Disability Income – The Price is Not Right, Nor is the Product

Munich Re is the largest reinsurer of retail disability income insurance in Australia and its recent review of experience, presented at an Actuaries Institute Insights Session, raises serious questions about the sustainability of existing products.

The industry has reported cumulative losses on retail disability income insurance (“DII”) since 2008 when APRA started reporting results separately on this product line. Insurers and reinsurers declared losses of A$569m¹ on retail DII in 2014 alone. These losses continue the industry’s long and difficult relationship with retail DII business – many will remember the pain associated with previous major loss cycles.

In 2014, Munich Re completed its most comprehensive analysis of retail DII claims cost ever, covering almost 20,000 claims over a 10-year period. This level of claims coverage is almost 70% of the claims used in constructing the FSC-KPMG 2007-2011 industry claims tables. Over the course of Munich Re’s investigation, our view of current claims cost became increasingly pessimistic.

Combining the results of Munich Re’s claims cost analysis with market premium rates suggests that premium rates are in the order of 35% below levels that would reasonably cover the cost of claims and deliver a reasonable profit margin². On this basis, life offices are not only adding losses with each new retail DII sale, business being sold will inevitably need large price increases to be profitable.

How did we get here?

There has been talk for a number of years throughout the industry of the need for change in retail DII product design and pricing. However, little has been done to remedy problems via product tightening or pricing changes, and indeed many product features were added and conditions relaxed in the period to 2012. There appears little doubt that competitive pressure to maintain research house product ratings which are in turn used to support “best interests” advice has contributed to product creep. Munich Re believes other drivers have been the lack of broad industry experience studies, and a very old standard industry table. Across the globe, Munich Re has repeatedly seen problems arise when reliance is placed on out of date tables.

Like many in the industry, Munich Re used the IAD89-93 table to assess experience, with many adjustments to cater for weaknesses in that base table. This IAD table is not only 25 years old, it lacks granularity. Products being sold, and society in general, are very different to those in 1990. We commend the FSC push to reinvigorate DII experience studies, and the recent release of a new standard table. Companies now need to decommission the IAD table.

Insights from Munich Re’s experience analysis

In 2013, Munich Re decided it could no longer use the IAD table, and set out to analyse experience and create our own “MRA” table. Undertaking this extensive analysis using biometric experience data from 2004-2013 was especially informative, revealing previously hidden risk factors and trends that drive DII experience.

Three key insights from our analysis were:

1. The cost of DII claims has been increasing over the last decade due to an increase in the incidence of accident-related claims. From 2009 to 2013, there was a 47% increase in the incidence rate of accident claims. An increase in claim rate is no surprise following the proliferation of benefits added to products in the noughties, some that included an incentive for accident claims through the ability to claim from day one. Worryingly, there is no apparent end in sight to the growth in accident claim rates, despite the fact that product changes were implemented five or more years ago. We believe one driver of the ongoing incidence increases is due to customers (and planners) better understanding of the power of the benefit features. There has been no reduction in sickness based claims to offset the increase in accident claims.

2. The rate of claims due to sickness increases with policy duration. Many in the industry have suspected selective lapses, and Munich Re’s analysis confirms this. The increase is significantly higher than what Munich Re believes the industry is pricing for. Sickness claim rates for policies in force for 10 years are double those of policies in their first year. The recently-released FSC-KPMG table now incorporates a policy duration impact, and when life companies begin to adopt this new table, they may be faced with critical decisions concerning the impact on reserving and pricing.

3. Termination rates have not changed. This is a surprise, because many industry participants believed that termination rates were improving, especially in light of recent heavy investment in claims improvement programs across the industry. It may be true that termination rates have improved over a short term, but not when taking a longer-term view. The tables below, showing termination rates for year one and year two of a claim, highlights how a long-term view is instructive. Year 2 termination improvements in recent years is returning levels to longer term averages. Munich Re supports the investment in claims programs, but suggest that this is no silver bullet for DII claims experience. Treating the symptoms will never be as effective as treating the cause.

