​Life Insurance - we are paying too much for too little

If you’re an average Australian you probably don’t have adequate life insurance.

If you do have life insurance, you are probably paying far too much for it.

Many articles discuss the under-insurance problem, some of these articles are self serving however independent research comes to the same conclusion; the majority of Australians are at risk.

I however, will be talking about the other problem: Australians are paying too much for life insurance.

Both of these issues are caused by the same problem: Life insurance policies are unsought goods.

Unsought Goods

Broadly stated, unsought goods are products or services that consumers don’t actually want; they are not purchased because of desire but rather through the fear of the consequences of not having the product. Other examples of unsought goods are cemetery plots and fire extinguishers (even if I do harbour a desire to blast a fire extinguisher).

It makes sense, there is no lovely box to unwrap, no compliments to be had as you show off your brand new insurance policy to family and friends, no immediate physical comfort gained or time saved. In fact if everything goes to plan, you will never use your insurance policies. 

Marketing Unsought Goods

Marketers will tell you there are two ways to successfully market unsought goods;

1. High volume advertising playing on people’s fears.

This method can be observed in the sheer number of sombre life insurance ads on daytime TV, they usually have two parents lamenting what would happen to their perfect family if tragedy struck.

2. A direct & motivated sales force.

Insurance providers (who often provide a range of financial products) have developed their direct sales force through a network of insurance brokers & financial planners, they motivate this sales force by paying them fees known as commissions.

Commissions are very motivating to this sales force indeed; ASIC estimated that 82% of insurance policies commenced in 2013 contained upfront commissions of up to 120% & ongoing (trailing) commissions of around 20%.

The Affect Commissions Have On The Price Of Insurance

Insurance companies exist to make profits. The problem for insurance companies is that they don’t know exactly how many insurance payouts they will need to make in the future, they can’t be 100% certain on how much their product costs them to provide, therefore they can’t be certain how much to charge.

To figure this out they use Actuaries.

Actuaries are responsible for analysing the possible outcomes of the types of events that cause policyholders to make claims against their policies. They study the overall likelihood that different events will occur, and they evaluate the potential risks each event poses. Using these figures insurance companies can price their products.

This price does not include commissions, it is what we will refer to as a fair price and later on will refer to as Component 1.

Due the need of insurance companies to motivate their direct sales force, commissions are now added to this price.

Insurance companies provide two forms of commission upfront & ongoing.

Upfront commissions are payable when a new policy is started, these commissions are commonly 100-120% of the first years premium. If a policy costs $100 per month, the member of the sales force ie financial planner or insurance broker will receive $1,200 - $1,400 from the insurance company.

Ongoing commissions are paid for the life of the policy, ongoing commission are commonly 10-20% of the premium so every time the policy owner pays their $100 to the insurance company that same member of the sales force receives $10-$20 every month.

Very motivating.

Once commissions are added to the policy the price now contains 3 components:

Component 1 (C1): The cost of the policy determined by actuaries, this is the true cost of the policy without commissions.

Component 2 (C2): The ongoing commission, this is usually 10-20% of component 1

Component 3 (C3): This is an extra cost added to the premium; to allow insurance companies to recoup the cost of the payment of the upfront commission.

An example:

Let’s do a comparison of an income protection policy:

  • Gender: Male
  • Age: 40
  • Occupation: Accountant
  • Policy details: Income Protection
  • Monthly benefit: $75,000
  • Waiting period: 60 days
  • Benefit Period: To age 65

Table 1 below shows the monthly premiums over 25 years, both when commission is included and when commission is removed. In this example the commission payable to the direct sales agent is 100% of the premium the first year and 18% of annual premiums every year.

Table 1. Premium costs to you

Age Monthly premium with Commission Monthly premium sans commission
40 $100 $62
41 $109
$67
42 $114 $71
43 $124 $77
44 $132 $81
45 $144 $89
46 $153 $94
47 $161 $100
48 $176 $109
49 $195 $121
50 $213 $131
51 $229 $141
52 $247 $153
53 $272 $168
54 $305 $188
55 $330 $204
56 $363 $224
57 $383 $237
58 $394 $244
59 $402 $248
60 $410 $253
61 $410 $254
62 $411 $254
63 $412 $255
64 $412 $255

We can see that adding commission to this policy would increase the cost to the policy holder by 38% .

