The purpose of an income protection insurance policy is two-fold:
- To protect the current and future lifestyle of the life insured, and those financially dependent on the life insured, if a sickness or injury impacts on the ability to work and earn; and
- To assist and encourage the life insured in a return to work, subject to this being medically advisable.
The protection is deemed to be required on a temporary basis albeit that “temporary” may be to age 65 or 70.
The manner of protection is by way of a guaranteed revenue stream, usually paid monthly, to replace the insured percentage of the life insured’s earned income. The guarantee is almost invariably enriched by being CPI-indexed on the anniversary of the claim starting.
It would be a hard task-person that would ask for more.
Income protection insurance is surely the perfect solution to the risk detailed above and yet, it, arguably more than any other form of risk insurance, delivers outcomes that are the antithesis of the Peace of Mind promised when the initial advice is provided.
When the insured-against sickness or injury strikes – work ceases, and often, with it, self-esteem takes a hit.
A claim is lodged, and navigation of the initial assessment process begins:
- claim forms, personal and medical, are completed or tele-claim interviews are undertaken;
- additional evidence, medical and financial, is generally required; and
- medical and Medicare authorities, the claim equivalent of blank cheques, are required.
Time will pass during which stress, arising from uncertainty, grows but all things being equal, the claim will eventually be accepted.
Unfortunately, far from this being Claim Hump Day, the ongoing assessment process begins:
- Regular monthly personal and medical claim forms are now needed;
- Provision of tax returns is necessary and, for the self-employed, business financial statements;
- Within the assessor’s arsenal will be tools such as factual interviews, independent medical examinations, surveillance and random assessor phone calls; and
- Regular changes of assessors as incumbents are shuffled internally or frisby from one insurer to another, leading to a return to uncertain times as already supplied information is requested again and the new assessor seeks to approach the ongoing claim assessment in a way they see, rather than the previous assessor saw, as appropriate.
Even if the above is not the reality, for many, it is perceived as such.
For those with a simple fracture, the process will quickly end when a return to work is affected but, those with a more complex and long-term prognosis, may face many months or even years of the above.
It is not uncommon, therefore, that after a year or two on claim, the claimant’s mind may yearn for freedom; or, it may even be that the insurer will yearn to be free of the claimant. If you like, the claim equivalent of a divorce.
When this happens, one settlement option is seen as the exchanging of regular monthly payments for an upfront lump sum or, to use the industry vernacular, to commute future benefit payments in exchange for the cancelation of the policy.
Numbers are not made public, notwithstanding, maybe they should, but it seems this option is becoming more prevalent which means, of course, it warrants scrutiny and the asking of questions.
Go it alone or seek assistance?
If considering the exchange of regular benefit entitlements for a lump sum settlement, should the claimant go it alone or seek assistance?
The short answer is, unless the claimant is skilled in all relevant aspects of commutations and able to remain devoid of emotional involvement, both of which are unlikely, seeking assistance would seem the better option.
Who can assist?
There are several parties that potentially possess the attributes of knowledge and the ability to remain emotionally detached:
- The insurer; great in theory but the insurer will be conflicted and perceived as not being impartial;
- A solicitor or accountant; better idea, but it would be crucial they had the necessary experience and technical knowledge;
- A financial adviser or independent consultant; conflicted – no, impartial – yes, experienced – likely and, as a bonus, they may also be well connected within the relevant insurance company such that they can be an effective communication conduit.
The stars therefore align in favour of option three.
There is an endless array of reasons, good and less-than-good, why a claimant would consider ending the financial relationship with their insurer.
The most common is that the relationship between the two parties has broken down; perhaps contributed to by:
- Perceived onerous, and seemingly endless, claim requirements with no apparent logic to them;
- The monotonous tedium and expense of monthly claim forms, personal and medical;
- Disagreement with decisions made and no apparent recourse; and
- A feeling of being bullied when questions are asked, or requests made are ignored.
If an adviser is called upon to assist, they might be tempted to accept the position on face value and proceed to work with the insurer to finalise the matter. A word of caution; this may not be in the best interest of the client.
As with initial advice, it is crucial that an informed decision be facilitated. In fact, bearing in mind that a claim will be in place, this is even more the case.
The adviser should make it clear that a long-term decision based on a relatively short-term aggravation could result in commuter’s remorse, financial and psychological, well into the future.
