Mennen, Josh --- "Life insurance reform legislation - a missed opportunity?" [2016] PrecedentAULA 30; (2016) 134 Precedent 14

LIFE INSURANCE REFORM LEGISLATION – A MISSED OPPORTUNITY?

By Josh Mennen

The much-maligned life insurance industry is facing a shake-up that is long overdue. The federal government’s Corporations Amendment (Life Insurance Remuneration Arrangements) Bill 2015 will change the way commissions are paid to advisers when recommending life insurance products. While the changes are a step in the right direction, in the author’s opinion they do not go far enough, and are unlikely to stamp out the systemic practices that have devastated so many customers’ lives.

BACKGROUND

In the fallout from the global financial crisis (GFC), thousands of Australians who had received financial advice suffered disastrous losses following their exposure to inappropriately risky investment strategies. In response, the then federal Labor government reformed the sector through its 2013 Future of Financial Advice (FOFA) legislation. However, FOFA’s reforms to adviser remuneration did not extend to life insurance advice. The life insurance industry dodged that legislative bullet.

Since then, however, an ASIC investigation in 2014, the Trowbridge and Murray inquiries in 2015 and a recent spate of allegations of dubious conduct and claims denials in the industry have all confirmed the need for further substantial reform of the insurance sector.

Unsurprisingly, the financial advice industry was broadly opposed to calls for any blanket ban on up-front and trailing commissions in life insurance advice, arguing that a purely fee-for-service environment would drive up the costs of advice for life insurance, making it unaffordable, and exacerbating the existing underinsurance problem.^[1]

The Corporations Amendment (Life Insurance Remuneration Arrangements) Bill 2015 (the Bill) is the government’s attempt to strike the right balance between industry and consumer interests. The Bill’s stated intention is to ‘better align the interests of retail life insurers with consumers’. The new legislation was intended to take effect on 1 July 2016 (with transitional provisions until 30 June 2018) however that start date is no longer possible since the election was called for 2 July 2016.

WHAT’S IN THE BILL?

A cap on ‘conflicted remuneration’

A post-GFC parliamentary inquiry observed: ‘A significant conflict of interest for financial advisers occurs when they are remunerated by product manufacturers for a client acting on a recommendation to invest in their financial product.’ ^[2]

FOFA imposed a ban on financial advisers receiving ‘conflicted remuneration’ including, subject to limited exceptions, commissions and volume-based payments.^[3] ‘Conflicted remuneration’ is defined as:^[4]

‘...any benefit, whether monetary or non-monetary, given to a licensee or their representative, who provides financial product advice to persons as retail clients that, because of the nature of the benefit or the circumstances in which it is given:

(a) could reasonably be expected to influence the choice of financial product recommended by the licensee or representative to retail clients; or

(b) could reasonably be expected to influence the financial product advice given to retail clients by the licensee or representative.’

FOFA allowed an exception^[5] for benefits relating to 'life risk insurance products' outside superannuation, which would include retail death and disability insurance policies. That exception enabled advisers to continue to receive commissions from insurers for recommending their products. Those commissions were often up to 120 per cent of the client’s premium for their policy in the first year.

A 2014 ASIC investigation^[6] identified a strong correlation between high upfront commissions and poor consumer outcomes, with 37 per cent of the advice it reviewed failing to comply with the law in force at the time the advice was given. The likelihood of advice breaching legislative standards was dramatically increased where the adviser received an upfront commission from the insurer: 45 per cent of upfront commission advice failed ASIC’s tests, whereas only 7 per cent of non-upfront commission advice failed.

The Trowbridge Review^[7] recommended that the life insurance industry move to a level commission model, limited to a maximum of 20 per cent of premiums, and the introduction of an initial advice payment (IAP) capped at $1,200 paid by the insurer to the adviser on a per client basis (rather than a per policy basis) no more than once every five years.

The Financial System Inquiry (FSI) led by David Murray AO recommended that upfront commissions to be no higher than the ongoing annual trailing commissions (which are typically no higher than 20 per cent of the premium paid by the client).

The Bill ultimately charts its own course, moving away substantially from the Trowbridge and FSI recommendations.

