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1 F I N A N C I A L S E R V I C E S B O A R D Rigel Park 446 Rigel Avenue South Erasmusrand Pretoria South Africa PO Box Menlo Park Pretoria South Africa 0102 Tel (012) Fax (012) info@fsb.co.za Int Int Toll free Internet: Enquiries: Deon van Staden D. Dialling No.: Our ref: 10/6/4 Fax: Date: 18 July deonv@fsb.co.za MEMORANDUM ON THE PROPOSED AMENDMENTS TO REGULATIONS TO DEREGULATE THE MAXIMUM COMMISSION PAYMENTS IN THE INSURANCE INDUSTRY ( DECAPPING OF COMMISSION ) 1. PURPOSE The amendments to the regulations to enable decapping of commissions are attached to this memorandum as explained in paragraph 12. The purpose of this memorandum is to solicit comments on the proposed amendments having regard to the background information provided in this memorandum. 2. INTRODUCTION 2.1 In both the long- and short-term insurance industries in South Africa, commission payable, by or on behalf of, insurers for the sale of insurance products are regulated by law by imposing a maximum level of commission calculated as a percentage of premium (also referred to as capping ).

2 2.2 During 1999 the Financial Services Board (FSB) prepared and widely circulated a consultative paper on the continued regulation of maximum commission. After consideration by the FSB as well as both the advisory committees on longand short-term insurance, respectively, a proposal was submitted to the Policy Board for Financial Services and Regulation (the Policy Board ) to do away with the statutory regulation of maximum commission. The Policy Board approved this in principle. It was however agreed that comments on the draft amendments to the regulations would be sought in the context of a full explanation of the development of the proposal. 3. BACKGROUND 3.1 The commission payable in both the insurance industries was not regulated until In that year the minister issued regulations that enabled the regulation of maximum commissions in terms of the Insurance Act, Maximum commission regulation was introduced as a result of unjustifiably high rates of commission and the continued escalation thereof due to a broker driven market. 3.3 Until the two new insurance acts came into operation on 1 January 1999, no legislation existed which compelled the insurers or intermediaries to disclose to the insured what commission was being paid to the intermediary for effecting, maintaining and servicing a policy. The new acts now make provision for the introduction of the Policyholder Protection Rules which will legally compel the insurers to give full disclosure to policyholders once implemented. The proposal has therefore been developed on the basis that there will be full disclosure before any alteration to the commission regulations. 4. STRUCTURE OF THE REGULATION

3 4.1 The commission regulations in terms of the Long-term Insurance Act, 1998 and Short-term Insurance Act, 1998 have a number of salient features. These include provisions that commission may only be paid in cash and that it may only be paid, in the case of short-term insurers, on an as and when basis save for some exceptions. Thus commission becomes payable as soon as the premium is received. In the case of long-term insurance, commission may be paid up front but subject to certain conditions. However in the case of any premium being reduced, refunded or if a policy is made paid-up or surrendered early, the commission not earned should be reversed ( claw back ). Maximum levels of commission are set for various types of policies except for assistance business. It is a criminal offence to make a payment that exceeds the prescribed maximum limit. 4.2 Reinsurance business is not subject to commission regulation. 5. INTERNATIONAL APPROACH 5.1 In most developed countries regulation has shifted away from price control to a regulatory regime where the emphasis is on disclosure. For example Lloyd s has pointed out that South Africa is the only one of one hundred countries in which they do business, where commission is subjected to maximum limits. 5.2 The IMF/World Bank conducted a financial system stability assessment of the South African financial sector recently. This assessment indicated that one of the main weaknesses of the South African regulatory framework is the continuing regulation of maximum commissions in the insurance industry. 6. THE DIFFERENT OPTIONS