The adviser might suggest and/or arrange steps to make the process more palatable:
- Less frequent progress claim forms to reduce the psychological, financial and physical impact of the claim;
- Letting the insurer know that mistakes and/or irritations are occurring, so these might be corrected;
- If there is a personality clash with the assessor, respectfully discussing with the assessor’s manager that a change may be warranted.
If these measures fail, commutation might be the fallback option.
If the claimant’s medical condition is stable and, realistically, it is not going to get better and it may even deteriorate, a return to their own occupation may be permanently highly unlikely. This may not, however, preclude a return to work in a different occupation.
In this situation, an income protection commutation could provide access to capital to fund the training for, and setting up of, a new business.
The downside includes:
- If a claim arose for a different reason in the future, the insured would have no income protection insurance;
- If the business or career moved failed, there is no fallback; and
- The insurer, when calculating a commutation amount may take into account the return to work possibility and discount the lump sum offer accordingly.
A left-field idea might be to approach the insurer about commuting the benefit payments but retaining the policy with an exclusion for the previous claim condition. This option, whilst theoretically possible, is only feasible for claim conditions that can be isolated effectively with an exclusion.
A third reason is the claimant becomes aware of an investment opportunity that might prove more financially advantageous than continuing to receive a long-term monthly income protection benefit; with a twist on this being a lack of superannuation savings means the receipt of a lump sum now is an opportunity to make provision for the longer-term future.
Downsides are similar to those in (ii) above.
Take back control
Even though the claim management process may be working fine, a claimant may simply want to take back control of their life
One real-life example was an insured on claim for chronic depression who was facing the loss of the family home due to financial pressures. This outcome may well have severely exacerbated the illness.
By negotiating a benefit commutation, sufficient funds were freed up to extinguish the home mortgage and leave a little over for shorter-term needs; resulting in an overall improvement in the persons mood.
While there are clear longer-term issues needing to be faced, sometimes the immediate may take precedent.
Insurer red flags
A claimant should consider that a commutation request may be seen as a potential red flag by the insurer, for example:
- If the subject is raised immediately or soon after a request for claim requirements, medical or financial, this may be seen as the catalyst, leading to an even greater insistence on the requirement or the making of a commutation offer subject to receipt of it; or
- The insurer may think the request for a commutation is being driven by something material to the claim of which it is not aware, for example, a change in the medical condition, either for the better, meaning the insured may be able to return to work; or
- The worse, meaning the early mortality risk has increased.
Either of the above might impact on the quantum of any commutation offer and the requirements needed to progress the matter.
No doubt there have also been situations where the claim was less than genuine but, the insurer realizes that obtaining definitive proof will be problematic. Pragmatically, the best way forward is to negotiate a settlement by way of a commutation, rather than continue an intrusive and expensive exercise of surveillance, investigation and constant vigilance.
Calculation of lump sum
When the matter of a commutation is raised either by the claimant or the insurer, the insurer might suggest “Let us know how much you want and we will come back to you.”
The initial claimant response may be to take the current monthly benefit (say $10,000), multiply it by 12 ($120,000), multiply it again by the number of years and months remaining until the policy expiry date (say 15.0), and then add two per cent compound interest for good measure … Bingo! $2.25 million.
This method is, of course, overly simplistic and underly realistic.
Worse still, it leads to an inflated expectation which will inevitably be brought back to reality if and when an insurer counter offer is made; possibly leaving the claimant feeling they are being “bullied by the hard-ball insurer”.
If the opening bid is to come from the claimant; which is not necessarily recommended, an understanding of the calculation process is crucial.
Step One is claims reserving i.e. the process of making an appropriate financial provision for, in this case, a long-term claim.
The claims reserve is the amount of money the insurer sets aside now so that, when interest is added to it, and regular benefit payments and expenses are taken from it, by the estimated end date of the claim, the claims reserve is Nil.
When setting up a reserve, the insurer will consider:
- The age of the claimant;
- The benefit period and policy expiry date;
- If claim benefit indexation applies and, if so, at what rate;
- The likelihood of early mortality and when;
- The likelihood and extent of recovery leading to a return to work; and
- The rate of interest that can be earned on the reserve.
The reserve might be seen as the present-day value of future benefit payments.
The estimated rate of interest to be earned on the reserve is treated as a discount factor. Thus, a five per cent rate, would see $2.25 million in 15 years, equate to $1.1 million now.
