Choosing the right risk insurance contract for your clients

There are a number of factors to consider when choosing the appropriate risk insurance contract for clients. Col Fullagar explains the details.

When assessing the appropriateness of a particular risk insurance contract for a client, the adviser may consider many factors, including:

• the policy terms and conditions;
• the adviser’s own relationship and experience with the insurer;
• the known experience of other advisers with the insurer;
• the reputation and stability of the insurer; and
• the premium at the time of the recommendation and into the future.

There is, however, another factor that ideally should be considered that unfortunately goes unreported and therefore is difficult to determine — the ‘sustainability’ of the quoted premium rates at the time of recommendation and into the future.

Sustainability can be defined as “the extent to which the current position is likely to be maintained into the future".

Clearly, it would be inappropriate advice for a recommendation to be made to attain or retain a particular insurance product where the product would be needed well into the future but it was known that the premium was underpriced and, as a result, it would be materially increasing in the near future.

This premise might even be extended to consider whether or not an insurer may be deemed to be involved in ‘deceptive and misleading conduct’ if it continued to offer insurance products at an unprofitable premium rate, in the full knowledge that a material increase is inevitable in the near future.

This practice can have catastrophic consequences for the client, potentially resulting in them being locked into a product they cannot afford if their ability to obtain alternative insurance deteriorates between starting the insurance and the premium increasing.

It would therefore seem that having some measure and reporting of premium sustainability would benefit all parties — the adviser, the insurer and certainly the client.

Before considering how this could be done, however, it is necessary to understand some premium pricing fundamentals.

There are four primary components of an insurer’s office insurance premium:

(i) Claim pool contribution (risk premium)

Depending on the insurer and the insurance product, this component might be between 40 and 60 per cent of the total premium.

The claim pool contributions are the funds set aside each year to pay current claims and to establish and retain sufficient reserves to pay future claims.

In order of risk insurance type, going from the highest to the lowest claim pool contribution in terms of absolute dollar amounts, the order would normally be:

• income protection insurance;
• trauma insurance;
• total and permanent disability (TPD) insurance;
• term insurance; and
• business expenses insurance (with the proviso that trauma and TPD would be closely aligned and their order may well be switched for some insurers).

Tables recording claims experience, morbidity for disability and mortality for death are used by actuaries to estimate the amount that needs to be set aside in order to meet future claims.

These tables can reflect the morbidity or mortality rates for:

• the general population;
• the insurance industry (eg, Institute of Actuaries mortality tables IA 95-97);
• company experience for the insurer itself; or most commonly
• a blend of industry and insurer experience.

Company experience is only valid for those companies with a large in-force portfolio. In Australia this would typically be limited to the top four or five insurers.

Otherwise a blend of industry and company experience will be used as indicative measures of expected experience.

The actuary for a particular insurer might adjust the tables, either up or down, to take into account factors unique to that insurer, for example:

• the terms of the cover reflected in the policy document;
• the insurer’s underwriting practices;
• claims management experience;
• the external environment, for example, the state of the economy.

It is contingent on the underwriters and the claims assessors working in such a way (ie, by following prudent underwriting and claims management guidelines) that risks are accepted at an appropriate premium rate and claims are prudently managed.

Both these roles play a pivotal part in whether or not the actuarial pricing assumptions are met.

Product pricing is an intricate, ongoing process and for this reason it is inappropriate for one insurer to simply take another insurer’s claims cost assumptions or premium rates and use them as a basis for their own pricing.

Theoretical questions around product pricing that might need to be asked could be:

• What basis for claims experience has been used in calculating premium rates?;
• If claims experience tables have been used, which ones?;
• If claims experience tables have been used, have they been adjusted, for example, for certain targeted insured ages? And to what extent have they been adjusted?;
• What percentage of standard claims experience has been assumed taking into account insured lives will usually demonstrate a better rate of morbidity or mortality than the general population because, statistically, they will be in better socio-economic groups, live healthier lives and afford better health care?; and
• Are ‘takeover terms’ being offered and, if so, on what basis? (To a greater or lesser extent these terms bypass the normally favourable experience that is generated by the underwriting process.)