4 The previous consultative process produced three different options, namely: 6.1 keep the status quo, at least for a number of years, while consumers are being educated; 6.2 remove the maximum limits on single premium business in the long-term insurance industry and keep the maximum limits on recurring premium business (at least, again, for a number of years while consumers are being educated). The partial capping proposal; or 6.3 remove the maximum limits on all types of policies after the disclosure regime has been introduced. 7. OPTION 1: KEEP THE STATUS QUO 7.1 Advocates of keeping the status quo were mainly the Consumer Institute of South Africa ( CISA ) and some of the insurance companies. 7.2 The most important arguments in favour of commission capping are: The socio-economic status of the majority of South Africa s population and the lack of business education and negotiating skills on the part of the majority of South Africa s population, call for a responsible and visible form of protection. Consumers must first be put in a position and educated to negotiate the commission up to a regulated maximum level for all types of policies. The decapping of commission should only be considered after independent evidence that the consumer has been properly educated to negotiate and could demand better service and more choice at lower cost It is undesirable for insurers to be competing for business by offering higher commission rates to intermediaries. In some instances, insurers are forced by the strong domestic broker fraternity to pay unreasonably

5 high commission. The South African insurance market already charges inadequate premiums for risk and decapping commissions will exacerbate the problem which could eventually lead to certain insurers becoming financially unsound The capping of commission protects the policyholder against unduly high charges in that insurers do not compete for distribution channels. Instead, insurers would focus their competitive efforts in more relevant dimensions of business, such as cost and scope of cover and the service they render Insurers and intermediaries have more knowledge and are in a better negotiating position than the consumer. Financial contracts are often very complicated and consumers are not able to make comparative product evaluations and negotiate a meaningful and equitable commission payment Consumers need to be protected against unscrupulous intermediaries who are driven by personal objectives where consumers interests are not best served International examples indicated that decapping results in a trend of rising commission The costs associated with shopping around for best value and advice are prohibitive for most consumers The higher commission charges could make insurance unaffordable for the emerging market consumer and may result in insurers withdrawing from the market altogether. 7.3 Some commentators proposed that the current limits should be lowered.

6 7.4 Despite the relevance of some of the points, the continued capping of commissions was rejected for the following reasons: The South African economy is essentially a free market economy where prices of goods and services are determined by supply and demand. The capping of commission goes against the principle of a free market system and is an intervention which inhibits free market forces from determining the appropriate levels of commission The existence of commission limits has led to an environment of noncompliance benefiting circumvention to the detriment of those who remain compliant. It places the industry and supervisor in an adversarial relationship adding to the cost of supervision. The limits are not conducive to creating a culture of compliance because the methods of circumvention can be easily concealed and there is no cost effective way of detecting circumventions and enforcing compliance Commission and charges on similar types of retail products in other industries such as unit trusts are already not subject to limits. Retaining the caps could lead to undesirable arbitrage The regulatory cap on commission stifles innovation and competition as well as the ability of insurers and intermediaries to co-operate to provide efficient services, especially in the current technology orientated market and changing distribution systems No major countries with significant financial services markets retain a regulatory approach which caps commission The focus on disclosure together with consumer education will foster the development of a healthy and vibrant retail market.

7 7.4.7 The proposed legislation on the regulation of intermediaries will restrict the operations of unscrupulous intermediaries in the markets Although it was always possible under the existing capped regime to negotiate commission, the commission charged was usually the maximum irrespective of the level of service. Only if consumers are made aware that there is no fixed rate of commission, will they avail themselves of their right to negotiate commission In an environment where the maximum becomes the norm, no consideration is given to the quality of the intermediary service rendered It is not possible to forecast the short-term effect of costs on the lower end of the market. However, it is expected that service providers will continue to provide products to serve these markets at an acceptable price. As long as the demand exists there will be competition to supply it Although overseas experience showed that commission rates per policy rose initially when caps were removed, the trend was reversed later on due to market forces and the aggregate cost for the industry/consumer actually came down over time as market forces impacted on, and increased the efficiency of the markets. 8. OPTION 2: THE PARTIAL CAPPING PROPOSAL IN THE LONG-TERM INDUSTRY 8.1 This option is only applicable in the long-term industry and was advocated by the Life Offices Association of South Africa ( LOA ). One commentator in the short-term industry proposed that personal lines business remains capped but commercial lines be net rated.

