Insurance Commission Regulation: Inappropriate and Undesirable

The continued existence in SA of insurance commission price control is the sole reason for yet another Commission of Enquiry. The Life Offices’ Association Commission of Enquiry into credit life / warranty commission regulation (CR) has as its first term of reference to establish whether commissions set by bureaucratic fiat rather than insurers are “appropriate”. The Enquiry is likely to find it almost impossible to respond fittingly to this question.

Without the free inter-play of manifold suppliers (insurers), intermediaries and consumers at widely differing times and places, neither the wisest man nor council of men has the ability to determine the correct price of any commodity or service. This is a well-established economic principle no longer debated in informed circles. Moreover, a one-size-fits-all price could never be “appropriate” in every circumstance.

CR interferes in the proper functioning of the insurance market. Insurance, which deals in the spreading of risks, is arguably one of the most complex of all commercial undertakings. Insurers will provide cover against risks based on complex assessments of myriad factors that could affect future events. Insurance intermediaries, (agents and brokers), are the interface between insurers and their customers. Traditionally, these intermediaries share in the risk analysis and placement process and their income is limited to a part of the premium paid, not to the greater general overheads of the insurer concerned. The usual practice is that the intermediary who introduces no business receives no income, he who introduces sound risks is well remunerated, and innumerable positions pertain in between. This ‘commission system’ holds distinct advantages, not only for the insurer but also for the consumer. It explains why the system originated centuries ago and why it persists in most countries today.

Who should determine the amount of the premium to be charged and the amount of the intermediary’s commission? Should it be distant bureaucrats, or should it be the buyers and sellers of insurance on the spot in an open and competitive market? The observed unintended consequence of CR is that it ultimately harms the people it seeks to assist. It tends to reduce inter alia competition between insurance companies and between intermediaries. Moreover, it tends to curtail the number of new competitors entering both sectors. Hence, in its March 2006 Discussion Paper, Contractual Savings in the Life Insurance Industry, the South African Treasury noted that: “The modern global trend concerning commission is one of deregulation combined with increased disclosure. Australia, Austria, Canada, Denmark, Japan, Singapore, Uganda and the United Kingdom, for example, do not limit commission (or insurer charges) in any way”. This trend, more latterly also recorded in World Bank surveys, is in line with a worldwide shift towards greater economic freedom and increasing ease of doing business. This in turn translates into greater competition and greater consumer choice (ie protection).

No economic activity functions effectively unless, within that activity, the ultimate determinant of prices is the value judgements of the consumers themselves. Government planners do not have, nor can they obtain, the necessary minute-by-minute, day-by-day information required to emulate the functioning of an efficient market. These consumer choices determine the prices that guide all production and delivery of goods and services, including insurance - except when politicised non-economic forces intervene.

Ill-considered as it is, CR is simply price control of insurance distribution costs. It has the same effect as price controls on all other goods and services. Purchasers of insurance receive less service than they would otherwise because of a reduction in the number of intermediaries, or they end up paying more for insurance because the regulated commissions ultimately result in higher total costs to them than would have been prevalent in a regulation-free market. Price control either leads to a reduction in supply because some suppliers withdraw from the market, or it leads to higher costs for the consumer because the price-controlled product is sold at a higher price than would have been charged in an openly competitive market. This was well demonstrated when decades-long SA price control on carbonated soft drinks was lifted and prices immediately fell, showing that the responsible government officials had unknowingly been sheltering less efficient producers.

Freely formed prices are the key attribute of an economic environment that will best serve the wishes of consumers and most efficiently guide the utilisation of resources. Commissions paid to insurance intermediaries are prices – they should be determined by the purchasers of insurance policies, not by regulation. The Treasury’s Discussion Paper notes that it is a modern global trend not to limit commission in any way. There are valid economic reasons for this trend, which SA should recognise forthwith.

Quite apart from the abovementioned evils, CR has had the following additional negative consequences:

1. It makes criminals of persons in the insurance industry engaged in commission negotiation that, in any other industry, is considered to be an entirely legitimate business practice.

2. The ostensible objective of CR is to benefit consumers. There is little to suggest that in over three decades CR has had the slightest impact on reducing the cost of insurance to consumers.

3. CR has played an appreciable role in preventing insurers from supporting the establishment of emergent new brokers.

4. CR is readily and legally circumvented by the established sophisticated institutions through the simple expedient of obtaining their own insurance licences (most banks now have their own), ‘cell-captives’, re-insurance brokerages and countless others besides.

5. Insurance supervisors, including a recently retired SA registrar, have openly admitted that CR is impossible to police and therefore makes a mockery of the law. Hence the fact that there is no CR in other leading jurisdictions.

6. Consequent to the above, consumers enjoy little protection from CR, whilst some large institutions earn more to the detriment of a competitive market and the smaller new entrants.

In sum, insurance commission regulation has not in 31 years had the desired effect on consumer protection, has apparently made criminals of otherwise respectable businessmen, may be readily circumvented by the sophisticated, has been detrimental to the emergence of new intermediaries and is largely impossible for regulators to police.

Commission regulation cannot be considered appropriate or desirable and should be scrapped in favour of industry-driven disclosure (and therefore regulation by consumers) of all insurance costs, not just intermediary commissions.

Author: Leon Louw is the Executive Director of the Free Market Foundation. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author’s and are not necessarily shared by the members of the Foundation.

FMF Feature Article/ 16 October 2007