CPD: APRA IDII changes – Why ‘new era income protection’ needs ‘new era advice’

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What are the strategic advice implications and opportunities accompanying ‘new era’ income protection products.

Introduction

The multibillion-dollar losses experienced by individual Disability Income Insurance (IDII) contracts over the last few years, and the resultant ‘sticker shock’ level of premium increases needed to shore up IDII books, became one of the largest sustainability threats faced by the life insurance sector in recent memory.

The prudential regulator, APRA, was left with little choice but to intervene in the sector, and in late 2019 they wrote to all life insurers[3], mandating sweeping changes intended to improve the sustainability of retail income protection contracts. These changes included the banning of agreed value policies, and a range of other measures impacting the assessment of income at claim time, income replacement ratios and contract terms.

October 2021 – when the bulk of these changes take effect – will see a significant refresh of income protection (IP) offerings across the market. Whilst these products will all be underpinned by the same APRA guidelines, there is considerable scope for variation in how individual insurers interpret the guidelines, challenging advisers to not only familiarise themselves with a diverse new range of products, but also a diverse range of underpinning philosophies. Furthermore, the more restrictive design parameters for newer contracts will create substantial strategic advice challenges, in terms of:

  • structuring risk portfolios around the new contracts so as to achieve the right balance between coverage and affordability, and
  • the most appropriate advice for clients with previous generation IP contracts, which are more generous, but are likely to be subject to large and continued premium increases going forward.

In this article we will revisit the background to the changes and then examine how those changes are likely to play out in the market in terms of product design, claims management practices, and customer impact. We will then explore the advice implications and opportunities accompanying these ‘new era’ income protection products.

2019 – APRA moves to shore up retail disability income

In December 2019 the Australian Prudential Regulation Authority (APRA) announced a raft of new guidelines for life insurers in respect of the retail disability income product category.

These guidelines were a response to the increasing sustainability challenges faced by the category, which saw life insurers lose more than $3.4 billion on individual disability income products over the prior 5 years[2]. (Alarmingly, a third of these losses – $1.1 billion – came in the last 12 months alone.) With at least one major reinsurer indicating they would cease supporting the IP market, and a strong possibility others would follow, APRA became concerned about the future viability of the product and – in order to help insurers protect the interests of both existing and prospective policy holders – decided to ‘intervene’.

The intent behind APRA’s intervention is to provide a framework within which life insurers can provide retail Income Protection in a truly sustainable way. Their guidelines around product features, pricing, and even policy contractual terms- are designed to ensure this valuable type of cover remains accessible and affordable and is ultimately more reflective of core customer needs.

How did we get to this point?

In a nutshell, Australian IDII contracts were simply too generous, and significantly under-priced relative to the benefits they offered.

A KPMG/Actuaries Institute comparison[3] of income protection offerings across Australia, the UK, the US, and South Africa, concluded that Australian contracts were more generous in their product terms and were more liberally managed at both underwriting and claims stage.

Features contributing to Australia’s outlier status included:

  • the offering of agreed value contracts
  • replacement ratios in excess of 100%
  • the generosity of the typical three-tiered disablement definition
  • more generous offset provisions
  • more generous underwriting limits
  • more generous specified injury cover.

The combination of these factors meant that claimants could quite literally be financially better off on claim, significantly reducing their incentive to return to work.

Further undermining the sustainability of these policies were the risks inherent in offering contracts that were guaranteed renewable for years, even decades into the future.

Over such a long timeframe, we would expect to see significant changes to the economy, medical technology, and society in general; changes which can substantially and adversely impact the claims experience of a product.  The growth of the gig economy, the growing incidence of mental health claims, and the continuing low interest environment are all examples of trends which have significantly impacted IP claims experience. Plus, at an individual policy holder level, the non-linear nature of work means many will experience changes in occupation and income patterns.

This level of change over the life of a contact is extremely hard to predict, and thus almost impossible to price for.

That these contracts were so generous in the first place was the culmination of intense competition amongst life insurers, coupled with a limited appetite to pull back on unsustainable product features for fear of ‘first mover disadvantage’ (the fear of market share loss because a product had become less attractive to customers), a phenomenon amplified by the role of research ratings.

The only mechanism insurers could rely on was price, and in recent years this product category was characterised by premium rises of increasing size and frequency. This created challenges for advisers, shocks for customers, and perpetuated potential anti-selective lapses, leading to worse claims experiences and falling profit margins.

All these factors contributed to the perfect storm which compelled APRA to act.

