Bollocks!!

Col Fullagar looks at when an insurer’s statement on income protection are taken as facts but are, in fact, bollocks.

A letter recently received from an insurer seeking to justify its position in a disputed income protection insurance claim stated, in part:

“The purpose of income protection insurance is to protect one’s income in the event of illness or injury… To pay benefits at a level in excess of 75 per cent of previous earnings is neither fair nor reasonable.”

It is not uncommon for these, or similar, assertions to be made and, on the surface, they do indeed sound fair and reasonable.

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If the product replaces income lost because of an illness or injury, then surely it is income that is being protected. Further, it is part of folklore that if a claimant receives more than 75 per cent of pre-claim income, the motivation to return to work and thus the viability of the product, is severely compromised.

Unfortunately, if the insurer’s statements are accepted as fact, risk exposure may well flow through to not only the client and adviser, by virtue of recommending and implementing an underinsuring policy but to the insurer itself, as slavish adherence might endanger credibility at best and compliance with the duty to act in good faith, at worst. 

This article will contend and seek to show that the above statements might more fairly and reasonably be described, with affection, as bollocks:

• Is the purpose of income protection insurance to protect one’s income in the event of illness or injury; and
• Are benefits in excess of 75 per cent of previous earnings neither fair nor reasonable.

Purpose of income protection insurance

In 2013:

• The ratio of household debt to household disposable income was around 180 per cent – up from 160 per cent five years earlier;
• Total debt repayments as a percentage of disposable income ranged from 31 per cent (high and middle income earners) to 60 per cent (low income earners); and
• Household savings i.e. that part of disposable income not directly used, was circa five per cent.

(Source: Australian National Accounts: Financial Accounts, December Quarter 2013; ABS Survey of Income and Housing 2013/14)

For individuals and families financially reliant on an “earned income”, sickness or injury leading to the loss or material reduction of that earned income can very quickly have a devastating impact. 

Enter income protection insurance…!!

But, whilst there is a temptation, as above, to tout the purpose of income protection insurance as being to protect income, the concept is flawed. To demonstrate, simplistically, income can be used in two ways:

• It can be spent, with what is spent dictating a current lifestyle for the individual and the family; and
• It can be saved, with what is saved dictating a future lifestyle for the individual and the family.

Following on from this, income protection insurance might more fairly and reasonably be represented as not so much protecting income as protecting the current and future lifestyle of the individual and the family, and thus, bollocks to the first assertion that: “The purpose of income protection insurance is to protect one’s income in the event of illness or injury”.

The distinction is not semantics, it is crucial to an understanding of the product when it is recommended, applied for and claimed under.

Protection of current lifestyle

When it comes to lifestyle, current and future, if nine per cent of earnings goes into superannuation and five per cent is otherwise saved, this leaves the average Australian spending about 86 per cent of earned income maintaining a current lifestyle.

The numbers of course will vary greatly in any individual situation, thus the need for professional financial advice, but the concept that a large percentage of earned income is spent maintaining current lifestyle, generally holds true.

Thus the “starting” point for lifestyle protection is maximum basic coverage i.e. up to 75 per cent of earnings, under an income protection insurance policy.

Protection of future lifestyle

A highlighting of the above makes obvious the problem for the individual and their family; if the average Australian can only protect 75 per cent of earnings under an income protection insurance policy, current lifestyle may be reasonably, albeit not fully protected, but future lifestyle will be compromised. 

The longer a disability claim continues, the greater the funding gap that will appear at retirement.

It was for this reason that, 20 years ago, an additional income protection benefit was first made available – the superannuation protection option.
Initially, this optional facility enabled an insured to protect up to 10 per cent of earned income in addition to the 75 per cent covered under their basic policy, with this additional amount being paid directly into superannuation.

The machinations of the superannuation protection option have morphed over time but the underlying logic remains unchanged; with the insurer’s full blessing, up to 85 per cent of earnings can be insured – 75 per cent to protect current lifestyle and 10 per cent future lifestyle.

The second insurer assertion that “To pay benefits at a level in excess of 75 per cent of his previous earnings is neither fair nor reasonable” moves higher on the bollocks-ometer.

