Income protection: Why is it so?

Carl Sagan, the American astronomer and science communicator, once famously said “you have to know the past to understand the present.” 

Carl’s sentiments very much apply when considering the derivation of various components of today’s risk insurance policies and the enquiring financial services mind will discover a galaxy of information simply by asking questions.

So let the countdown begin …

10. Why should pre-disability earnings (“PDE”) be indexed?

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PDE is a defined term within income protection insurance policies that records the insured’s earnings prior to the sickness or injury causing total or partial disability.

PDE impacts the benefit payable in a number of areas, including:

• Within the partial disability formula, it is the benchmark against which an insured’s current earnings are assessed so that the partial disability benefit can be calculated; and
• As part of an offset clause, it is often used to determine the maximum amount an insured can receive.

Because PDE acts as a benchmark, if it is being compared to something that is subject to inflation increases, the real effect of PDE will be eroded over time unless it is also CPI indexed.

Case Study

Jim is an employed person. He suffers an illness and, as a result, his earning capacity reduces to 50 per cent of his pre-illness level and, for the sake of this Case Study, it’s assumed that this reduction remains constant for the duration of his illness.  

Jim claims under his income protection insurance policy and is assessed partially disabled with a PDE of $10,000 a month.

In Year One, as Jim’s earning capacity is 50 per cent of his pre-illness level, he will earn $5,000 a month. His partial disability benefit formula becomes:

($10,000 - $5,000)/$10,000 x the benefit amount...  Jim receives 50 per cent of the benefit amount which equates to his reduced earning capacity; so far, so good.

In Year Two, Jim receives a CPI salary increase (CPI assumed constant at 2.5 per cent); his earnings increase to $5,125 a month. His partial disability benefit formula becomes:

($10,000 - $5,125)/$10,000 x the benefit amount... Jim receives 48.75 per cent of the benefit amount notwithstanding his reduced earning capacity is still 50 per cent. After only one year, Jim is in a prejudicial position.

By Year 10, the benefit amount percentage has reduced to 36 per cent again, notwithstanding Jim remains 50 per cent disabled. 

There are two unfavourable outcomes from the above:

• Jim is receiving less than his reasonable entitlement; and
• Because of the above, Jim’s partial disability benefit plus his post-disability earnings soon become less than what he would receive if he stopped work altogether and claimed a total disability benefit.

Not only does Jim lose but the insurer is at risk of doing so also.

Protection for both parties is provided by increasing PDE by CPI increases so that its relative position to current earnings is maintained.

9. WHY IS 25 PER CENT OF THE TRAUMA INSURANCE BENEFIT AMOUNT SOMETIMES PAID ON DIAGNOSIS?

Trauma insurance policies often provide for payment of 25 per cent of the benefit amount on diagnosis of certain insured events, well in advance of the definition being satisfied.  

This facility was introduced in the late 1990s with the catalyst of the declining of a claim for multiple sclerosis because the insured’s medical condition was not sufficiently severe to meet the definition.

Insurer internal soul-searching followed. The initial concern was poor public perception but, of itself, this was considered insufficient cause to make a benefit payment.

It was realised, however, that some trauma insurance insured events shared the following:

• They were chronic by nature and experienced a relatively low early mortality rate,  and thus would almost inevitably progress from diagnosis to meeting the definition;
• There was no known cure and no indication of a cure in the short-term; and
• The mere diagnosis of these conditions was itself a traumatic event that would expose the insured to additional medical expenditure and a likely lifestyle change – the underlying purpose of trauma insurance.

The events included multiple sclerosis, Parkinson’s disease, muscular dystrophy, Motor Neurone Disease, cardiomyopathy, and others.

To reasonably provide for the above, the facility to pay 25 per cent on diagnosis was introduced. The balance, plus indexation increases in the interim, was paid when the definition was satisfied.

This facility overcame both the pragmatic and PR issues.
 

8. WHY SHOULD PRE-DISABILITY EARNINGS (“PDE”) HAVE A DEEMED MINIMUM VALUE?

Case Study

Jenni graduates and starts work on a salary of $80,000. She takes the advice of her financial adviser and purchases an income protection insurance policy for $5,000 a month.

The next day, Jenni is badly injured. She is on a total disability claim for six months after which she is able to return to work part-time but because Jenni only worked for one day, her PDE is effectively nil.

