The trouble with buy-back in trauma insurance

While the buy-back structure within trauma insurance policies exists to benefit clients, Col Fullagar identifies a series of inconsistencies in how the facility is represented within the various insurers’ policies.

The first trauma insurance policies appeared on the Australian market in the late 1980s. 

While considered state-of-the-art at the time, in comparison to the contracts available today, they could either be described as “basic” or “focussed”, depending on the view taken.

The number of insured events was much fewer than today, with cover typically being provided for conditions such as:

• Heart attack;
• Stroke;
• Cancer;
• Coronary artery bypass surgery;
• Kidney failure;
• Major organ transplant;
• Paralysis;
• Multiple sclerosis;
• Blindness;
• Major head trauma;
• Severe burns; and
• Parkinson’s and Alzheimer’s disease.

Policies were only available as riders to other insurances such as term life. The trauma insurance benefit amount had to be equal to, or less than, the term insurance. When a trauma insurance benefit was paid, the term insurance was reduced by the amount of the payment.

It was not long, however, before advisers identified a problem associated with this structure.

Case study

John’s adviser identifies that John needs:

• $600,000 of term insurance in order to provide John’s wife with sufficient funds to invest and replace his income if he died; and
• $200,000 of trauma insurance, being made up of $150,000 medical reserve, $25,000 to fund the children’s school fees, and a $25,000 contingency reserve.

Two years later, John has a severe stroke which leaves him almost totally incapacitated.

He receives a payment of $200,000 under his trauma insurance; however, because of the severity of his stroke, the full amount goes towards funding the immediate and ongoing medical costs.

In line with the policy terms and conditions, John’s term insurance has been reduced to $600,000 – ie, by the amount of the trauma payout.

Unfortunately, John never recovers from the effects of the stroke and he dies just over a year later.

The term insurance of $600,000 is paid; however, unfortunately this amount is well short of what John’s widow required to invest and replace his income.

The trauma insurance payment, while assisting John at the time of his stroke, had the effect of exposing his family to financial risk when he died.

The problem arises because the term insurance and the trauma insurance needs are quite separate and distinct from each other.

Term insurance is protecting in areas such as:

• Final expenses;
• Income replacement;
• Estate equalisation;
• Charitable bequests; and
• Funding of school fees, etc.

Trauma insurance is protecting in areas such as:

• Ability to obtain optimal medical care;
• Financial access to rehabilitation; and
• Lifestyle needs such as pre-funding school fees, funds to enable a reduction in working hours, a superannuation boost to fund early retirement, etc.

To overcome this problem, by the early 1990s a facility was incorporated within trauma insurance policies that enabled the term insurance lost when a trauma payment was made to be reinstated or bought back subsequent to the payment.

This was, and continues to be, referred to as the term insurance buy-back benefit.

Buy-back design

Initially, the buy-back facility provided for the reduced death cover to be reinstated in equal instalments on the first, second and third anniversary of the trauma insurance claim payment.

The logic (ignoring whether or not the logic held true to reality) was that if a trauma insurance payment was made, the life insured would indicatively put that money in the bank. If the life insured died the next day, the full trauma insurance payment would still be intact.

As the trauma insurance payment equalled the reduction in death cover, the money in the bank plus the subsequent reduced death cover payment would equal the original amount of term insurance required.

If, on the other hand, the life insured survived for a period of time after the trauma insurance payment was made, the funds in the bank would gradually be used. Again, the original logic was that these funds would be expended equally over a three-year period.

Therefore, to compensate for this, the facility to repurchase the reduced death cover was also spread evenly over a three-year period.

Product designers driven in part by a realisation that there would be a front-end load to the expenditure of the trauma insurance payment and driven in part by risk research competitive pressure, eventually amended the buy-back design such that two-thirds of the reduced term insurance cover could be repurchased after one year and the remaining third after the second year.

Eventually, this evolved to the current position where generally 100 per cent of the reduced term insurance cover can be repurchased after one year.

Basis of buy-back

While the logic underpinning the buy-back facility is consistent, even if sometimes viewed as consistently flawed (as is often the case with product design), how the facility is represented within the various insurers’ policies is far from consistent across the market.

The inconsistencies fall into a number of areas:

When can the buy-back be exercised?

The majority of contracts indicate that the term insurance can be bought back on the first anniversary of the drawing of the trauma claim cheque or the crediting of the insured’s account with the claim proceeds. Typical wording is:

“The option to restore the sum insured for death cover becomes available one year after we pay the full trauma cover claim.”

