What is switching?
The term ‘switching’ refers to personal financial advice that recommends the full or partial replacement of one financial product with another. Risk insurance products are, of course, financial products. Therefore, whenever an adviser recommends that an existing risk insurance policy be fully or partially replaced, the rules regarding switching come into play.
The replacement aspect is the crucial one here. Adding a new insurance policy to insurance policies that are already in place is not a ‘switch.’ A switch only occurs when an existing policy is completely or partly replaced.
The disclosure rules on switching
The ‘rules’ on switching are contained in paragraph 155 of ASIC RG 175. That paragraph states:
The SOA should state that the client’s existing product has been considered, and should include information about:
- the cost of the recommended action (i.e. the disposal of the existing product and acquisition of the replacement product);
- the potential benefits (pecuniary or otherwise) that may be lost; and
- any other significant consequences of the switch for the client: s947D(2).
Note: The SOA should include information about:
- the exit fees applying to the withdrawal;
- the loss of access to rights (e.g. insurance cover) or other opportunities, including incidental opportunities (e.g. access to product discounts) associated with the existing product (also including rights or opportunities not presently available to the client but which may become available in the future); and
- the entry and ongoing fees applying to the replacement product.
These rules are limited to the ways in which the switching of financial products must be disclosed to the client. In this article, we will also discuss those things that need to be considered before it comes time to present a client with an SOA.
As this article is devoted to risk insurance, we will restrict the discussion to this type of financial product.
Why these special rules exist
The special disclosure rules for switching exist do discourage financial advisers recommending that new insurance policies be taken up purely to gain access to increased commissions. Historically, the initial commission payable to advisers for new risk insurance policies has been up to 120% of the first year’s premium. As the name suggests, this initial commission is received in the first year of the policy being in place.
Commissions received in the second and subsequent years of a policy have traditionally been much lower. These commissions, commonly referred to as ‘trailing commissions,’ typically were paid at a rate around 10% of the annual premium.
The mismatch between the amount of commission payable in the first year of a policy and the commissions payable in second and subsequent years meant that there was an incentive for advisers to discontinue policies after the first year and replace them with new policies. The new policy would attract a commission of up to 120% of the first year premium for the new policy – much higher than the 10% ongoing commission payable on the existing policy.
In some cases, this incentive had the effect of encouraging advisers to switch insurance policies for no reason other than to gain access to an increased commission payment. This process was known as ‘churning.’
Not all switching is churning. Churning is a pejorative term specifically used to describe switches that are recommended solely or primarily to increased commission payments to the adviser. Churning is a switch that is not in the client’s best interests, but from which the adviser benefits through increased revenue.
The rules regarding switching and its disclosure were developed specifically to discourage churning. The idea is that, by requiring the adviser to provide written justification for switching, advisers would find it more difficult to churn policies. Any switch would need to be shown to be in the client’s best interests.
Even before the tightening of the disclosure rules (the precedents to RG 175 were released in 2003), it would be fair to say that it was only very naïve advisers who participated in churning. This is because there are various risks inherent in the practice. These risks far outweigh any short term benefit of an increase in premium.
The risks apply to all risk insurance switches. But the risks are mitigated when the switch is being done for genuinely client-centred reasons.
These risks are discussed in the next section.
Before we address them, though, it is worth noting that the mix of commissions available after 1 July 2016 is different to the mix outlined above. By 1 July 2018, the cap for initial commissions is no more than 60% of the value of the premium. Ongoing commissions are capped at 20% of the ongoing premium.
The risks of switching
There are various risks inherent in switching an insurance policy. These include:
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The main risk of switching from one insurance policy to the other is that the new policy might not provide the same level of cover as the one that is being replaced. This creates the chance of an event happening for which the client is not insured under the new policy, but for which they would have been insured under the previous policy. This represents a loss for that client. Where the switch was recommended by an adviser, this means that the adviser may be subject to a claim that their advice caused loss to their client.
This raises the prospect of some form of action being commenced against the adviser.
At this point it is worth remembering that the main time at which clients take action against insurance advisers is when a claim fails. This happens some time after – sometimes many years after – the policy is first established. This means that clients typically do not take action against advisers at the time a new policy is put in place. It is not until some event occurs, for which the client thought himself or herself to be covered, but which is then rejected by the insurer as not being covered by the policy, that a client will typically take action.
That is to say: there will often be little or no indication at the time of the switch that the adviser has done something risky. This is why it is only the naïve advisers who participate in churning. More experienced or knowledgeable advisers simply know better.
There are various ways in which a new policy will have different coverage to the one being replaced. The first is where the new policy simply does not include aspects that the previous policy did include. For example, the new policy might not include early stage cancer as an insured event, instead limiting the payment of benefits to only those policy holders who enter later stages of that illness.
Related to this, the new policy might use different and more stringent definitions of insured events. For example, in March 2016 it was revealed that Comminsure, a large provider of risk insurance, was using a very restrictive definition of a heart attack when determining whether policy holders were entitled to insurance benefits. Other insurers were using a less restrictive definition, meaning that person could receive a payment following certain forms of heart attack from other insurers, but not from Comminsure. A client who was switched to Comminsure might then have experienced a loss attributable to the switch.
