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Effect of commission changes on your business

Michael Naylor, a senior lecturer in finance and insurance at Massey University, has designed a template for advisers to work out what commission changes would mean for them.

Thursday, September 10th 2015, 6:00AM 9 Comments

Current indications are that the Ministry of Business Innovation and Employment (MBIE) review of the financial advice sector will involve some controls on the maximum levels of commissions.

These controls have recently been imposed in the UK, Australia and Singapore. Some sectors of the New Zealand insurance adviser industry have made alarmist comments about the impact of commission controls on adviser profits and consequently the number of industry participants.

Given that New Zealand is heavily underinsured in the area of personal risk, it is vital that any reform of insurance commissions does not decrease adviser income.

It needs to be noted that the general insurance sector has had lower upfront commissions and higher trail commissions for decades, with no adverse impact on the number of industry participants.

Pre-reform Australian and UK levels of upfront commission were far lower than current New Zealand levels for personal risk insurance.

In theory, a decrease in upfront commission and an increase in trail commission can be structured so that business income is unaffected.

Assessing the impact of a change in commission structure on the profits, the cash-flow and the value of an insurance business can, however, be complex.

As a guide for industry I have created a spreadsheet which will allow users to adjust the key variables and assess the impact on their business of differing commission structures.

The key variables  to be considered are:
(i) the level of upfront,
(ii) the level of trail
(iii) the number of years trail is paid
(iv) the rate of policy lapse
(v) the amount of fees paid
(vi) the cost of setting up a policy
(vii) the cost of maintaining a policy on the books, including client reviews
(viii) the discount rate applied to income derived in future years
(ix) the number of policies sold per year, and;
(x) the multiple used to value a business from trail commission or profit.

The example below shows that for an 8% per annum lapse rate, a four-year trail, and a 4% discount rate, then 220% upfront plus 6% trail, gives the same annual profit as 100% upfront, 40% trail and a $165 annual fee. This shows that a reformed commission structure could have little impact on sector profitability.

Average policy size $200,000
Average annual premium per policy $2000
Number of policies sold per year 45
Lapse rate per year 8
Discount rate 4
Upfront commission 220% 100%
Trail commission 6% 40%
Years trail 4 4
Fee per policy per year - $150
Per policy set-up cost $1200 $1200
Per policy maintenance cost p/a $30 $100
Valuation multiple 3 4
Policy value $9,000,000 $9,000,000
Upfront commission per policy $4,400 $2,000
Trail commission policy year two $120 $800
Total trail commission per policy $434 $2,893
Total upfront commission all policies $198,000 $90,000
Average income per policy $4,834 $5,043
Average profit per policy $3,623 $3,806
Total profit all policies $152,526 $155,019
Business value based on trail $47,962 $426,332
Business value based on profit $457,578 $620,075

Two things stand out. Firstly, when we include a business valuation based on a trail multiple, the low upfront/high trail model has a consistently higher valuation, whether based on trail commission or profit. 

A realistic valuation, however, will also depend on book quality and factors such as goodwill, brand, liabilities, work in progress and earn-outs. It can be argued that a higher trail model provides more of an incentive for an adviser to retain existing clients and improve the book’s quality.

This will increase policy maintenance costs, but should decrease the lapse rate and allow an annual fee to be charged. This improved book quality will allow sale at a higher multiple and will increase the valuation gap between the two commission structures. The table uses an optimistic multiple of 3, whereas it is common for an undeveloped book to struggle to obtain a multiple of 2.

Secondly, a move to a lower upfront and a higher trail has a substantial impact on income earned by new entrants, as trail takes time to accumulate. The tables below show that, even if the higher trail model ends up providing a higher profit in the long run, it can be up to seven years before a new entrant pulls ahead of the high upfront model, and the initial year differences are substantial.