8 8.2 The option entails the removal of caps on lump sum and pensions business, while retaining the caps in those areas where there is an overwhelming risk attached to the sudden removal of caps, in particular on ordinary recurring premium business. 8.3 The important arguments in favour of such an approach are: The South African market consists of a relatively small number of consumers who are financially sophisticated and well informed, and a huge mass market of relatively unsophisticated consumers. This is exacerbated by extremely wide geographic dispersion, multiple languages and a history of unequal access to formal education. These unsophisticated consumers need protection It is argued that lump sum policies are normally acquired by the more sophisticated consumer who, with the proper disclosure, does not need costly protection. 8.4 Although this proposal has merit, all the arguments against retaining caps would still apply if some but not all insurance business was subject to a limit on maximum commission. It is therefore better to deregulate entirely rather than a partial regime requiring enforcement. 9. OPTION 3: REMOVE THE MAXIMUM STATUTORY LIMITS ON ALL TYPES OF POLICIES 9.1 This option was favoured by the intermediary associations and some insurers. 9.2 Although favouring decapping, the Financial Intermediaries Federation of South Africa ( FIFSA ) was nevertheless prepared to consider functioning under the partial capping framework as proposed by the LOA, but suggested that the practice of

9 paying a fee, in addition to the regulated maximum, for certain services rendered by intermediaries be clearly legitimised as part of the process. This should, however, only be for a restricted or phase out period. 9.3 Arguments in favour of this scenario were positive expressions of the arguments raised against keeping the status quo, as expressed in paragraph OTHER INFORMATION To assist in the evaluation of the above arguments, the following information should be noted: 10.1 Disclosure regime will be introduced with substantial support from the industry; 10.2 Most commentators favoured ultimate decapping - differences centred around the timing; either immediately (the big bang approach) or only after a period of times Five years or longer were suggested by some commentators The South African Insurance Association ( SAIA ) surveyed their members in 1999 and reported that of the 49 companies involved: - 21 (43% in number and 63% in premium income) favoured continued regulation of maximum commissions; - 13 (26% in number and 11% in premium income) favoured a phased out approach; and - 15 (31% in number and 26% in premium income) were in favour of full decapping.

10 10.4 The partial capping proposal in respect of the long-term industry implies that approximately 75% of the new business in number of policies and 25% in premium volume, would still operate within the capped environment. 11. RECOMMENDATIONS 11.1 Financial Services Board (FSB) The FSB s preferred position would be to have a dispensation under which commissions are decapped together with an appropriate compulsory disclosure regime. The FSB is also of the opinion that commission on all kinds of policies should be decapped and that it should be with immediate effect and not phased out over a period of time Certain aspects of commission should still be regulated, i.e. commission may only be paid in cash and unearned commission should be reversed The Policyholder Protection Rules published in terms of sections 55 and 62 of the Short- and Long-term Acts respectively, require, inter alia, full disclosure of commission. It is anticipated that these rules will be implemented by October / November Advisory Committees and Policy Board The Advisory Committees on Long-term and Short-term Insurance were consulted on the matter. Both committees concluded that de-capping is inevitable but views on the process of implementation and timing thereof differed. The Long-term Advisory Committee made the comment that retaining the capping at the lower end of the market as well as for recurring premium business, especially for credit and funeral insurance was desirable. Ultimately, however, the majority view was that the big bang approach in a totally decapped environment be followed.

11 The Policy Board also approved the total decapping of commission, provided disclosure measures, supported by consumer education, are put in place. 12. PROPOSED AMENDMENTS TO LEGISLATION To enable the FSB to implement the proposal of decapping of commission, changes need only be made to the regulations under the Long-term Insurance Act and Shortterm Insurance Act. The proposed changes to the regulations are attached hereto. The proposed changes will become effective on a date to be determined which will not be before the coming into operation of the Policyholder Protection Rules referred to above. The Policyholder Protection Rules will create an environment where there is compulsory disclosure of commission in a capped environment. The regulations will be in terms of section 70 and section 72 of the Short-term and Long-term Insurance Acts respectively, and shall, if approved by the Minister of Finance, be published in the Gazette.