Step Two is to appreciate that the insurer is unlikely to offer the full reserve amount; they might just as well keep paying and let the claim run its course.
The proportion of the reserve an insurer is willing to offer, is unknown to the insured and likely to remain so because it is dictated by insurer attitude and claim circumstances.
If the claim is seen as totally genuine, a higher percentage of the reserve might be offered, whereas, if there is some doubt, correctly or not, the insurer might start low and negotiate hard-ball up.
In the example above, if the proportion of the reserve offered was 75 per cent, the commutation lump sum would be $825,000.
The balance, $275,000, would eventually be booked to insurer profit.
The problem for the claimant is, of course, if the insurer is unwilling to provide any insight into how the commutation lump sum is calculated, which is all but universally the case, how does the claimant know if the offer is fair and reasonable or foul and miserable.
An insurer response that the basis of the calculation is irrelevant, is missing the point.
As with all insurance dealings, the duty for parties to act in good faith towards each other is arguably being breached if an insure engages in a process that could see acceptance of an unfair offer.
An alternative, albeit at claimant cost, is for an independent actuary to be engaged to undertake the calculation of what might constitute a reasonable offer.
The stark reality is, however, that commutation outcomes can be fraught …
In the above example, the claimant would receive a lump sum of $825,000. After tax, they might be left with, say $480,000.
If this was invested at 10 per cent – a healthy return in the current environment – the investment income would be $48,000 or $4,000 a month.
Therefore, unless there was a capital draw-down to complement the investment return, the claimant has exchanged a CPI-linked monthly benefit of $10,000, for a monthly payment of $4,000 that is at the mercy of fluctuating returns.
If a capital draw-down was made, indicatively the lump sum, and with it the interest return, would end in around five years; which, in the above example, would leave the insured without any income for the remaining 10 years to age 65.
As intimated above, a crucial factor in any lump sum commutation process is the impact of tax with the consensus being that the lump sum would be fully taxed in the year of receipt.
A theoretical alternative is to commute part of the policy one financial year and the balance the next, but this would require the co-operation of the insurer, something they may be unwilling to do.
Whatever action is taken, it would be essential to seek formal tax advice prior to finalizing or even entering discussions with the insurer.
Income protection lump sum optional benefits
Lump sum commutations are generally not a contractual right within income protection insurance contracts; thus, any offer is subject to insurer discretion.
While no definitive data exists, it appears that some insurers are willing to enter these negotiations with a greater willingness than others; some are in fact, openly anti, seeing it as against the principle of the product.
At time of writing, however, there are five retail insurers that make available an optional benefit that gives a claimant the contractual right to opt for a lump sum commutation payment. Not only this, the payment is tax-free – based on tax advice received by the relevant insurer.
The workings of the option differ slightly but, in general terms:
- The option can only be added at the time of the initial application;
- It only applies to policies with a benefit period of age 65 or longer;
- There may be additional restrictions in regard to waiting periods and other options concurrently available; and
- Activation of the option is contingent on the insured being deemed “totally and permanently disabled” but not “terminally ill”.
The option entitles the claimant to a multiple of the “annualised benefit” based on their age when the option is exercised. For example:
If the insured is less than age 40, the multiple of the annualised benefit is 15;
If the insured is 40 to 44, the multiple is 13 … and so on.
The option may come at both a premium cost and the loss of tax deductibility for a proportion of the income protection insurance premium.
Situations when the option might be appropriate include:
- If the insured was suffering a terminal condition but was not yet “terminally ill” the lump sum may provide access to a greater benefit payment than would be the case if monthly payments continued; and
- If the insured found they were under-insured for TPD due to the nature and severity of the TPD condition, a tax-free lump sum might go some way to making up the shortfall.
The main negative, as with any commutation of a revenue stream is, of course, if the lump sum is invested poorly or spent unwisely, there is no income protection insurance fallback facility.
What to do …
As with many decisions revolving around someone’s finances, generally the claimant should:
- Avoid making rushed, ill-informed and/or emotional decisions;
- Get, consider and compare all relevant information; and
- Crucially, give very serious consideration to engaging an informed third party, such as a financial adviser, to assist in the process,
- Because a poor commutation decision might make a standard divorce settlement look like a windfall!
Col Fullagar is principal of Integrity Resolutions Pty Ltd.