(ii) Expenses

Depending on the insurer and the product, this component might be around 10 per cent to 15 per cent of the total premium.

The majority of expenses occur at the time the policy commences and they include data entry, administration, underwriting and policy preparation costs.

Other costs would include staff salaries, general administration and claims management costs.

As would be expected, claims management costs for revenue style claims are higher than for lump sum claims.

When up-front commission is used by advisers, the insurer has the additional expense of the capital strain this generates.

At an accounting level, expenses are spread through the anticipated term of the policy. Thus there are two measures that are relevant:

• expenses as a percentage of premium, in particular new business premiums; and
• rate of attrition or lapsing, which governs the in-force policy duration and therefore the period of time over which expenses can be recovered.

Care needs to be taken with younger and smaller portfolios where there is a high rate of growth as this will artificially reduce the attrition rate.

(iii) Commission

Depending again on the insurer and the product type, this component might be around 30 per cent of the total premium.

In a similar way to ‘expenses’, commission is sensitive to the lapse rate of the insurer’s portfolio of policies as there is normally a large (eg, 115 per cent) initial commission that is recovered over the life of the policy.

Controlling lapse rates is probably the most significant factor in maintaining or improving the profitability of the book of risk insurance business.

Typical industry lapse rates are around 11 to 14 per cent for both lump sum and revenue insurance.

Another way to look at lapse rates is by commission type.

While precise data is not available, it appears lapse rates are higher for upfront commission, followed by hybrid, with the lowest lapse rates being for level commission.

Insurers often encourage advisers to utilise level commission as much as possible, citing that it is ‘good for your business’.

However, while it may be good for the adviser’s business, it is certainly the case that level commission is good for the insurer’s business.

(iv) Profit

Depending on the insurer and the product, this will be in the order of 10 per cent of the total premium.

One of the key drivers of the profit target is the amount of regulatory capital that is required to underpin the business — the higher the level of capital, the higher the required profit target needed to ensure an appropriate return on the investment of that capital by the insurer.

Capital is required to cover many different types of risk — pricing, asset default and so on.

Profit is typically measured by the average profit on premiums paid over the life of the policy and it takes into account expected investment earnings on premiums and claims reserves, reduced by interest foregone in respect of high initial expenses.

If an insurer chooses to lower its premium rates below its actuarially determined level for strategic reasons, profit is unlikely to be acceptable over the long term, which may lead to:

• premium increases;
• expense reductions, which may be reflected in lower client service levels;
• harsher claims assessment; or even
• the cessation of the insurer’s participation in the particular line of business or cessation of insurance business altogether.

Sustainability measure

The main factors that would need to be considered in assessing sustainability would be:

(i) The regulatory capital and target surplus requirements that are reported to APRA.

Observing the levels of capital and surplus can provide a guide to the financial health of the insurer, which in turn may help assess premium sustainability.

(ii) Lapse and profit rates that are included in the insurer’s Financial Conditions Report prepared by the appointed actuary each year.

Naturally, insurers would be reticent to provide details of their lapse and profit rates, but knowing the actual rates is unnecessary. All that needs to be known is the extent to which the actual results differed from the actuarial assumptions.

Thus, for example, it may be that a ratings system could be set up along the lines of:

• an ‘A’ rating — actual results are within 5 per cent of assumptions. A low risk of premium increases.
• A ‘B’ rating — actual results are within 10 per cent of assumptions. A moderate risk of premium increases.
• A ‘C’ rating — actual results are greater than 10 per cent of assumptions. A high risk of premium increases.
• A ‘D’ rating — results are not available. For example, the insurer was unwilling to participate.

All that would remain is for an appropriate body to make the sustainability rating available in a way that could readily be accessed by advisers.

This, in turn, would enable advisers to reasonably assess the appropriateness of a risk insurance product in this particular area.

Discussions around a premium sustainability rating system have been ongoing for a number of years, but unfortunately this important factor is still missing. There is one thing that could possibly lead to it being set up: adviser pressure.

Col Fullagar is national manager, risk insurance, at RI Advice.