Why income protection is behind the times

Many definitions within life insurance have been subject to drastic changes as time rolled past. However, Col Fullagar notes income-protection cover definition is one of the most outdated.

When it comes to risk insurance, great attention is paid both by insurers and financial advisers to the various core definitions that exist within the contract.

This attention is well warranted because it is these definitions that play such a significant part in establishing benefit eligibility: for example, the definitions of the various trauma insured events, total and permanent disability and total and partial disability are vital to whether or not a benefit is paid and how much is paid.

Financial advisers who are involved with risk insurance will be well aware of the dramatic changes these and other definitions have undergone in the past and continue to undergo.

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There is one definition, however, that has, for many years, largely slipped under the radar, which is surprising when its impact is considered.

Whilst of lesser relevance for the other risk insurance types, this definition is at the very heart of income protection insurance:

• Dictating what can be insured at the time of application;
• Dictating what can be paid under indemnity contracts;
• Proof of which is required on virtually all claims; and
• Anecdotally, has been the focus of more disputes, legal and otherwise, over the years than any other aspect of this type of insurance.

The definition is of course that of earnings or income and its subsequent manifestation as pre and post-disability earnings.

A review of a policy issued in the 1980s found the following definition applied:

“If you own any portion of a business or professional practice, ‘monthly earnings’ means income earned by that business or practice due to your personal activities, less your share of business expenses which are necessarily incurred in earning that income.

“From any other source of employment ‘monthly earnings’ means your salary, fees, commissions and bonuses and any other income earned for services performed.” (Source: Associated National Life, Income Reserve Plan.)

A policy available at the time this article was written has the following definition:

“If you are self-employed, a working director or partner in a partnership, your monthly income is the monthly income generated by the business or practice directly due to your personal exertion or activities excluding superannuation contributions, less your monthly share of business expenses.

“If you are not self-employed, a working director or partner in a partnership, your monthly income is the total monthly value of remuneration paid by your employer including salary, fees, commission, bonuses, regular overtime and fringe benefits, excluding superannuation contributions.” (Source: CommInsure, Income Care Plus.)

Unlike other aspects of income protection insurance, the above indicatively shows that the definition of ‘earnings’ has not altered materially over the years in that it was, and still is, linked to the employment status of the life insured.

In turn, the employment status of the life insured tends to be linked to a crude criterion: ie, whether the life insured does or does not have any direct or indirect ownership of the business.

In much the same way that Henry Ford said about his Model T in 1906, “You can have any colour provided it’s black”, insurers still only offer the choice of two employment status options – employed or self-employed.

It would seem, however, that life is not as black and white as Ford or the insurers would like, particularly when the reality of employment and remuneration are considered.

The range and conjugations of variations is vast, for example:

• Simplistically, people can either be employed or unemployed;
• Those who are unemployed or employed without the intention of being remunerated, ie, non-gainful employment, theoretically do not require nor can they obtain income protection insurance.
• Those who are employed can be employed in one or more than one of a variety of different ways:

- As an employee;
- As a contractor;
- Self-employed; or 
- As the owner or part-owner of a corporation.

• Employment can be full-time, part-time, casual or seasonal;
• People may have one or more than one ‘employment’, which may be on the same or a different basis;
• Irrespective of the basis of employment, in general terms those who are employed may:

- Have no financial interest in the employing entity;
- Have a private financial interest in the employing entity, ie, own shares not publicly listed; 
- Have a public financial interest in the employing entity, ie, own publicly listed shares; or
- Be a separate legal entity to the employing entity or the same legal entity.

• An employed person may receive remuneration by way of one, or more than one, of the following:

- Wages;
- Salary;
- A retainer fee while working on a commission basis;
- Commission;
- Fees;
- Tips;
- Payment in kind; 
- Superannuation;
- Performance bonus;
- Share distributions and option entitlements; 
- Fringe benefits; 
- Profit share;
- Overtime;
- Loadings;
- Allowances;
- Increase in goodwill;
- Cash; and
- Tax minimisation, for example, income splitting.

• Remuneration can be received immediately, received in advance or deferred.

No doubt there are other variations in addition to the above, but the point is that the range of variables when it comes to employment and earnings is clearly considerable, which means that the forcing of these into two categories of employed and self-employed on the basis of business ownership has the potential to complicate and confuse the financial advice and underwriting process.

Because there is a relatively lower level of scrutiny by insurers at the time of application, it may be that everything appears to be okay.

The reality could in fact be that problems exist but they are deferred, with well-intentioned financial advice foundering at the time of claim.

