Partial Disability – Trick or Treat?

Financial Newswire’s risk insurance specialist, Col Fullagar looks at the current situation around disability income insurance and the related intricacies challenging advisers and their clients.

The purpose of income protection insurance has long been held to be two-fold ……..

First, and most often touted, to support the lifestyle of the insured if a sickness or injury renders them unable to work.

It is not sufficient; however, for a policy to simply pay benefits to the insured who is unable to work; if it was, the only policy benefit required might be that payable for total disability.

There is a second, and arguably equally important policy purpose; to encourage and assist the insured to return to work provided this is in line with the advice of the treating medical practitioner.

The importance of this purpose comes about because it brings into play the reasons why people work, for example:

• to establish and maintain a certain standard of living;
• to feel that personal skills are being used productively; and
• to foster a sense of self-worth.

Not only do many people have to work, but most of that many also want to work.

In a claim scenario, it is clearly to the benefit of the insurer to encourage and facilitate a return to work for those who possess the medical ability to do so and the policy feature that most obviously assists this is the Partial Disability Benefit.

Whether the benefit achieves its primary purpose is largely dictated by two things:

• The Contractual Position, discussed in Part 1 of this article; and
• The Management of the Partial Disability Claim, discussed in Part 2.

These two things will make Partial Disability a Trick or a Treat of the income protection contract.

1. THE CONTRACTUAL POSITION

Partial Disability Benefit

The generic purpose of the partial disability benefit is to pay a proportion of the benefit amount with the proportion being calculated by comparing the reduced post-disability generated earnings to pre-disability generated earnings. The theory is that this reduction reflects the impact of the sickness or injury on the insured’s ability to work and earn.

The common formula for the partial disability benefit is:

Benefit Payable = (Pre-Disability Earnings minus Post-Disability Earnings) divided by Pre-Disability Earnings and then multiplied by the Benefit Amount

Case Study 1

Pre-disability earnings = $10,000 a month;

The insured benefit is (75%) = $7,500 a month; and

Post-disability earnings = $4,000 a month.

Thus, the benefit payable would be ($10,000 – $4,000)/$10,000 multiplied by the benefit amount of $7,500. The reduction in generated earnings is 60% and thus 60% of the benefit amount should be payable, i.e. $7,500 x 0.6 = $4,500 a month.

The encouragement to return to work is by way of financial advantage ie if the insured did not work, the total disability benefit payable is $7,500. If, however, the insured returns to work and is paid a partial benefit, they receive the benefit payment of $4,500 PLUS the part-time earnings of $4,000, ie a total of $8,500.

The insured in this example is $1,000, or 13%, a month better off by returning to work, and the more the insured works, the greater the financial advantage, for example:

• a 50% return to work increases the total amount payable to $8,750 ie $1,250, or a 17% advantage;
• a 60% return increases the amount payable to $9,000, ie $1,500, or a 20% advantage, and so on until the partial disability benefit ends when the insured has returned to work 100%.

Whilst the formula may be consistent to most insurers, its operation is not and thus various components of the partial disability formula warrant attention.

Pre-Disability Earnings

If life was simple, pre-disability earnings would be the earnings of the insured when they suffered a disabling sickness or injury with these earnings representing that which enabled the insured to establish a personal and family lifestyle.

Life, however, is not always simple and thus, when establishing a basis for pre-disability earnings influencing factors might be considered, including:

• the impact of the disabling event being immediate (v) gradual;
• the insured’s earnings being stable (v) volatile; and
• the influence of external factors such as economic downturn, seasonality, or a pandemic even.

The disabling sickness or injury can be caused by an infinite variety of events, the impact of some is immediate, for example, a heart attack or a motor vehicle accident while the impact of others can be gradual, for example, a long-term debilitating illness such as multiple sclerosis.

If the impact is immediate, the insured’s earnings are stable and there are no external influences, earnings immediately prior to stopping work would generally represent lifestyle earnings.

If the impact is gradual and/or earnings are volatile and/or there are external influences, earnings immediately prior to ceasing work may bear no resemblance to the earnings used by the insured to establish their lifestyle. This situation can be exacerbated if the insured tries to “soldier on” rather than succumb to the injury or illness.

Even if earnings volatility or lack of same can be predicted, it is not possible to know the nature of the disabling event in advance of it happening and often external influences cannot be reasonably predicted, therefore well-designed income protection insurance policies should take this into account when defining pre-disability earnings.

An averaging period of 12 months makes sense as this caters to some extent for fluctuating earnings especially arising out of seasonal factors.

With apologies to APRA; however, taking the average over the 12 months immediately prior to the claim start date has the potential to be highly prejudicial to many insureds. The manifestation of the recent Covid pandemic is a good example of how earnings may be impacted for a year or even two years, but people will still wish to, and be enabled to, maintain and/or recover their lifestyle.

Arguably, a reasonable balance for the calculation of pre-disability earnings is achieved with a definition that averages any 12 consecutive months earnings in the three years immediately prior to the claim start date.

This might be supported by an additional clause within the policy along the lines of:

“If the life insured suffers a sickness or injury and monthly earnings reduce as a direct result of the sickness or injury, whilst this continues pre-disability earnings will be the value, we agree would have applied at the time the reduction started …”

Partial disability claim follows Total disability claim

A technical problem with a prejudicial outcome can arise if an insured is totally disabled, returns to work and then, within the pre-disability earnings averaging period, the insured become partially disabled from a different cause.

Case Study 2

Jan receives a total disability benefit for 15 months because of a back injury. She returns to work but after 6 months she is diagnosed to be suffering from a chronic debilitating condition that not only forces her to reduce her work hours but, her “partial disability” continues through to age 65.