Protection for severe disabilities

Concurrent with the launch of future lifestyle protection, was a realisation that the design of income protection insurance had been predicated on the flawed assumption that “all disabilities are created equal”. 

Commonsense indicated that this is not the case. Whilst, for many, a return to work will be possible, for some, the impact of the sickness or injury is such that they will be rendered permanently unable to return to work in either their own or, possibly, any occupation. 

This realisation led to the question being asked:

“If the impact of an insured’s sickness or injury was such that a return to work was not possible, might this give rise to costs additional to those encountered by someone suffering a less severe disability?”

The answer is, of course, known to be in the affirmative.

These costs fall into two categories:

• Medical and rehabilitation expenses; and
• Personal costs such as home and car modifications, costs incurred in having someone perform tasks the insured is no longer able to undertake.

Some of these costs will be one-offs, which are well protected by a lump sum total and permanent disability (TPD) product. Others, however, will recur, potentially for many years and thus, a more appropriate solution might be an inflation-linked monthly payment through to age 65.

Thus, concurrent with the launch of the superannuation protection option, was another income protection insurance optional benefit termed at the time, the Disability Plus Benefit. This provided for up to 50 per cent of earnings to be insured in addition to the 75 per cent of earnings under the basic income protection insurance policy and 10 per cent under the superannuation protection option; a total of up to 135 per cent of earnings covered.

To provide for payment in appropriate circumstances, the benefit was payable if the insured satisfied a more severe definition of disability that approximated that under TPD insurance. 

Any concerns about an insured’s motivation to return to work are logically covered off by the fact that a benefit payment in excess of 75 per cent or even 85 per cent, will not impact on the motivation to do something that has been deemed medically not possible. 

The insurer’s statement continues to take a bollocking!

Graduate insurance

Most insurers recognise the need to protect not only actual but also potential earnings, with the most obvious example of this being graduate insurance.

As one insurer puts it in the adviser handbook:

“We understand that it may not be possible for new graduates and newly qualified professionals to provide financial evidence in support of their application for cover. (Graduate cover) allows your client to apply for income protection insurance without the need for them to provide financial evidence.”

Rather than having to provide proof of income sufficient to justify the level of cover, benefit amounts up to preset maximums were made available on the basis of proof of the professional qualification and the applicant working full-time, with the preset maximums potentially being in excess of 75 per cent of the then level of earnings.

With some insurers, the protection offered was further enhanced by virtue of pre-disability earnings having a deemed minimum value. This ensured that not only was protection provided if the insured was totally disabled, but the position for partial disability was also considered.

To demonstrate:

It’s Monday, first day of full-time work for Gary Graduate who has accepted a role with a large accounting firm; package of $60,000. As one of his first tasks he applies for and is issued with an income protection insurance policy for $7,500 a month under the graduate cover arrangement. 

Whilst this represents a benefit well in excess of 75 per cent of his earnings, Gary is confident that his potential to earn at a rate to justify this level of cover will be realised within a matter of six to 12 months; he appreciates the need to ensure his lifestyle now and into the future is fully protected.

Unfortunately, fate had another plan for Gary – during his first lunchbreak, he is injured when a car mounts the curb and runs him down.

Gary is in hospital for two weeks and then spends six more weeks at home recovering, before he is able to start a return to work plan that will see him initially restricted to two days a week.

For the first month of benefit payments, Gary receives a total disability benefit equivalent to the full insured benefit amount; financially he is OK.

When he returns to part-time work, however, his benefit proportionally reduces in line with the formula (A-B/A) where A is pre-disability earnings i.e. his earnings in the 12 months prior to the date of disability. The potential problem is clear:

Gary has only worked and earnt for one day which means his pre-disability earnings is virtually nil, which compromises his partial disability benefit payment.

Fortunately, protection for Gary is provided by way of a deemed minimum value for pre-disability earnings of the benefit amount divided by 0.75 i.e. 7,500/0.75 = $10,000.

When the numbers are crunched, Gary’s total and partial disability benefit payments are greater than 75 per cent of his pre-claim earnings; however, because it is lifestyle that is being protected rather than income, it would arguably be bollocks to say this “is neither fair nor reasonable”.

