Royal Commission bedtime stories

The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry provides some interesting and worthwhile stories for those who work in the relevant industries.

Frozen in time

To calculate the premium payable for a risk insurance policy, it is necessary to take the standard premium rate and multiply it by the benefit amount; then add a policy fee and, for some insurances, stamp duty.

Voila! You have the annual premium.

If, however, the insured wishes to spread payments over the year, i.e. by way of paying monthly, a premium frequency loading will apply. The annual premium is multiplied by the frequency loading; divided by 12 and Sacrebleu! you have the monthly premium.

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The insurer will likely represent the loading as being necessary for two reasons:

• Firstly, to cover the higher administrative costs involved in collecting premiums monthly. Whilst that may be the case, it is only reasonable that the extent of any additional charge is reflective of those costs. Also, one would expect that these costs, and thus the frequency loading, would have reduced over the years, bearing in mind the impact of technical advances that have been made; and
• Secondly, the cost of money; the insurer will not have the use of the full premium amount up front, so this needs to be considered. The cost of money is, of course, reflected in the rate of inflation.

Taking up these points, a search back in time to 30 years ago will reveal that:

• the annual rate of inflation in Australia was 7.3 per cent (Source: rateinflation.com); and
• the frequency loading for monthly premiums was eight per cent.

All looks fair and reasonable so far but, then a search back in time to yesterday will reveal that:

• the annual rate of inflation in Australia is 1.9 per cent (Same source); and
• the frequency loading for monthly premiums is ……. “No, surely not”…. Yes, for at least some insurers, it is all but frozen in time at around eight per cent.

So, insurance taken out yesterday, that would cost $2,400.00 if paid annually, could cost an additional $192.00 a year (or $16.00 a month), if paid monthly …. the same as would have been the case 30 years ago despite technology improvements and a much-reduced rate of inflation.

If a simplistic position is taken in regard to the above numbers, this charge could be anything up to six per cent too high.

Bearing in mind that indicatively 95 per cent of retail risk insurance premiums are paid monthly and the total amount of risk insurance premiums paid in Australia last year was “lots”, it is reasonable to assume the above is a material revenue source for the insurer, arguably at the expense, quite literally, of the insured.

“C’est pa vrai!!!”

Upset by offsets

Within many income protection insurance policies reside various machinations of offset provisions.

These enable the insurer to reduce benefits that would otherwise be paid, by monies received from other sources; with the sources usually listed within the policy.

Not infrequently, these offset provisions will detail how a lump sum compensation settlement received as a result of the disability will be treated. A typical example is:
“The insured benefit amount will be reduced by one sixtieth of the lump sum each month.”

Some policies, but not all, have additional wording to the effect that, only that component of the lump sum compensating for “loss of earnings” will be taken into account and the offset will only apply “for 60 months”.

The rationale is relatively straightforward; the insurer is assuming the insured will either:

• draw down one-sixtieth of the lump sum each month for 60 months; or
• invest the lump sum and earn interest on it.

The draw down or interest will represent “income” and, when added to the insured benefit amount, would otherwise take the total to in excess of 75 per cent of earnings; thus, reducing the insured’s motivation to return to work.

By reducing the benefit amount payable each month by one sixtieth of the lump sum, the problem is theoretically avoided.

But, in much the same way as the frequency loading above, the lump sum benefit reduction formula has, for at least some insurers, remained all but unchanged since Mike Taylor last wore a safari suit.

So, is the formula fair and reasonable or is more French exclaiming required?

Notwithstanding a lump sum may be awarded, the reality is that the insured does not necessarily receive the awarded amount as it may be subject to reductions by way of tax, albeit the position with tax might be far from straightforward, and legal or other expenses.

If this is the case, the insurer’s offset of one-sixtieth each month may leave the claimant with considerably less than 75 per cent of prior earnings in hand.

The position, however, for the claimant who invests the lump sum is potentially much worse, as can be seen by the following example:

• Assume a lump sum of $600,000.00; one sixtieth of this $10,000.00; then
• If the benefit amount is reduced by $10,000.00 a month; this equates to $120,000.00 a year.

