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Advisor remuneration on risk products - the pros and cons

01 February 2012 Paul McKillen, FMI

In November 2011 the Financial Services Board (FSB) invited insurance industry associations to comment on intermediary services and related remuneration. This is seen by many as a first step to bring risk product commission practices in line with the regulator’s Treating Customers Fairly regime.

The basic thrust of the latest round of reviews and proposal papers appears to be that of defining the triangular relationship between the client, the advisor and the product provider. Regulators want to ensure that the customer is fairly and transparently treated and receives advice that is truly independent.

A flawed triangle

"The triangular association – whereby the intermediary provides advice to the policyholder, is rewarded by the insurer, who in turn recoups such costs from the policyholder – is fundamentally flawed. An intermediary who receives commission cannot, by definition, be thought of as truly independent.” {This quote was drawn directly from a an FSB circulation titled "Letter to industry associations – intermediary services & remuneration.” dated 11 Nov 2011}

The material circulated by the FSB last year further suggests that the primary focus will remain on advisor remuneration in the investment product space, where a fee based model consistent with models being adopted in Australia and the United Kingdom is proposed.

Follow the leader

Questions around the appropriate remuneration basis to apply in the risk product space appear to be something of an afterthought, again consistent with the approach in other major dispensations. In Australia and the UK risk products still remunerate advisors through largely up-front once-off commission payments despite wholesale changes to investment product remuneration structures in those markets.

The FSB has put forward a proposal that risk product commissions move to an as-and-when based model, but has stopped short of proposing a fee-based model in this space. If this thinking is accepted it is likely that we will end up with some form of regulated hybrid structure similar to that currently applicable to investments products.

Best of both worlds

The hybrid model stands up under scrutiny. Advisors should receive some form of up-front payment to compensate them for the cost of providing advice and executing the sale, and some form of as-and-when income stream to compensate them for the cost of servicing the client over time.

We do not believe that this review will result in a move to a fee based environment, nor to a 100% as-and-when based environment, in the risk product space. As we move away from the current up-front commission model, to some form of hybrid, or even a 100% as-and-when income stream, we are likely to see the following positive impacts:

• A reduced incentive to churn policies on a three to four-yearly basis, leading to an improved persistency experience and lower overall business acquisition costs across the industry. This will also result in more affordable premiums for consumers.
• A reduced risk of commission driven miss-selling.
• Greater alignment of advisor remuneration across investment and risk product lines, removing any undesirable distortions or bias in terms of advice and sales practises.
• The annuity income created by an as-and-when commission stream will increase the equity value in a book of business, and therefore increase the value of the advisor’s practice.
• Any as-and-when income stream that can be cancelled at the client’s discretion will create a strong incentive to intermediaries to provide on-going reviews of their client’s risk portfolios. Current remuneration models have created an environment where fundamental changes in a client’s insurance needs are not adequately monitored over time.

The positives are balanced by at least six negatives, including:

• Any form of as-and-when remuneration will make it financially unviable for intermediaries to operate in the lower income markets. Given that making financial advice available to this sector is should be one of the critical objectives of the review, it seems likely that changes to commission structures will include concessions to allow for greater up-front payments on lower value business.
• Irrespective of possible concessions for lower value business, any reduction in up-front commissions will encourage direct marketing and "single-need sell” distribution models. Lower income consumers will rarely have any face-to-face interaction with a professional advisor, nor are they likely to enjoy the benefits of a financial planning process supported by a comprehensive financial needs analysis.
• As-and-when commission structures implicitly penalise intermediaries with small client bases and will act as a barrier to entry for new entrants to the market. Start-ups will not be able to sustain the high initial business establishment costs in addition to covering the costs associated with acquiring and selling to new clients – unless they receive large up-front payments on sales. This is a material concern given the aging population of existing intermediaries.
• At the extreme, it is possible that established intermediaries will exit the market in response to further remuneration regulation, exacerbating the problems caused by an already ageing intermediary population
• Unless the revised regulations are extremely tightly defined, specifically the principle of equivalence of reward and the rules applicable to the outsourcing of services, any such change might drive the industry to find alternate, non-commission based, methods to remunerate intermediaries. This would obviously run contrary to the regulator’s intent.
• It can also be argued that the risk of advisors providing advice that is not independent is mitigated in a tightly regulated market where all products pay identical commissions, irrespective of the structure of that commission. A large part of the solution, as the FSB has noted in its discussion document, may simply involve a levelling of the playing fields and the removal of non-commission incentives from the market.

Pro-consumer initiative

It is great to see the regulators driving change that is in the best interests of the consumer. It is also encouraging that all stakeholders have been given the opportunity to contribute to the discussion. We hope that the final outcome is balanced, benefiting the consumer while taking into account the valuable role that intermediaries play in the financial planning process. Intermediaries have a right to appropriate remuneration for the services they provide.

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