Sustainability of the current product

Munich Re’s view is that the current price does not match the product design. So, is the product underpriced or is the product overly generous? We believe that products include unnecessary and costly benefits, and urgently need re-design. We believe that within the industry there is overwhelming support for product change: A Munich Re survey across all areas of the industry revealed that more people than not believe nine specific product features were not aligned to the principles of insurance and they would like to see six of those removed immediately. Talk to any claims team, and you will hear very quickly how benefit features in standard products make their job impossible. Let’s pick out a few examples:

• Policyholders can work 10 hours per week and still receive their full benefit. This creates strong incentive for policyholders to work for just below 10 hours per week, undermining the equity and sustainability of DII. Experience suggests many claimants are indeed working between 9 and 10 hours per week.
• Policyholders can insure themselves for as much as 70-hour working week, burn out and return to a normal 40 hours per week and receive a DII payment for the 30 hours they are no longer working. [Dear readers, please don’t get any ideas].
• The trauma benefit can see policyholders get paid 6 months’ salary replacement after needing only two weeks off work even though they were covered by sick leave and therefore suffered no loss. This example is common, yet being perfectly within product rules it is not contentious and therefore senior management can be unaware of the full implications of product design

A sustainable product

For each of these examples, Munich Re believes the product design is not in line with basic principles of insurance and incentivises anti-selective behaviour. In response, Munich Re has developed what it believes is a sustainable and cost-effective DII product, removing costly features and bringing cover in line with the principles of insurance. Munich Re estimates that this product will reduce industry claims costs by approximately 35%, while maintaining the integrity of paying an appropriate claim payment to those with genuine need.

The new product also addresses technical and behavioural weaknesses within the current product design. The product is better aligned to the needs of the customer, ensures equity among policyholders, and is affordable so that policyholders are more likely to have cover when they need it. More details are available in the article Income Protection – A time for review.

Industry response

When Munich Re discusses product or price change with life offices in Australia, we see real buy-in to the messages of how product simplification will enhance sustainability, but see less desire to take the lead on change. Most of the important barriers highlighted by life offices come under the catch-cry of “no-one will sell it”. Some of this can be traced to the fact that rating houses currently take the view that if a product pays more benefits it is better, regardless of the overall cost, equity and sustainability to policyholders. In other words, a sustainable product aligned to basic insurance principles would be poorly-rated by the rating houses, making it more difficult for an adviser to sell in a best interests duty environment. Munich Re has been discussing options with the rating houses.

Munich Re has also heard correlative arguments that due to the best interests duty planners would not sell the sustainable product even it was for sale because it has fewer features. We believe this is incorrect. Munich Re’s broad portfolio shows advisers already sell significant volumes of lower specified (and cheaper) products when there is an alternative. Munich Re envisages a price differential of at least 20% for the new product, surely enough for a planner to recommend given that basic needs of policyholders are met.

Munich Re acknowledges that there are barriers to change, however we are optimistic about the skill and ingenuity of the people working in our industry. We are convinced that a sufficiently determined company can successfully take the lead on change.

Next steps

Based on our analysis, insurers may face a scenario where their current DII products become increasingly unaffordable to the people who rely on them for the financial protection provided. Munich Re believes steps must be taken to develop and introduce more sustainable terms in DII products. Terms offered should be clear and meet the insurance needs of those who purchase the products. As actuaries, we should ensure products are issued fairly and equitably. Each insurer will need to identify and address the causes that have led to these concerns.

As a first step, each insurer has opportunity to analyse their experience against the recently-released FSC-KPMG table. This should be a key input into a full review of the terms, conditions and pricing of DII products. A return to sound design must become a priority to ensure the long-term future of DII in the market. There is an opportunity for actuarial leadership through this process.

Munich Re is committed to working with industry participants to address the design and pricing of DII products. We welcome input into this important debate.

¹ Source: APRA quarterly life insurance performance statistics.
² Based on high level assumptions regarding life office manufacturing and distribution costs.

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