Jenni’s adviser, cognisant of the unique risk she faced, made sure her policy included a deemed minimum value facility whereby PDE was guaranteed to be no less than the annualized benefit amount ($5,000 x 12) divided by 0.75 (the insured per cent), i.e. $80,000.

The equivalent problem exists if an insured receives a material increase in earnings, for example, via a promotion or a moving to a new employer on a materially increased level of earnings and the increase is insured. 

An additional benefit of a deemed minimum value, is that if a claim is lodged many years after the policy start date and proof of earnings cannot be provided, the deemed minimum value provides a built in level of protection.

If earnings increase over time, pre-disability earnings would similarly increase thus rendering the deemed minimum redundant but, in the meantime, it plays a crucial role.

7. WHY DOES TRAUMA INSURANCE INCLUDE SOME DEFINED INSURED EVENTS BUT NOT OTHERS?

Believe it or not, when trauma insurance was first made available in the 1980s, there was a logic underpinning the inclusion or exclusion of insured events. 

First, medical events for which death was certain were already covered under the terminal illness benefit within term insurance; thus, they could be excluded from the trauma insurance product.

Next, medical events needed to carry significant treatment and rehabilitation costs, and potentially give rise to a level of psychological and/or physical impact such that a change in lifestyle might be considered.

And finally, the statistical benchmark for the definition of the insured event was set to approximate an 80 per cent, five-year survival rate or, in common language, whilst the medical event was serious and worrying, and would be expensive to treat, there was a good chance of survival. 

The importance of the above is that the consistent application of a logic within product design better enables an adviser to objectively match the client’s risk exposure to a solution.

Unfortunately, over the ensuing years the logic fell into a black hole and has been all but lost, arguably resulting in a reactive design process that adds insured events and changes definitions in response to product research and opinion rather than focusing on need.

6. WHY ARE SOME PREGNANCIES INCOME PROTECTION EXCLUDED AND OTHERS AREN’T?

Insurance is meant to cover a loss arising out of an unintended and unexpected event. 

For this reason, pregnancy was initially fully excluded as it was considered to be neither unintended nor unexpected; thus financial provision could be made for it both prior to and during the term of the pregnancy. Also, to not exclude pregnancy, would open up the insurer to a significant, anti-selection risk.

Whilst the above might hold some theoretical merit, at best, it only did so for ‘normal’ pregnancy; an abnormal and/or complicated pregnancy leading to an inability to work, was neither intended nor expected and thus should, based on the same logic, not be excluded.

This issue was recognised and first provided for by adjusting the exclusion so that pregnancy was covered if ‘disability’ continuing for more than two months after the pregnancy ended either by way of birth, miscarriage, etc. The point being that any illness arising out of pregnancy that lasted for longer than two months would constitute an abnormality or complication. 

The exclusion was later simplified to ‘normal and uncomplicated pregnancies are excluded’ which meant, by default, abnormal and complicated pregnancies were covered with that cover being immediate.

5. WHY IS A FIVE-DAY RETURN TO WORK DURING THE WAITING PERIOD ALLOWED?

Income protection insurance initially only provided for benefit payments if the insured was ‘totally unable to work’. As such, the waiting period required the insured to be ‘continuously’ unable to work for the entire waiting period. If the insured returned to work at, and for, any period of time, even one day, the waiting period would restart.

Later partial and rehabilitation benefits were added to encourage an insured that wanted to work, and had a medical ability to work, to attempt to do so.

It became clear, however, that there was little to encourage an attempt to work, especially during the waiting period, if to do so meant risking having the waiting period restart. 

A facility was therefore added enabling the insured to return to work for up to five days, i.e. one calendar week, without this impacting on the continuity aspect. If the attempt to work failed, the return to work days were added to the end of the waiting period such that the insured could satisfy a 30-day waiting period by being totally disabled for 30 out of 35 days.

There have been various changes since then but the above was where it all started.

4. WHY CAN WAITING PERIODS START PRIOR TO A CLAIMANT ATTENDING A DOCTOR?

Historically, waiting periods started ‘when the life insured attended a medical practitioner who confirmed totally disability’.

This worked nicely for acute medical events such as a heart attack, stroke and broken legs, as these generally resulted in an immediate medical attendance. For people suffering from chronic conditions however, the reality could be quite different. For example, an insured may hurt their back but decide to soldier on in the belief or hope it will correct itself. A day or two later, they are still unable to work so contact is made with the doctor but the earliest appointment is several days hence. Thus, it might be up to a week before the requisite medical confirmation is obtained.

