House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Minister for Revenue and Financial Services, the Hon Kelly O'Dwyer MP)

Chapter 2 - Regulation impact statement

2.1 On 20 October 2015, the Government announced as part of its response to the Financial System Inquiry (FSI) that it would support the retail life insurance industry's proposed reforms as announced by the then Assistant Treasurer on 25 June 2015. In taking this decision and subsequent decisions on the details of the reform package, the Government was informed of the regulatory impacts of various reform options by the findings of three independent reviews as well as through targeted consultations with industry stakeholders.

2.2 The independent reviews of the life insurance remuneration arrangements are:

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Australian Securities and Investments Commission Report 413: Review of retail life insurance advice, October 2014 (ASIC Review).

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John Trowbridge, Review of Retail Life Insurance Advice Final Report, 26 March 2015 (Trowbridge Review).

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FSI Final Report, November 2014.

2.3 The reform package announced by the then Assistant Treasurer on 25 June 2015 was constructed on behalf of the life insurance industry by the Financial Services Council (FSC), the Association of Financial Advisers (AFA) and the Financial Planning Association (FPA). Targeted consultations with these stakeholders has been ongoing.

2.4 Treasury has certified that the independent reviews and consultations is a process and analysis equivalent to a Regulation Impact Statement (RIS).

2.5 The Australian Government Guide to Regulation identifies seven questions that a RIS should address. Following is a summary of the analysis of these questions that occurred as part of the independent reviews and stakeholder consultation process.

Problem

2.6 In 2014, ASIC undertook a surveillance to understand the personal advice consumers were receiving about life insurance and to identify opportunities to promote personal life insurance advice that is in the best interests of consumers. The findings from this surveillance were presented in the ASIC Review published in October 2014.

2.7 ASIC found unacceptable levels of poor quality advice, and a strong connection between upfront commissions, policy lapse rates and poor consumer outcomes. ASIC found that, overall, 37 per cent of the advice reviewed failed to comply with the quality of advice standard in force at the time the advice was given. The non-compliance rate for advice provided under an upfront commission model was even higher, with 45 per cent of this advice failing to comply.

2.8 The factors ASIC identified that affected quality of advice were:

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adviser incentives;

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inappropriate scaling of advice;

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lack of strategic life insurance advice;

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weak rationales for product replacement advice; and

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failure to consider the relationship between life insurance and superannuation.

2.9 After reviewing over 200 files, ASIC found that the way advisers were paid had an influence on the likelihood of their clients receiving advice that did not comply with the law. The prevailing form of remuneration was upfront commissions (in the order of 100-130 per cent of the premium), with an ongoing commission of around 10 per cent of the premium.

Need for government action

2.10 There have been many regulatory interventions by Australian Governments in recent years to help improve trust and confidence in the financial services industry and the quality of information for which consumers of financial services have access. Government intervention is justified because of the significant costs to individuals, the community and/or taxpayers that can result from poor information on the benefits and risks of financial services, including life insurance.

2.11 The problems associated with remuneration arrangements that involve commissions have been known for some time. Under the Future of Financial Advice (FOFA) reforms, conflicted remuneration, such as commissions, was prohibited.

2.12 However, benefits paid in relation to life insurance were exempt from this prohibition. The ban on conflicted remuneration does not apply to life insurance due to the features which make it unique from investment products, including the absence of investible funds from which to pay for advice and concerns around levels of underinsurance in the Australian community.

2.13 The evidence of poor quality advice found by the ASIC Review justified further efforts by the Government and the industry to reform the remuneration arrangements in the life insurance industry.

Policy options and likely net benefits of the options

2.14 The FSI drew on the ASIC Review to inform its consideration of the problem of poor quality life insurance advice. The FSI recommended the implementation of a 'level commission' structure, whereby the upfront commission is not greater than the ongoing commission. It was argued that:

'this would provide a balanced and cost effective approach to better align the interests of advisers and consumers. The remuneration model needs to be sustainable; otherwise there is a risk that providers may exit the market, making it more difficult for consumers to obtain life insurance advice.'

2.15 The FSI did not determine the percentage amount of the level commission that should apply in the life insurance sector as it considered that this should be left to the market and industry.

2.16 The Trowbridge Review recommended a remuneration model with the following key features:

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an Initial Advice Payment (IAP) of $1,200 or, for customers with annual premiums below $2,000, no more than 60 per cent of the first year's premium, payable once every five years; and

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level commission at a maximum of 20 per cent of the premium.