The Bill puts a cap on the ‘conflicted remuneration’ an adviser may receive. The cap will be set by ASIC through a legislative instrument. Specifically, under ASIC’s proposed legislative instrument,^[8] from 1 July 2018:

(a) the level of commissions will be set at a maximum of 60 per cent of the premium in the first year of the policy; and

(b) an ongoing commission for policy renewals will be set at a maximum of 20 per cent of the total of the premium paid for the renewal.

It is significant that the 60 per cent cap on first year commissions is triple the 20 per cent cap recommended by the Trowbridge Review, which was determined to be an appropriate level while still ensuring the insurance advice industry’s long-term viability.

The Bill includes transitional provisions to grandfather ‘conflicted remuneration’ payments that are made under pre-existing arrangements in relation to pre-existing policies. It also proposes a transitional period of two years, commencing on 1 July 2016, as follows:

Table 2: Transitional arrangements – maximum commission levels
Date	Maximum total upfront commission
From 1 July 2016	80% of the premium in the first year of the policy
From 1 July 2017	70% of the premium in the first year of the policy
From 1 July 2018	60% of the premium in the first year of the policy

Hence, despite the government proclaiming that the Bill ‘removes the current exemption in the Corporations Act from the ban on conflicted remuneration for benefits paid in relation to certain life risk insurance products',^[9] it in fact accepts that ‘conflicted remuneration’ in insurance advice is acceptable up to a point, at least during the transitional period.

Commission ‘clawback’

Because advisers receive much higher commissions in the first year of a policy’s term than in subsequent years, they are incentivised to sell their clients replacement policies against the client’s best interest (known as ‘churning’). Many rapacious advisers have succumbed to this notorious practice, with devastating results for their clients, who are subjected to new disclosure obligations each time they buy a new policy. This increases the risk of having their eventual disability or death claim declined by the insurer due to non-disclosure.

The practice of churning has given rise to much litigation in recent years,^[10] the most notable case being Commonwealth Financial Planning Ltd v Couper.^[11] In Couper, the late Mr Stevens was advised by a CBA adviser to cancel his existing Westpac life insurance policy and replace it with a vertically integrated CommInsure product, which he did. The subsequent claim made by his estate for his life insurance benefit was declined and the policy avoided on the basis of non-disclosure under s29 of the Insurance Contracts Act.^[12] The Court of Appeal found that the financial adviser was negligent and engaged in misleading and deceptive conduct. The Court noted that while the Statement of Advice did disclose the risk of avoidance for non-disclosure, it failed to disclose the ‘three year rule’, namely that:

- because his Westpac policy had been on foot for more than three years, it could not be avoided by the insurer except by proving fraud; and

- the CommInsure policy could be avoided for ‘innocent non-disclosure’ within the first three years from inception, and was therefore an inferior product.

The three-year rule was, in the adviser’s words ‘news to me’.

It is not just consumers who find churning abhorrent: insurers are understandably frustrated by the practice because it undermines their business model, which depends on policies remaining on foot in the long term.

The Bill seeks to neutralise the churning incentive by introducing a ‘clawback’ provision, whereby a certain portion of the upfront commission is paid back to the life insurer by the financial adviser in the event that the policy is cancelled or the premium is reduced. The specifics proposed by ASIC^[13] are:

‘if a life insurer pays commission other than under a level commission arrangement, and ‘clawback’ is triggered:

• in the first year of the policy – 100 per cent of the commission paid in the first year will be repaid to the life insurer; and

• in the second year of the policy – 60 per cent of the commission paid in the first year will be repaid to the life insurer.’

However, the ‘clawback’ approach has its critics, including John Trowbridge, who argues that it is an ill-targeted incentive against churning, because ‘there are many valid reasons for policyholders and their advisers to cease a policy, and there is no workable method for distinguishing between genuine policyholder-initiated policy replacement and policy replacement initiated or encouraged by the adviser’.

Hence Trowbridge’s emphasis on the ‘fundamental problem of high initial commissions on replacement policies’.

The clawback also requires advisers to retain contingency funds in case of clawback (rather than investing those funds in new business, for example), and does not disincentivise churning after two years.

WHAT’S NOT IN THE BILL?

Vertical integration

Vertically integrated advice (sometimes called ‘cross selling’) is where an adviser recommends a financial product (including life insurance) offered by entities with which they are associated, often at the exclusion of more suitable non-affiliated products. This potential conflict of interest has been and remains a root cause of poor advice outcomes.