What are the APRA IDII measures?

The APRA mandated measures include:

  • an additional capital charge on insurers, proportionate to their IDII exposure
  • a more collaborative and transparent approach to sharing claims experience data (insurers must make sure premium rates reflects up-to-date claims experience), and
  • significant changes to product design and claims management.

Product design changes

As a result of insurer interpretation of the APRA mandates[4], and in addition to the existing ban on agreed value contracts, advisers will see some version of the following changes play out across the IDII market:

  • ‘income at risk’ for policyholders with stable incomes is their income at time of claim and not more than 12 months old
  • ‘income at risk for policyholders with variable incomes will be based on average earnings over a time appropriate to their occupation
  • replacement ratios do not exceed 90 per cent of earnings at time of claim for the first six months of the claim and do not exceed 70 per cent of earnings thereafter
  • a scrapping of the 14-day waiting period by many insurers
  • the offering of stepped premiums only
  • a simpler definition of total disablement which changes from own occupation to any occupation after 2 years on claim
  • a tightening of the rules around offsets
  • the removal of ancillary benefits not directly linked to a claimants’ income earning capacity (trauma, specified injury), and
  • the policy contract is for a term not exceeding five years.

The first three changes described become effective October 2021, whilst the five-year contract limit takes effect in October 2022. Under this change, the maximum contract term for IDII contracts will be 5 years, at which point policyholders will effectively be re-underwritten from a financial perspective (not a medical perspective) and may be offered cover under a more contemporary contract.

Supporting a return to work

Whilst some observers have decried APRAs changes as undermining the value of income protection, the reality is that:

  • the core consumer demand for income protection remains as strong as ever (because people still suffer accidents and illness), and
  • the new era IP products continue to offer protection in line with this core consumer need.

APRA has been particularly keen to reinforce the historically important role of income protection in providing a financial safety net in a way which encourages an appropriately timely return to work. The quality and nature of the rehabilitation and return-to-work benefits within new era IP products will become an important criterion by which to assess competing offerings.

There are several reasons why IDII product design and processes need to more explicitly encourage a timely return to work.

Firstly, research shows that every extra day a claimant spends away from work, the lower their chances of ever returning to work become.

A study by the Royal Australian College of Physicians[5] quantified the odds of returning to work as:

  • 60% for a person off work for a month
  • 40% for a person off work for 2 months, and
  • 30% for a person off work for 3 months.

As expected, the prognosis for longer term disablement is equally grim, with research[6] suggesting that a person on claim for 5 years has only a 5% chance of returning to work the following year.

Secondly, this desire to encourage people back to work is not just about claims management and product sustainability, it’s also about returning people to health, consistent with community expectations and giving legitimacy to insurers’ social licence.

Evidence‐based research also proves a positive relationship between health and work. Simplistically, work, in general, is good for health and wellbeing.

According to the biopsychosocial model[7], work may confer many benefits including:

  • ensuring that some physical activity is undertaken on workdays
  • providing a sense of community and social inclusion
  • allowing workers to feel that they are contributing to society and their family
  • giving structure to days and weeks
  • financial security, and
  • a decreased likelihood that individuals will engage in risky behaviours, such as excessive drinking.

To the extent that issues around health, mental wellbeing, and workforce productivity are of national interest, the concept of return to work clearly has relevance well beyond the context of life insurance, and indeed is the central focus of the ‘National Return to Work Strategy’[8] which has been endorsed by government, industry, and medical bodies.

Advice implications and considerations

For advisers active in the risk space, the IDII changes create a new set of challenges:

  • how to best structure a portfolio of risk products to meet the customer need to replace their income when disabled, and
  • how to deal with customers who hold previous generation products which are more generous but are more likely to experience significant premium increases in the future.

All in the context of Best Interests Duty!

Best Interest Duty

Despite the perception that Best Interests Duty (BID) compels the use of the most comprehensive products available, lest an adviser be exposed to increased compliance risk, ASIC does not actually mandate such an approach.

Through RG 175[9], and various other reports (including REP 413)[10], ASIC makes it clear that in the context of life insurance, BID requires advisers to recommend products that are both appropriate and affordable. This encompasses the affordability of cover not just now, but well into the future.

Using new era products in a ‘core and satellite’ approach

This refresh of income protection products, and consumer demand for more affordable, stable pricing, is likely to spur advisers to revisit and reconsider the role played by other risk products in achieving core objective of protecting income. This is especially the case now that many ancillary benefits – including lump sums for trauma and specified injury – have been stripped out, reducing the extent to which IP could also be used as a substitute for other coverages.