To make $120,000 a year from a lump sum of $600,000.00, the insured would need to earn interest at the rate of …… (grabs calculator) ….. 20 per cent!!

Mon Dieu!

And, of course, if the offset clause does not stipulate a time limit for the operation of the offset, it could continue through to the end of the claim or benefit period, whichever comes first.

And thus the reason for being “Bouleverse par les compensations”.

What is good for the goose ….

“A Guarantee is a formal assurance that certain conditions will be fulfilled, it is a promise with certainty. A Guarantee can be absolutely relied upon.”

In December 1993, Tyndall Life became the first insurer to introduce a Guarantee of Upgrade into the Australian market …. “I didn’t know that!”

This Guarantee provided that, if in later years an insurer improved the terms and conditions of its policy offering, those improvements would automatically be flowed back to existing policy holders of the equivalent policy.

The one proviso was that, the flow back would not occur if the improvements led to a higher premium rate being charged.

Since then, some insurers have invoked slightly different wording, but the underlying essence of the Guarantee prevailed; improvements, if made subsequent to a policy being issued, would flow back to the earlier policies.

The Guarantee of Upgrade delivered to policy holders:

• Equity; for each age, all policy holders enjoyed equivalent benefits at an equivalent premium rate; and  
• Assurance; it was unnecessary to swap to a new policy to gain access to the latest policy terms.

Nothing could be simpler unless, of course, you take a gander at the following...

A non-cancellable policy issued in 2000, contained the following clause:

“Guarantee of Upgrade

Should we improve the benefits under this policy, where such improvements result in no increase in premium rates, we will automatically add these benefit improvements to the policy.”

The policy contained a pre-claim indexation benefit that provided for the benefit amount to be indexed each policy anniversary by the greater of CPI or three per cent.

To ensure policy owners were able to maintain control over the level of cover and premiums, the policy appropriately provided that “the policy owner may refuse an increase or cancel the indexation”.

In 2007, the insurer increased the guaranteed minimum rate of indexation for new policies from three to five per cent, clearly an improvement which no doubt was recognized as such by risk research.

However, contrary to the policy Guarantee, the change was not added “automatically” to existing policies, rather it was “offered” via a brochure mailout.

Acceptance required completion and return of the cut-out form within 60 days.

As is often the case with mailout offers requiring policy owner action, the take up rate was in the low percent’s, no doubt due to many reasons such as inertia, the rejection of what would seem to be spam mail, incorrect address details, and the like.

The result was that many thousands of policy owners were left without the benefit of the “improvement”.

Several years later, the above insurer was the subject of a merger with another insurer.

In recent years, an insured became aware that his policy had not received the benefit of the higher guaranteed minimum rate of indexation.

A complaint was lodged and duly rejected with the new insurer stating:

“We believe the determinations made by (the insurer) in this matter are consistent with its contractual obligations. The circumstances do not suggest an error that requires rectification by (us).” 

In effect, the new insurer was asserting that, despite the guarantee that improvements would be automatically added to existing policies, the actions taken by the previous insurer were correct and it, the new insurer, would have acted in an equivalent way in the circumstances.

This defense would have greater credibility if the new insurer had not, in 2002 and under the equivalent Guarantee of Upgrade, communicated to its existing policy owners the following in regard to the pre-claim indexation benefit:

“We have improved this option by introducing a guaranteed minimum indexation offer of three per cent (previously no guaranteed minimum applied). Now, we will offer to increase your benefit each year by the increase in CPI or three per cent, whichever is the higher.”

So, there you have it – not only can a brochure evidently override a non-cancellable risk insurance policy but that which is good for the goose is not necessarily good for the gander!

C’est pas possible!!!!

Trap for the young and innocent

A generally recommendation-preferred type of income protection insurance policy is Agreed Value which provides that the total disability benefit payable is not adversely impacted by a reduction in the insured’s earnings between when the policy started, and the claim started.

