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Has the removal of agreed value products and the wide-scale reduction in the replacement ratio percentage meant the end of financial underwriting? With indemnity-only products, does “financial underwriting” now move to claims? Or do we need stricter financial underwriting to help return the Individual Disability Income insurance (IDII) product to a sustainable footing, as some industry stakeholders have stated?
In the first blog in our series, we stated that IDII should go back to its intended purpose: “The insurance offering and contract should be balanced and fair to all parties, with an abundance of clarity of what is and is not covered. It exists to adequately replace income when it is needed most, and customers should know exactly what they are buying, how it is structured and what they can claim for should the need arise.”
This time around, we examine the various financial aspects of the IDII product, along with the supporting underwriting and claims practices.
We believe that it is as important as ever, if not more so in these challenging times, to get the basics right and strengthen the rules already in place when financially assessing income protection applications, at all stages of the application / policy / claim cycle. In addition to strengthening some practices at application, we need to take the principles of financial underwriting and build them into the terms and conditions of the product in order to establish more certainty for policyholders and clarity of intention for all stakeholders.
The basic intention of financial underwriting is to make sure that the applicant is not over-insured, and that he or she or the beneficiaries will not be in a better financial position when a claim is paid than before it. Insurance benefits should not provide a windfall.
But what happens after the policy has incepted and been in‑force for many years? The long-term nature of these products means that by the time a policyholder submits a claim, his or her circumstances may be very different and any mitigating factors that applied at underwriting may no longer be in effect. For that reason, we need to ensure that provisions are written into the terms and conditions of the product that allow consistency of practices across underwriting and claims, and that help us to preserve the intention of the product and help to protect the portfolio from opportunistic claims.
Financial underwriting is about more than checking proof of income and following a formula. It includes identifying:
These factors and many more are the bread and butter of financial underwriting, and regardless of whether the contract is indemnity or agreed value - no matter what the pre‑disability income definition is - it is important that the underwriter asks all of these questions and decides on what terms the cover will be offered. The underwriter should think about how the product works and what will be possible and likely at claim stage. The fundamental question, “Does this make sense?” should always be considered.
But before we even get to underwriting, some financial considerations need to be built into the product to allow for clarity and consistency across the life cycle of the policy.
Australian IDII replacement ratios (RRs) - the income received from all sources after claim vs what was earned before claim - are among the highest in the world at between 75% and 85%. We all know that the higher the RR, the lower the incentive to return to work, which is why the Actuaries Institute and companies around the market are looking to reduce them.
What we also have to realise is that there is more to RRs than just the percentage published in a PDS (Policy Disclosure Statement) or issued by quote software. RRs can be increased unintentionally by other factors already built into the product, such as automatic indexation, waiver of premium, payment of ancillary benefits, non‑payment of tax, and ongoing income from various sources. These can all be addressed by tightening up on some of the policy provisions, and we have already discussed some of these measures in our previous articles.
Terms - such as “passive”, “unearned” and “personal exertion” income - are commonly used in the industry but are not always clearly defined. They also do not relate back to the financial underwriting practices employed at application. Therefore, having them written into the policy terms and conditions can lead to a confusing situation for claimants, with the different process between claims and underwriting in the treatment of income and benefit calculations sometimes leading to an unavoidable payment of a higher benefit than was intended.
In Part 2 of this blog series, we described how we have tried to simplify the product design and to effect consistency across claims and underwriting practices. This benefits policyholders by establishing certainty at time of claim, and by taking a “plain English” approach to definitions, it allows transparency for all stakeholders.
To achieve these goals, we removed the terms “passive”, “unearned” and “personal exertion” income from the policy terms and conditions and replaced them with more specific and easily understood definitions. We have described the Definition of Income more clearly, allowing the calculation that is applied at underwriting to be applied at claim, and we have included these terms in the offsets.
On the surface, the definitions of income in the market seem fairly clear. For employees, they include salary/wages, fringe benefits that would cease if they stopped working, and in many cases, regular bonuses, or commissions. For people who are self-employed, it includes salary/wages, directors’ fees, other allowable add‑backs, and profit/income/earnings from their business or partnership.
But what can cause confusion is when we look more closely at business income. Is the profit of the business, to which the applicant is entitled, considered “personal exertion” or “passive” income, if he or she has other income-generating employees?
While generally accepted accounting practices apply, every applicant’s situation is unique and needs to be individually assessed. Sole traders often (but not always) express their income only as profit. People who are employees of their own company or are in a partnership may or may not pay themselves a salary, and they may or may not distribute the profits at the end of each year.
Standard practice for advisers and underwriters is to include all the profit generated by the business to which the applicant is entitled by share of ownership when calculating the insured benefit. Salary, wages, profits, and allowable add‑backs are all included in the final amount known as insurable income or earnings, without judgement about how the applicant and his or her accountant has structured the business accounts.