2.17 Additional elements included: a continuation of existing arrangements for retention periods ('clawbacks') on the first year commission and IAP; reforms to Approved Product Lists (APLs) and Statements of Advice (SoAs); and the introduction of an industry Code of Practice.

2.18 Trowbridge argued that if advisers did not receive an initial payment beyond the ongoing commission, there would be a substantial mismatch between initial advice costs and the initial payment to advisers. This could lead to large numbers of financial advisers ceasing to offer life insurance advice, with the diminished supply of advice likely to exacerbate the underinsurance problem in Australia.

2.19 On 25 June 2015, the then Assistant Treasurer announced the reform package that industry had developed following the recommendations made in the Trowbridge Report. The proposals on commissions and remuneration of advisers included:

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reduction in upfront commissions, going from a maximum upfront commission of 80 per cent of the first year premium from 1 January 2016, to a maximum upfront commission of 60 per cent of the first year premium from 1 July 2018. The maximum ongoing commission would be 20 per cent from 1 January 2016;

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clawback over three years to apply from 1 January 2016;

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ban on other forms of conflicted remuneration consistent with the FOFA reforms from 1 July 2016; and

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life insurance companies to offer fee-for-service insurance products for those advisers who wish to operate on a fee-for-service basis.

2.20 The Government also announced further proposals relating to APLs, SoAs and an industry code of conduct.

Consultation

2.21 The FSI took initial submissions on the issues set out in the inquiry's terms of reference and a second round of submissions in response to its Interim Report. In developing the Government's response, Treasury took submissions on the recommendations in the Final Report.

2.22 The Trowbridge Review received 137 submissions from the industry, consumers and other interested parties. Consultations were held with consumer groups, government agencies (ASIC, the Australian Prudential Regulation Authority and Treasury), individual advisers, licensees and insurance company executives.

2.23 The Government consulted on a regular basis with industry stakeholders throughout the policy development process. This included two industry roundtables involving the FSC, AFA and FPA following the Government's announcement of its response to the FSI to settle the final details of the reform package.

Agreed Option

2.24 On 20 October 2015, as part of its response to the FSI, the Government announced it would support the retail life insurance industry's proposed reforms as announced by the then Assistant Treasurer on 25 June 2015.

2.25 Following consultations with stakeholders on some outstanding issues, the Minister for Small Business and Assistant Treasurer announced the final reform package on 6 November 2015. This package included a revised commencement date of 1 July 2016, and a change to the clawback period from three to two years. The reform start date has subsequently been revised to 1 January 2018, following the lapsing of the Bill when the Parliament was prorogued on 15 April 2016.

2.26 A regulatory costing for the reform package has been prepared, consistent with the Government's Regulatory Burden Measurement Framework. These costs are summarised in Table 1, noting that the 2016 offsets for the chosen option will be found from with the Treasury portfolio.

2.27 For life insurers, implementation costs include: IT costs, and updating of internal policies and procedures, including training courses. There are ongoing costs associated with monitoring compliance with the new regulations.

2.28 For large and medium sized licensees, there are implementation costs associated with updating IT and other systems. It is assumed that small licensees do not have advanced IT systems and so the IT costs are not likely to be material. All licensees will have additional costs associated with monitoring compliance with the new regulations.

2.29 Individual financial advisers will incur a small cost associated with updating their knowledge of the remuneration arrangements, including clawback.

2.30 It is estimated that the increase in annual compliance costs for the industry as a whole is amount to $27.8 million.

Table 1: Regulatory burden and cost offset estimate table

Note: Offsets will be found for 2016 from the Treasury portfolio.

Implementation and Evaluation

2.31 Implementation of these reforms, which will commence on 1 January 2018, will be a joint effort between industry, ASIC and the Government.

2.32 The Government is amending the Corporations Act 2001 to give ASIC the power to create a legislative instrument to set caps on commissions and implement clawback arrangements. Ultimately, the final form of ASIC's instrument will be a matter for ASIC, as the independent regulator.

2.33 The FSC has responsibility for creating the Life Insurance Code of Practice. Similar to existing codes for Banking and General Insurance, the Code would set out best practice standards for insurers, including in relation to underwriting and claims management. This work is already underway.

2.34 ASIC will conduct a review in 2021 to consider whether the new industry arrangements for life insurance advice have better aligned the interests of firms and consumers. ASIC has consulted with industry to ensure appropriate and reliable data will be available to support this review. If the review does not identify significant improvement, the Government will move to mandate level commissions, as was recommended by the FSI.