The Life Insurance Framework (LIF) announced recently by the Assistant Treasurer Josh Frydenberg put forward a new model of maximum life insurance commission payments and potential clawbacks to be implemented over the coming years.
If you closely examine the model’s planned commission and clawback rates, you can’t help but come to the startling conclusion that the LIF has an inherent fatal flaw.
Given churn has been a key driver behind the need for reform, the new model should be constructed in such a way that advisers are financially indifferent to whether they churn or not. That is, the LIF should not at its very heart have a financial incentive for advisers to churn. Unfortunately it does.
The model as it stands has an inbuilt financial incentive for advisers to churn every year. If they churn each year, they add just under 50 per to the net commission they receive over three years.
The model also has an incentive for advisers to churn every second year. Under this scenario they are 42 per cent better off.
Benefits of churning
The benefits of churning will rise and fall depending on how many years you model commissions over, but advisers will always be financially ahead by churning. There is a misalignment of the interests of insurance advisers and consumers.
It should be recognised that there is a whole raft of valid reasons why a policy could be churned in the first two or three years. Professional advisers will outline the rationale in their Statement of Advice (SoA) and this will be fine. However, those same reasons in a SoA template can be used as a cloak by those less professional advisers who wish to financially benefit from churning.
It threatens the life industry’s ongoing viability for the industry to knowingly embed into the new model a financial incentive to churn for those who don’t operate to the same high professional standards.
Note that as the 20 per cent ongoing commission is the same regardless of whether you churn or not, it can be ignored for comparison purposes.
ASIC will fix it
You could argue that ASIC might be able to pick up such churn well after the event when it is reported to them under the new rules. This could potentially stop such churn at some stage in the future. That assumption is based on ASIC’s ability to promptly analyse adviser behaviour and implement action.
Here I would highlight ASIC’s notification and response times on issues arising inside CBA, Macquarie Bank, NAB and other financial institutions. I’d argue that this performance is not compelling.
Instead of hoping the budget-constrained regulator ASIC may be able to identify the churners well after the event, I’d argue it’s better for the industry’s ongoing viability to remove the flaw in the model that creates the financial incentive to churn.
A simple solution
Intuitively and logically, the clawbacks over the three years should have a relationship between time and the quantum of clawback. In the first year 100 per cent should be clawed back as the LIF currently holds. In the second year this should be at least a 2/3rds clawback (66 per cent instead of the current 60 per cent) while in the third year it should be at least a 1/3rd clawback (ie 33 per cent instead of the current 30 per cent).
I say “at least” because the model should also account for the time value of money. When advisers are paid commission up front, they benefit from earnings on that money and in a true finance model this benefit should be recognised and added to the clawback.
The simple solution to resolving the conflict the model creates is to increase the clawback rate in year two from 60 per cent to 70 per cent and in year three from 30 per cent to 40 per cent. Doing so decreases the financial distortion motivating advisers to churn.
My prediction
Despite the fact that I oppose commissions, I believe an adjusted model should be given the best chance of succeeding. If we are going to undertake transformational change, we may as well get it right. Implementing it sown with the seeds of its own demise will do no one any favours.
Over the coming years the industry has a number of transitional windows of higher life insurance commission rates before they drop to lower rates. This will likely provide another incentive to churn in the short term.
Combined with the incentive to churn identified above, I predict adviser churn will spike and premiums will go up in the coming years under the new Life Insurance Framework as it stands.
This should be concerning because if churn spikes and premiums go up then the LIF potentially may not benefit the average Australian consumer. If this flaw is not addressed now, the model’s architects are dooming advisers to more change and uncertainty in 3 years’ time when the Life Insurance Framework is reviewed.
Finally, it is disappointing to see the tone of life insurance commission debate lowered with personal attacks on the Minister and others. These issues are incredibly important for the industry and should be debated on their merits. As an industry, we don’t need to resort to ad-hominem attacks.