Other contracts, however, have a different option date, for example:

“The (buy-back) option can only be taken up 12 months after the later of:

• The date we receive your fully completed claim form; and
• The date when you satisfy the criteria under (the insured event definition).”

The advantage of the above wording is that both these dates would generally pre-date a claim payment, resulting in an earlier availability of the buy-back option to the client.

Finally, at least one policy has the following wording:

“12 months after a valid claim form is lodged with (the insurer).”

A “valid claim form” is subsequently described as: “one which resulted in a claim payment … and where (the insurer) determines the … definition of the trauma condition suffered was met within 30 days of the claim form being lodged. If there is no valid claim form, the relevant date for reinstatement is 12 months from the date the trauma sum insured was paid in full.”

The reasons behind the inclusion of an arbitrary 30-day time limit are difficult to understand for two reasons. Firstly, control over the timeframe is in part with the insurer which calls for and assesses the requirements, and secondly, the consequences of failing to meet this timeframe are potentially dire – ie, the substituting of an early trigger date with a much later one.

Whatever the reason, the position is further exacerbated by the fact that the meaning of the wording is unclear. Must the insurer make the assessment within 30 days? Or is it that the definition must be met within 30 days and the insurer can make their assessment subsequently?

What are the terms of buy-back?

The repurchased term insurance is generally subject to equivalent underwriting additional premiums and exclusions as the original term insurance, although one insurer – not quite logically – carries over any loadings and exclusions that applied to the original trauma insurance, rather than the term insurance.

While it should be unnecessary for the client to provide any information concerning their health, finances, occupation or pursuits when applying for the buy-back, a number of policies simply refer to health, and remain silent on the other three. At least one insurer appeared to reserve the right to reassess smoking status.

The buy-back facility will have an expiry date which – depending on the insurer – might be age 65, 70, 75 or the policy anniversary after age 74, or potentially some other date.

The repurchased term insurance may or may not be eligible for subsequent indexation increases, again, depending on the insurer.

A potential disadvantage can occur if the buy-back does not apply to partial trauma insurance payments. For example, if the buy-back wording for a full trauma insurance payment is: “The policy owner can affect a new policy … for a sum insured equal to the trauma insurance payment”, it could be that the life insured is only able to buy-back the reduced amount of insurance that applied subsequent to a partial trauma payment, as set out in the example below:

Original trauma insurance benefit amount = $500,000
Partial trauma payment = $125,000
Subsequent full trauma payment = $375,000
Buy-back only applies to the $375,000.

Is buy-back pro-active or re-active?

Some insurers state, “We will write to the policy owner within 30 days (of the option date)”; whereas others indicate, “You must notify us in writing of your intention to exercise the (buy-back option)”.

Still, others are silent as to who will do what, simply stating that the buy-back facility will become available at a particular time.

As one adviser reports:

“Our firm has had about 100 claims over the past 4 years and the issue of buy-backs is a real concern. We have only found one company that has a process that ensures the buy-back offer goes to the client. We have lost count of the number of times we have had to make sure the offer is made. It’s ordinary when insurers make offers and then [do] not deliver on them.”

It is important for the adviser and client to know who will do what, because if the responsibility to activate the process lies with the client, this responsibility may well be deemed to pass through to the adviser. Were a buy-back option to be missed because the adviser did not remind the client, this could result in liability also passing through to the adviser.

Commission payable?

The insurer’s commission schedules are often silent as to whether or not commission is payable on the term insurance put in place as a result of the buy-back facility.

The attitude of some insurers appears to be that there is little or no work involved in effecting a buy-back facility, possibly due to the mistaken belief that commission is to compensate advisers for the effort involved in “making the sale” which – in the case of a buy-back – would generally be small.

If commission is not payable, the client and adviser may logically feel that the ‘no commission’ premium discount should apply, although this is unlikely to be the case.

Further, if the adviser knows that commission is not payable, the adviser may feel that it would be appropriate to charge a fee for the work involved in assisting with the implementation of the buy-back facility.

While it is important for contracts to allow for different terms to apply between insurers so that normal competitive forces can exist, a number of aspects of the buy-back facility would benefit from consistency within the industry – eg, the basis of the option date.

Consistency in areas such as this would reduce the chances of an adviser or a client misunderstanding the position and missing out on what would otherwise have been a genuine risk insurance opportunity.

The catalyst for this article was a very recent real life example of a terminally ill client who almost missed their buy-back opportunity because of confusion and uncertainty as to when the buy-back should apply.

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