12 13. COMMENTS REQUESTED You are invited to finally comment on the rationale of commission decapping as well as the attached proposed changes to the regulations. Kindly submit your comments, by not later than 15 September 2000 to: Yours sincerely Deon van Staden Financial Services Board P O Box MENLO PARK 0102 TEL: (012) FAX: (012) deonv@fsb.co.za A SWANEPOEL DEPUTY EXECUTIVE OFFICER: PROVIDENT INSTITUTIONS

13 DEPARTMENT OF FINANCE FINANCIAL SERVICES BOARD AMENDMENT OF REGULATIONS UNDER THE SHORT-TERM INSURANCE ACT, 1998 (ACT NO. 53 OF 1998) The Minister of Finance has made the regulations in the Schedule under section 70, read with section 48 of the Short-term Insurance Act, 1998 (Act No. 53 of 1998). SCHEDULE Definition 1 In these regulations the Regulations means the regulations published under Government Notice R of 27 November 1998 Substitution of Part 5 of the Regulations 2 Part 5 of the Regulations is hereby amended by the substitution of the following Part 5- PART 5 REMUNERATION TO INTERMEDIARIES (SECTION 48) General limitations 5.1 (1) No consideration shall, in respect of short-term insurance business carried on in the Republic, directly or indirectly, be provided to, or accepted by or on behalf of, an independent intermediary for rendering services as intermediary, otherwise than by way of commission in monetary form. 1.No commission shall be paid or accepted otherwise than in accordance generally with this Part read with the written agreement entered into by the short-term insurer or Lloyd s broker with the independent intermediary which determines the basis on which the commission will be calculated with regard

14 to a specific policyholder or product of the short-term insurer or the Lloyd s broker. (3) Commission shall not be paid or accepted before the date on which the premium in respect of which it is payable has been paid to the short-term insurer or Lloyd s broker. Reversal of commission 5.2 If a premium or any part thereof is for any reason refunded by a short-term insurer or Lloyd s broker, the commission payable in terms of this Part in respect of that premium, or the part of that premium, which is so refunded, shall be refunded, to the short-term insurer by the person to whom it was paid. oooooo EXPLANATORY MEMORANDUM TO THE PROPOSED AMENDMENT OF THE

15 REGULATIONS UNDER THE SHORT-TERM INSURANCE ACT This explanatory memorandum relates to the attached amendment. (a) Current position Presently maximum commissions are prescribed by regulation which can be paid by the short-term insurers and Lloyd s brokers to a person for rendering services as an independent intermediary. (b) New approach The regulation is substituted with a new regulation which no longer prescribes maximum commissions that can be paid for services rendered as an independent intermediary. Commission will now be a part of the marketing process and should be determined by assessing the value of the service that has been rendered. Shortterm insurers and Lloyd s brokers will also have to keep written records on the prearranged commission payments negotiated with each independent intermediary regarding a policy sold to a specific policyholder or with regards to a specific product. The written records are necessary since the authorities will have to supervise the full disclosure of inter alia commission to be paid, that will follow with the implementation of the Policyholder Protection Rules. Commission payments will have to be a predetermined amount which should not be manipulated once the policy has been sold. Independent intermediaries will still have to reverse commission if premiums are refunded. (c) Reason The fact that the maximum commission payments were regulated with the intention to protect the policyholder, had the effect that most policyholders are unaware of commission payments to intermediaries. Controls on remuneration cannot, entirely protect the public, because while legislation can help to reduce the incentive for unethical behaviour, it cannot ensure its elimination. Different types of policies offered by the same insurer carry different rates of commission and amounts of commission vary directly with the size of policies. Consequently, as in the case of many other products, there will always be scope for intermediaries, whether company representatives or broking firms, to recommend the types or size of policy which are most rewarding to themselves. Whatever steps are taken to safeguard the interest of the insuring public, it is important for them to realise that, as in any other business transactions generally, they must accept responsibility for exercising judgement and care in what they are buying. Compelling insurers to disclose particular information, will assist significantly to focus the minds of consumers on what is relevant to their decisions and as such will serve as a valuable instrument in educating policyholders. The proposed Policyholder Protection Rules to be implemented soon will ensure full

16 disclosure of the product which the policyholder or the potential policyholder are buying from the insurer and will therefore fulfil that very important role of making information available to the client to put him/her in a position to make an informed decision. Although we do not see this as a complete answer to all problems, we regard it as probable that the advantages that can be expected to flow from a system of full disclosure will exceed the disadvantages, taking into account the manipulation that is taking place of the regulations currently in place and the costs involved in the supervision thereof.