The tables show upfront, trail and fees income by year of policy origin. Some later figures for high upfront are negative because policy maintenance costs exceed trail + annual fee. The same variables are used as in the first table. This shows that serious consideration is required around the transition period to a reformed commission structure and a pathway created for new entrants. This may involve borrowing from future commission to fund the initial entry.

The spreadsheet is available as a downloadable template from here. This will allow advisers to play around with the variables and analyse the impact of possible changes to the commission structure on their business. This should enable industry participants to give feedback to MBIE on what changes are possible to commission structure without advisers suffering any decrease in profitability.

Entrant income per year

Commission structure one

                                                                    Policy origin

  New policies sold Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Total income
Year one 15 $48,000             $48,000
Year two 25 $1242 $80,000           $81,242
Year three 35 $1143 $2070 $128,000         $115,213
Year four 40 $1051 $1904 $2898 $128,000       $133,854
Year five 45 $967 $1752 $2666 $3312 $144,000     $152,697
Year six 45 -$297 $1612 $2453 $3047 $3726 $144,000   $154,541
Year seven 45 -$273 -$494 $2257 $2803 $3428 $3726 $144,000 $155,447

Entrant income per year

Commission structure one

                                                                    Policy origin

  New policies sold Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7  Total income
Year 1 15 $12,000             $12,000
Year 2  25 $11,739 $20,000           $31,730
Year 3 35 $10,792 $19,550 $28,000         $58,342
Year 4 40 $9928 $17,986 $27.370 $32,000       $87,284
Year 5 45 $9134 $16,547 $25,180 $31,280 $36,000     $118,142
Year 6 45 $494 $15,223 $23,166 $28,778 $35,190 $36,000   $138,851
Year 7 45 $455 $824 $21,313 $26,475 $32,375 $25,190 $36,000 $152,632


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Comments from our readers

On 11 September 2015 at 8:46 am Next Generation said:
A couple of things come to mind scanning the above article, without reading too deeply:

1) The paragraph noting general insurance commission structures; if the writer is trying to compare the 2 insurance mediums as similar and therefore the way one is remunerated should be similar they are clearly not dealing with people who need these insurance products or understand the need and motivation to purchase. One product line is usually brought the other sold, one product line is usually held for a lot longer period (through ones life time) than the other as people always see the importance of insuring a home immediately but not themselves.

2) One of the assumptions included in the model is charging a fee. Why should consumers cost's increase? All that has been done in your model is transferred some of the distribution cost from the insurer (commission) to the client (fee). In general, New Zealanders do not like paying fees for these types of services.

3) The insurers have been reasonably quiet in discussions on commission, the reason being is they have created the high upfront commission issue (albeit through competition) and they need a regulator to create a frame work (commission model) under which they can work, in doing so this will help them in reducing their cost of intermediated distribution. You only have to go back 8-10 years and most insurers were paying around 160% upfront, noboday complained about receiving this level remuneration but some insurers saw increasing upfront remuneration as a means to gain market share, in doing so they have created a rod for their own back. The insurers need a regulator to create a commission framework to fix this issue they've created!
On 11 September 2015 at 10:50 am Mike Naylor said:
The issue is one of 'first mover disadvantage'. The insurers think that whoever moves first will lose market share, so nobody moves. The insurers would prefer MBIE imposed caps, as mots other countries have.
The insurance companies via the FSC approached the Ministry about capping upfront commissions. They were told they that as group they were not allowed to jointly suggest this or impose it, as it breached competition law. Hence their quietness.
The danger to advisers is that MBIE will impose levels which cut adviser income - look at the recently agreed Aust change. My impression is that MBIE will welcome industry feedback on what ideal caps should be.
The examples used are not the point - the point is that advisers need to think about this, and then via IFA/PAA give feedback to MBIE. Urgently. Otherwise advisers have no reason to complain if Aust caps are imposed.
NZ advisers now use a diverse mix of upfronts, trails and fees. The template enables them to examine differing mixes to see which would maximise their income. Try it with no fees. There is no suggestion that the example was good or ideal.
On 11 September 2015 at 11:29 am Tony Walker said:
Unless I am missing something I am struggling to see the correlation with a higher multiple for higher trail. What are the arguments to support this
On 11 September 2015 at 1:32 pm lewiboy said:
The only problem I see with lower upfront commission, is that newer advisers will struggle in what is already a very tough field. I've been in this business over 20 years and been taking lower upfront commission for years, so it won't affect me or other older advisers with established clients bases.

