CRIKEY DICK …… I CAN’T AFFORD IT!!

Financial Newswire’s life/risk expert, Col Fullagar looks at the complexities of talking to clients about income protection insurance, particularly when cost comes into the equation.

The purpose of income protection insurance is to protect the current and future lifestyle of the insured who is unable to work because of a sickness or injury; however, how many financials advisers named Richard have put together a comprehensive recommendation only to have the client respond with those fateful words “Crickey Dick ….. I can’t afford it!!”

Whilst a Recommendation, initial or review, may be technically compliant it is sometimes necessary to work with the client on a compromise that will provide the most appropriate solution possible at a premium cost within budget.

To do this requires an understanding of the factors that impact the income protection insurance premium and, to do this safely requires, in part, an understanding of a reasonable priority order of compromise.

In regard to the former, some factors that influence the premium are outside the immediate control of the insured, for example age, gender, smoking status, occupation, etc. The client “is what they is” at the time of application.

Equally, of course, there are other factors that can be adjusted such that price might be, to an extent, massaged down. This article will consider some of those factors and also offer a generic priority order of adjustment supported by reasonable logic BUT before embarking on the exercise, it is necessary to have the mandatory Disclaimer ………..

“What follows, including the numeric examples shown, is indicative only, provided primarily as a basis for consideration and discussion. As the specific needs and circumstances of the individual client are not known, the ideas put are general in nature and should not be used as a definitive guide.”

As an aside, this article will not consider the option of changing a PRE-APRA income protection insurance policy, ie issued prior to September 2021, for a POST-APRA policy, issued after September 2021. This is a question warranting separate consideration – please refer to “Can advisers feel safe recommending new DII products” (Financial Newswire 22 July 2022).

To begin ……….

• Alter Premium Type; Level to Stepped

Notwithstanding level premium has taken a credibility beating in recent years, it remains a factor warranting consideration in an initial recommendation particularly when the intention is to retain cover long-term. The immediate drawback of level premium is, of course, that it is materially more expensive than stepped premium in the short-term ie anything up to double the stepped premium.

Thus, if price is a problem, the same quality and quantum of cover can be retained at a lower initial price simply by utilising stepped rather than level premium.

Eventually, the stepped premium will increase and move past the level premium but:

• For lives insured under age 45, the stepped premium increase curve is often relatively flat; and
• By the time stepped premium starts to become prohibitive, other changes detailed below might be considered.

Delete Some Optional Benefits

Whilst certain optional benefits might be considered “nice, or even important, to have”, the primary purpose of income protection insurance is encapsulated in the total and partial disability benefits and the policy features underpinning them.

If the latter are under threat, consideration might be given to deleting the former, examples of which include:

• Day 1 Accident;
• Guaranteed Future Insurability
• PLUS Cover giving access to a range of ancillary benefits

Two optional benefit worthy of special consideration are the Increasing Claim Benefit and Lump Sum Commutation Benefit which are discussed in (vii) and (viii) below.

• Convert to a Basic Policy

Converting a comprehensive income protection insurance policy to a basic equivalent brings with it the advantages of:

• A premium reduction of varying amounts but, indicatively up to 20%; and
• An increase in the % of the premium that can be claimed as a tax deduction.

The opportunity cost is the loss of various ancillary benefits but, as suggested above, income protection insurance is largely about total and partial disability benefits.

• Agreed Value to Indemnity

A reasonable definition of Agreed Value income protection policies is “if the earnings of the insured reduce between when the policy starts and when a claim is made, the reduction will not impact on the Total Disability benefit amount payable”.

For Indemnity policies, the opposite applies which places considerable importance on the definition of Pre-Disability Earnings (“PDE”).

Additional to the above, and as stated in the article “Let Prudence Prevail” (Money Management, 21 February 2020); “The plight of newly qualified graduates, people suffering from chronic, debilitating medical conditions, those recently rendered redundant and those recently returned to work following a claim but suffering a new disability, appear to be collateral damage.”

Notwithstanding the risks, the negatives should only become realities if earnings reduce and/or a disability arises prior to the expiry of the PDE averaging period, thus bearing in mind the considerable cost difference, a switch may be warranted.

To be clear, the above is considering the merit or otherwise of switching a PRE-APRA agreed value policy for a PRE-APRA indemnity policy as distinct from moving to a POST-APRA indemnity policy.

• Lengthen Waiting Period

Disabilities arising out of sickness or injury, can be categorised in many different ways with one being the extent of the impact of the sickness or injury on lifestyle ie the impact can be minor, medium or massive.

By lengthening the waiting period, a client is effectively giving greater priority to protecting against the impact of medium or massive disabilities, at the expense of minor disabilities.

By using the example of the excess on motor vehicle insurance, a simplistic way of demonstrating this for a single claim can be offered ie, for an insured benefit amount of $10,000 a month, an increase in the waiting period from:

• 14 to 30 days, is equivalent to an increase in the “excess” from $5,000 to $10,000; and
• 30 to 90 days, is equivalent to an increase in the “excess” from $10,000 to $30,000, etc.

