"I don't want to pay commissions." Understanding Life Insurance and Annuity Commissions

The word 'commission' can bring about a few unpleasant thoughts. It's often associated with over-priced and under-represented items such as cars. It also is a seller's overhead in selling real estate by paying a commission to the real estate agent.

Is there a difference between getting your contract direct from the insurance company or from an insurance agent?

Life insurance and annuities are the exact same design and structure whether you get them direct from the insurance company (if you can), or from the insurance agent.

If the contract design and structure is the same whether or not you go through an agent, then what is the difference of working with an agent?

There is no difference! Working with the agent is essentially a free benefit by comparison! You gain the expertise, service, and advocacy of an agent without paying extra for it in most cases.

How do commissions work with life insurance?

With life insurance, the commission is based on a portion of the first year's premium.

However, it doesn't come from your policy! This is a huge misunderstanding. Some people may see that they have no cash values in the first year and think that it all goes to the agent. Not so! Part of your premium is set aside in the insurer’s reserves to back up the promises they’ve made to all policyholders.

The money that compensates agents comes from their marketing and compensation funds. Insurance agents are paid by insurance companies based on the policies they sell.

When does the insurance company finally make money on the policy? They make money in two ways:

1. The policy stays on the books past its validation period. This period is often many years—sometimes close to a decade!
   

2. The client cancels or lapses their policy. How does the company make money that way? They keep all the premiums paid, minus any cash values that may be owed back to the policyowner. And since the policy is no longer in force, the company doesn’t have to pay the promised death benefit.

   
   

   Granted, they may take a short-term loss from acquisition and setup costs, but long-term the lapse relieves the company of a potentially very large liability. The bigger the policy, the greater the sigh of relief by the insurer.

   
   

   But here’s the catch: the risk that policy was designed to insure is now squarely back on the client’s shoulders. And if their health has changed since they first applied, they may not even be able to qualify for that coverage again — or it may come at a much higher cost.
   

How do commissions work with annuities?

With annuities, it's just a little bit different because there is no reduction of the contribution amount in the contract. Yet, the agent is still paid a commission. How? The same principle applies: the insurance company pays a commission based on the contribution made in the contract and those funds come from their marketing and compensation budget.

Like above with the validation period for life insurance, the annuity contract also needs to be "on the books" for a period of time before it is profitable for the insurance company.

To discourage such cancellations or excess withdrawals, the annuity company places a surrender charge schedule to help make the company 'whole' if the annuity contract owner withdraws too much or cancels the contract too soon. These are typically 3 to 10 years in length, but some are longer.

How does the insurance company make money?

The insurance company must be profitable to pay out promised benefits. They make money on the spread of what they collect for their reserves in the general investment account as well as how well they have managed their operations budget and promised benefits.

As with life insurance and annuities, they both take time before the company is profitable and the policies stay on the books past their validation periods.

Is commission the right term to use for this compensation method?

Technically, the industry calls it a commission, and that’s the term regulators require. But if you think about it in everyday language, it functions more like a referral fee. The insurer compensates the agent for bringing in a client who fits their underwriting standards. The important point is this: the money comes from the insurer’s operating budget, not by cutting into your policy.

Why do fiduciary advisors advise against and even refuse to accept commissions?

I wrote a full white paper on this topic for the insurance and financial services industry. The biggest reason is that any outside compensation is considered a conflict of interest because it is assumed that the agent/advisor is working only to maximize their own compensation. Then because of the sizeable commissions that can be offered, they look at how these contracts perform by comparing their performance to their investment portfolios. To me, this isn't the best comparison to make as there are far more factors, but it's most often how they are compared and they determine that "these aren't good for the consumer" so "I'd rather die and go to hell than sell an annuity."

I would be remiss if I didn't point out that commission-based compensation does have a tendency to be abused by unethical agents looking to maximize their compensation.

However, all methods of compensation can be abused.

• Commission-based agents may be tempted to recommend products primarily for the payout rather than the client’s best interest.
  

• Fee-only planners may have little built-in incentive to expand their expertise, since their fees don’t automatically increase with added knowledge unless they raise rates or attract more clients.
  

• Captive agents may fall into cookie-cutter advice, offering the same standardized solutions to everyone. One company even branded this as a “Happy Meal” approach to planning — the package was always the same, they just swapped out the toy.

The truth is, no compensation method is immune to abuse. What matters most is the advisor's integrity, the transparency of their process, and the alignment of their recommendations with the client's best interests and desired objectives.