How the LIF reforms impact practice profitability
Dover has completed a comprehensive study of the effect of the 2018 LIF commission cuts on a typical start up risk insurance practice.
The study shows that a hypothetical new practice opening its doors on 1 July 2018 faces a drop in the real value of its commission income by as much as 40% in the first year, compared to earlier times. The new practice will recover somewhat in subsequent years as the increased trailer commissions are paid, but not completely, leaving the typical new risk insurance practice about 20% worse off after seven to eight years.
This dramatic drop in the real value of commission income is caused by:
- doubling the claw back period to two years
- chronically high and growing lapse rates and
- the time value of money.
The drop in the real value of gross commission income affects all practices not just 2018 start-ups. The effect of the LIF commission cuts is best observed and measured by creating a hypothetical new practice without trailer commissions. But the effect is the same on all practices not just start ups. The real value of their commission income will fall by up to 40% in the first year dropping to about 20% over seven to eight years. Dover chose seven to eight years because this is the life of an average risk insurance policy. Most commission streams stop by the end of the eighth year due to the policy lapsing.
Dover’s analysis assumes:
- pre-reform commission rates of 120% for the first year and 10% for subsequent years
- post reform commission rates of 60% for the first year and 20% for subsequent years
- a discount rate of 6% per annum
- a lapse rate of 12% per annum after two year claw back period
- a lapse rate of 14% in the two year post reform claw back period
- a lapse rate of 4% in the one year pre-reform claw back period.
This dramatic drop in the real value of gross income is an existential threat for most risk insurance practices. Few will survive such a big hit to their top line. Net cash flow, profit and goodwill values will fall by more than 20% in the long term, and much more in the short term. In many cases profits will disappear completely: risk insurance practices just aren’t this profitable.
Fewer new advisers will enter the risk advice space and many will leave it. This will worsen the already chronic under-insurance position and increase social welfare costs for the government.
A drop in the present value of a practice’s future income stream of between 20% and 40% over a seven year period also means that the practice’s goodwill, i.e. its market value in a sale situation, will disappear or, at best, will be seriously reduced, unless it dramatically reinvents itself along the way.
The position will be worse if as part of its 2018 review ASIC determines these changes have not been effective and introduces level premiums. Given ASIC’s views on commissions, and the insurers’ views on commissions, this is a highly likely outcome. Another step towards the ultimate destination of a commission free insurance model, and a strictly fee for service financial planning profession.
The legislative tide will not turn until the commission system is washed away. It’s what Treasury, ASIC and the insurers want.
Because of the complex interconnections between the different parts of the life insurance industry and the first mover paradox, the changes will be gradual and progressive over time. This will hopefully give advisers time to adjust their business models or exit the industry while there is still some value in their practices.
What can be done now?
The LIF reforms are done and dusted. Treasury has made its decision, and has cut commissions and given ASIC the power to determine future commissions.
The LIF reforms are a disaster for traditional risk based financial planning practices.
The LIF reforms mean:
- net cash flow and profits will fall, even disappear: few practices can sustain a hit of 20% plus to the real value of their commission income
- goodwill values will fall, and in many cases disappear, since an unprofitable practice has no value
- there will be fewer new industry participants. The risk is not worth the return and better opportunities lie elsewhere and
- over time, as the buffer of existing trailer commissions fades, older advisers will drop out, suffering much lower goodwill exit values than they expected.
Fewer advisers means the existing chronic under-insurance problem will increase. The burden on the Federal Government’s social security system, i.e. the public insurance system will increase as the private insurance contracts.
As traditional risk based financial planning practices disappear non-traditional fee for service based practices will take their place. The fee for service deliveries will be direct, for example via a bank, an insurer’s website or a group superannuation fund. Robo-advice will play a big role, and some will arrange their life insurances over the phone via apps. There will still be a role for a fee for service adviser operating through an AFSL, but this will not be for the average person, and will be for higher net income persons and other persons with more complex presentations, and is more likely to be part of a comprehensive financial plan than a limited or scaled advice. Generalist practices, offering the wide range of financial planning services and allied services such as mortgage broking and accounting will assume the risk adviser role.
The process will be evolutionary, not revolutionary. It will reflect the summed effect of thousands of individual adviser’s decisions as to how they run their practices and how they react to the changing legislative environment, and the summed effect of how the insurer’s choose to market their products.
Without adaptation evolution leads to extinction. Nothing is more certain.
If you want to prosper you need to accept the changes and adapt to them. You need to change. You have to anticipate what is coming and set your sails accordingly. Don’t be a dodo.
As Bob Dylan once sang: you had better start swimming or you’ll sink like a stone, for the times they are a changin.