The danger with lower early termination values

The National Treasury recently released a document containing proposals which will have a significant impact on the life insurance industry. In a paper titled: “Contractual Savings in the Life Insurance Industry.” Treasury suggests a number of changes to Part 3 of the Regulations under the Long Term Insurance Act (1998). And these changes will require significant sacrifices from both life assurance companies and insurance intermediaries.

Treasury wants radical changes to the way in which commissions are paid and administered through the life of the insurance policy; and outline further improvements to the early termination values of said policies. The Board of LUASA (The Association of Professional Financial Planners) has issued a response to Treasury’s proposals. In today’s newsletter we examine some of their comments on the impact of ‘softer’ early termination penalties. And on Thursday we’ll share some of LUASA’s views on the commission debate.

Unintended consequences of lower exit penalties

LUASA says “the further enhancement in the early termination values to a guaranteed minimum of 85% of the investment value in the first year to 100% by mid-term of the policy (with a maximum of 10 and minimum of 5 years) is cautiously welcomed.” The reason for this caution is that LUASA feels lower exit penalties could discourage savings by increasing early policy terminations. “A most unwelcome unintended consequence of the proposed ‘low exit penalty regulations’ that could rise, is that policyholders will more easily discontinue their future saving policy premiums, rather than making budgetary sacrifices, on expenditure items that advance instant gratification and debt driven life styles.”

LUASA fears that the current 30% termination in the first three years would deteriorate significantly should early termination penalties be softened further. This would contradict Treasury’s overarching goal of improving South Africa’s dismal savings rate. Although heavy penalties are punitive for someone who desperately needs the cash from an early termination we certainly agree that a higher termination offers a definite disincentive to terminate a ‘savings’ policy.

Endowment versus retirement annuity

LUASA also urges Treasury to acknowledge that the products sold under the life insurance banner are not all the same. Endowment products were never intended as long term retirement savings products. They were created to provide access to the stock market at a time when participation in the exchange was difficult due to high barriers to entry. This fact is supported by the long terms early endowment policies ran – usually between 10 and 15 years. The terms on newer endowment policies seldom exceed five years. And today’s individual saver enjoys simple and affordable access to the exchange through a range of collective investment products (unit trusts).

“Retirement annuities, on the other hand, were specifically designed to create a retirement vehicle and this is borne out by the fact that the earliest these policies can mature is when the policyholder attains age 55,” said LUASA, suggesting that National Treasury recognise these essential differences. “The key differentiator between the two products (viz. short to medium capital accumulation vis-à-vis long term wealth creation) [must] be recognized and factored in to policy making...” This differentiation should then direct the handling of early policy terminations.

Another call for greater cost transparency

The life insurance industry manages approximately R30bn of savings funds. At present these funds attract very high costs. LUASA contends that Treasury could achieve greater benefits for savers by ensuring these funds are managed cost effectively. They believe the current Section 14 transfer process is a disincentive to intermediaries wanting to move clients to more profitable (cost effective) funds.

To this end, LUASA encouraged Treasury to call for “the inclusion of full actuarial accounted cost transparency in the proposed regulations, signed off by the insurer’s chief actuary, which disclosure should enable a policyholder/intermediary to determine whether fair and equitable insurer costs were applied within the permitted 15% cap.”

A delicate balance

When announcing the new measures, the National Treasury stated that the proposed changes would “contribute to a significant improvement in consumer perceptions of the value offered by the savings products of the life insurance industry, particularly with respect to the burden of cost in the event of early termination.” Although the sentiment expressed by Treasury is commendable, LUASA warns that the industry is finely balanced and the overall impact of these changes should be well considered before simply forcing them through.  LUASA's full reponse can be read here (PDF file 65kb).

Editor’s thoughts:
The LUASA response to Treasury shows how quickly unintended consequences can creep into legislation. Tampering with commission benefits could result in less ‘savings’ policies being sold; and lowering early termination penalties could result in a flood of money leaving the national savings pool. Do you think a reduction in early termination penalties will have a negative impact on savings? Add your comment below, or send it to gareth@fanews.co.za.