Let prudence prevail

As per its website, the Australian Prudential Regulation Authority (APRA) is an independent statutory authority that supervises institutions across banking, insurance and superannuation and promotes financial system stability in Australia.

As per the online dictionary, “prudential” means “involving or showing care and forethought, especially in business”.

APRA has for some time been concerned about the sustainability of individual disability income insurance with sustainability effectively meaning will insurers and reinsurers continue to make the product available if they are not receiving a reasonable profit from it?

In May 2019, APRA addressed a letter to life insurers and friendly societies, announcing its findings from Phase 2 of the “thematic review of individual disability income insurance (“DII”)”. Phase 2 was made up of “onsite reviews with the top eight primary writers of individual DII, engagement with other stakeholders, including rating houses, industry/professional bodies and ASIC…” Phase 1 consulted with reinsurers.

The APRA letter may not have received all the attention it deserved due, in part, to financial advisers, representing current and intending insureds, not being on the immediate distribution list. 

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The letter set out APRA’s expectations of insurers and noted that “addressing these expectations will be critical to enhancing the sustainability of the market for individual DII”.

"The life insurance industry's failure to design and price sustainable individual DII products has been an area of heightened focus for APRA. APRA's objective is to identify and drive changes required to improve the performance of individual DII and enhance the product's sustainability to ensure life companies remain willing to offer this product to consumers."

It is of course, hugely disappointing to learn that life insurers have “failed” yet again and so soon after the Royal Commission exposures; however, not only have they failed but they have comprehensively done so in what is often seen as the jewel in the risk insurance protection crown, DII. 

DII has, in kind and reality, protected countless Australians and their families since its genesis more than 50 years ago. It would be an unimaginable tragedy if access to it was lost. Good on the independent regulator for picking up on and exposing the failure and seeking to get the insurers back on track.

“APRA identified several factors that are impeding life companies' ability to improve the performance and sustainability of individual DII. To address these factors, APRA has listed four themes (thus 'thematic review') . where greater attention and action are needed by life companies.”
The identified themes were:

(i) Strategy and risk governance

Essentially, the insurance company board had to own and drive a long-term strategy to address issues pertaining to individual DII sustainability and management needed to formulate and execute the strategy. 

What is scary is that this needed APRA identification and communication.

(ii) Data

“APRA observed that the quality, quantity and timeliness of data used in the management of individual DII are poor...

• - Necessary data are unavailable;
• - Data used is inconsistent or inappropriate;
• - Data analysis is conducted within business function 'silos' with no feedback to other relevant areas in the business.”

“APRA is concerned that FSC ADI 2007-2011 table (the first new DII experience table for more than 20 years) is so out of date that it is unlikely to be appropriate for life companies to rely on to set their base assumptions.”

The scare-ometer started by (i) above, continues to rise when it is realised that premium pricing is apparently being based on out of date data. The old saying “rubbish in – rubbish out” springs to mind. 

(iii) Resourcing

“The complex nature of individual DII products requires support from adequately skilled and experienced staff.” 

This is a bit of a “duh”, yet APRA “...observed that some (insurers) have not adjusted resourcing to keep pace with the increased level of workload and complexity. This has resulted in inadequate resourcing and staff expertise in key functions such as risk, data management and analytics, claims handling and actuarial”.

“The impact of inadequate resources was demonstrated in data from some (insurers) which showed a strong positive correlation between high caseloads per claims assessor and poor termination experience” i.e. where insufficient and/or inexperienced staff existed, claims experience was poor.

The scare-ometer is now shooting towards the stratosphere… not only are boards and management needing to be advised of the fundamentals of their role, not only is it identified that pricing data used is out of date but resourcing and staff experience levels are not up to scratch either. 

Clearly, the above facts and findings are of concern and, whilst it should not have been necessary, identification and correction are right up the APRA’s alley; this is its role and its area of qualification and expertise. 

As an aside, is there any chance of APRA naming insurers in the above categories to assist insured’s and advisers to make an informed decision about where to place cover or, in the alternative, should the offending insurers be banned from offering DII until they are able to manage it properly?

Getting back to the APRA letter; however, the fourth theme is detailed…

(iv) Pricing and product design

“APRA is concerned that product design and pricing decisions MAY be contrary to the long-term interests of policyholders... Pricing and product development and design are crucial components of the value chain for individual DII... APRA considers that poorly formed pricing and product development and design decisions MAY have exacerbated the risks life companies are exposed to with their individual DII portfolios.” (writer’s emphasis)

Unfortunately, APRA now moves from previously-identified facts and findings into somewhat rumour and innuendo evidenced by the use of the word “may”.

Also, in the absence of direct policyholder engagement, is there an inherent concern that the interests, short and long-term, of policyholders are precariously being based on assumptions rather than known facts?

“...APRA found most (insurers) have acknowledged the need to develop simpler individual DII offerings that are more sustainably designed and priced, but are reluctant to develop such products due to the first mover disadvantage.”

“First mover disadvantage is another way of saying 'not possessing the ability to explain changes in a compelling way' thus removing any suggestion that management, by retaining its head in the sand, similarly retains its sales bonus.

"APRA believes that product design needs to be more robustly aligned to the commonly accepted principles of insurability with sustainable product features that are priced appropriately based on underlying assumptions that reflect a realistic view of the future.”