Going forward we are likely to see advisers construct life insurance portfolios using a core and satellite approach, where the bedrock of their protection is built around a new era income protection policy, and then TPD and trauma cover are added, structured in a way that optimises decisions around:

  • waiting and benefit periods
  • ownership Inside/outside super
  • own v any occupation TPD
  • the selection of products which can pay lump sum benefits in instalments.

Case study – optimising cost v coverage

Work by Zurich[11] shows the impact on IP premiums of changing benefit and waiting periods.

For example, the premium difference between a 30-day waiting period and 90 days could be as much as 41%, which may prompt the question:

Is there any way at all the client could self-insure for a period of time which would make a longer waiting period acceptable?

Similarly, a 6-year benefit period can be as much as 26% cheaper than age 65.

With statistics (KPMG)[12] suggesting the average income protection claim is 12 months (14 months for cancer and 18 months for mental health claims), and that any claimant still off work at 5 years is likely to remain permanently disabled, the question must be asked:

is an age 65 benefit period really the best balance of appropriateness and affordability?

Other examples of creative advice solutions could include:

  • the use of split waiting periods, for example a shorter waiting period (30 days) for an essential level of income replacement, supplemented by the balance of the 70% maximum with a 90 day wait
  • insuring below the 70% limit may be viable for joint income households
  • keeping some element of an existing product in force but dialling back to a longer waiting period and complementing it with a more affordable ‘new era’ product for short term claims.

Process and communication implications of the changes

As well as necessitating an adviser rethink of how to construct the optimal risk portfolio and strategy for each individual client, the IDII changes are also likely to see advisers recalibrate aspects of their advice and client engagement processes, particularly as they relate to fact finding and client education and communication.

Revisiting Business Expenses Cover

Business Expenses (BEX) cover could almost be called ‘the forgotten cover’, so low is the market uptake.

Designed to cover those fixed business expenses that continue even while the client is disabled and unable to work and generate an income, such as rent, wages, utilities and leasing costs, BEX cover is crucial in minimising the need for claimants to dip into their income protection benefits to pay business expenses.

Without BEX cover, the value of the benefits intended to meet their own personal living costs could be severely eroded, leaving claimants to live off only half, or even a third or lower, of their pre-disability income.

Could Business Expenses Cover be about to have a new moment in the sun?

Conclusion

Despite concerns that new era income protection products are less generous than their predecessors, it is clear that the bells and whistles that once characterised these products were largely driven by competitive forces which were amplified by the use of research ratings.

Refreshingly, the new style APRA approved products are not only designed to ensure that the core customer need – to protect their income and promptly return to work – is still met, but that it is done in a way that ensures cover can remain more affordable and more contemporary.

Notwithstanding the need for process changes, and the challenges associated with clients holding legacy products, the more sustainable design of these new products should obviate the need for advisers to constantly defend premium rate rises that were increasing in size and frequency.

 

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References
[1]     https://www.apra.gov.au/sustainability-measures-for-individual-disability-income-insurance
[2] https://www.apra.gov.au/news-and-publications/apra-intervenes-to-improve-sustainability-of-individual-disability-income
[3] https://www.actuaries.asn.au/Library/MediaAndPublicPolicy/2020/DIPaper03022020.pdf
[4] https://www.apra.gov.au/final-individual-disability-income-insurance-sustainability-measures
[5] https://www.worksafe.qld.gov.au/rehabilitation-and-return-to-work/getting-back-to-work/benefits-of-returning-to-work
[6] https://home.kpmg/au/en/home/media/press-releases/2020/06/joint-study-reveals-large-rise-life-insurance-claims-costs-22-june-2020.html
[7] https://www.aihs.org.au/sites/default/files/downloads/ealising_the_health_benefits_of_work_AFOEM_Position_Statement_May_26_2010111.pdf
[8] https://www.safeworkaustralia.gov.au/rtw
[9] https://asic.gov.au/regulatory-resources/financial-services/giving-financial-product-advice/acting-in-the-client%CA%BCs-best-interests/
[10] https://asic.gov.au/regulatory-resources/find-a-document/reports/rep-413-review-of-retail-life-insurance-advice/
[11] https://www.zurich.com.au/advisers/tools-and-resources/change-navigator/individual-disability-income-insurance.html
[12] https://home.kpmg/au/en/home/media/press-releases/2020/06/joint-study-reveals-large-rise-life-insurance-claims-costs-22-june-2020.html

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