Commuting an income protection policy

Col Fullagar delves into the pros and cons of winding up an income protection policy and taking a commuted benefit, and what the process of commutation involves. 

The risk insurance fact find is completed and the data analysed, the recommendation presented and accepted, and insurance duly put in place. Plans have been made and solutions implemented. All is good. 

Several years later the unexpected but prepared-for happens; sickness or injury strikes and the future changes. 

Thankfully, however, insurance weaves its magic and the insured’s income continues, albeit at a reduced level. 

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Again, several years pass and the position is much the same – inability to work continues as do the benefit payments. 

It is not uncommon that around this time the insured’s mind turns to alternatives as the tedium of claim requirements takes its toll; periodic claim forms, provision of financial information and occasional medical testing and questioning. 

One alternative that may be considered is the idea of winding up the policy or, to use the industry jargon, taking a commuted benefit. 

If this thought arises, several questions may concurrently arise. 

To whom should the insured turn? 

There are a number of reasonable alternatives: 

• The insurer – but the insured may not be comfortable about the insurer’s impartiality; 
• A solicitor or accountant – possibly, but do they possess the desired pragmatic experience and the necessary contacts in this area; or 
• A financial adviser – impartial, yes; possessing experience, likely; possessing the necessary contacts, more than likely. 
• The stars appear to align in favour of a financial adviser. 
• The adviser is ideally placed to: 
• Understand the insured and the insurance; 
• Know who to approach; 
• Facilitate the asking of questions; and 
• Sort out the answers and provide the necessary advice. 

Naturally, as part of this process, the adviser may play a facilitation role involving the insurer and arranging referrals to others such as an accountant and/or a solicitor. 

Why would the insured commute? 

There are several reasons why an insured would consider a commutation of their income protection insurance benefit. 

The first, and sadly apparently the most common, is that the claims management process including contact with the insurer is so unpalatable for the insured that they feel it necessary to “cut their losses” and get out of the contract. 

Reasons cited can be many and varied, warranted and sometimes not: 

• Onerous and/or ongoing claim requirements; 
• The monotonous tedium of monthly form completion; 
• Disagreement with claim decisions; and  
• A desire to be free of the process. 

Whilst the temptation might be for the adviser to display that all-important empathy and agree to assist the insured to cancel their policy, take their money and run, this does not necessarily constitute appropriate and informed advice in the best interests of the insured. 

One thing that would be even more tragic than an insured making a long-term decision based on a short-term aggravation is that the aggravation continues well into the future by way of ‘seller’s-regret’, brought on by the deterioration in their financial decision as a direct result of their actions. 

If the issue is the claims management process, a better alternative is possibly for the adviser to suggest that, in the first instance, steps be taken to make the process palatable, sort out the problems, get things back on an even keel or even improve the position in real terms: 

• Negotiate less frequent progress claim forms to reduce the psychological, financial and physical impact of the claim on the insured; 
• Alert the insurer to where mistakes or irritations are occurring so that changes can be made; or 
• In the extreme, discuss a respectful change of assessors (where personalities clash in the absence of other issues). 

A second reason for insureds to seek a commutation is where there exists a long-term, stable impairment that would render them totally disabled in respect of the ‘own occupation’ through to the policy expiry date and beyond. 

In this situation, some insured’s may think that whilst there is no opportunity to work in their previous ‘own occupation’, there exist opportunities to work in a new ‘own occupation’.  

An example might be a carpenter who has lost a hand in an industrial accident and thus is rendered permanently unable to work as a carpenter. Rather than remain ‘at home’ and not work, the insured would prefer to train for and pursue an alternative career. 

The insured, while motivated to try a new occupation, may not however want to sacrifice their future entitlement to benefits under their income protection policy. 

The adviser, in this situation, may suggest an approach be made to the insurer to commute future benefits in exchange for the appropriate lump sum – which then frees the insured up to pursue new career opportunities. 

It may even be that the commutation could be made in exchange for an exclusion being placed on the policy in regards to the previous basis of claim payment, so that the balance of the policy might continue to provide cover. 

A third reason for considering a commutation may be that, notwithstanding the claims management process is working in an acceptable way, the insured believes they can improve their future financial position by way of a gaining access to a lump sum rather than having a regular income stream. 

For example, an investment opportunity in a business or a property becomes available which is ultimately going to prove more financially advantageous to the insured than continuing to receive a long-term monthly income protection insurance payment. 

A similar, real-life example was an insured who was on claim for chronic depression, who was also facing the loss of the family home due to financial pressure. This outcome would have severely exacerbated his illness.  

By negotiating a benefit commutation, sufficient funds were freed up to extinguish the debt on the home and leave something over for the shorter term needs – resulting in somewhat of an improvement in the insured’s illness.

Yes, there was the issue of longer-term financial exposure; however, in this instance the immediate need took priority. 

A final reason for considering commutation might be that the insured is suffering from a debilitating condition which will preclude any effective return to work; however, they wish to engage in certain activities now rather than wait out the future. 

Whilst this may not be the most economically sound reason for a commutation, the basis for it is understandable and, again, adviser support, assistance and guidance will prove invaluable. 

A slight deviation on the above might be if an insured approaches the insurer for a commutation upon receipt by the insured of certain requested claim requirements. 