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A third way in which many new policies offer more restricted coverage arises from the fact that term risk insurances are guaranteed renewable. This means that the insurer is obliged to continue to offer clients a policy on the same terms as were offered when the client initially commenced the policy. This in turn means that any health issues that a client has encountered since first taking out an existing policy should be covered by that policy.
If a client changes policy, then any health issues that exist on the date the new policy commences will not be covered. This means that changing risk insurance policies can result in more restricted coverage for clients who develop health issues following the commencement of the initial policy.
Obviously, this risk becomes greater the longer a client has had an existing policy. The older a policy is, the more likely it is that it includes health events which commenced after the old policy was first taken out.
Simply put: older clients have more existing health issues. New policies exclude existing health issues. So, a new policy for an older client will typically have more restricted coverage than that same policy would have for a younger client.
And a client with a longstanding existing policy will typically be older.
This issue arose in a well-known recent legal case: Swansson v Harrison & Ors (2014). This case involved a claim for an illness that worsened in the period immediately after a 49 year old client met their adviser to discuss a switch of policy. The adviser had set the new application process in train, and in the three weeks or so that the application process took, an ailment that had originally been diagnosed as an infection started to manifest as a form of cancer. The client did not bring this to the adviser or the insurer’s attention. Because the illness was present when the new policy commenced, but was not disclosed, the new policy did not cover it. The previous policy had been in place for eight years, and would have covered the illness. But that policy had been cancelled.
As a result, the client was left uninsured for the cancer. He sued his adviser for more than $1.4 million, which was the amount that he would have received had he retained the original insurance. The court found that the adviser had been negligent, although it reduced the award by 50% to reflect the fact that the client had contributed to the unhappy situation by not disclosing that his health condition had worsened.
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Section 29(3) of the Insurance Contracts Act 1984 (Cth) permits an insurer to avoid a contract of risk insurance for breach of the duty of disclosure before entry into the contract, providing no more than 3 years have elapsed since that date. The breach cannot have been deliberate: it can only have been inadvertent.
This means that if a client unintentionally fails to disclose something that would affect the insurer’s decision to offer a policy, then the insurer may use that non-disclosure as a way of denying a claim on the policy.
However, the insurer can only do this during the first three years of the policy. Once the three year mark has passed, the insurer is obliged to continue to offer the existing policy as a guaranteed renewable product. This means that, if an existing policy is more than three years old, any health matters that the client inadvertently failed to disclose when the existing policy was taken out can no longer be used to deny a claim.
This means that a switch of insurance policy creates a ‘new’ three year period in which the insurer may be able to avoid the contract in the event of inadvertent non-disclosure. This creates an increased risk of a claim being rejected.
The solution here is to (i) minimise the likelihood of an inadvertent non-disclosure by ensuring that the client understands fully their duty of disclosure; and (ii) ensuring that the client understands that they are not covered for any inadvertent non-disclosure in the first three years of the new policy.
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Often, risk insurance policies do not allow certain types of claim within a given period of time following the commencement of a new policy. For example, it is common for death cover not to pay a claim within the first thirteen months of a policy where that death is caused by suicide.
For existing insurances, these waiting periods will typically have expired. Accordingly, changing to a new insurance policy may ‘re-set” the non-payment periods for certain types of insured events. Basically, the switch creates a temporary exclusion on cover currently held by the client.
This creates a risk that a claim may not be paid under the new policy, where it would have been paid had the existing insurance policy been retained.
The benefits of switching – why it should sometimes be done
Given the risk, it makes sense that a switch would only take place where there are clear benefits to taking out a new policy. There are, of course, times when such a change is clearly in the client’s best interests.
In terms of identifying these benefits, the process is much the same as the process used when choosing any insurance policy. The only difference is that the selection process must include the existing policy – with all of the benefits that it may have accrued over the years – as one option.
In fact, Dover’s principle of conservatism dictates that the ‘starting point’ for selecting a policy must be that the existing policy should be retained. Switching should only take place when there is another policy which clearly better meets the client’s needs.
Typically, the features that see one insurance policy being selected over another include:
From Dover’s point of view, this is the most significant factor in determining whether one policy is better than another. The starting point should always be that the policy with the best coverage is the preferred policy. Once this has been established, then other factors such as price and affordability may be included in the calculation – especially if affordability issues mean that the policy with the best coverage would not be purchased.
But the starting point must be the coverage provided by the policy.
Specifically, insurance advisers should be very cautious about ever switching to a policy with more limited coverage. Doing so can negate the very reason for having insurance in the first place. It increases the chances of a later claim being rejected. This is bad news for the client, obviously, but it can also be bad news for the adviser if it is found that the adviser did not properly address this factor when recommending the insurances.
Coverage also refers to the way in which an insurer might define an insured event. For example, in March 2016 it was revealed that Comminsure, a large provider of risk insurance, was using a very restrictive definition of a heart attack when determining whether policy holders were entitled to insurance benefits. So, advisers can (and should) include an insurer’s track record regarding definitions when considering the coverage being offered.