If the definition of pre-disability earnings in the policy is the average of the 12 months earnings immediately prior to the date of disability, Jan could find herself severely disadvantaged.

Because Jan has only been back at work for 6 months since her first claim ended and prior to that her earnings for 18 months were Nil as she was on claim, the formula for pre-disability earnings is effectively 6 months of income divided by the 12 months in the definition.

As a result, Jan’s pre-disability earnings will be artificially reduced impacting on the proportion of a partial benefit she will be paid.

There may also be a second impact if Jan has an indemnity policy as the reduced pre-disability earnings may also lower the benefit amount used within the partial disability formula.

A similar outcome arises if a partial disability claim arises subsequent to a previous partial disability claim albeit the disadvantage to the insured is not as great.

Indexation of pre-disability earnings

Technical complexities involving pre-disability earnings do not end with its calculation; it also has to be inflation-proofed otherwise the ‘real’ value of the partial disability benefit payable can be compromised.

Looking again at Case Study 1, in the first year the insured receives 60% of the benefit amount, i.e. $4,500, under the partial disability benefit.

If the insured remained 60% partially disabled but earnings increased in line with inflation at say 5%, in the second year, notwithstanding the insured is still 60% partially disabled, earnings would increase to $4,200 ($4,000 x 1.05).

As a result, the benefit amount payable reduces to 58% rather than the full 60%.

If this trend continued, the financial impact on the insured in subsequent years can be to the tune of many tens of thousands of dollars.

To inflation-proof the partial disability benefit, contracts should link pre-disability earnings to the rate of inflation. By indexing pre-disability earnings, usually on each 12-month anniversary of the claim starting, the above issue is overcome.

Deemed minimum pre-disability earnings

The insured can also be disadvantaged by an artificially low pre-disability earnings if their earnings materially increase, the increase is insured under an income protection policy but, the insured is disabled before the increased earnings have continue for the pre-disability earnings averaging period of 12 months.

Situations where this could occur include an insured being disabled shortly after putting income protection insurance in place after graduating or receiving and insuring a substantial increase in earnings.

The problem can be overcome, however, by having within the policy a deemed minimum value for pre-disability earnings of “the benefit amount divided by 0.75”.

Capability Clauses

These clauses enable the insurer to “deem” the earnings an insured is capable of earning if it is believed the insured is not working to their full capacity. The deemed earnings are then used within the partial disability benefit formula instead of actual earnings.

These clauses were first introduced in the early 1990’s. At the time, to be eligible for a partial disability benefit the insured had to be “working”. Thus, if the insured was partially disabled but could not obtain work, there was no contractual entitlement to a benefit payment. To make matters worse, contracts often contained a clause stating the policy would end if the insured was not working “for reasons other than TOTAL disability” ie not only would there be no benefit entitlement but the policy was at risk of being cancelled.

Capability clauses were introduced to overcome the first issue and termination clause were amended to protect against the second.

Since then, the application of capability clause was more to reduce benefit entitlements than to protect them with this being further extended in recent times to include total disability benefits.

The other very real issue with capability clauses is the extent of the discretionary powers they deliver ie, in order to apply the clause, an assessor needs to make the following assessments:

• How can an insured’s capability best be measured eg hours, earnings, medically?
• Is the insured working to their capability?
• If not, to what extent is the insured falling short of their capability?
• What additional earnings can be ascribed to the capability shortfall?

To add to the obvious complexity, if the impact of the claim condition varies each month and/or the extent of work undertaken by the insured varies each month, this assessment has to be undertaken each month.

One would be forgiven for asking what degree qualification a claim’s assessor would require in order to undertake the above assessment?

Delay in receipt of earnings

In the same way some policies contractually recognise not all disabilities occur in the same way, some recognise not all earnings are received in the same way.

For insured’s who are employed, calculating the partial disability entitlement is generally not complex as earnings are taken into account as and when they are received, i.e. during the month of the partial disability benefit payment.

For insured’s who are self-employed; however, the position may be quite different as earnings may be generated by the personal exertion of the insured in the month of the disability benefit payment, but invoicing and actual payment may not occur until a subsequent month.

For a claim continuing through to age 65, this theoretically does not create an issue for the insurer until the last monthly benefit payment prior to the policy expiry date. If, however, a claim ends prior to the expiry date, the insurer can be disadvantaged by this delay as towards the end of the claim some generated earnings will not be taken into account.

It is for this reason that a delay clause may be included in the policy, for example, “If there is a delay between earnings being generated and received then, with the consent of the insured, post-disability earnings will be calculated taking this into account.”

Some contracts are less conducive to obtaining permission and simply dictate that “We will deem the income to have been received in the month it was actually generated.”

Offsets against 100% of pre-disability earnings

Notwithstanding an income protection insurance policy may be an agreed value contract, when an offset against the total disability benefit applies, the maximum amount payable, i.e. the offset payment plus the benefit payment, cannot exceed 75% of the insured’s pre-disability earnings.

Partial disability benefits should be designed so that the more the insured returns to work, the greater the financial incentive by way of earnings plus partial disability benefits they will receive.

To achieve this outcome, any offset of “other benefit payments” in a partial disability situation should be assessed against 100% of pre-disability earnings as distinct from 75% of pre-disability earnings in a total disability situation.

Summary

Whether the partial disability benefit achieves its primary purpose, as set out at the start of this article, is largely dictated by two things:

• The Contractual Position, discussed above; and
• The Management of the Partial Disability Claim, to be discussed in Part 2.

Stay tuned …………………

Col Fullagar is the principal of Integrity Resolutions Pty Ltd