17 DEPARTMENT OF FINANCE FINANCIAL SERVICES BOARD AMENDMENT OF REGULATIONS UNDER THE LONG-TERM INSURANCE ACT, 1998 (ACT No. 52 OF 1998) The Minister of Finance has made the regulations in the Schedule under section 72, read with section 49 of the Long-term Insurance Act, 1998 (Act No. 52 of 1998). SCHEDULE Definition 1 In these regulations the Regulations means the regulations published under Government Notice R of 27 November 1998 as amended by Government Notice No. R. 197 of 1 March 2000 Substitution of Part 3 of the Regulations 2 Part 3 of the Regulations is hereby amended by the substitution of the following Part 3- PART 3 Definitions REMUNERATION TO INTERMEDIARIES (Section 49) 3.1 In this Part, unless the context otherwise indicates- Commission-paying term" in relation to a multiple premium policy, means the whole period during which an amount or several amounts of commission are payable by the long-term insurer to the independent intermediary and which period has to be determined in writing by the long-term insurer and the independent intermediary; Independent intermediary means a person, other than a representative, rendering services as intermediary; policy means a long-term policy other than a reinsurance policy; premium, in relation to a premium period, means the premium which is payable and received under a policy that does not include any fee charged to the policyholder by the independent intermediary; premium period, in relation to a policy, means one of a succession of periods of time, each of 12 months duration, the first of which commences on, and ends 12 months after, the date on which the policy is entered into or, if it is a later date, the date on which the obligation of the long-term insurer becomes operative;

18 rendering services as intermediary means the performance by a person other than a longterm insurer or a policyholder, on behalf of a long-term insurer, of any act directed towards entering into, maintaining or servicing a policy; representative means a person- (a) employed or engaged by a long-term insurer for the purpose of rendering services as intermediary only in relation to policies entered into or to be entered into by- (i) that insurer; (ii) another insurer which is a subsidiary or holding company of that insurer; or (iii) another insurer which has entered into a written agreement with that insurer in terms of which persons employed or engaged by that insurer may render services as intermediary in relation to the other insurer s policies; and (b) on conditions of employment or engagement complying with the principle of Equivalence of Reward, in terms whereof the remuneration paid by an insurer, whether in cash or in kind, shall substantially be in accordance with this Part. General limitations 3.2 (1) No commission shall be paid or accepted otherwise than in accordance generally with this Part read with the written agreement entered into by the long-term insurer and the independent intermediary which determines - (a) the basis on which the commission will be calculated; (b) the commission-paying term ;and (c) the timing when the predetermined amount of commission is to be paid by the long-term insurer, with regard to a specific policyholder or product of the long-term insurer. (2) No consideration shall, directly or indirectly, be provided to, or accepted by or on behalf of, an independent intermediary for rendering services as intermediary, otherwise than by way of the payment of commission in monetary form. (3) Commission shall not be paid or accepted - (a) unless the first premium period has commenced; and (b) the first premium which is payable has been received. Adjustment and refund of commission 3.3(1) If a premium or any part thereof is for any reason refunded by the long-term insurer within the first two premium periods of a policy or, in the case of a multiple premium policy for any reason not paid on its due date, including that the policy has been made paid-up or surrendered, but excluding termination upon a health event, a disability event or the death of a life insured during the first two premium periods in the case of a policy, the commission payable in terms of the agreement referred to in regulation 3.2(1) shall be recalculated by reference to the following scale and shall not exceed the percentage of maximum commission in column A or B, respectively, and any amount of commission which has already been paid in excess of the commission as so recalculated shall be reversed by the long-term insurer and refunded to it by the person to whom it was paid: 18