The likelihood of claims complications also increases if the insurer wants to apply what is often an arbitrary restriction: ie, the basis of calculating earnings at the time of claim must be consistent with that which applied at the time of application.

While this may sound fair, it is not necessarily the case because:

• The basis of employment and earnings may alter between the date the policy starts and the claim starts, particularly if the policy has been in force for a number of years;
• The basis of earnings may alter between the date the claim starts and later in the claim; and
• The manner of treating a particular type of earnings may alter simply because a claim occurs. The most topical example of this is financial adviser renewal commission, which contractually alters from generated to non-generated when the adviser is totally disabled.

And at the risk of complicating things even further, it is also possible the insurer would not seek to enforce the need for consistency, if by doing so they disadvantaged their own position.

There may be a temptation to brush this off as earnings being the poor second cousin of the client’s medical condition when it comes to claims’ critical issues. A review of several case studies might help provide perspective.

Case study 1

Ron is the 50 per cent shareholder, managing director and sole revenue generator of a private company employing two other people.

In this situation, the claims assessor would look to identify ‘the income of the business or practice generated by the personal efforts of (Ron) after the deduction of (his) appropriate share of business or practice expenses in generating that income’.

In the above situation, the current time-tested approach may be practical and appropriate.

The position, however, might be viewed quite differently if Ron’s company had a larger number of employees – for example, 20 – and there was also more than one revenue generator.

In this situation, trying to identify the income of the business generated by Ron and his share of the business expenses may be all but impossible if the current approach was used.

Case study 2

Brian purchases a start-up franchise. The franchisee recognises that it will take time for the business to reach profitability, so it makes provision within the remuneration arrangement for Brian to receive a modest retainer so that he can support his lifestyle.

The franchisee also requires that Brian has income protection insurance. He applies and is granted an indemnity contract due to the start-up nature of the business.

Five sales staff are hired and the doors are opened.

Nine months later Brian is disabled in a car accident. Whilst considerable and steady progress has been made, the business is still not trading at a profit: ie, revenue less expenses is negative.

Under his indemnity income protection insurance policy no benefit entitlement would exist, even though Brian was basing his lifestyle on the retainer he draws and he appropriately was looking to have that lifestyle protected.

Case study 3

Jessica runs a successful small business which employs her husband as a means of minimising tax.

Jessica is totally disabled for a period of time but then returns to work part-time.

She reads her income protection insurance policy and realises that if she reduces the earnings she receives by transferring most of them into her husband’s name and classifying them as expenses, she can increase the partial disability payments to her.

Thus, even though Jessica’s business is only suffering a 40 per cent drop in profits, she is able to receive a partial benefit at a rate considerably higher than that.

In case study 3, it is the insurer that is being disadvantaged, and while some may say “Good on you Jessica”, this is not the point. Insurance should be about equity, and inflated benefit payments will eventually lead to higher premiums being charged.

It is clear there are potential issues associated with the current definition of earnings, with those issues also potentially impacting the insured, insurers and financial advisers.

Whilst it may be frustrating for some to read an article that purports to identify a problem without proposing a solution, there remains merit in proposing some actions that can be taken:

• Insurance applications might be designed such that a more accurate reflection of the client’s financial position can be presented;
• Underwriting guidelines might be reviewed to ensure the insured have access to appropriate protection;
• If the current basis of defining earnings within income protection insurance policies is outdated, insurers could be encouraged to look at alternatives; and
• Claims management protocols and particularly claim forms, both initial and ongoing, may need to better appreciate the true financial position, rather than simply forcing claimants into employed/self-employed boxes.

The reality is that the difficulty of balancing contractual certainty, flexibility and equity means that arriving at and agreeing on a way forward will not necessarily be easy.

For financial advisers

The more important reality is, however, that financial advice and protection must go on. Thus, even if none of the above changes occur, advisers can still ensure that:

• Fact finds and financial advice documents facilitate the obtaining of a clear picture in regards to the client’s earnings, such that appropriate advice can be provided;
• Field underwriting skills can clearly represent the actual position of the client so as to facilitate an optimal assessment by the insurer;
• Regular reviews will ensure that any material changes in a client’s financial situation are identified at an early date; and
• Assistance is provided at the time of a claim so that any misunderstandings or over-simplifications are avoided, such that the appropriate benefit payment is made.

A client left to their own devices can easily be inadvertently caught up in a case study situation.

A core component of the value of advice is that financial advisers are forewarned and therefore forearmed.

Having access to this professional financial advice will unquestionably mitigate the risk of clients being short-changed by their earnings.

Col Fullagar is the national manager for risk insurance at RA Advice Group.