Absent a vision for the future, insurance is an industry in run-off

Blind Freddy can see

The Australian life insurance sector, encompassing total and permanent disability (TPD), income protection, and trauma insurance, is undergoing immense strain. Through a combination of industry lobbying, industry-encouraged government intervention, and legislative changes, the sector has entered a state of run-off – with new premiums unable to offset policy cancellations and claims.

Industry-led lobbying has precipitated the current situation, with the unintended consequences of commission caps, declining insurance pools, rising premiums, now requiring structural reform to ensure the sector's survival.

The societal impact of underinsurance

The chronic underinsurance problem that has emerged in Australia, is worsening, and has far-reaching consequences, both economically and socially.

Deloitte's recent Mind the Gap report (August 2023) reveals a staggering potential loss of $25 billion that Australian families could have claimed last year if they were adequately insured for life insurance events. This gap underscores a grave societal issue: the vulnerability of families facing financial hardship upon the serious illness or loss of a breadwinner.

While certain players seem convinced that group cover through superannuation might save the day they would be well placed to think again.

AFSA's Developments in Insurance Provided through Superannuation report (February 2024) highlights a significant 36 per cent drop in the number of lives insured for death benefits through superannuation from June 2018 to June 2023. The decline largely stems from the Protecting Your Super (PYS) and Putting Members Interests First (PMIF) measures aimed at protecting superannuation that have inadvertently exacerbated underinsurance by restricting automatic insurance cover to those who opt-in.

Fund members in aggregate may be paying less premiums, the AFSA report says, but there has been a substantial cost in terms of foregone benefits, with tens of thousands of fund members now not having their super protected or their interests put first by the PYS and PMIF changes.

The impact on the Australian community was that there were 5,000 sets of beneficiaries of death benefits who missed out on payments of $665 million in aggregate in 2022-23 alone. Further, says AFSA, without the PYS and PMIF changes there would have been an additional 11,000 individuals a year receiving around $1.5 billion in TPD benefits.

This underinsurance not only leads to increased dependency on government support systems but also strains societal resources and reduces economic productivity.

The situation is worsened by the misalignment of product offerings in group superannuation plans, where only half provide income protection (IP), and even then, nearly 80 per cent limit benefits to a two-year period, contrary to community expectations of long-term security up to retirement age.

These statistics and trends underscore the need for a re-evaluation of legislative frameworks and industry practices to address the root causes of underinsurance and align them with the societal needs for financial security and resilience.

This not only involves rolling back certain regulatory measures but also enhancing the role of financial advisers in guiding Australians towards adequate coverage, ensuring that insurance serves its fundamental purpose of providing peace of mind and financial stability.

Own goal

A root catalyst has been misguided government intervention into insurance policy and pricing frameworks at the urgent behest of industry lobby groups.

To arrest the current decline, deregulation, or even re-regulation, must be pursued.

The only viable path is to roll back changes which undermined adviser engagement and policy reliability. Strong decisive action is vital to avoid the gradual collapse of the life insurance industry in Australia. Insurers must also take responsibility – in what is best described as shocking own goal, they secured short-term gains but lost sight of long-term sustainability in pushing for interventions that backfired severely.

Rebuilding trust and distribution channels is essential even if it impacts margins.

Government intervention and cost capping

The Trowbridge Report and subsequent Life Insurance Framework (LIF) fundamentally altered the regulatory landscape for Australian life insurers. Most significantly, commissions payable to advisers were capped at 60 per cent - a near halving from previous levels.

This compromised the commercial viability of insurance advice. With commissions no longer covering the time and risk costs of delivering advice, fewer advisers could rationally justify doing the work. This commission cap was a direct result of lobbying by insurance industry bodies.

The arguments put forward by industry were that reducing the commission cost would help return profitability to the writing of new business, and that it would also address the problem of “churn”.

Both arguments were disingenuous. The higher upfront commission model was designed specifically to encourage new business growth and had served that purpose well over decades. Reducing that incentive so significantly made regular advice and servicing of policies much less viable. Insurers assumed advisers would keep writing the same amount of business despite drastically lower compensation.

The churn argument was fallacious because very few advisers actively replace policies simply to earn higher upfront commissions again. The evidence did not support that being a widespread practice. To the extent that churn risks needed further management, there were many other ways for the industry to address that issue besides halving the income of their distribution partners. The commission cap was a short-sighted attempt by insurers to improve profitability at the expense of the adviser channel that had fuelled their new business growth for years.

Consequences for insurance advisers

The impact of commission caps on advisers was two-fold. Firstly, the number of advisers willing to service and advise insurance clients declined drastically. With income slashed on new policies, many practices found it unviable to dedicate resources to proactive insurance advice and ongoing policy management.