The “excess” impact can be partly mitigated by the presence of ancillary benefits within more comprehensive income protection insurance policies that provide cover during the waiting period, for example:

• Bed confinement benefit;
• Scheduled injury and/or crisis benefits;
• Rehabilitation benefits, and so on.

Another way to position the option of lengthening the waiting period is to consider the interplay of waiting and benefit periods and price, i.e. for ages to around 40, the premium for a 14 day waiting period and 5 year benefit period IS APPROXIMATELY THE SAME AS the premium for a 30 day waiting period, benefits payable to age 65.

The obviously emotive question that might be put to the client is, would they prefer to receive:

• An additional 16 days payment at the start of the claim ($5,000); or
• An additional 20 years payment throughout the potential claim duration ($3,000,000)

(Based on CPI of 4%; claim duration 25 years)

There is an important proviso and that is the eligibility criteria for disability benefit payments. If, as has been the case in the past, eligibility required totally disabled for the entire waiting period, then a lengthening of the waiting period could materially impact on the client’s ability to qualify for a long-term disability benefit payment. Risk mitigation requires the presence of a relatively short period of total disability with the balance of the waiting period being enabled on a partial disability basis.

• Reduce the Benefit Period

Statisticians might espouse that the average duration of an income protection insurance claim is around 2 years and, as such, a 2 year or even a 5 year benefit period is adequate; however, as Mark Twain is reported to have once said “There are three kinds of lies: Lies, Damned Lies, and Statistics” 

It would be a brave adviser who made a Recommendation with a shortened benefit period simply on the basis of this type of statistic which may not adequately consider relevant matters such as:

• Recurrent claims arising out of the presence of chronic conditions;
• Claims that cease for reasons other than recovery, for example, death, short benefit periods, etc.

As the aim of the exercise, however, is to consider factors affecting price, then the need to shorten the benefit period might be considered.

The logic being that if premium dollar limitations mean that all contingencies cannot be covered, better to focus on those “more likely to occur” ie it is arguably better to cover 75% of earnings for 2 or 5 years than to cover 40% of earnings to age 65. At least in this way, the client is “appropriately” protected for 2 years rather than “inappropriately” protected for 2 years and through to age 65.

One crucial factor to consider if reducing the benefit period and that is whether multiple 2 or 5 year benefit periods can be claimed for different disabling events (v) the policy having a single 2 or 5 year benefit period irrespective.

• Delete Increasing Claim Benefit

The increasing claim benefit is generally considered to be an almost “essential” addition to any income protection insurance policy, except, for example, if the policy is protecting a non-inflating expense such as debt repayment but, this optional benefit comes at a not-inconsiderable cost particularly for longer benefit periods.

Whilst the removal of the increasing claim benefit is fraught for longer benefit periods, for example,  to age 65, arguably, if the benefit period is pared back to 2 or 5 years, the increasing claim benefit is of lesser import. This is even more so the case if:

• The policy is within a few years of expiry;
• A low inflation environment is being enjoyed; or
• The financial position of the client does not warrant benefit payments to be indexed.
• Delete Lump Sum Commutation Option

Whilst this is not a direct additional cost option, it does impact on client cash-flow by way of a reduced tax deduction for the income protection insurance premium.

To the extent that this option only applies for benefit periods to Age 65 or longer, it potentially becomes an automatic casualty of a reduction in the benefit period – refer (vi) above.

• Reduce % of Earnings Insured

There is strong logic to suggest that the last area of price compromise should be a reduction in the % of earnings insured.

The consideration of this factor falls into two areas:

• Removal of any Superannuation Protection Benefits

Introduced into the market in the early 1990’s, these “optional” benefits are intended to protect the “future” lifestyle of the insured by underpinning superannuation savings that might otherwise not continue if a claimant only received 75% of pre-disability income. If superannuation is not protected, even if the policy has a benefit period to age 65, the claimant will be left financially bereft when their policy expires.

Having said that, if price desperation is present, arguably better to sacrifice future lifestyle in order to shore up current lifestyle.

• Reduce Base Benefit Amount

Many people find it difficult to make ends meet when they are healthy and working full-time. Even more so when they lose their health and ability to work and need to survive on 75% of their prior earnings ie the general maximum level of cover that can be insured under the base policy. Thus, the reason for a reduction of the base benefit amount being put up as the last line of price defence.

Again, however, for the sake of the exercise, it must be considered an option albeit a reluctant one. To put it quite simply, better some protection than none at all.

Summary

There may be many counter arguments to the above and other options that might be considered, for example, placing cover in superannuation, and there will be individual client circumstances that warrant an alternate approach, which is all totally OK.

A further reality is that price factors will be changed in tandem rather than one at a time.

As stated at the start of this article, the aim is not to provide a definitive guide, simply because it is neither possible nor appropriate. The aim is to note the need for an underlying logic to this part, as with all parts, of the risk insurance advice process, and then to offer up ideas.

All income protection policies do not start on the same basis and all income protection policies do not have to end on the same basis as they started.

One of the many roles of a financial adviser is to find, if necessary by compromise, a risk insurance solution that provides the most appropriate protection possible within the price constraints that exist, not only when the cover starts but throughout the time it remains in force.