Risk

When the Law of Unintended Consequences meets income protection insurance

It’s hard to argue against the need to reform a sector that is losing hundreds of millions of dollars each year, when there is a real risk that without reform the sector, and the protection it provides consumers, will not be around in the future.

However, when the regulator launched an intervention to protect the sustainability of individual disability income insurance (DII), or income protection insurance, it may not have anticipated that consumers could be the ones to lose out.

“We are too solicitous for government intervention,
on the theory, first, that the people themselves
are helpless, and second, that the Government
has superior capacity for action. Often times
both of these conclusions are wrong. 

Calvin Coolidge

Australia’s big life insurers stopped offering Agreed Value on new DII policies from April 1, 2020, following an upfront capital requirement imposed by APRA forcing DII providers to address the regulator’s sustainability concerns.

Instead, people wanting to take out DII can apply for an indemnity value policy, meaning that instead of a pre-agreed amount, the payout is based on your income at the time of the claim. Unlike traditional policies, the policy term is just five years.

Research from CoreData conducted in February found two thirds of financial planners (67.4 per cent) do not think indemnity is a reasonable substitute for Agreed Value. Four in five (80.9 per cent) did not agree with APRA’s decision to prevent life companies from offering these policies to new clients.

While clients who took out an Agreed Value policy before April 1 can keep it, the adverse claims experience that contributed to net loss after tax of $1.4 billion on DII for the year to March 31, 2020 means life companies will have little choice but to raise premiums in the future.

Our research suggests that in general, planners would prefer to maintain the sum insured (68.1 per cent) on DII policies with a rise in premiums over a reduction in the sum insured and stable premiums (31.9 per cent).

However, few clients would be able to stomach a large premium hike. And if forced to choose between a client either losing their income protection cover because they can’t pay the premiums, or a reduction in benefit, it’s safe to assume most planners would prefer the latter.

Higher premiums are likely to be the norm in the new financial year, as life companies adjust their policies to reflect the ‘new normal’ under APRA’s directive. With the Australian economy in recession and a likely spike in unemployment from September when JobKeeper ends, there’s a real risk of large-scale policy lapses exacerbating the underinsurance gap in Australia.

Unintended consequences for policies under the new arrangements

Most life companies updated their product disclosure statements (PDS) for income protection policies on April 1 2020, outlining the way in which indemnity value would be calculated.

Click on the table to enlarge

Three of the five life companies CoreData reviewed base the payout amount on the insured’s highest average earnings over a consecutive 12 month period in the two or three years immediately prior to the disability. However company B and D calculate earnings based on average earnings in the 12 month period (or latest financial year) immediately prior to the start of the waiting period.

Policies that base calculations on a recent 12-month period are less than ideal for those whose income may fluctuate considerably year-on-year – for example, the self-employed and small business owners, or those who rely heavily on commission for their income, such as real estate agents and other sales people.

Someone who takes parental leave or caregiver leave at a reduced or no wage, or takes unpaid leave to travel, and then makes a claim within 12 months of that period, could also be negatively impacted. 

Importantly, the pre-disability earnings calculations also impact people who may have taken a temporary pay cut or had hours reduced in the period before they lodge their claim. Given the COVID-19 pandemic has seen wide-spread implementation of company policies enforcing reduced hours across staff to manage cash flow and keep people employed, anyone who took out a policy post April 1, had their hours reduced during or immediately following the pandemic, and then made a claim in 2021 would be negatively impacted. 

The timing of when one becomes unable to work due to illness or injury is not something within our control. 

Indemnity value shifts the risk of an ill-timed accident or illness squarely to the consumer, raising questions over the feasibility of income protection for anyone who does not have stable future income. In today’s ‘gig’ economy, in which income for many is variable, the workforce is highly casualised and job insecurity is prevalent, that is a worry.

2 Comments

  1. jeremy@businessfp.com.au' Jeremy Wright says:

    The Law of unintended consequences, seems to be the basis upon which the Government and Public service sector operate.
    Those who have little practical experience, are always prone to errors of judgement, simply because they do not have sufficient, if any, time at the coal face.
    People prioritise and unfortunately Life and Disability Insurance is low on the ladder of priorities, so when premiums rise, so do lapses.
    There is a misconception that people actually read all the documentation placed in front of them. They don’t.
    Losses in Income Protection was brought on by continual changes, excessive Regulation and restriction of trade impositions placed on advisers, that has led to mass exoduses and the remaining advisers, reluctant to write New Business, which has always been the basis of sustainability.
    The Life Insurance Framework must be changed as it has gone way to far.
    The APRA intervention will not stimulate the sale of Disability Insurance, it goes much deeper than that.

  2. Excellent article covering a very pertinent issue. As advisers we are dammed if we do (recommend retaining existing policies with an overhanging threat of increasing premiums) and dammed if we don’t (recommend clients change to cheaper more sustainable but inferior contracts and getting sued due to a failed claim or unintended consequence that may have been paid under an old contract). We live in hope of reasonable regulator and industry consensus but will this utopian outcome ever exist.

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