Agreed value income protection insurance

Of course, the consummate example of situations when an insured might receive more than 75 per cent of pre-claim earnings under an income protection insurance policy is when the policy in force is an agreed value contract.

Meg Marsala is an outstanding mathematics graduate who forges a stellar career in management with a major player in the financial services industry, earning in excess of $300,000 a year. Meg recognises the importance of having maximum lifestyle protection and effects income protection insurance for:

• 75 per cent of earnings under an income protection insurance policy; plus
• 10 per cent of earnings under a superannuation protection option; and
• 50 per cent of earnings under a revenue TPD facility.

Several years later, Meg decides she will take a year off to undertake 12 months of unpaid philanthropic work overseas. 

Whilst Meg was fortunate, suffering neither an injury or illness whilst overseas and returning rested and raring to go to her previous role, had statistics worked against her, any benefit paid under her income protection insurance policy would have been well in excess of 75 per cent of her pre-claim earnings.

As with Gary Graduate, Meg would hardly have seen this as “neither fair nor reasonable.”

Non-medical impact on potential earnings

There remains one other aspect of lifestyle protection that has not been pursued in the matter of applications for income protection insurance and rarely recognised at the time of claim and that is the impact of natural disasters; environmental and personal.

Richard Carpenter is a very successful tradie who, unlike Meg Marsala, is the subject of repeated bouts of bad luck.

First up, one of his major clients goes into liquidation leaving Richard with bad debts of more than $500,000. Whilst financially devastating, Richard is arguably fortunate in that he can continue to work and generate revenue at full capacity albeit, from an accounting perspective, his net earnings take a hit as the debt is written off.

Then, just when Richard is getting back on his feet, fate strikes again; a burst watermain floods the basement of his house destroying his tools of trade and business vehicle. Because Richard is still financially stretched by the flow-on effects of the bad debt, he is unable to purchase replacement tools and a ute until the insurance money comes through. There is an earnings hiatus in his business of several months’ duration. 

Funds finally arrive, tools and vehicle are purchased, and Richard is able to start earning again only to suffer a further and permanent setback when he is seriously injured in a work accident. 

For reasons that were appropriate at the time, Richard has indemnity insurance in place but, due to the impact of the flood, his contractual pre-disability earnings are lower than they otherwise would have been. The immediate impact is that the benefit amount payable is around half what it would normally have been. 

In this situation, what is fair and reasonable?

One answer is for the insurer to dogmatically enforce the policy definition and right off Richard’s situation to “bollocking bad luck”.

Another, arguably fairer and more reasonable answer, is to consider pre-disability earnings not on the basis of actual earnings but on a robust assessment of pre-claim economic loss.

In a real-life example, relevant facts pertaining to “Richard” were:

• He worked as a carpenter in the high-end luxury renovations market;
• He worked in excess of 40 hours a week;
• He had completed a Bachelor Degree in Project and Construction Management; and
• He traded in a self-employed capacity.

The forensic accountant undertaking an analysis of the pre-claim economic loss noted: “In my opinion, it is not possible to draw any conclusions as to the economic loss (if any) suffered by Richard based solely on a review of the distributions … (thus) in undertaking my calculations, I have focused on the loss of income which Richard would have expected to have had under his control and at his disposal by exercising his earning capacity rather than the level of income he returned for Income Tax purposes. Accordingly, I have assessed the economic loss suffered as a result of the incident, as being referable to Richard’s loss of earning capacity”.

The accountant sourced various market texts to ascertain “the earning capacity” for someone of Richard’s qualifications and business size. 

The result was that the full indemnity value was financially justified and eventually paid.

Whilst the process is not without complications, for example, should market downturns be taken into account, used prudently, it is arguably in line with the insurer’s duty to act in good faith.

Summary

Perspective, insight, experience and expertise: these are the qualities that, for an insurer, dictate whether simply insurance products are made available as distinct from lifestyle risk solutions. Similarly, these qualities, for an adviser, dictate whether service is provided to clients as distinct from advice. 

Long may the latter apply with bollocks to the former!

Col Fullagar is principal at Integrity Resolutions.