Secondly, new policy sales slowed significantly as fewer advisers made active recommendations or submissions. With fewer younger and healthier lives entering the insurance pools, this invariably worsened the risk profile of the remaining insured groups over time, compounding rising claims pressures.

Insurers had failed to predict how severely the commission cuts would impact both acquisition and retention of insurance clients. As advisers retreated from actively servicing policies, large numbers were effectively "orphaned" - left to inadvertently lapse without reviews or have claims denied due to lack of expert support. This led to faster depletion of insurance pools alongside sharply reduced new business inflows. Insurers damaged their own distribution pipeline in seeking quick margin gains.

Rising premiums and policy cancellations

With fewer policies sold and gradually declining pool health, insurers faced untenable claims costs as the risk profile of remaining policyholders worsened. Premiums were thus aggressively increased in an attempt to maintain profit margins, often rising well above inflation and wage growth. These extreme premium hikes placed immense financial pressures on policyholders, forcing many to reluctantly cancel cover simply due to affordability issues. This further depleted the declining insurance pools in an accelerating downward spiral.

Insurers were unable to stem the rapid lapse rates as pools shrank. The consequences of industry-driven legislative changes had now come full circle to deteriorate the sector which unwisely sought short-term margin gains via intervention.

The stage was set for a run-off crisis unless insurers reversed course on the flawed assumption that higher premiums could offset the loss of scale.

The run-off state of insurance pools

In other industries, run-off refers to a declining business state whereby revenue streams fail to cover costs (and claims) over time. As new premium inflows drop below the rate of cancellations and payouts, insurance pools have entered an unprecedented run-off state. The insurance lobby groups had failed to foresee these predictable long-term consequences in their push for commission regulation.

While seeking quicker profits, they underestimated how severely slashing adviser compensation would contract distribution channels and new client acquisition. The short-term thinking behind such urgent calls for legislative change, when insurers were still profitable overall, has turned into an existential threat for parts of the Australian life insurance sector.

Legislative changes and their impact

Adding further strain, 2019 legislation redefined income protection insurance from guaranteed renewable policies to indemnity style cover. This reduced the quality of the paper and made it less attractive for both customers and the advisers still motivated to recommend it. Insurance is fundamentally about providing peace-of-mind and transitioning this important part of the sector to indemnity severely degraded the reliability and trust previous policies cultivated.

Essentially, income protection was no longer a guaranteed safety net if unable to work. Another example of self-inflicted damage from industry lobbying, as insurers sought regulatory mandate to cut costs in hopes of improving profitability. Facilitated by government, such changes sacrificed customer goodwill through erosion of policy quality - further diminishing trust in insurance overall.

The insurance industry has now twice sought protection from normal competitive forces through government-mandated intervention. Reducing competition allows preserving margins, but the long-term consequence is loss of reputation, distribution channels, and ultimately customers. It could be called a regulated cartel, with the government effectively restricting normal market pressures at the industry's behest - to the ultimate detriment of both insurers and consumers.

The vicious cycle of increased costs and reduced demand

Thus, the effects of reduced commissions, inflated policy premiums and the reduced quality of terms, fed into each other in a dangerous spiral. This would further diminish the viability of insurance pools by removing healthier lives. Insurers would cite that deterioration to justify even larger hikes, perpetuating the downward cycle.

While seeking to improve profitability, insurers failed to recognise how premium increases can reach a point where they trigger lapses faster than the remaining pool can absorb. The cycle is accelerated by shrinking adviser networks unable to subsidise costs to retain clients. Industry bodies failed to grasp these second-order effects before lobbying for commission cuts and reduced policy guarantees. The ramifications outstripped short-term margin gains.

The crucial role of advisers and the commission model in the health of the insurance sector

The role of financial advisers in the life insurance industry is paramount, not only for ensuring that individuals and families have adequate coverage but also for the overall health of the sector. The commission-based remuneration model has historically been a key driver in promoting active engagement of advisers with clients, facilitating informed and tailored insurance solutions that meet specific needs.

Research data underscores the critical impact of adviser-driven sales. According to the Australia’s Life Underinsurance Gap report (October 2022) commissioned by the Financial Services Council (FSC), adviser sales constitute the backbone of the industry, with less than 10 per cent of life risk advice being executed without any commission. This statistic highlights the deep reliance of the insurance market on the commission model to motivate and compensate advisers for their specialised knowledge and the intensive effort required to manage client needs effectively.

Any proposal to remove adviser commissions is misguided and would drastically alter the landscape. From the same FSC report, a 32 per cent reduction in in-force policies was forecast by 2027 if commissions were to be eliminated, this prediction illustrates a clear relationship between adviser remuneration and insurance coverage levels.

