APRA’s push for a more sustainable income protection offering could lead to industry-wide product reform, according to industry experts.

In May 2019, the Australian Prudential Regulation Authority (APRA) released an industry letter to address the poor performance of individual disability income insurance (IDII). The regulator considered the trajectory of the products unsustainable and demanded changes from insurers.

APRA made recommendations to address aspects of the products they considered were putting their viability at risk. These included issues such as agreed value, sustainable policy constructs and capital reserves requirements.

APRA was clearly concerned the industry’s failure to address problems such as product design, pricing and management was resulting in mounting losses, despite significant premium increases. The product predicament was building towards a nadir that could be terminal. At worst, they thought Income Protection (IP) products could disappear from Australian shelves.

How we got here

Ben Martin

According to Ben Martin, Senior Technical Manager, AIA Australia, losses totalled $3.4 billion over the preceding five years across the retail IP book.

“The prudential risk had been building for some time and APRA was hoping the industry would sort it out themselves. That didn’t happen so APRA initiated step-change and set October 1, [this year] as the date their sustainability measures for IDII would take effect,” he said.

“And on balance, I think APRA got it right. They engaged with the industry and a robust consultation process led to certain desirable client outcomes, including an improved definition of pre-claim income for self-employed people with variable incomes. On the other hand, issues such as the five-year initial contract mechanism still need further discussions.

“For some time there was an arms race amongst insurers as incremental bells and whistles were added to policies to gain competitive advantages.”

This arms race, as Martin colourfully described it, resulted in a highly competitive (too competitive as it turned out) market where one-upmanship trumped prudent policy design and pricing.

Changes to policy definitions and benefits were happening so quickly, there wasn’t enough time to properly gauge the impacts. Whether this resulted in stressed out actuaries claiming on their own IP is not known but the movable feast of rapid changes certainly made it harder for insurers to set premiums that reflected the reality of the risk.

Exacerbating this was a deteriorating claims experience. Disability definitions became more liberal, which also contributed to claims duration. Old claims durations averaged around 12-months but mental health claims pushed that out to around 18-months.

Bottom line: There were more people on claims for longer durations receiving enhanced benefits.

Advances in medical technology and significant shifts in the underlying macro-economic environment compounded by the pandemic also contributed to the claims blowout.

“The old product settings also provided a disincentive for someone on claim to return to work. APRA’s paper was very clear about overly excessive income replacement ratios, which is code for a claimant sometimes receiving a payment from the IP contract that exceeded their pre-claim income,” Martin said.

“APRA also noted Australian IP was out-of-step compared with similar jurisdictions in the OECD. There was a fundamental disconnect between the monthly benefit payment and the claimants prevailing level of income.”

The changes

By setting the October 1 deadline for insurers to meet APRA’s IDII sustainability consequence management measures, the regulator effectively gave the industry the chance to reconstruct their products without any one company having a competitive advantage.

Stressed or not, the number crunchers at AIA were called into action early, as Elise Sanders – Head of Retail Enablement, Marketing & Communications – explained.

Elise Sanders

“When the APRA guidelines came out, we thought someone has to set the tone. The reality is the market should probably have moved before APRA made those determinations but AIA was comfortable being among the first to move,” he said.

“We started by conducting a wholesale review. We looked at every aspect of our product. We reviewed all of our definitions. We worked with our reinsurers and discussed their concerns. We debated robustly.

“Our key areas of review were pre-disablement income, offsets that exacerbated claims, ratios and a ‘suited occupation’ definition for longer-term claimants.

“Essentially, we stripped back the bells and whistles and reset our product to reflect the true intent of income protection.

“And we went early with the objective of establishing a sustainable product in the market. Other insurers may be happy to have an outlier-type product and a more volatile rate, but we looked at this through a customer lens. We know they are sick and tired of big rate rises and we don’t want to be involved in those difficult conversations.”

Insurers face capital charges if they don’t comply with the APRA guidelines. Some insurers will have a greater appetite for this risk than others but at some point down the track, they may have to load these charges onto their clients in the form of premium hikes.

Sanders said stabilising rates was at the core of AIA’s product redesign, and avoiding these capital charges was one of the levers in achieving this stability over the longer term.

Opportunities for advisers

Income Protection has become a very difficult operating environment for advisers to navigate because of the increased product variations. The APRA intervention seems likely to calm the waters.

Ben Martin said that advisers were frustrated about out-of-cycle, ad hoc rate increases for existing policies, and were keen to provide input into AIA’s new product design.

“Our discussions with advisers centred around two fundamental issues – reimagining and replacing ancillary benefits, and ensuring clients are protected in the event of long-term disablement,” says Martin.

“As well as limiting core income protection benefits available under the new products, the maximum income replacement ratio specified in APRA’s guidelines will have a significant impact on the availability and generosity of the traditional ancillary benefits, such as Severity Benefit, Crisis Recovery Benefit and Family Care Benefit.

“In the past, these paid additional lump sum payments or boosted income replacement benefits. In the new world of income protection, these benefits will be significantly restricted and, for many, will simply not be practical under the new regime.

“But an advisers’ typical client cohort is aged forty-plus and this group is statistically more likely to suffer from these conditions. Now, an adviser’s best-interest duty will likely mean considering a base supplement contract of comprehensive, stand-alone crisis/trauma insurance.

“While 90 per cent of AIA’s claims are completed within a two-year period and the client returns to work, a needs analysis may have shown, say, a significant level of debt and dependent children with private education costs.

“Bundling in a lump sum TPD contract alongside the IP and Crisis cover provides a second line of defence for those longer-term claims, and indeed would be crucial in the presence of significant levels of non-deductible debt within the family balance sheet.”

On balance…

“AIA has decided to take a responsible position and act within the guidelines,” said Martin. “We’re comfortable that our product meets the intent of APRA’s requirements. We have created a product we see as the future of IP. We have simplified the offering and we’re comfortable we’ve struck the right balance between sustainability and meaningful, affordable client outcomes.”

Elise Sanders said that while legacy IP products are guaranteed renewable, she understands this is going to be a testing time for advisers, who will have to consider whether their clients should stay with the old or move to the new.

“AIA intends to provide extensive support in this area and have appropriate materials available to assist advisers with these challenging conversations,” she said.

This In Focus article was written in partnership with AIA Group Limited

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