The insurer may view this as a signal the insured does not want to provide the requirements because this may compromise some aspect of the claim.

In this circumstance, the insurer may make a commutation offer, but make it contingent on the provision of the requirements. 

In several of the above situations, a theoretical alternative is a partial commutation whereby a portion of the monthly benefit is surrendered for a smaller lump sum, with the balance continuing or even a yearly partial commute whereby full year’s benefits may be taken at the start of the year. 

Whilst theoretically possible, and thus worth considering, the administrative costs involved may prove prohibitive to the insurer making a reasonable offer. 

On occasions an insurer may approach an insured with an offer of commutation.  

A situation where this might arise is where the insurer has reasonable grounds to believe the circumstances surrounding the claim are less than genuine but definitive proof is elusive.

By way of negotiation, the parties involved can eventually walk away without the need for constant surveillance and vigilance. 

How is the commutation value calculated? 

An often-made mistake in assessing the reasonableness or otherwise of a lump sum commutation expectation or offer is to simply calculate the total future benefit payments – for example, $10,000 a month to age 65, indexed at 5 per cent, for a 45-year-old, equates to around $4 million. 

This method will generally lead to the insured feeling that any amount offered by the insurer is deficient and the insurer is “playing hard-ball”. 

A better understanding of the calculation basis may lead to a more realistic expectation of what the insurer will offer or has offered. 

In making appropriate financial provision for long-term claims, an insurer will set up a claims reserve. 

This is the amount of money the insurer believes needs to be set aside now so that when interest is added to it and regular benefit payments are deducted from it, by the estimated end date of the claim, the reserve is exhausted. 

In setting up a claim reserve, the insurer will consider factors such as: 

• The current age of the insured; 
• The benefit period and expiration date of the policy; 
• The basis of benefit indexation; 
• The likelihood of early mortality and when; 
• The likelihood of recovery and return to work; and 
• The rate of interest the insurer believes can be earned on the claims reserve. 

In effect, the claims reserve represents the present-day value of future benefits to policy expiry, or estimated date of death if earlier.

To obtain the present-day value, the insurer treats the rate of interest they believe will be earned in the future as a discount factor. 

Thus the $4 million above may come back to $2 million in today’s dollars if an interest rate of 7.5 per cent is used to discount the payments. 

Any lump sum commutation offered will generally represent a proportion of, but not necessarily all of, the claims reserve. Any difference would be booked by the insurer to profit. 

The insurer is unlikely to offer the full claims reserve because they would be just as well served to retain the reserve and continue paying the claim. 

The proportion of the reserve an insurer will be willing to offer may, in part, be dictated by the circumstance of the claim. 

For example, if the claim was considered quite genuine, a high percentage might be offered. In situations where questions surround the claim validity, the insurer may be more likely to start low and enter into a round of discussions before settling on a final figure. 

Whilst insurers are generally unwilling to provide details of their offer calculation, one alternative is for the insured to engage a consulting actuary to undertake an independent calculation which can then be compared to the amount offered, thus providing a basis for negotiation. 

Having said that, the question might be reasonably asked, “Is the insurer potentially compromising their Duty to Act in Good Faith if it does not share the calculation basis with the insured, thus forcing the insured to make an uninformed or at best ill-informed decision?” 

If the initial approach of a commutation comes from the insurer, an adviser may recommend to the client that any offer made should be accompanied by details of core assumptions used such as discount factors and duration. 

Will the payment be taxed? 

One of the most critical factors to consider in regards to a benefit commutation is the impact of tax on the lump sum payable. 

It is not unusual for the lump sum commuted payment to be fully taxable, meaning the effective loss of a large proportion of the commutation payment. 

It may be possible to reduce the impact in part by spreading payments; however, this action may not be sufficient to make the commutation sufficiently attractive. 

The bottom line is that formal tax advice should be obtained prior to finalising or even entering into commutation discussions. 

What about so-called “commutation” optional benefits? 

Several income protection insurance policies in the market make provision for the insured to add an optional feature which enables a lump sum commutation to be obtained on a tax-free basis. 

The basis of the option operating varies by insurer. However, in general terms: 

• It can only be added at time of application; 
• It can only be added to policies with a benefit period to age 65; 
• Restrictions may apply in respect of waiting periods and other options available in conjunction with the option; and 
• Benefit entitlement is contingent on the insured being “totally and permanently  disabled” through to age 65. 

The facility, in turn, entitles the insured to a multiple of the annualised benefit amount based on the age of the insured at the date the optional benefit is exercised. 

Thus, for example, with one insurer: 

• If the insured is less than 40, the multiple of the annualised benefit is 15; 
• If the insured is 40 to 44, the multiple is 13 ... and so on.  

As indicated above, the main advantage of this optional benefit – and it is a significant advantage – is the lump sum does not incur the normal tax liability (based on tax ruling obtained by the insurer). 

The optional benefit comes at both a premium cost and a loss of tax deductibility for a proportion of the income protection insurance premium. 

What should an insured do? 

As with many important decisions that involve the financial position of the insured or the insured’s family or business, as a general rule the insured should: 

• Avoid making ill-informed, rushed and emotional decisions; 
• Get, consider and compare the relevant facts; and 
• Absolutely seek qualified financial advice.

Col Fullagar is the principal of Integrity Resolutions Pty Ltd.