19 Premiums received with an equivalent value to monthly premiums for- Column A Maximum percentage of first premium period commission payable Column B Maximum percentage of second premium period commission payable 0-6 months Nil not applicable 7 months 29,17 not applicable 8 months 33,33 not applicable 9 months 37,5 not applicable 10 months 41,67 not applicable 11 months 45,83 not applicable 12 months 50 not applicable 13 months 54,17 8,3 14 months 58,33 16,7 15 months 62, months 66,67 33,3 17 months 70,83 41,7 18 months months 79,17 58,3 20 months 83,33 66,7 21 months 87, months 91,67 83,3 23 months 95,83 91,7 24 months (2) Subparagraph (1) shall- (a) (b) not apply to the extent that, and for so long as, payment of an unpaid premium is effected by means of the maintenance of the policy in force as contemplated in section 52(2) or (3); be deemed not to have been applicable if, and to the extent that, any premium or part thereof which was unpaid is later paid to the long-term insurer, and in that event any reversed commission refunded to the longterm insurer may again be paid to the person by whom it was refunded. Voidness of certain agreements 3.4 (1) An independent intermediary shall not charge, in addition to any remuneration contemplated in the agreement referred to in regulation 3.2(1), any fee which is payable by a policyholder, unless the amount thereof is disclosed expressly and separately to the policyholder by the intermediary. (2) An independent intermediary shall not be remunerated by the long-term insurer for any fees charged to the policyholder by the independent intermediary. (3) Any agreement, scheme or arrangement to provide consideration for the rendering 19

20 of services as intermediary otherwise than in accordance with this Part shall be void. oooooo EXPLANATORY MEMORANDUM TO THE PROPOSED AMENDMENTS OF THE REGULATIONS UNDER THE LONG-TERM INSURANCE ACT This explanatory memorandum relates to the attached amendment. (a) Current position Presently maximum commissions are prescribed by regulation which can be paid by the long-term insurers to a person for rendering services as an independent intermediary. (b) New approach The regulation is substituted with a new regulation which no longer prescribes maximum commissions that can be paid for services rendered as an independent intermediary. Commission will now be a part of the marketing process and should be determined by assessing the value of the service that has been rendered. Long-term insurers will also have to keep written records on the prearranged commission payments negotiated with each independent intermediary regarding a policy sold to a specific policyholder or with regards to a specific product. The written records are necessary since the authorities will have to regulate the full disclosure of inter alia commission to be paid, that will follow with the implementation of the Policyholder Protection Rules. Commission payments will have to be a predetermined amount which should not be manipulated once the policy has been sold. Independent intermediaries will still have to reverse commission not earned if premiums are being reduced, refunded or when the policy is made paid-up or surrendered early. (c) Reason 20 The fact that the maximum commission payments were regulated with the intention to protect the policyholder, had the effect that most policyholders are unaware of commission payments to intermediaries. Controls on remuneration cannot, entirely protect the public, because while legislation can help to reduce the incentive for unethical behaviour, it cannot ensure its elimination. Different types of policy offered by the same insurer carry different rates of commission and amounts of commission vary directly with the size of policies. Consequently, as in the case of many other products, there will always be scope for intermediaries, whether company representatives or broking firms, to recommend the types or size of policy which are most rewarding to themselves. Whatever steps are taken to safeguard the interest of the insuring public, it is important for them to realise that, as in any other business transactions generally, they must accept responsibility for exercising judgement and care in what they are buying. Compelling insurers to disclose particular information, will assist significantly to focus the minds of consumers on what is relevant to their decisions and as such will serve as a valuable instrument in educating policyholders

21 The proposed Policy Holder Protection Rules to be implemented soon will ensure full disclosure of the product which the policyholder or the potential policyholder are buying from the insurer and will therefore fulfil that very important role of making information available to the client to put him/her in a position to make an informed decision. Although we do not see this as a complete answer to all problems, we regard it as probable that the advantages that can be expected to flow from a system of full disclosure will exceed the disadvantages, taking account of the manipulation that is taking place of the regulations currently in place and the costs involved in the supervision thereof. 21