If the benefit amount is $10,000 a month, a week means a loss to the insured of $2,500; a high price to pay for trying to do the right thing.

A facility that enabled the start date of the waiting period to be backdated by up to seven days, subject to subsequent medical confirmation, covered off the above pragmatic issue.

3. WHY DO PDE DEFINITIONS SOMETIMES GO BACK THREE YEARS BEFORE THE POLICY STARTED?

Way back when, the definition of PDE for agreed value policies was ‘the highest 12 consecutive months in the three years prior to disability’.

In the late 1990s, an insurer launched a ‘true’ agreed value policy in which the definition of pre-disability earnings was the highest 12 consecutive months since the date 12 months prior to the policy start date. This not only covered the duration of the policy but also included the earnings declared within the application form.

It was soon realised, however, that an insured on a partial disability claim in the first three years of the policy duration could be in a better position under the previous definition of three years prior to the date of disability.

To overcome the anomaly, the definition became the highest 12 consecutive months since the date three years prior to the policy start date.

2. WHY WAS A SUPERANNUATION PROTECTION OPTION INTRODUCED?

Prior to income protection superannuation protection options being made available, the maximum percentage of income that could be insured was 75 per cent, with the reason being if, whilst on claim, an insured received more than 75 per cent of their prior earnings, statistics indicated that the motivation to return to work would diminish resulting in the number and duration of claims increasing to an unsustainable level.

From the insured’s perspective however, if they only received 75 per cent of prior earnings, in many cases these funds would be spent on the ‘today’ expenses such as mortgage, food, utilities, education expenses and clothing. There would be little, if any, funds remaining for superannuation savings.

If this continued through to the policy expiry at age 65, the claim benefit would cease and the insured would be left with deficient superannuation savings, with the deficiency being directly linked to the period of claim.

The superannuation protection option was specifically introduced to overcome the above problem. In essence:

The 75 per cent standard benefit would protect current lifestyle; and

The 10 per cent superannuation protection option would protect future lifestyle by way of ensuring continuity of superannuation contribution.

Because the funds in excess of 75 per cent were not immediately ‘available’ to the insured, motivation to return to work was theoretically not impacted.

1. WHY SHOULD MONETARY LIMITS WITHIN POLICIES BE CPI INDEXED?

It is not unusual to see benefit limits with policies being expressed not as a multiple of the benefit amount but as a dollar amount, for example, within income protection policies, the death benefit is payable to a maximum of $60,000.

In a similar way to point 10 above, which considered the indexation of PDE, if fixed dollar amounts within a policy are not CPI indexed their real value is eroded by inflation.

Provision is easily made by referencing same within the introduction section of the policy, for example.

0. WHY SHOULD INCOME PROTECTION INSURANCE REHABILITATION BENEFITS BE IMMEDIATELY AVAILABLE?

The aim of these benefits is to reduce the amount of benefit payments by assisting and encouraging the insured to return to work. Rehabilitation 101 designates that, the sooner it begins, subject to medical sign-off, the greater the chance of a favourable outcome.

Thus, the logic is simple; access should be immediate rather than being contingent on the insured ‘receiving a disability benefit payment’ which, by definition, requires waiting until the end of the waiting period.

BLAST OFF…

As per Carl Sagan, knowledge of the past provides an understanding of the present. However, whilst understanding aspects of the evolution of risk insurance products might serve to titillate the enquiring mind, there are compelling reasons to not only know and understand but to record.

First, if the reasons for introducing a particular product feature are lost, the chances increase that the feature itself will also eventually be lost. Evidence to support this is the fact that, whilst the policy features detailed above have existed in the Australian risk insurance market in the past, not all can be found in current retail products. 

Further, if the logic underpinning a product is set aside, the chances increase that the product will lose consistency and focus, making the role of matching solutions to needs, that much more difficult.

But, most importantly, when advisers recommend a risk product, they do so based on their understanding of how the policy wording will be applied should a claim be made. If that understanding is forgotten, contemporaries to come may inadvertently rewrite history to fill the void in a way that suits their purpose, albeit that purpose was unintended.  

Col Fullagar is the principal of Integrity Resolutions. This is the 100th column he has written for Money Management.