Retail life insurance reforms in Australia - Part 2

The first part of this update discusses the status of the proposed 2016 retail life advice reforms in Australia following the outcome of the recent Federal election and the return of the Liberal National party Coalition, and on the regulatory and legislative environment of life insurance (Part I). The focus of the current proposed reforms are to better protect the interests of consumers.

This second part of the update provides a background for the catalyst of these changes and the recommendations made by legislators and regulators since 2009 (Part II). The future of these reforms remains uncertain and is a hot topic within the industry given the outcome of the recent federal election, particularly the composition of a new bill and whether the Coalition government will be able to progress a new Bill through the Senate.

PART II: A CATALYST FOR CHANGE - BACKGROUND TO THE CURRENT LIFE INSURANCE REFORMS

What was the catalyst for the retail life insurance advice reforms?

Parliamentary Joint Committee on Corporations and Financial Services

On 25 February 2009, the Parliamentary Joint Committee on Corporations and Financial Services (Joint Committee Inquiry) resolved to inquire into financial product and services provider collapses, including Storm Financial and Opes Prime.

Future of Financial Advice – Ban on conflicted remuneration for financial products

Following the Joint Committee Inquiry and the move to improve the quality of financial advice and enhance retail investor protections, Future of Financial Advice (FOFA) became mandatory on 1 July 2013 (and was voluntary from 1 July 2012).

The objectives of FOFA are to improve the trust and confidence of Australian retail investors in the financial services sector and ensure the availability, accessibility and affordability of high quality financial advice. Further reforms were made through the Corporations Amendment (Revising Future of Financial Advice) Regulation 2014 and 2015 and became law on 18 March 2016.

FOFA introduced a ban on commissions and volume based incentive arrangements (ie conflicted remuneration) for financial products, including group or default policies in superannuation (however, grandfathered payments are permitted). Importantly, there was an exemption for retail life insurance commission arrangements as the industry assured the Government that the life insurance industry would self regulate. However, the industry was unsuccessful in self-regulating.

RG 246 – The ban on conflicted remuneration

Regulatory Guide 246 – Conflicted remuneration dated March 2013 (RG 246), the Corporations Act prohibits:

1. AFS licensees and their representatives (including authorised representatives) from accepting conflicted remuneration (s963E, 963G and 963H);

2. product issuers and sellers from giving conflicted remuneration to AFS licensees and their representatives (s963K); and

3. employers from giving their AFS licensee or representative employees conflicted remuneration for work they carry out as an employee (s963J).Conflicted remuneration refers to any benefit given to an AFS licensee, or its representative, who provides financial product advice to retail clients that, because of the nature of the benefit or the circumstances in which it is given, could reasonably be expected to influence (i) the choice of financial product recommended to clients by the AFS licensee or representative; or (ii) the financial product advice given to clients by the AFS licensee or representative: s963A.

A benefit is not conflicted remuneration if it only influences financial product advice provided to wholesale clients. There is a presumption that volume-based benefits are conflicted remuneration: s963L. Some performance benefits may also be conflicted remuneration.

ASIC review and the FSI report

In its Review of Retail Life Insurance Advice released in October 2014, ASIC expressed concerns regarding the quality of advice being given by some financial advisers. It went on to recommend that insurers:

• Address misaligned incentives in their distribution channels.
• Address lapse rates on an industry-wide and insurer by insurer basis.
• Review their remuneration arrangements to support good-quality outcomes and better manage conflicts of interest.

It is also recommended  that the licensees would:

• Ensure remuneration arrangements support good-quality advice and prioritise client needs.
• Review business models to provide incentives for strategic life insurance advice.
• Review the training and competency of advisers.
• Increase the monitoring and supervision of advisers.

The Financial System Inquiry (FSI) report was released in December 2014. Relevantly, it included as Recommendation 24:

“Better align the interests of financial firms with those of consumers … and ensuring remuneration structures in life insurance … do not affect the quality of financial advice”

The FSI considered 'Legacy products' which are life products that are closed to new investors and have become uneconomic or rendered out of date by changes to market structure, Government policy or legislation. Such products increase costs to fund managers and life insurers. They can also prevent consumers from accessing better features in newer products.

Accordingly, the FSI recommended introducing a mechanism that would have facilitated rationalisation of genuine legacy products — that is, not simply those that are performing poorly — subject to a "no disadvantage test" for relevant consumers. It would also have provided tax relief to ensure consumers were not disadvantaged as a result of triggering an early capital gains tax event.

