Victimless Crimes IV: Chargebacks and Insurance Agents
The title of this article may be somewhat misleading, as nothing here is likely directly criminal. But I will try to shine some light on compensation practices in the life and health insurance sector. These compensation practices can be murky for the consumer. Even for insurance agents, I often hear in class from agents that they aren’t exactly sure how their compensation is structured. (I’m not sure how true this is; but I hear it often.)
In a future article, I will examine the amount of compensation tied to insurance product sales. For our purposes here, it’s useful to consider that the total compensation tied to a life insurance sale is roughly twice the first year’s premium. Some portion of that goes to various intermediaries, leaving an insurance agent typically with approximately one and a half times the first year’s premium as their compensation for selling a policy. This is roughly the same across all individual insurance lines. Group insurance premiums are substantially different; they are typically around 4-10% of the total premium paid.
Trailing commissions are also paid but represent only a fraction of the compensation paid up front. In the industry, this is known as a heaped commission.
Insurers take on a substantial amount of risk when issuing a new insurance policy. The worst case for an insurer is that a policy is issued and an expensive claim arises in the first 2-3 years after issue. The best case is that the policy stays in force for decades and is allowed to lapse with no claim. A bad case is that the insurer issues a policy, which is an expensive undertaking, and that policy lapses early after it’s issued. The insurer has paid marketing, administrative, and underwriting costs to issue that policy. Typically, the insurer needs the policy to stay in force for at least about 8 years to fully recover its costs.
To encourage agents to do good business, most insurers apply some sort of chargeback schedule. The most common form of these schedules would see that, if an agent sells a policy and that policy lapses in the first 2 years after issue, the insurer will recover any commission paid. This is usually not prorated and will simply represent the sum total of premiums paid.
My father sometimes tells a story of selling a policy in small-town Saskatchewan in the early 80s where the life insured died a few months after the policy was issued. The insurer paid the death benefit with no problems, but the chargeback schedule was still in force, and my father had to repay the commission earned on the policy. Insurers stopped applying chargebacks in these cases not long after.
The chargeback seems to be a positive step. It encourages agents to write good business and be active and concerned 'field underwriters’. They are supposed to represent the interests of the insurer when selling life insurance.
However, some bad practices do arise. Because the up-front commission paid to insurance agents is so lucrative, an occasional response to a missed premium payment is for the insurance agent to pay that premium. The math here is pretty easy – the commission paid was more than the few months of premium that would get the agent past the chargeback period.
This leads to an obvious conflict of interest, where the policy owner might be considered indebted to the agent. Is this premium payment a loan? Will the agent seek to recover it at some point? Did the agent really fulfill their obligations to the insurer as a field underwriter?
In the case of agents who come and go quickly from the insurance business, it can happen that a chargeback arises after an agent is no longer active in the business. That can lead to insurers recovering chargebacks from supervisors. For agents working in multi-level-marketing systems, this is a significant risk, as an agent could end up with chargebacks for policies they never sold.
I’ve always found chargebacks fascinating. Most agents are at least somewhat aware of the possibility, but I’ve run into numerous cases of agents getting burned when they didn’t have reserves available to manage a chargeback. I am often reminded of a former student who sold a very large policy (mid-6 figure commission) early in his time in the business, received the commission, and then faced a chargeback when the client discovered that one of his golf buddies could have sold (and ultimately did sell) him the same policy.
It's one of the many components of the insurance business that is widely accepted as ‘just the way things are’. Is it really the best way of doing things? Do we need heaped commissions in the insurance business? The group benefits space seems to do just fine with level commissions. I know that level commissions have been available in the past with little to no uptake, but I also know insurers didn’t necessarily do a great job of communicating these options.
Life insurance is a good and necessary product. I believe there is lots of opportunity to clean this business up. Fixing how agents are compensated is one such area.
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