Saturday, April 21, 2012

Incentives Matter: Insurance, Banking and Performance Based Pay

One of the causes identified for the meltdown in the US property securitisation market – those CDOs, CDOs squared and the CDSs used to back them up – is that even when it was obvious that the US housing market was in trouble, commercial banks continued pushing for higher originations, and investment banks kept pushing out synthetic products to securitise them.

And the reason for that was simply because pay was tied to performance, which in this case involved pushing product out the door, whether or not it was in the long term interests of the employees and the financial firms doing the pushing, much less the investors doing the buying. As Charles Prince of Citi put it, “…as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

It’s a kind of madness akin to the mythical mass suicide of lemmings, or how seemingly sane ordinary people could perpetuate atrocities – it’s embedded in the environment in which people have to live in. These are the “rules” of the “game” and if you want to “get ahead”, these are the things you “have” to do.

Which brings me to this: I received an email from Kenny Peh on a complaint he made to the authorities regarding the practice of rewarding financial advisors on the basis of commissions. He asks to publicise this issue, so I’m reprinting his letter in full.

Ordinarily this isn’t something I would normally do, but its a fairly widespread issue, and something that will become more acute later on as Malaysia gains in affluence. It’s not on the level of the US sub-prime mess, but the principle’s the same – people respond to incentives, and perverse incentive structures begets perverse results that aren’t optimal for social welfare.

In this case, commissions paid to financial advisors and insurance agents ensures that the products “pushed” to consumers aren’t necessarily the ones best suited to their interests, but rather the ones that pay the highest. This is not to disparage the profession – I know many who can’t let go of their integrity that easily. But it only takes a few to bring down the reputation of all.

So here’s the letter in full:

Time for a revamp of the insurance/personal financial advisory industry

I believe that the insurance/personal financial advisory industry is due for a revamp.

How many insurance policy consumers know how much out of the premium amount is paid to the agents as commission? I believe not many people know.

As an example, to illustrate: Average commission breakdown over 6years for a plan: Year 1: 20%, Y2: 20%, Y3: 13.5%, Y4: 18%, Y5: 15%, Y6; 15%
So, if customer A bought an insurance plan of $200 premium monthly. $200 x 12mths x 20%=$480 commission for year 1 $200 x 12mths x 20%=$480 commission for year 2 and the list goes on for 6 years, where the total commission earned exceeds 100% of the annual premium paid.

To makes matter worst, there are various plans with different commission structures, and the insurance agents are financially encouraged naturally to sell financial policy with higher commission rates, which might not be the best policy for the client. Do people asks what are the various insurance plans available, and what are the commission structures earned by the agents for the various plans? Most industry practitioners I come across just push a single policy to the consumers as the "best" insurance policy available.

Recently, the Monetary Authority of Singapore (MAS, Singapore's Central Bank) started to engage in an exercise to revamp the personal financial advisory and insurance industry, and it is ampty called FAIR, which stands for Financial Advisory Industry Review ( More details can be found here: Financial Advisory Services: Putting the Customer First. link: It is very enlightening to read MAS's point of view and I encourage insurance policy consumers to read. There is a survey ongoing now in our neighbouring country up to 1 May 2012 to gather feedback from the Singapore public and a panel has been set up to study the impact.

FAIR aims to increase the professionalism, transparency and reduce the costs in the financial advisory industry to benefit consumers.

One of the proposed amendments in FAIR is to change the financial advisory industry from a commission based structure, to a fee/salary based structure.

Naturally, there will be resistance, as some people's rice bowl is threatened by the proposed revamp. I shall not provide argument for the proposed revamp here, as our neighbour down-south already have some good opinion articles for it:

Fee-Based Advisory Service the way to go

This move will eliminate the multi-tiered commission structures, reduce the costs, and hopefully eliminate the practices of selling financial/insurance plans that generates more commission for the agents, yet might not be the best plans for the consumers. The move will also encourage insurance agents to have deep knowledge about the products they sell, and be transparent with the pricing of such products. Besides that, it will also discourage the practice where some agency managers in the industry purely just recuit agents to earn a cut of the commissions, many of the agents fell for the trick of the easy, dangerous and greed driven material wealth motivational talk.

Recently, I have seen talents go to waste. Doctors, Engineers and other professionals that abandon their academic qualifications to pursue a career in selling insurance. In my opinion, the insurance industry is not a productive service to the society and nation as it does not generate external revenue to the country, instead, it just accumulates wealth to a selected few individuals. Countries such as the UK and Australia has noted the issue with a commission based structure and have since moved on to a fee/salary based structure in a bid to promote transparency and increase professionalism. One can argue that insurance is a beneficial product as it protects the consumers from accidental harm, and I agree with it. I am however against the practice of commission driven middle-men, and I would like to argue with a question: Why do we need middle-men ("insurance agents") to purchase life insurance? We can now purchase travel insurance and motor insurance through the internet online without middle-men, why can't we purchase life insurance online as well? I am sure the elimination of the commission driven middle-men will surely reduce costs to the consumers, and increase the insured ratio of the population. Supporting documents can be submitted online as well.

I hope Bank Negara Malaysia can take a proactive action similar to MAS and conduct a study on the feasibility of a similar revamp in the local insurance industry. If countries like the UK and Australia can do it for the benefit of consumers, why can't we?

Besides that, for the Ministry of Health, by reducing the cost of insurance coverage and raising the insured population is a good alternative to the proposal of a 10% deduction from basic salary for healthcare. This will prevent a negative impact to the economy due to lesser discretionary income.