More lately, there has been an ability to go one step further and Teflon coat the cover by way of providing financial evidence at the time of application such that the insured benefit amount is “guaranteed”.

Assurance for the insured in this way, generally translates to safety for the adviser ……….. EXCEPT …

It is generally the case that when a guaranteed agreed value policy is issued, additional wording appears, as if by magic, in the policy schedule.

Typical wording might be:

“This guarantee is provided in reliance upon the evidence of income you provided with your application for insurance …. Should the evidence of income provided with the Application be learnt at time of claim to be misleading or incomplete, the Insured Monthly Benefit will be reduced to an amount we would have offered at time of Application based on your actual income.”

At first glance, this may seem fair enough but, if misleading information, financial or otherwise, is provided at the time of application, the insurer has rights of redress as detailed in section 29 of the Insurance Contracts Act 1984 (‘ICA’).

The manner of those rights alters after the policy has been in force for longer than three years.

The clause above gives every indication of ignoring the three-year demarcation date by purporting to enable the insurer to reduce the benefit amount at any policy duration point.

Would the insurer consider doing this? Arguably only the insurer can respond to that question, but one would be forgiven for thinking …!

Also, whilst protection under the ICA is provided if “misleading” statements are made, the position in regard to “incomplete” statements is quite different:

“Where a person:

                     (a)  failed to answer; or

                     (b)  gave an obviously incomplete or irrelevant answer to;

a question included in a proposal form about a matter, the insurer shall be deemed to have waived compliance with the duty of disclosure in relation to the matter.” (ICA, section 21(3))

If not worded correctly, clauses such as these have the potential to be significantly worrisome, for example, is the adviser that recommends a policy be rendered Guaranteed Agreed Value, in some way reducing the insured’s legal protection and, by so doing, is the adviser exposing them self to the risk of dispute, if clauses such as the above are invoked to the client’s detriment, at the time of claim.

There’s a trap for the young and innocent, adviser and client alike!

As an aside, the offending clause might be more appropriately worded if it simply noted that said guarantee “was contingent on the Duty of Disclosure being met”.

“Informed decisions” are overrated

A fundamental premise underpinning the initial advice process is the need to enable a client to make an informed decision.

To facilitate this, the adviser is required to do many things including, setting out all pertinent facts and options for the client’s consideration and, if anything is unclear, it is expected the adviser will provide a meaningful and intelligible explanation.

Fast forward to an insured who is on a long-term income protection insurance claim.

It seems that it is becoming increasingly common for the insurer to make an approach to the long-term claimant about whether he/she would consider commuting their future benefit entitlements for a current, lump sum payment.

If the claimant responds in the affirmative, the insurer may then come back with a formal offer; an offer which is likely couched very nicely but essentially as “This is our best offer – take it or leave it”.

The dilemma facing the claimant is whether or not the offer is fair and reasonable.

Sadly, an approach to the insurer, either by the claimant or the claimant’s representative, for an explanation of how the amount offered was calculated, for example, what assumptions (expenses, interest, early mortality, etc) were made and what percentage of the insurer’s specific claim reserve for the claimant is being offered, will all but certainly be met with a refusal, and the citing of commercial confidentiality.

Is this because:

• From an insurer’s perspective, in matters such as this, informed decisions are overrated;
• The insurer is concerned about other insurers finding out about its reserving assumptions; or
• Any difference between the offer made and the specific claim reserve might be booked to the insurer’s profit line.

Hard to say really …!

Summary

The above stories are true to the best of the writer’s knowledge and research, albeit not universally applicable to all insurers.

Whether these examples represent conduct worthy of attention from external bodies is not the focus of this article; more it is to suggest that whilst there have been some big-ticket items receiving much scrutiny and attention over the last few weeks, there are smaller-ticket items that have the potential to place the client in a prejudicial position and thus, they too warrant attention.

The identification and rectification of matters such as these is yet another value add of the astute financial adviser.

Good night. Sleep tight … Don’t let the bed bugs bite.

Col Fullagar is the principal of Integrity Resolutions.