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What's the best income protection when incomes fluctuate?

Changes in income can be large and happen more often than you may expect. With this in mind advisers need to consider whether to use indemnity or agreed value income protection cover. Russell Hutchinson considers the options.

Monday, November 4th 2013, 6:34AM 6 Comments

by Russell Hutchinson

I have heard advisers argue about income changes a lot – the question is at the heart of the debate about whether or not a client should buy agreed value income protection cover. 

Many advisers, and I guess their clients, prefer to take their chances with the ‘best 12 months out of the last three years’ definition. It is generous, and people employed full time can consult their experience and feel that it is unlikely to be a problem. But what exactly are the risks?

OECD data shows that income volatility is large and relatively common. This should affect how we see the choices we have for income protection insurance.

Income volatility is the chance of a change in income of more than 20% includes the ‘risk’ of having your income rise, but with our focus on income protection insurance our interest is in the chances of a decrease in income.

No data was given for New Zealand but two similar economies, the UK and the US, show the risk of a decrease in income of more than 20% are just above 15% for the UK and just below 20% for the US. That’s plenty of risk. But the story doesn’t end there.

The risk rises for certain kinds of people. It is 5% higher just with earning above the average, and it is more than 14% higher for earning in the top quartile (most insurance clients). It is more than 6% higher for someone with poor health (think of loaded lives). It is a whopping 23% higher for someone who is self-employed.

The chance of a big increase is actually slightly higher. This is important because of the ‘best 12 months out of the last three years’ definition for pre-disability income that is common in most indemnity and ‘loss of earnings’ contracts – it is often argued that after ‘one bad year’ things sort themselves out: well the chance of a 20% increase in income in the UK is about 18% and the chance in the US is nearly 30%. But read the other way, there is an 80% chance that their income won’t recover, which isn’t so good.

That doesn’t sound very good. On the other hand we know from recent claims surveys that on average Agreed Value has a pay-out ratio only 1% higher than Indemnity contracts (the category includes contracts we refer to as Loss of Earnings).

Ultimately it comes down to how you rate certain relative risks. If you are more worried about getting a higher claim amount paid if your income falls you should choose Agreed Value, if you are more worried about getting the maximum if you are going to be getting an ACC payment then you would choose Loss of Earnings.

Is there any place left for indemnity cover? Yes, of course, because lots of income volatility or disability due to accident are actually both a minority of claims for class one and two lives. So if you just want the most cost effective cover for most claims then you can choose Indemnity.

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Comments from our readers

On 8 November 2013 at 8:36 pm 6ftndr said:
As with most cases, the policy put in place needs to be discussed and worked through with the client, each has its own benefits and each has drawbacks - but overall I would say (from claims experience) that agreed value seems the better choice overall
On 15 November 2013 at 12:58 pm Regan said:
I would submit that the 20% chance of increase and 15 - 20% chance of decrease stands lowly against the 100% of people who have to consider the impact of ACC on their policy, and the great numbers who must also consider other offset potential, such as business income and the treatment of partial disability income.

Further; there are those with negatively geared investment property - what does switching to a non-taxed income source do to that structure?
On 15 November 2013 at 3:14 pm Steve said:
Not sure I get your first point. Agreed value policies offset the likes of ACC the same way that Indemnity/loss-of-earnings type contracts do.
You point on negatively geared rental property is important if held personally but, I think, no longer relevant if the property is held in a company.
On 19 November 2013 at 8:55 am Mark Ogden said:
Indemnity contracts are so last century, of course the data would show LOE pays less than agreed value if it's data is bundled in with Indemnity figures, that's the problem with statistics.

With the risk of fluctuation either way why consider one or the other, why wouldn't you do both with a LOE/Agreed value policy like Asteron's LOE+. Chuck in a mortgage/disability agreed value top-up/hybrid (and no offsets) and for most clients you can tailor a very slick tax efficient plan for less than a bog standard indemnity/LOE or AV approach.

With more companies now offering LOE, I generally find for most clients one product isn't going to be the best solution.

On 19 November 2013 at 11:31 am Regan said:
Steve my point is in every example I have seen LOE will out-perform AV and most indemnity policies by paying 75% of the 20% "loss" (IF repeat IF ACC pays 80% and the examples get better if ACC pays less) meanwhile the good ol' 55% and 75% plans might pay nothing. The worst LOE can do is pay the same. With LOE+ the AV hybrid captures the advantages of AV and the advantages of LOE.
On 20 November 2013 at 1:20 pm Mike King said:
RE: Geared investment property. Whether personally owned or held through a company, if there is a downward effect on final taxable income the client is better off with a maximised cash flow - that is, 75% (esp. if agreed value) or LOE+.

In any case, though, I understand claims assessors look not at the final taxable income, after deductions, but at the pre-tax gross income from personal exertion.

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