion of 45-year-olds who will die.
These cost increases become steeper over time, following the increase in the mortality rate at older ages.
This creates the risk that premiums may become unaffordable as time goes by, causing policies to lapse just when they are most needed.
The insurance industry is all about managing risks, so how can this risk be protected against?
Obviously, this can be achieved by recommending policies with premiums that do not increase (ie, level premium policies).
Locked in
Whenever level premiums are discussed, it usually leads to the claim that they lock people in to a policy, which may not always be the best option in the market.
The problem with this allegation is that it is false.
Whether clients are paying level or stepped premiums, they have the option to cancel and switch to another policy.
There is zero loss of flexibility. If the level premium policy has been in place for many years, the clients will have had the benefit of saving money compared to having paid stepped premiums — but that does not force them to retain the policy.
It is true that, should they change, they will have to pay the current rates on a new policy — but that would be true whether their existing policy was level or stepped.
Perhaps what those who allege clients would be locked in are actually saying is the existing policy will be so attractive that it won’t make sense to switch. But this is not a criticism — it is a benefit.
However, there is another consequence of level premiums: it makes it hard to justify churning.
I have acknowledged that there are honourable people among the ranks of insurance advisers.
There are also those in the business of recommending high commission policies, favouring policies that pay volume over-rides and are frequently churning.
Some run a business model of switching clients every couple of years, after the commission write-back period passes.
Under the pretext of saving clients money by switching to a policy which at that time is cheaper, clients are forced to pay much more over their lifetimes compared to having been in a level premium policy for the whole period.
Worse, clients run the risk of being forced to cancel their policy as premiums soar in later years.
The practice of churning drives up the cost structure of the industry. Insurance companies’ costs are higher in the year of creating a policy and the year in which it is cancelled than in the years it is in place.
Hence churning increases the costs of the industry by causing the repeated establishment and cancellation of policies.
Moreover, if a policy is churned every three years causing a new commission of 100 per cent of one year’s premium to be paid each time, one third of all the money the clients pays for their insurance is skimmed off to the adviser.
Without this the insurance cost could be reduced by a third.
However, the issue of churning has been understood for years, yet no one has been able to do anything about it.
Eliminating churning would be good for manufacturers of insurance and for their consumers.
Then why has it not come about? Because it is to the benefit of certain advisers — this is the power of ‘distribution’.
Fees
In this context it is striking that several recent articles have appeared in Money Management reporting the decision of different businesses to charge fees for insurance advice. These are the first straws in the wind.
At the beginning of the 1990s there were a handful of planning groups using fees. There was widespread resistance, even scorn, towards this development among financial planners.
Today, it is clear that — like it or not — the financial advice industry will move onto fees. A similar process is beginning for the life industry today, with the difference that the regulators are already scrutinising the question of commissions.
Without doubt, there will always be a requirement for risk advisers with valuable skills who perform a vital role.
Some clients attain coverage or receive benefits solely due to the negotiating skills of their adviser. These advisers deserve to be paid.
However, some advisers have now expressed a willingness to provide this service on a fee basis.
This will be slow to catch on, but inexorably it will.
Some who resist this development will claim that a fee is no different from a commission.
There is no basis for this claim. For example, consider the situation after cover is in place: compare commission to a fee arrangement involving an annual retainer for which needs would be reviewed annually, and any changes recommended, plus a rebate of ongoing renewal commissions.
Commission advisers have a financial incentive to switch policies, but fee advisers do not. Commission advisers may be biased towards stepped premiums to facilitate switching, but fee advisers are not.
Commission advisers will still be paid whether they review their clients’ needs or not.
The fee advisers will only get paid if they provide service.
It is disingenuous to pretend these differences do not exist. It is unrealistic to pretend that churning does not exist or that there is no bias introduced by commission levels.
While some advisers will not be influenced by bias, many will.
There will also be objections that fees will increase costs. Yet if a level commission option is selected, it is not unusual for commission to be at a flat rate of 30 per cent of annual premiums.
Thus any fee arrangement of less than this will save clients money.
Further, as noted above, churning lifts industry costs. Hence fees are likely to reduce them. Incidentally, please note that the above example of a fee arrangement was an agreed annual retainer.
The adoption of fees does not necessitate moving to a time charge.
Not easy
In recent articles I have acknowledged the difficulty for insurance advisers moving to fees.
The rebating of commissions will make it affordable for clients but advisers would need to protect themselves against commission write-backs.
Fees will also increase demands on administration to invoice and collect annual fees and rebate annual commissions.
It is not a surprise that fee-based financial planners have been the early movers towards fee-based insurance, because they have this infrastructure in place.
However the fundamental change needs to be a psychological one.
Historically, most life advisers have thought of themselves as sales people who get paid commission on what they sell.
Yet the cream of the industry are professionals who provide services as valuable as financial planners, lawyers or accountants. They are entitled to be paid for their work and their value add.
Above I claimed that fees for insurance advice would inexorably catch on. Already the regulators are looking at the commission issue.
The facts are that some advisers do churn, some advisers do take commission into account when recommending products, and some are disinclined to recommend level premiums despite its benefits as it makes it harder to churn.
I would like to know the statistics about the correlation between the selection of the highest up front commission option and average periods for which policies are in place.
This would start to reveal exactly how widespread commission maximisation is.
It took a long time in the financial planning industry for the balance to tip away from practices with biased advice. It will also take time for insurance.
But it will happen. Eventually the regulators, the media and the marketplace expose inappropriate practices.
It is important to restate that the ranks of insurance advisers include high quality professionals genuinely serving their clients interests.
Further there are times it is appropriate to recommend stepped premiums for clients. There can never be a ‘one size fit all’ approach to advice.
However, the insurance industry today carries a chronically high cost structure brought about by the practices of some advisers.
This drives up premium levels making cover less affordable. Over time there will be a move towards providing insurance advice on a fee basis.
This is likely to see a move towards the recommendations of level premium policies, which reduce the risk of clients cancelling their cover just when a claim is most likely.
Robert Keavney is an industry commentator.