Trowbridge report

The catalyst for this report was the ASIC Review of Retail Life Insurance Advice of October 2014 as it criticised the quality of advice and misaligned financial incentives. In an immediate industry response, the Association of Financial Advisers and Financial Services Council (FSC) engaged John Trowbridge to chair the Life Insurance Advice Working Group in order to develop a set of independent recommendations on these issues.

The Trowbridge report, released in March 2015, considered industry practices within the Australian Life Insurance market. The report recommended:

• The imposition of maximum commissions.
• The offering of an Approved Product Lists and choice of insurer.
• A Life Insurance Code of Conduct.

Imposition of maximum commissions

The imposition of maximum commission terms for advisers (ie prohibition of volume based incentives to advisers) was recommended to sustain a competitive life insurance industry and a competitive financial advice industry. It would oblige the insurers to compete on products, prices and services to consumers through advisers and licensees instead of, as at present, by competing for the favours of licensees and advisers.

The report found that non-commission benefits commonly available (ie volume-based payments or shares) can create conflicts of interest for licensees that affect advised clients, because in effect the conflicts are transmitted to their advisers.

These practices are currently prohibited under the FOFA Legislation in respect of investment products, but life insurance products have been exempted from this prohibition. The relevant legislative clause prohibits benefits to licensees that can be expected to influence recommended investment product choices or the investment advice given by the licensee’s advisers.

Approved Product Lists and choice of insurer

The report recommended that all licensees operate an Approved Product List (APL) that contains a selection of life insurers from among the current list of 13 providers that service the retail life insurance market. Some licensees are currently tied to one insurer while some licensees have an "open architecture" approach that lists all 13 insurers.

An APL that provides good market coverage across life insurance providers was recommended to increase the level of product choice, market competition and consumer access to life insurance products and services including pricing, underwriting, administration and claims management.

It was recommended that Licensees need to strike a balance between a licensee’s desire to limit its APL so as to contain risk and administrative costs on the one hand and, on the other hand, the need for advisers to have adequate choice to meet their Best Interest Duty to their clients.

The report recommended that all licensees include at least half of all retail life insurance providers on their APLs. This recommendation was aimed at improving access to life insurance products for all advisers whose licensees currently have a narrow APL and encouraging all licensees to review their insurance APLs regularly.

On 3 November 2015, the Federal Government announced that the life industry would have responsibility for widening APLs through the development of a new industry standard. No further details of this standard have been publicly disclosed to date.

Life Insurance Code of Conduct

The report recommended that a Life Insurance Code of Practice (the Code) be developed and modelled on the General Insurance Code of Practice and aimed at setting standards of best practice for life insurers, licensees and advisers for the delivery of effective life insurance outcomes for consumers.

Currently, this code is in the process of being drafted. However, the recent issues with the management of life insurance policies have caused the Code to be reviewed and amended to respond to the current market.

The objectives of the Code are to commit insurers to high standards of customer service, and to improve trust and confidence in the industry. The Code will be an FSC standard, which means it is mandatory for all FSC members.

The Code will have extra robust governance via an independent governance framework, with compliance monitored by an independent committee of experts, including a consumer representative.

As part of the industry’s response to the Trowbridge review, the FSC had initially committed to having a Life Insurance Code of Practice in place by 1 July 2016. However, as already discussed, there was a double dissolution of Parliament and it still remains uncertain whether the Coalition will have majority support. Given the current uncertainty of the structure of our Government, it is remains unknown if and when the Code will come into effect.

ASIC Report 413 – Review of retail life insurance advice

Upfront commissions incentivising new business

The report found that high upfront commissions give advisers an incentive to write new business and "churn" customers. There is no incentive to provide advice that does not result in a product sale or to provide advice to a client that they retain an existing policy unless the advice is to purchase additional covers or increase the sum insured.

The key concern canvassed by this report was that a remuneration arrangement tied to a product sale creates an incentive for the adviser to make a sale, rather than provide non-product-specific advice or strategic advice for which the adviser may not be paid.

How AFSL licensees can manage the risk

ASIC recommends these risks must be actively managed by AFS licensees who must consider:

• Declining to provide advice if they cannot do so in compliance with the best interests duty and related obligations.
• Structuring remuneration arrangements so they receive some remuneration from clients for advice where there is no product sale.
• Structuring remuneration arrangements to minimise the effect of conflicts of interest and create financial incentives for advisers to meet compliance obligations.
• Ensuring they provide appropriate levels of training to improve adviser competence.
• Performing regular file audits.