What I see this doing is driving new advisers into banks, where they have security.
On 11 September 2015 at 4:25 pm Mike Naylor said:
Tony - the article says - 'It can be argued that a higher trail model provides more of an incentive for an adviser to retain existing clients and improve the book’s quality.'

However you can adjust this in the spreadsheet to suit what you think is right. Then tell us your preferred upfront/trail mix - how much would trail have to rise if upfront was capped?
On 15 September 2015 at 12:56 pm Tash said:
If up-front commissions are reduced too much, new "independent" advisers will generally not be able to survive. We need to be conscious of the fact that making it impossible for advisers to make a living, especially in the beginning part of their careers (when they don't have loads of clients/renewal commissions) will simply result in tied salaried adviser forces becoming the norm.
This will lead to worse outcomes for consumers and probably RAISE insurer costs and therefore premiums.
On 15 September 2015 at 5:09 pm dcwhyte said:
Tash - you make a good point. I've seen nothing in this remuneration debate that will reduce retail premiums. In fact, quite the opposite - increasing renewal commission will push premiums up!
On 15 September 2015 at 5:14 pm Mike Naylor said:
lewiboy & Tash - yes, the new entrant problem is the major issue with commission regulation - up to 7 years in the example.

Before the govt regulates and mucks things up - what suggestions do you have?

It can't be 'no change'.

Lawyers etc have a clerical arrangement for new entrants, a contract which allows income diversion, which is paid back from later profits. Would this work?
On 16 September 2015 at 12:23 am interested2 said:
Well done Mike for prompting a good discussion and including some numbers to support.

A couple of tidy up points that might assist… typically there is no renewal in second year when receiving a high upfront. This may help negate argument for fee as I agree consumers don’t like them, and the F&G brokers usually have to hide them (that’s a generalisation, but a fair one). Also your servicing costs are light, but $100 is better than $30.

Please note that an ‘average’ life insurance writer, even when established doesn’t do $90k of new API year on year – so this change to commission may not reduce ‘churn’ but could increase it for those that rely on the method of generating income. I agree with earlier comment that insurers have created a rod for themselves by paying such high upfront, but I believe the market will correct, disclosure & digital competition will bring commission down as it has for other ‘middle men’.

If there is a ‘churn problem’ which is harmful to consumers, then that needs to be dealt with by scrutinising advice given. Make every adviser accountable to the same guidelines and then inforce them. If it’s in the clients best interests to change a policy, it is not churn, its doing the right thing for your client – which is where loyalty should lie (and does currently under FAA). Loyalty cannot be to the insurer that hasn’t or won’t upgrade/ pass back/ discount/ innovate. Insurers have all the options, and full control.

Your recent comment says to make a recommendation that is anything but 'no change'. I feel the remuneration model isn’t broken, it’s just at a high point in the cycle, leave it to the market but regulate and enforce against dishonest behaviour.

Finally, making it any harder for ‘start ups/ new advisers is only in the interests of tied adviser groups or banks. It is a backward step for everyone else, as consumers will have less access to non-tied advice, insurers have fewer qualified ‘sales reps’, and existing businesses have fewer options for sale (therefore achieve a lower price). It’s already hard starting in this business, so any change must not be detrimental to good quality, ethical start ups. If you/ I/ we can’t come up with a better remuneration model, then we should leave it. Certainly don’t change it toward something you expect to be detrimental.

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