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.

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

Entrant income per year

Commission structure one

                                                                    Policy origin