Obligation to give priority to the client’s interests

The client priority rule means that an adviser must not recommend a product to create extra revenue for themselves where additional benefits for the client cannot be demonstrated. Such a conflict of interest cannot be managed; it must be avoided (see Regulatory Guide (RG) 175 at 175.367–175.382).

Issues to consider when giving life insurance advice

The report provides certain obstacles for arrangements where advisers may be tied to one insurer. Specifically, advisers and financial planners will be required to consider the following when giving insurance advice:

• What are the client’s objectives?
• What are the client’s financial situation and needs?
• Providing balanced scaled advice (ie give advice that is aligned with the clients objectives).
• Making a recommendation to retain a current insurance product (ie investigate what products fit needs, rather than what products are profitable to the adviser).
• Making a recommendation to pay for insurance from superannuation.
• Personal or general advice.
• Provide a Statement of Advice (ie this must set out the basis that the advice was given in accordance with ASIC regulations RG 175.159-196).

Statement of Advice: Disclosure of product range

The Statement of Advice (SOA) is already a mandatory requirement under ASIC regulations. A SOA must include the description of the product range of financial products and a statement on how the adviser has acted in the clients best interests.

Of particular importance is RG 175.161 which states that a SOA should clearly disclose if a providing entity’s recommendations are restricted to products from an Approved Product List. This is critical in complying with the best interests duty, where the advice provider’s AFS licensee has an approved product list (see RG 175.322–RG 175.330.).

In administering the law (and subject to RG 175.169–RG 175.171), ASIC will take the view that the SOA should normally include information about all the remuneration, commission and other benefits that the providing entity will, or reasonably expects to, receive for the advice.

ASIC Consultation Paper 245 – Retail life insurance advice reforms (Corporations Amendment (Life Insurance Remuneration Arrangements) Bill (the Bill) 2016)

Concerns addressing the quality of advice

The Government proposed to amend the Corporations Act 2001 (Cth) (the Corporations Act) to provide ASIC with a power to make a legislative instrument setting out:

• The maximum levels of upfront and ongoing commission payments permitted in relation to life insurance products (ie capped commissions).
• The amount of upfront commission to be repaid to life insurers under clawback arrangements.

Conflicted remuneration

Conflicted remuneration is already prohibited for investment products as discussed. However, advice in relation to life insurance is currently exempted from this prohibition. The Consultation Paper indicates that there have been specific recommendations about the need to monitor the quality of advice about the sale of life insurance.

Implementation of the reform proposals

The proposed final industry package of reforms (Reform package) was to commence on 1 July 2016 (prior to the double dissolution of Parliament). The proposals on commissions and remuneration of advisers included:

• A reduction in upfront commissions—starting with a maximum upfront commission of 80% of the first year premium to apply from 1 July 2016, decreasing to a maximum upfront commission of 60% of the first year premium to apply from 1 July 2018. Ongoing commission would be set at 20% from 1 July 2016.
• Clawback over two years to apply from 1 July 2016 as follows: (A) If a policy lapses or the premium decreases in the first year of the policy, the amount of commission to be repaid is calculated with reference to 100% of the commission on the first year’s premium; and (b) if a policy lapses or the premium decreases in the second year of the policy, the amount of commission to be repaid is calculated with reference to 60% of the commission on the first year’s premium.
• A ban on other forms of conflicted remuneration to apply from 1 July 2016.
• Life insurers to offer fee-for-service insurance products for advisers who wish to operate on a fee-for-service basis.

The Government proposed to amend the Corporations Act to:

• Remove the exemption for life insurance advice from the ban on conflicted remuneration under s963B(1)(b)—this means that benefits (commissions) paid in relation to life insurance products would generally be considered conflicted remuneration and therefore be prohibited.
• Enable ASIC, through a legislative instrument, to permit benefits (commissions) to be paid, if requirements are met relating to (i) the maximum level of commission paid compared to the premium payable (referred to as the "acceptable ratio’ in s963BA of the draft legislative amendments); and (ii) clawback arrangements (ie the amount of upfront commission an advice licensee or its representatives must repay to a life insurer under certain circumstances).