ASIC has described the vertically integrated advice model as being inherently conflicted, and lacking in customer transparency. For example, ASIC’s submission of December 2014 to the Scrutiny of Financial Advice Inquiry noted:

‘The inherent conflict of interest created by vertical integration may not be readily apparent to clients, particularly if the product manufacturer and advice parts of the business operate under separate licences and business names. Roy Morgan Research found that 55% of surveyed consumers receiving financial advice from an entity owned by a large financial institution, but operating under a different brand name, considered it to be independent – in contrast, only 14% of consumers considered financial planners working under the brand of the same financial institution to be independent. This was also an issue identified by the Financial System Inquiry, which recommended that advisers be required to disclose ownership structures of the advice firm to consumers.’

The vertically integrated players are predominantly owned and controlled by the big four banks, and AMP (including AXA). These dealer groups collectively enjoy around half of the total market share in the financial advice sector, and their stake is increasing.

Dealer groups utilising a vertical integration model are not obliged to have any retail life risk insurance product on their Approved Product List (APL) other than their own affiliated product.

This inherent conflict was further verified by Roy Morgan research, which stated that over a three-year perio[d], these dealer groups allocated an average of over 70 per cent of their sales to their own products.1414 http://www.roymorgan.com/findings/6262-superannuation-political-football-but-new-report-shows-what-members-think-201505270222.

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As the big vertically integrated players have such vast distribution channels to sell their ‘in-house’ products they do not rely on other advice firms to do it for them. This selling, marketing and distribution model means that they are disinclined to take the lead on product design, which in turn leads to inappropriate or defective products being paid for by the client, and often results in the insurer denying liability because of those defects.

Recent controversies have exposed stark examples of this, such as CommInsure’s retail trauma policies, which contained medically obsolete heart attack and severe rheumatoid arthritis definitions. Despite knowing the definitional flaws, CommInsure relied upon them to decline claims. It took a media exposé to prompt CommInsure to update its obsolete clauses.^[15]

Urgent action is needed now to deal with the vertically integrated sales model, which remains rife in the advice industry. The draft Bill, however, does not propose any substantive reform on this issue. Instead, it entrusts the industry with ‘responsibility for widening Approved Product Lists through the development of a new Industry standard’. Given the advice industry’s poor track record of self-regulation and its manifest commercial interest in continuing to sell ‘in-house’ products, such an approach is deeply flawed.

The vertical integration conflict could be addressed by simply requiring financial advisers to demonstrate that they consider and recommend both affiliated and non-affiliated products. Improvements could be achieved by requiring financial advisers:

1. to include a balance of affiliated and non-affiliated products in their APLs, and/or a minimum proportion of non-affiliated products; and

2. to disclose any affiliation in Statements of Advice produced for customers that recommend an affiliated product, and that such Statements of Advice should show a comparison with one or more comparable non-affiliated products to demonstrate that the affiliated product is more appropriate.

These measures would provide prescriptive requirements to support compliance with the best-interest test established by FOFA. These measures are also directed towards achieving the recommendation of John Trowbridge that APLs be reformed to ‘ensure competitive access and choice for all advisers and their clients’.^[16]

Shelf-space fees

These are levies paid by insurers to advisers to have their product listed on the adviser’s APL.

Some insurers have themselves called for a ban on these payments, with ClearView managing director Simon Swanson reportedly stating that ‘customers are often recommended a product not because it’s the most suitable and appropriate, but because of an insurance company’s willingness and ability to pay shelf space fees’.^[17]

Despite these concerns, and as with vertical integration, the government continues to allow the industry to self-regulate on this issue.

Life insurance Code of Practice

While the general insurance and banking sectors adopted Codes of Practice long ago, no Code for the life insurance industry presently exists. The government has delegated the responsibility for creating a Code to the Financial Services Counsel (FSC), the peak body representing the insurance industry. The Code is to cover best practice standards for insurers, including in relation to underwriting and claims management.

However, questions need to be asked about the wisdom of entrusting the creation of the Code to an industry which has consistently failed overall to meet public expectations. This is why the ALA Disability Insurance National Special Interest Group has proposed a Code of Practice, and is seeking to engage with industry and other stakeholders to ensure that the protocols agreed to will sufficiently protect consumers.