Everything else being equal, lower price is a benefit to clients. But we do urge some caution here: when comparing two or more policies the lower premium is only a benefit if the policies are the same (or the cheaper one is better). It is not so simple as to say that lower price is always better.
To understand this, think about what the insurer is doing: it is setting a premium at a level that it thinks will allow it to pay out all claims and still make a profit. If an insurer is setting lower premiums, then it is either (i) more efficient; (ii) prepared to accept a lower profit; or – very importantly – (iii) anticipating paying out fewer claims.
If an insurer is calculating that it will face fewer claims, this may indicate that its policy is more restrictive. Accordingly, the cheapest policy is not necessarily the best – especially if the policy is so restrictive that a client has a greater chance of having a claim refused. Remember, the main risk to an insurance adviser becomes apparent at claim time, not at the time the policy is established.
That said, when recommending a policy for which there are cheaper alternatives, the non-financial reasons for your decision should be detailed.
In many ways, this is linked to price. Everything else being equal, a policy with a lower premium will be more affordable. But there are other factors that impact affordability. These factors include how the policy is to be paid for. For example, paying a premium from superannuation benefits, rather than day-to-day cash flow, may make that premium more affordable for eligible clients. A client may not be able to afford to use non-superannuation cash flow to buy insurance (or to buy as much insurance). Using superannuation benefits makes it more affordable.
Bear in mind that ASIC have recently made it clear that they expect any advice to use superannuation benefits to finance insurances to be accompanied by a warning that this will reduce the eventual superannuation benefits available to the client. ASIC imposed an enforeceable undertaking on an adviser in part because the adviser “failed in some cases to consider the competing priorities of adequate insurance versus affordability, including the longer term impact of placing insurances within superannuation.”
Some insurers are easier to deal with than others, either at the time that a policy is put in place or at a time when a claim is being made. Choosing an insurer with a preferred administrative system is a valid decision.
That said, this would not be the most compelling reason. If an insurer has a reputation for being difficult to work with, but their policy has better coverage and the insurer is known to pay claims appropriately, then theirs would normally be the preferred policy.
Communicating the Switch
As ASIC RG 175 establishes, when recommending a switch the SOA must demonstrate that the adviser has considered the existing policy, with all of its inherent advantages, and still found that the new policy will be of greater benefit to the client. This is not the same as simply saying that this is the case. Nor is it a matter of simply listing features of the replacement product.
The additional benefit that the new policy entails must be made abundantly clear.
Please click here to view a sample SOA that properly details a risk insurance switch.
Alternatives to Switching: Adapting Existing Cover
One alternative to switching insurance policies is to adapt existing cover. This is often done in response to changing needs for a client. For example, a client may start a family, necessitating an increase in death cover. Conversely, a client’s children may mature into adulthood, reducing the need for death cover.
Rather than switching policies, adapting the existing policy may better suit the client. This is because adapting the existing policy may reduce or remove the risks that would arise were a new policy to be implemented.
Different insurers will have different approaches to, and processes for, adapting an existing insurance policy. For that reason, it is difficult to be too specific about how adaptations take effect. But some general points can be made. Generally, reducing the sum insured will not change the other terms of a policy, such as guaranteed renewability or the expiration of waiting periods. The reason is simple: the risk to the insurer is being reduced by the change. The only thing that changes is the amount of benefit that can be paid in the event of an insured event happened.
Conversely, increasing the amount of cover may see the insurer act much like it would when assessing a new application. The process is similar: the client needs to apply and the process may be underwritten. This will especially be the case where a large increase is requested: an obvious thing for someone who has received some bad health news is to increase their insurance cover.
The insurer may (and usually will) choose to treat the increased insurance amount in the same way that it would treat a new policy, and things like the three year period in which inadvertent non-disclosure negates a policy will often apply. Ideally, these limits only apply to the increased amount, not the whole policy.
An adviser recommending that the amount of insurance be reduced is effectively doing the same thing as an adviser recommending that an insurance policy be discontinued. Therefore, all of the risks outlined above – which basically boil down to the risk of a client not being able to make a claim post-advice that they could have made had they not followed the advice – need to be thoroughly thought through before they are acted on.
An adviser recommending an increase in the amount of insurance is effectively recommending a new policy. That adviser should be able to demonstrate that increasing the existing policy, rather than taking out a new policy altogether with a different insurer, is in the client’s best interests. This will not always be the case – but it often will be.
Summary Points: Switching Risk Insurance
The following points should always be considered when contemplating a switch of risk insurance policy:
- Start with the assumption that the existing policy is the best and should be retained;
- Itemise the features of the existing policy;
- Review these features against the features of any and all other policies being considered;
- Make sure that the existing features are at least matched – and preferably bettered – by any new policy being recommended;
- Make sure that the client understands – and document this – that they have a duty of full disclosure and, in particular, that they will not be covered for inadvertent non-disclosure during the first three years of the new policy;
- Make sure the client otherwise understands the risks of switching insurance policies; and
- Make sure all of these things are clearly communicated to your client via an SOA, as well as recorded elsewhere in your client file.