Other draft legislative amendments also cover scope of proposals, level of commissions, the 'clawback' provisions, 'grandfathering' provisions (which allow some commissions and some volume based payments), and amendments to section 912C of the Corporations Act requiring provision of information to ASIC in a specified manner.

Setting a maximum level of commission: ASIC proposed requirements

Under the terms of the instrument, ASIC proposed that, if a life insurer adopts an upfront or hybrid commission model, the commission levels would be set at:

• A maximum of 60% of the premium in the first year of the policy.
• A maximum ongoing commission of 20% of the premium in all subsequent years.

ASIC proposed a transition period of two years to allow businesses to move smoothly to the new regime.

Note: The term ‘premium’ includes the premium payable for the policy and any fees payable (e.g. policy fee and frequency loading), but excludes taxes imposed by the Commonwealth, or a state or territory (e.g. GST and stamp duty), in line with the definition of ‘relevant amount’ in the draft legislative amendments: see s963B.

The Reform package did not eliminate conflicts of interest in remuneration, given that an upfront commission of 60% of the first year’s premium will still be permitted.

Clawback arrangements

Under the terms of the instrument, ASIC proposed that, 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% of the commission paid in the first year will be repaid to the life insurer.
• In the second year of the policy—60% of the commission paid in the first year will be repaid to the life insurer.

This proposal intended to remove the incentive for advisers to inappropriately rewrite new business within a two-year period, which was said to lead to better outcomes for consumers.

ASIC indicated that the combination of the cap on upfront commissions and the clawback of commission over a two-year period should bring about better quality advice, as it significantly reduces the incentive for advisers to inappropriately switch a client’s policy.

Ongoing reporting to ASIC

ASIC proposed they would require detailed information:

• On life insurance policies (ie how many policies are in force; details of the policies in force; how many policies have been exited (and the reasons for the exit).
• Remuneration data (ie including historical data; type of remuneration model; and level of upfront and ongoing commissions).
• Lapse rates and clawback amounts.
• Data on policies (ie personal advice, general advice etc).

ASIC's rationale for requiring this information is based on monitoring changes in industry practice and to see whether advisers are rewriting business for their clients in order to get the (still relatively high) upfront commissions in the transition period, or whether the reforms are effective in removing the incentive to rewrite policies, and in creating a better environment for advisers to give good quality advice to their clients.

As already discussed, there has since been a double dissolution and the Bill for these amendments has ceased as Parliament was prorogued. This is discussed in more detail below. Although a new bill is likely to be introduced by a new government, it is important to consider the mindset of the government and regulators in order to prepare for potential regulatory changes which may affect the Australian life insurance market.

WHERE TO FROM HERE?

As discussed, there are various legislative and regulatory issues with the current retail life advice framework. It is evident that the best interests of the policy holder has sometimes been relegated as a secondary consideration as a result of current remuneration structures. This is at the very core of the proposed legislative amendments. At this stage, there is no certainty of what legislative changes may come into effect, or when, given the recent re-election of the Coalition government and their current priorities. However, it remains clear that legislators and regulators have identified systemic issues with the current framework, and it seems that they will put forth similar recommendations in future bills to evolve the current industry in line with the propositions discussed in in this update.

Materials consulted for this paper

The following documents have been considered for this paper.

• Insurance Contracts Amendment Act 2013.
• Insurance Contracts Act 1984.
• Explanatory memorandum for Insurance Contracts Amendment Bill 2013.
• Commonwealth Government Financial System Inquiry (FSI) Final Report - November 2014.
• APRA Inquiry into the Scrutiny of Financial Advice – Life Insurance Submission to the Senate Economics Committee April 2016 (APRA Submission).
• ASIC Consultation Paper 245 – Retail life insurance advice reforms (Consultation Paper 245)
• ASIC Report 413 – Review of retail life insurance advice (Report 413).
• Review of Retail Life Insurance Advice 25 March 2015 (Trowbridge report).
• Regulatory Guide 175 - Licensing: Financial product advisers—Conduct and disclosure (RG 175).
• Regulatory Guide 246 – Conflicted remuneration March 2013 (RG 246)
• Corporations Amendment (Life Insurance Remuneration Arrangements) Bill 2015 – Explanatory Memorandum (Explanatory Memorandum).
• Senate Notice dated 29 February 2016.
• Financial Services Council (FSC) press release dated 16 March 2016.
• This paper is not legal advice and has been prepared for research purposes.
• Industry’s election party may prove short-lived by John Wilkinson (insurancenews.com.au)