Having said that, I believe that there are genuine financial advisors out there that sell personal financial products for the benefit of the consumers. If the above proposed revamp is adopted, it will change the mindset of the industry's practitioners, from being sales/comission driven, to be more client driven, where the insurance agents/financial advisors practice as a personal financial planner to their clients, and sell genuine financial plans and products that benefit their clients.

The objective of such a revamp is to: 1. Reduce the cost of insurance coverage to the consumers 2. Reduce healthcare cost related risk for consumers 3. Reduce the unethical practices by industry practitioners due to conflict of interest 4. Increase transparency in the industry 5. Increase the ratio of the insured population


Concerned citizen,

p/s: Addressed to: Bank Negara Malaysia ( Kementrian Kesihatan Malaysia ( Federation of Malaysia Consumers Association (


  1. I must say i absolutely agree. People now are more profit driven actually focus on the real product. Technical skills like engineers and doctors make real product that actually increases welfare of the people.

  2. Thanks Hishamh.

    I agree that the current system might not be optimal for social welfare.

    The key question to any proposed changes is this:
    Whether the Malaysian consumers are willing to pay an upfront fee for financial advices (fee based, instead of commission based).

    The financial advisors' responsibility is then to tabulate a few financial plans for the consumers to adopt (eg: for savings/retirement/protection etc). The informed consumers can then make their own purchase decisions later, directly from the companies itself. The role of the financial advisors is then to advice, not to sell, which I believe is better for services related to social welfare.

    Besides that, smart consumers can skip the process of seeking financial advisors' advice entirely, and directly purchase the policy/plans they require, which should reduce the costs for consumers.

    Appreciate comments for discussion.


  3. Hi Hishamh,

    I hope you don't mind me linking another blog here, but this guy really does argue very well for a fee-based model:

    It's in the Singapore context, but it applies to Malaysia as well.


    Best Regards,

  4. Why not have the insurance agent declare his commissions to the customer? Or maybe have a standardized system of agency fees, like how they do in stockbroking?

    At least the customers go in with their eyes open.

  5. Hi Roger,

    How do you want to enforce the declaration of commissions? It will be harder to prevent agents from selling a single plan (which pays best commission) than giving multiple choices.

    Note that the target here is also to reduce costs to the consumers.

    If there is a cheaper alternative, consumers would prefer that. Similar to the online purchase of travel insurance, stock transactions etc.

    Best Regards,

  6. Gentlemen,

    The answer lies in what the UK’s Financial Services Authority (FSA) is implementing in Jan 2013. As a mature economy and having had an IFA (Independent Financial Advisors) “industry” since time immemorial in the UK the FSA was in the same brain wavelength as Kenny circa 5 years ago. So to address this the concept of Retail Distribution Review (RDR) was hatched. The plan is to move all independent financial advisors to fee based and eradicate commissions. To make it more interesting advisors are also required to have a minimum qualification which is by UK standard in known as “Level4” i.e. Diploma and an advisor can go on to become chartered by undertaking for more exams after the Diploma level.

    With regards to fee, it should not be regarded as payment in advance but as a payment for an advice that warrants it. This way an advisor puts his(or her) clients interest first (whether he/she likes it or not). Think about the other professions and this will make sense. Also it enhances the professionalism of financial advisors and the perception of the consumers will change for the better.

    Pertaining to declaration of commissions, this is enforced by minimum standards that regulated firms are required to adhere to in “selling” to a client. From inception“suitability” letter is mandatory for all clients of any financial advisor. The FSA can at anytime pick an advisor for compliance check and if the required standard is not seen to be met, a hefty fine will duly follow and in some instances the advisor being struck off.

    I don’t know how regulated the financial advisory sector is in Malaysia, but Kenny brought to light a very important issue. All Malaysia has to do is look to policies and regulations that is being implemented elsewhere and adopt it for its own benefit. Why reinvent the wheel??

    By the way I am a Chartered Accountant a Malaysian residing in the UK and have my own accounting practice with an IFA department.

  7. Hi Kamal,

    Thanks for your insightful reply.

    I have a concern here, perhaps you can enlighten me on how the UK address this.

    Did the UK prevent the financial services companies from paying a "bonus/incentive" to the independent financial advisors for recommending a product of their company? If the practice is allowed, then it will defeat the independence of the financial advisors.

    I believe there are other areas to be addressed / fine-tuned as well.


    Best Regards,

    1. Hi Kenny,
      Well, “bonuses” per se are obviously not allowed otherwise as you have highlighted the independence goes out the window.

      However the industry has a culture of it inducements, incentives, etc , etc where financial advisors get certain privileges for example tickets to top events i.e. football, concerts, golf, cricket, rugby, the list goes on and on. Interestingly the criteria (if one can use this term) placed by the insurance companies are not performance based but if they feel you have the right attributes to deliver then you can drape yourself in your favourite teams gear (in my case Arsenal ) and wait for an invite to land on your table. I suppose there is nothing any regulator can do to police this practice as this is indeed very deep rooted in the City of London’s financial services culture. In fact you will agree that this practice perhaps goes on in any economy and in any industry. Unfortunately we humans live by the ethos “what’s in for me”.

      I agree that there are areas to be addressed and fine tuned and my strong view is for the starting point to be emphasised on the quality of product/service.

      If insurance companies and advisors strive to achieve top quality in everything they do then sooner or later you will have more business than you can handle. Interestingly price and quality have a habit to tango with one another...however any more on this topic is beyond the scope of this discussion.

      Think Apple (not the fruit) and it will make sense.

  8. Hi Kamal,

    Agree with your point of view, think Apple :)

    Now I just hope the authorities are willing to take some steps towards the benefit of consumers.


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