In early December 2019, the Australian Prudential Regulation Authority (APRA) announced an extraordinary direct intervention in the income protection market. In an attempt to improve the prudential sustainability of this product class and amid threats of reinsurers looking to exit the Australian market, APRA is seeking to limit the nature and quality of the terms within income protection contracts available to consumers. With the changes set to be applied to new contracts purchased after 31 March 2020, understanding the nature of APRA’s intervention and how it may impact you and your ability to protect your income in the event that you are unable to work is a time sensitive issue.
Why is this important?
Historically, there have been two types of income protection contracts available which each define ‘pre-disability income’ differently:
- Agreed Value Policies: whereby an insured provides income evidence at inception of the contract and the insurer thereby agrees to pay that ‘agreed’ monthly benefit at the time of claim (providing certainty regarding the sum insured, regardless of future income changes); and
- Indemnity Policies: whereby, for a cheaper premium relative to an agreed value contract, the insurer only indemnifies and pays out the insured based on income immediately prior to disability.
For those who can have significant variances in their income (e.g. self-employers, farmers and women moving in and out of the workforce for maternity leave), it is often worth paying a slightly higher premium on an agreed value contract for the additional certainty of a known amount being payable at claim time. However, significant premium increases of between 15-30% p.a. have become a regular occurrence. APRA also claims that life companies are aiming to capture market share by keeping premiums at unsustainably low levels and designing policies with excessively generous features and terms that sometimes provide a financial disincentive for policyholders to return to work. These premium increases have often been in excess of what individuals (and their advisers) would have expected at the commencement of these contracts.
What is APRA changing?
APRA is introducing measures to drive changes in product features that violate the ‘principle of indemnity’ or exhibit heightened risk due to the uncertainty arising from long-time horizons such as:
a) Income at risk: APRA considers it imperative that claim payments should be linked to income at risk when a claim is made, i.e. indemnifying true income losses. APRA asserts that allowing claim payments to exceed the income at risk is inconsistent with the principle of indemnity. This gives rise to moral hazard, heightens risk and impedes sustainability. A specific application of this principle relates to agreed value (and endorsed agreed value) contracts, where the insurance benefit is based on earnings at policy application and not on earnings at the time of claim. APRA no longer want agreed value contracts offered to consumers.
b) Income replacement ratio: Current income protection products have features and ancillary benefits that can cause the insurance benefit to exceed earnings at claim. Evidence shows that returning to work is usually in the best interest of claimants, and the incentive to return to work is undermined by excessive income replacement ratios. Offering products with excessive income replacement ratios can also result in consumers paying extra premiums for insurance cover that they don’t actually need. APRA considers that product characteristics with adverse impacts on the income replacement ratio include:
- Indexation, which increases the amount of insurance benefit so that it exceeds earnings at claim, either permanently or for a given period of time; and
- Features that allow the insured to earn income from continued work, with no offset to the insurance benefit being paid.
c) Policy contract term: Most policies in the market are Guaranteed Yearly Renewable contracts, where the life company has the right to change the premium every year. The underlying contract terms and conditions are, however, set for an extended period of time, typically until retirement age. Guaranteed renewability for such extended periods may cause significant difficulty in designing products that will remain sustainable and appropriate for consumers. As a result, APRA wants to ensure that there is an appropriate mechanism in place to keep products in step with changing external and consumer circumstances, and moderate the extent of premium increases that may otherwise be needed. APRA deems it inappropriate for life insurance companies to offer income protection contracts with fixed terms and conditions exceeding five years.
d) Benefit periods: Currently, the majority of income protection policies sold have long benefit periods, typically to retirement age. If the risks associated with long benefit periods are not managed appropriately, they can detract from a claimant’s motivation to return to work and have an adverse impact on claim duration. Long benefit periods also exacerbate the impact of other problems that may exist with product design and controls.
What does this mean for you?
The most significant change will be that from 31 March 2020, agreed value income protection contracts must no longer be available for new policies. This means that from 31 March 2020, indemnity contracts will be the only options available. If securing an agreed value income protection contract is in your best interest, there is a short window of time to do so. Our understanding is that applications for new or upgraded policies received before 31 March 2020 will be processed as per current policy conditions.
With the deadline looming, if you do not currently have income protection cover or if your insured benefits don’t match your current income, it may be worth reviewing your insurance strategy sooner rather than later. Please get in touch if you’d like to have a chat with one of our team.
Disclaimer: This article contains general information only and is not intended to constitute financial product advice. Any information provided or conclusions made, whether express or implied, do not take into account the investment objectives, financial situation and particular needs of an investor. It should not be relied upon as a substitute for professional advice.