Chapter 04 – The future of life insurance advice

The LIF reforms?

The immediate future of life insurance advice depends heavily on the impact of the LIF reforms.

LIF stands for life insurance framework. The life insurance framework has many different aspects, including significant changes to the availability and size of commission payments to advisers who recommend life insurances. This article will focus on these commission payments.

Regarding commissions, the LIF changes involve two main elements. These are:

  1. A cap on upfront and ongoing commissions. This cap will eventuate in an upper limit of 60% for upfront commissions, and 20% for ongoing commissions. The full force of these caps is scheduled to be in place by 2020.
  2. An extended ‘clawback’ period, during which advisers must repay at least some of the commissions they receive on policies that are lapsed. The current ‘clawback’ period is one year. This will be extended to two years. Lapses in the first year will see 100% of the initial commission repaid. Lapses in the second year will see 60% of the ongoing commission repaid.

Traditionally, upfront commissions have been much higher than this. Upfront commissions of 120% are not unusual, and are typically combined with an ongoing commission of around 10%. Essentially, then, the LIF changes mean that upfront commissions are halved and ongoing commissions are doubled. This apparent symmetry has led many commentators to argue that the LIF reforms are simply a swap of upfront commission for trail commission. This is a little wrongheaded, and we discuss why below.

The doubling of the clawback period gives a good indicator of the rationale behind the changes to the commissions. Under the old system, an advisor received a large upfront payment on the policy needed only to be in place for the first year. This did lead some advisers to recommend policies with high premiums which were unlikely to be renewed in second and subsequent years. By moving more of the total adviser remuneration to the second and subsequent years, and by allowing an extended clawback period on commissions, the hope of the regulators is that advisers will give more consideration to their clients’ ability to afford to renew their risk insurance policies.

The financial implications of LIF for advisers

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 its first year, compared to the level of commissions that would be achieved in the absence of LIF reforms. 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:

  1. doubling the claw back period to two years;
  2. high and growing lapse rates; and
  3. the time value of money. We used 6% as the discount factor.

A note on the time value of money

The time value of money refers to the fact that the real value of money tends to fall over time. It is generally better to receive a dollar now than to receive a dollar at some point in the future. There are two reasons for this.

The first is inflation. Inflation reduces the purchasing power of a given amount of money. Historically, Australia experiences inflation of between 2 and 3% per year. This is, in fact, the Reserve Bank of Australia’s target rate of inflation – the RBA worries if inflation falls below this point. If inflation is running at 3%, and payment of a dollar is deferred by three years, then the purchasing power of that dollar equates to less than $.92 in today’s money.

The second reason is ‘opportunity cost.’ Money that is received sooner can be invested in some income or capital generating enterprise. When the receipt of money is deferred, so is the investment and the recipient misses out on returns that would have been available if money was received immediately.

In our observation, most commentators discussing the LIF miss this critical point. This is probably due to the fact that they concentrate on risk insurance and tend not also to be investment advisers – which is an increasingly dangerous business strategy for financial advisers generally.

Existential threat

This dramatic drop in the real value of gross income is an existential threat for most risk insurance practices. Put simply, many risk-only practices won’t 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.

That said, the drop may not feel all that dramatic. The LIF changes are being introduced over time, and so the reduction in practice income they come to resemble the famous frog in a pot of boiling water.

In case you don’t know the analogy (and our apologies to any frog lovers), if a frog is thrown into a pot of heated water, the frog will typically jump straight out. It might be scalded, but it will live. However, if a frog is thrown into a pot of cold water which is gradually heated, the frog tends not to notice the incremental changes until, eventually, it is boiled to death.

This sounds macabre and it is not what we want to happen to any of our advisors! That is why we are making an enormous effort to assist advisers to generate income streams in addition to life insurance commissions. And we urge advisers to act now before the water gets too hot.

What can advisers do now?

The first thing that advisers need to accept is that they cannot change the politics of the situation. The LIF reforms are done and dusted. Treasury has made its decision. Treasury has cut commissions and given ASIC the power to determine future commissions.

Remember, a reduction in commissions paid to advisers means a reduction in expenses for life insurers. The insurers are large companies with substantial lobbying ability. They are ‘banking’ on saving enough money through lowered expenses to more than offset any reduction in the number of policies taken up.

Advisers have two broad options to replace the reduced income. The first is to see more clients. If commission revenue is going to fall by 20%, then advisers need to increase the number of clients by 25% to replace the lost income (125% times 80% equals 100%).

Seeing more clients simply means working other. There is also the obvious problem of where these extra clients will come from – presumably, advisers are attracting as many clients as possible right now (that is before the reforms).

The second way to replace the reduced income is to offer more services to the same number of clients. If advisers could generate additional fees equal to 25% of their new commission income, they will have restored their income to pre-LIF levels.

This is a much more appealing option. After all, the cost of attracting a client have already been incurred, such that there is no marginal cost in providing an increased range of services to existing clients.

Within Dover, across the whole group approximately 50% of statements of advice address risk insurances only. In many cases, this is a terrible case of missed opportunity. Most clients have other problems that an intelligent advisor can assist them with. Some of these are obvious, such as superannuation. Others are less obvious, such as better debt management, better cash flow management, improving a client’s ability to generate income, et cetera.

This is why it is always a good idea to have clients complete a thorough fact finder even if, at first glance, it appears that they have quite limited risk insurance needs. The fact-finding process, as well as an intelligent conversation with clients, often reveals areas of potential assistance that a client may not even know exists.

The list of areas that advisers can assist clients with is almost limitless. These areas are addressed in other sections of this website, and so we encourage all advisers to read widely and think laterally about problems faced by their clients to which the adviser can offer an intelligent solution.

The Dover Group