Such a significant drop in active policies would not only exacerbate the already critical issue of underinsurance but would also destabilise the financial security of millions of Australians.

Globally, there is scant evidence to suggest that a fee-for-service model in the insurance sector can sustain the same level of engagement or coverage as a commission-based system. The intricate nature of insurance advice, which requires an ongoing assessment of personal circumstances and the complex product landscape, makes the commission model particularly effective. Advisers are incentivised to maintain long-term relationships with clients, ensuring that coverage remains appropriate over time and adjusting plans as life circumstances change.

In Australia, the link between underpayment of professional advisers and the growing problem of underinsurance is evident. The commission model does not merely compensate advisers; it aligns their interests with those of their clients and the broader goals of the insurance industry. Ensuring that advisers are adequately compensated for their expertise and the significant professional risks they bear is crucial for maintaining a healthy, responsive, and robust insurance sector capable of meeting the needs of the Australian populace.

CALI's approach to the current insurance sector challenges

The establishment of the Council of Australian Life Insurers (CALI) represents a significant new development in the Australian insurance landscape, having emerged from the need for a dedicated body to address the specific concerns of the life insurance sector.

While the formation of CALI as a distinct entity from the Financial Services Council (FSC) aims to provide focused advocacy and policy direction, there are concerns regarding its grasp of the sector's more pressing issues.

CALI’s policy agenda, as outlined since its inception, focuses on a broad range of commendable initiatives such as enhancing consumer protection, contributing to the national economy, and addressing topics like mental health and genetic testing in insurance.

These priorities, while important, might suggest a lack of urgency in addressing the more critical, foundational challenges that are causing the sector to falter.

The life insurance industry is currently grappling with a severe underinsurance crisis, spiralling premiums, and a regulatory environment that has strained the very distribution channels upon which the industry depends.

Despite these pressing challenges, CALI’s publicly articulated policy efforts appear to skate over the surface, emphasising long-term industry stability and consumer standards without tackling the immediate, systemic issues that threaten the sector's viability.

For instance, the considerable decline in the number of insured lives and the effects of commission caps on the adviser community require urgent, decisive action that seems underrepresented in CALI's current policy focus.

The organisation's emphasis on upholding existing standards and improving professional codes of conduct, while vital for long-term health, might not sufficiently address the immediate financial pressures that the industry and its consumers face.

CALI's role is undoubtedly crucial, yet there is a pressing need for it to pivot towards more immediate solutions that can stop the haemorrhaging within the industry.

Advocacy should go beyond group insurance as the best future, and beyond supporting legislative changes to allow insurers to provide product specific advice to consumers using unqualified advisers. A more nuanced understanding of the interactions between regulatory changes, adviser activity, and insurance uptake must inform their advocacy. By aligning their efforts more closely with the urgent needs of the market, CALI can truly champion the cause of life insurers and their customers.

This alignment is not just a matter of adjusting priorities but of recognising that without a healthy distribution network and a sustainable model for adviser compensation, other initiatives may lack the foundation necessary to be effective. It is essential for CALI to demonstrate not only a commitment to long-term industry standards but also a robust strategy for immediate recovery and resilience.

A vision for the future and the need for structural reform

Through intense lobbying efforts, the Australian life insurance sector secured commission and policy framework regulations from complacent governments. However, they failed to foresee the predictable consequences - from declining adviser engagement through to shrinking, high-claim insurance pools entering run-off.

With steep premium hikes leading to unaffordable policies and ballooning cancellations, insurers have initiated a vicious cycle of reduced demand despite increased costs.

The myth that group insurance alone can solve the structural and societal issues facing us was brought into stark focus in the aforementioned ASPA Developments in Insurance Provided through Superannuation report that highlighted the shocking human impact of underinsurance.

As viable pools continue to diminish, the need for structural reforms to roll back short-sighted government interference is urgent. The industry must shoulder its fair share of blame for this state by its demands for quick relief from competitive forces without modelling long-term impacts.

Failure to deregulate commissions and policy terms will slowly choke the life insurance industry out of existence. Rebuilding distribution partnerships and trust in insurance policies is essential - even if at the cost of short-term margins. The alternative is the inevitable decline and extinction of the whole sector.

Insurers and governments must act decisively in their own interest by reversing dysfunction they jointly created.

A wise man once said, “in the absence of vision, a vision exists and that is one of survival. And if the vision is one of survival, then that is all that will be achieved – temporarily at least”.

Hardworking risk specialists and advice networks with a strong and passionate commitment to personal risk insurance can only do so much.

It's time for industry executives to get their heads out of the sand and develop a vision for the future that goes beyond survival.

Keith Cullen is managing director of WT Financial Group.