Insurers’ ‘race to the bottom’ putting the industry at risk

Duration discounting is the practice by which insurers will offer lower premiums in the first year and gradually increase them over time until they reach their actual base rate, often over a period of five or 10 years.

The rate of discounting can vary considerably depending on the insurer, with research from Skye Wealth looking at 10 Australian life insurers showing that a 40-year-old client may encounter an upfront discount ranging from anything between 9.0 per cent and 38.6 per cent.

While this may sound like a good thing as clients are paying less in premiums, at least initially, Skye Wealth founder Phil Thompson argued that the lack of disclosure by insurers about this practice, while not illegal, is certainly misleading for customers.

“So, the reason why it’s not good is because a lot of consumers and a lot of advisers don’t even know that duration discounting happens in the market because it’s really difficult to understand the actual discount,” Thompson told ifa.

“If I’m going to buy an Apple laptop, and I see that it’s normally $2,000 but today it’s $1,500 then great. I can see what the original price is and what the discount is today, and I also don’t need to purchase it once I’ve already bought it, but if I have to purchase it every year, I would want to know what the likely long-term cost is.

“And the insurance companies actually under disclose these discounts. Most of them don’t actually disclose it at all.”

Meanwhile, Thompson argued that this practice incentivises advisers to rewrite policies every 12 months, creating an unsustainable feedback loop.

“That’s bad because it’s very expensive to get a new client for the insurance companies. So, if every client did that, the models will break. It would blow up the whole industry,” he said.

While some may consider this a potential option, back in 2018, the insurance sector underwent the Life Insurance Framework (LIF) reforms that dropped initial commission for advisers to 66 per cent and trail commission to 22 per cent, following major concerns that advisers were churning out new policies to boost their income.

“Now, post-LIF, [commissions] have come down to disincentivise what they used to call ‘churn’, but now insurance companies have basically gone back to incentivising this churn behaviour,” Thompson said.

Why does it happen?

If duration discounting is harming the insurance industry, then why does it happen?

Answering this, Thompson explained that, because product recommendations are often made based on year one premiums, advisers are inclined to favour the insurer with the lowest cost, which in turn encouraged insurers to continue this practice.

“Because insurance companies know that, if they become the cheapest in year one, they will get the majority of new policies signed up. There is an argument that just the cheapest premium doesn’t necessarily automatically mean that you’re meeting best interest, but it is a very easy metric to prove that you’ve put the client in a better position if you’re saving them money,” he said.

“So, that’s why there is this race to the bottom. Who can have the cheapest year one premiums without, you know, completely blowing up their business?”

As time goes on, Thompson said this practice will inevitably drive up base insurance premiums for loyal policyholders, while feeding a vicious and ultimately unsustainable cycle of discounts for new clients.

“Sustainability means that we have X amount of policyholders paying Y amount in premiums, but it is not covering our claims liability, so the amount of claims that we need to pay out,” he said.

“If we can’t increase the pool, then it just means that we need to increase the premiums for everyone who’s still in that pool. What insurance companies will do is they’ll continue to have their new policy holders being as cheap as possible, and it’ll be subsidised by existing policyholders.

“So, if you hold your policy for a long time, you’re going to be paying for this unsustainable behaviour.”

So, what can be done about it?

While it may seem a simple fix – that insurers could simply stop offering this discount – Thompson suggested the situation is somewhat more complicated.

The issue is that no insurers would want to be the first to do so as they would likely see a steep decline in new policies.

Furthermore, if all insurers were to collectively decide to stop this practice, premiums would increase across the board and consumers could perceive this as a money grab, particularly as Australia is still in the midst of a cost-of-living crisis.

Beyond this though, it is possible that a collective decision to cease duration discounting by insurers could also be considered collusion or anti-competitive, risking the wrath of the Australian Competition and Consumer Commission (ACCC).

For advisers, if they were to stop recommending products offering a discounted rate, by default they would be suggesting a more expensive product by year one terms.

“If you are recommending a product that’s more expensive and therefore getting paid a higher commission, then there’s a much higher obligation to prove that you’re doing the best interest by your client, and not just, you know, making more money for yourselves,” Thompson said.

“The regulators yell at the life insurance companies for doing it. The life insurance companies yell at advisers for recommending it. And so that’s kind of the difficulty in this whole space; this negative downward spiral. We’re all pointing our fingers at each other, and no one really has the capacity or ability to properly solve it.”

While it would seem that advisers and insurers are stuck between a rock and a hard place, Thompson said a joint effort by the Australian Prudential Regulation Authority (APRA) and Australian Financial Services (AFS) licensees could be effective in addressing this.

“I think there is ability for APRA to have a cap on initial discounting. That’s a big solution. Another solution is for the AFSL to decide that we are not going to allow a life insurance company on our approved product list if they have an initial discounting over and above a certain percentage,” he said.

“[AFSLs] should also be considering how insurance initial discounting is appropriate or not appropriate, and discounting at 30 per cent or 40 per cent, which some insurers are doing, in my view, it is inappropriate.

“Those two industry players are really the only people who want it solved, or who have the ability to solve it, because insurance companies don’t want to do initial discounting. They don’t like these practices. Advisers don’t like it. An AFSL doesn’t have an individual best interest to that client, because they’re not the one sitting in front of their client, but they do need to protect their licensee.”