‘INDEPENDENT’ ADVISERS LEADING THE WAY

One encouraging development is the growing number of self-described ‘independent’ advisers who have voluntarily opted to unshackle themselves from their insurance paymasters by moving to full fee-for-service models. While this innovative approach may decrease their profits in the short term, it will distinguish them from their conflicted peers, thus helping them to gain market share in the longer term, as vigilant consumers seek greater integrity and transparency.

As positive as this development is, it is difficult to envisage the big banks’ financial advice arms ever embracing anything like a truly ‘independent’ structure: their business models are far too entrenched towards the sale of their own ‘in-house’ products.

With such variety in the directions taken by different industry players, we will likely see an ever greater gulf in the quality of advice available; the fundamental distinction being between those who are interested in providing personally tailored advice, and those who are going through the motions in order to sell a particular product.

WATCH THIS SPACE

Since the Bill’s release in late 2015, a further string of scandals in the banking sector has led the Labor opposition to call for a Royal Commission, including for the purpose of examining vertically integrated cross-selling and associated conflicts of interest. The fate of the Bill may therefore rest on the federal election on 2 July 2016.

However, assuming the government is re-elected and passes the Bill, its plan to review the new arrangements in 2018 and if it does not find significant improvement, to move to mandate level commissions, as was recommended by the FSI.

The government’s diluted plan buys the industry time to clean up its act before more severe measures are imposed. However, history tells us that elements within this troubled industry will not change its behaviour unless and until such behaviour is deemed unlawful.

As ever, it will be the consumers who suffer the consequences if the Bill does not sufficiently deter advisers from recommending higher-cost or otherwise inadequate policies against their clients’ best interests.

It is, of course, too early to tell for sure whether the proposed new laws will be enough to protect consumers while also preserving a viable industry that can rebuild public confidence. However, the numerous missed opportunities explored above give good reason for scepticism.

The key early indicators of eventual success will be:

- whether the self-imposed ‘new Industry standard’ will open up APLs and compel advisers to source the market for the product that is in the client’s best interests, including non-affiliated products; and

- whether the industry will embrace a meaningful Code of Practice, noting ASIC’s warning to industry that a ‘code without credibility is worse than no code at all’.^[18]

Josh Mennen is a Principal at Maurice Blackburn Lawyers, Sydney. Josh specialises in superannuation and insurance claims, and financial advice disputes. See more at: https://www.mauriceblackburn.com.au/our-people/lawyers/josh-mennen/#sthash.MeDoKEc0.dpuf. PHONE: [phone] EMAIL: [e-mail].

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^[1] ‘FPA positions on insurance commissions’: http://www.moneymanagement.com.au/news/insurance-property/fpa-positions-insurance-commissions.

^[2] ‘Inquiry into financial products and services in Australia’ by the Parliamentary Joint Committee on Corporations and Financial Services 2009.

^[3] Corporations Act 2000 (Cth) s761G for definitions of retail client and wholesale client.

^[4] Corporations Act 2000 (Cth) s963A.

^[5] Corporations Act 2000 (Cth) s963B(1)(b).

^[6] ASIC Review of Retail Life Insurance Advice, October 2014.

^[7] Report by John Trowbridge, Review of retail life insurance advice, published 26 March 2015.

^[8] ASIC Consultation Paper 245 (December 2015).

^[9] Explanatory Memorandum, p6.

^[10] See also Swansson v Harrison & Ors [ 2014] VSC 118.

^[11] [2013] NSWCA 444.

^[12] 1984 (Cth.)

^[13] ASIC Consultation Paper 245 (December 2015).

[d]

^[15] http://www.moneymanagement.com.au/news/financial-planning/comminsure-upgrades-heart-attack-definitions.

^[16] See note 7 (Policy Recommendation 4).

^[17] http://www.riskadviser.com.au/news/13030-clearview-calls-for-shelf-space-fees-ban.

^[18] Peter Kell, ASIC's deputy chair: http://www.smh.com.au/business/banking-and-finance/asic-seeks-data-on-life-insurers-20160315-gnj3hi.html#ixzz437OqAEgU.