#9 | Levelized Commission

Strange, irrational things sometimes proliferate and thrive simply because the cost (politically, socially, monetarily) to change them is astronomical. The Internal Revenue Code is a senselessly convoluted hodgepodge creating all sorts of counterproductive incentives and yet throwing it out the window would impose an apparently unbearable amount of change on business and individuals who are currently taking advantage of its provisions. The QWERTY keyboard was designed originally to slow down typists so that the typewriter ink wouldn’t smudge – hardly a problem in today’s world. And yet I can’t imagine typing this sentence with any other key arrangement and probably never will. The FAA is still using radar because the cost to switch to a more efficient and safer GPS based system is too high. And life insurance carriers are still paying most of the commission in the first policy year. Why?

High first year commission (FYC) causes all sorts of financial strain. Carriers pay out somewhere near 130% of Target after accounting for agent direct compensation (90%), brokerage and aggregator commission (30%) and compensation for sales people inside the company (10%). That’s a massive cash drain that carriers compensate with higher fixed charges in the early years – usually about $2.5 for every $1 of first year Target. FYC also requires a substantial surrender charge to ensure the carrier is repaid if the client surrenders or exchanges the policy. Due to a change in accounting rules, FYC has a more direct adverse impact on earnings than it used to. And FYC also means that carriers have to dig deeper into their capital to fund the reserve requirements in the first year because more cash went out the door than was received.

I think FYC is also becoming a bigger issue as carriers try to switch sales to non-No Lapse Guarantee products. The beauty of a No Lapse Guarantee product is that commission is baked into pricing along with a host of other factors. The highest commission NLG isn’t always (or even often) the most expensive. If the main decision factor is price, and it almost always is with NLG, then commission will sort itself out. A producer who pushes a higher commission product that’s also higher priced runs the risk of another agent stepping in with a better deal. But with non-NLG products, pricing is more transparent because the focus is also on cash value. Or, in other words, commission recapture charges are obvious in non-NLG products but not obvious in NLG. Big commissions have consequences but producers also have leeway to justify a high commission product by focusing on hypothetical, illustrated product performance way down the line. My hypothesis is that the switch away from NLG products and towards cash value products begs the question – why are cash values so pathetic for almost a decade in even the best products? Put yourself in the client’s shoes: “so let me get this straight, this product has variables that can change at the carrier’s discretion and I can’t pull my money out for 10 years without losing my shirt?” I’d be skeptical of that deal, too.

And changing commission payments could basically get rid of that problem. My proposal is pretty straightforward – pay commission for 10 years (or longer) with premium thresholds. If the client decides to stop funding it prior to 10 years, commission stops. If the policy is surrendered, commission stops. A simple structure but the impact on pricing would be profound. If the carrier chose to allocate a 1-to-1 policy charge for the commission, surrender charges would cease to exist and would save the client roughly $1.5 for every dollar of Target. Products would generate better cash value faster which could, in turn, mean lower lifetime premiums.

What if an agent wants all of the commission in the first year? Third party vendors (or carriers themselves) could front agents commission if they so desired at a calculated present value and with clawback provisions. That would open up a whole new market for financing providers to compete to provide the best terms to agents with the risk now resting on a third party rather than the carrier who forced the policyholder to compensate for it. The same logic applies to firms who might be interested in purchasing a life sales firm and now can count on a stream of renewal revenue. Life agents could actually divest of their firms for cash rather than just closing the doors.

Switching to this commission strategy would also have some other positive effects. My bet is that more life insurance would be sold because more clients would feel comfortable with higher early values. Making commission contingent on persistency would also weed out many of the aggressive sales strategies that work well on paper but fall apart in reality. It might also make financial advisors more comfortable with selling life insurance because the compensation schedule more closely approximates other financial products. In short, I’m arguing that switching to levelized commissions would meaningfully improve value for consumers, open new markets, push out most of the shadiest sales practices and relieve much of the strain FYC places on carriers and is currently passed on to policyholders at an exacting price.

But everyone says commission will never change. Levelized commission has been proposed for a long, long time and hasn’t happened. I’d like to think times have changed, although I’m probably wrong. Past attempts at levelized commission haven’t produced gains for consumers because the products also had a heaped option, so the carriers couldn’t make the levelized version obviously better than the heaped one. I’m arguing for a wholesale jump into levelized commission where the heaped option is handled by a third party. I think other factors are also at work. Producers are getting older and want value in their practices – value which FYC can’t deliver. Carriers are hard pressed to make FYC economics work when interest rates are so low and it attracts so much fickle business. Distribution companies are desperate for ways to differentiate themselves and offering a levelized commission product with powerful consumer value could do the trick.

On a final note, if you read this and you like the idea of having levelized commissions, tell all the carriers you work with. The most common argument I hear against levelized commission is that agents don’t want it. Prove them wrong.