This particular policy pays an ongoing commission (Component 2) of 18% to the sales agent that set up the policy.

We can also see that at 20.2% Component 3 adds a significant cost to the premium.

Component 3

C3 of the policy can be problematic for consumers, C2 (the ongoing commission) can be rebated to savvy consumers through a range of rebating services. However C3 is there to stay, it’s kept by the insurance company.

Because C3 is designed to recoup the outlay the insurance company made to the sales agent, it may be reasonable to expect it to diminish over the life of the policy.

The following shows the percentage of C3 in relation to C1 over 25 years of the policy.

As we can see, C2 remains more or less a constant 20% of C1.

This is a problem for consumers because in the majority of insurance policies C1 increases over time to reflect the increased risk of the owner making a claim on the policy as they get older and generally less robust(policies that flatten this cost are available but less common).

Consumers are now paying 20% of an increased C1, in many cases to compensate an insurance company for a cost that has already been recouped.

The following graph shows the Net Present Value (NPV) of C3 to an insurance company, when the NPV of C3 reaches $0 the upfront commission had been recouped by the insurance company.

We can see that the insurance company are compensated for their initial outlay of $1,200 soon after year 5; beyond this point they are profiting at the expense of the consumer.

A Vicious Cycle

The size of C3 is not purely down to the greed of the insurance companies; they face the problem of not knowing how long a policy will be active before it is cancelled, therefore they do not know how long they have to recoup the upfront commission they have paid.

The longer that insurances companies’ data indicates that policies will remain active the smaller percentage C3 will become as companies will know they have longer to recoup their expenses.

This is a vicious cycle as two of the major reasons that insurance policies are cancelled are exasperated by commissions;

  1. The increasing cost of insurance. We have seen that commissions add significant costs to insurance premiums.
  2. The sales agents have a financial incentive to move clients to new policy and receive another upfront commission. This is known as churning.

The cost to the consumer of commissions is exasperated by shorter duration cycles, and shorter duration cycles are exasperated by the commission system.

Progress

On the 9th of Feb 2017 the parliament passed legislation that restricts commission payable for new policies.

Upfront commissions will be capped at the following:

  • 88% of the policy cost in 2018
  • 77% of the policy cost in 2019
  • 66% of the policy cost in 2020 and beyond

Upfront commissions won’t be paid to sales agents until 2nd year of the policy they will also be limited to 22%.

Clawbacks of the initial commission payable will also be forced, this will reduce the frequency of churn and help to reduce the size of C3.

I look forward to see what impact these reforms have for consumers.

While this should reduce the cost of life insurance to consumers it will still be preferable to only pay the fair price (C1). It also may not help consumers with insurance already in place.

Where Can I Get A Fair Price On Insurance?

Despite the unsought nature of personal insurance the cold hard truth is, most people do need it; the consequences of not having adequate insurance (which I won’t try to list here, there are enough ads) are sufficiently unpleasant that I am personally unwilling to risk them. Situations that give rise to these consequences are also more likely to happen to you than you think.

So where can you find fairly priced insurance?

Superannuation

The Future of Financial Advice reforms banned the payment of commissions to sales agents when the advice relates to either:

  1. A group life risk policy inside superannuation; or 
  2. An individual life risk policy in a default superannuation fund.

Industry Superannuation funds also refuse to pay commissions to sales agents.

But be aware; insurance within superannuation has advantages but also restrictions.

GeekPeek

MoneyGeeks negotiates to have commissions removed from the insurance policies we recommend to our clients. Our GeekPeeks identify how much C2 & C3 you are paying in your current insurance policies. Our GeekPeeks also tell you the premium we can find for a suitable alternative policy. Because we are not beholden to any insurance provider we can often find comparative insurance products that not only don’t require you to pay C2 & C3 but also have a smaller C1 for you to pay. Check out a GeekPeek here.

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