While underwriters ask, “How much of your income would continue if you were disabled?” this figure obviously difficult for self-employed individuals to predict with any degree of accuracy, given the long-term nature of the products and the potential changes in their business models during that time. Depending on the length of time since application, they may have more income-generating employees and they may have taken a step back from day‑to‑day operations and/or expanded into new areas. Additionally, their wealth may have increased, allowing them to have in place investments and assets that generate further income.
At claim time, this issue becomes problematic. With terms and definitions that are unclear and don’t stipulate exactly what sort of income is offset or taken into account in the benefit calculation at claim time, it is possible and not unusual for the claimant to legitimately receive his or her monthly benefit along with income from several other sources. However, the question arises whether the ongoing business income is “unearned” or from “personal exertion”.
For these reasons, we believe that for self-employed individuals the definition of “Income” should include the share of profit and income they are entitled to as owner of the business, whether paid to them or not. This not only provides clarity of intention and certainty for policyholders but allows consistency across all claimants, no matter how their business and tax arrangements are structured. It also helps to mitigate the ability to manipulate accounts to maximise benefit payments.
For further clarity, we define not only “pre‑disability income” but “post‑disability income” and include that in the offsets to the benefit. This means that any ongoing business income, whether paid or not, is offset from the benefit paid to the claimant. If the ongoing business income is negligible, it will have little impact. However, if the business continues to operate at a similar level, whether the claimant can perform duties or not, the benefit will be reduced accordingly.
Additionally, we believe that “post‑disability income” should include income from any source, which means not only ongoing business income but investment income as well (unless it was disclosed to us at underwriting and taken into account).
Is any of this fair to policyholders? Some people argue that it isn’t fair to reduce the claimant’s benefit by the amount of investment income, particularly because investment income was not insured anyway. But think of the impact on the replacement ratio of paying the full benefit to someone who receives other supplementary income from any source. In many cases the replacement ratio exceeds 100% and can go much higher. And that isn’t fair to the majority of policyholders who are paying increasingly higher premiums to fund this windfall.
For these reasons, we believe that companies and advisers should proactively encourage clients to review their financial situation regularly and modify their insurance benefits to their changing needs. We fully endorse the industry’s investigation into the possibility of regular reviews of the non‑medical aspects of in‑force policies to further strengthen that practice. The incentive for those who are found to be over‑insured of course would be more affordable premiums.
As with all benefits, the underwriter will look to see what other policies of the same benefit type are already in place, and acceptance of the new application is usually conditional upon cancellation of the existing business, or the amount of coverage being applied for is reduced to ensure the applicant is not over‑insured.
It has not been usual practice to consider Total Permanent Disability (TPD) and IDII together in financial calculations; however, we would believe that this is something companies should consider when assessing long-term IDII. It is common in other markets for TPD and IDII to be financially underwritten together.
Along with all lump sum insurance applications, considering both the purpose of the cover and the identity of the beneficiaries is important in every case. But in most applications for TPD, the purpose of the cover is for personal protection, and the financial assessment is based on either a needs analysis or a multiple of income. In either case, an element of income replacement goes into the TPD amount, in which case, how does that fit together with the IDII amount? Even if the TPD lump sum goes toward paying off a mortgage and other expenses, it is replacing some of what the regular income would otherwise be used for. And as a final consideration, the income used to calculate the sum insured (in the case of multiples) is pre‑tax income, which can inflate the amount the applicant would otherwise receive as paid income by 20%‑50%.
A provision which could also be considered is to build into the policy an offset of any lump sum payment intended as a replacement of income after a period of time on claim. This means converting to a monthly amount any payment that is received as a lump sum, and that is intended as compensation for loss of earnings, and that is not allocated to a specific month. This could include TPD amounts but would also cover Workers’ Compensation and motor vehicle accident settlements, among others. It could also potentially include situations where a sale of assets was made to supplement the income stream, particularly where a claimant sold his or her business with the intention of not returning to work.
For all of these reasons, we recommend that companies re‑examine their financial guidelines. In our view the amount of TPD benefit allowed when also taken out with Long Term Income Protection should be reduced. If the TPD cover is in place first, the Income Protection benefit should be reduced in recognition of that. While it is preferable to have a full needs analysis performed, where that is not practical and a multiple-of-income approach is used, in our view it seems reasonable to reduce the multiples significantly - potentially by up to half - when TPD and long-term IDII will be in place together. Each company will have its own philosophy in this regard and commercial considerations to take into account, but underwriters should always remember that they should not rely only on the policy terms and conditions, and cannot allow the applicant to take out and pay for cover they will not be able to claim for or that will be offset.
Radical thinking and action are required across the industry to achieve long-term sustainability of IDII and to make it more affordable and relevant for genuine and honest policyholders. Part of that includes tightening the financial rules to remove incentives for opportunistic claimants who find themselves either over-insured or wanting to get their “money’s worth” following a long period of being covered, or those who are able to claim benefits while maintaining a comfortable lifestyle through substantial other income sources. The changes considered in this article would also make products easier and less ambiguous to administer for underwriting and claims teams, and in aligning them more closely to the needs of individuals, encourage companies and advisers to enact a “best advice” model for their clients.