“Principles of insurability” are not detailed but one of its key principles is to place the insured in the same or similar position after an unintended and unexpected insured event as existed prior to the event? 

Whilst dogmatism might suggest the inclusion of “immediately” when considering the “prior position”, this is where insuring people differs from insuring things because the risk insurance needs of people, especially within the realm of DII, requires understanding and flexibility bearing in mind advice, to use APRA’s own words, should be “appropriately based on underlying assumptions that reflect a realistic view of the future”. 

APRA then expressed a need for insurers to place “more emphasis on providing policyholders with greater certainty about the expected future premiums”.

Whilst some degree of certainty about future premiums would no doubt be welcomed, arguably more important to the policyholder would be greater certainty and confidence of insurer conduct and claim experience. It is worth recalling that the focus of the recent Royal Commission was on the failure of insurers in the last two areas rather than the first?

In their defense, insurers offered up “… individual DII products need to be fully featured to be rated highly by the rating houses and distributed by financial advisers' but APRA was not having a bar of that, hitting back with “...compliance with financial advisers’ best interest obligations requires advisers to balance the type, level and structure of coverage with affordability and sustainability considerations for their individual clients.

Unfortunately, whilst an adviser might analyse and advise on affordability, they are currently unable to do so in regard to sustainability. Showing prudential forethought APRA expects insurers to “proactively engage with rating houses throughout their product development stage to discuss and agree on how the sustainability characteristics of the product could be better reflected in the product pricing.”

In case it is of assistance, the article “Insuring within your clients’ means” (Money Management, 3 February, 2011) considered the matter of premium sustainability and measures more than nine years ago.

As the APRA letter draws to a close it leaves little doubt about what the future holds:

“Specific actions within set timeframes will be communicated to each (insurer) separately. 

“APRA will assess the adequacy of each life company's response, and monitor the progress in executing the planner actions. If APRA considers the action plan proposed by the life company to be inappropriate, or the life company's progress in implementing that action plan to be inadequate, APRA will increase its supervisory intensity of that life company and may impose an entity-specific capital charge.

“Boards of all life companies need to also consider whether APRA's expectations are applicable to other product groups that may be experiencing performance challenges (read as 'lousy profits'), such as total and permanent disability insurance.”

The May, 2019, letter was followed in December, 2019, by a media release which has received widespread attention.

Sadly, in the intervening period, insurers reported further losses to the tune of $1 billion dollars, providing APRA with cause to “escalate its response” and go after the insurers with all the subtlety of Miley Cyrus atop a wrecking ball.

“Insurers know what the problems are, but the fear of first-mover disadvantage has proven to be an insurmountable barrier to them making the necessary changes. By introducing this package of measures, APRA is forcing the industry to better manage the risks associated with DII and to address unsustainable product features or face additional financial penalties.

“To underline the urgency of the situation, APRA has decided to impose an upfront capital requirement on all individual DII providers, effective from 31 March, 2020. The capital requirement will remain in place until individual insurers can demonstrate they have taken adequate and timely steps to address APRA's sustainability concerns.

“APRA is introducing measures to drive changes in product features that violate the principle of indemnity or exhibit heightened risk due to the uncertainty arising from long term horizons. These product features contribute to adverse financial impact on life companies, as well as continual premium increases, presenting consumers with affordability challenges.”

Between May and December 2019, uncertainty has given way to an irrevocable confidence that the cause of DII sustainability problems are known and will be named such that they can be put to the sword. Further, APRA flags that, what follows “should not be regarded as a definitive list of the areas where changes may be required.”

The APRA hit list is impressive:

(i) Agreed value 

“With effect from 31 March, 2020, APRA expects that life companies discontinue writing IDII contracts where insurance benefits are not based on income at time of claim...

“With effect from 1 July, 2021, APRA expects that income at risk for all new IDII contracts be based on annual earnings at time of claim, not older than 12 months.”

The plight of newly-qualified graduates, people suffering from chronic, debilitating medical conditions, those recently rendered redundant and those recently returned to work following a claim but suffering a new disability, appear to be collateral damage.

(ii) Income replacement ratios

“Current IDII products have features and ancillary benefits that can cause the insurance benefit to exceed earnings at claim. Evidence shows that returning to work is usually in the best interests of claimants (Spoiler alert but not always possible despite best efforts), and the incentive to return to work is undermined by excessive income replacement ratios (Further alert depending on severity of medical condition).

On the hit list are indexation increases and features that allow the insured to earn income from continued work, with no offset to the insurance benefit being paid. 

“With effect from 1 July 2021, new DII contracts will be designed so that:

• - Insurance benefits do not exceed 100% of earnings at time of claim for the first six months of the claim, taking into account of all benefits paid under the IDII product as well as all other sources of earned income; and
• - After the initial six months, insurance benefits are limited to 75% of earnings at time of claim.
• Suddenly, the definition of pre-disability earnings takes on even greater importance.

(iii) Policy contract terms

In regard to IDII policies being guaranteed renewable, APRA notes “The underlying contract terms and conditions are set for an extended period of time, typically until retirement age. Guaranteed renewable for such extended periods causes significant difficulty in designing products that will remain sustainable and appropriate for consumers APRA views it as not appropriate for life companies to offer IDII contracts with fixed terms and conditions exceeding five years.”

With effect from 1 July, 2021, APRA expects insurers will only offer new IDII contracts where:

• The initial contract is for a term no longer than five years; and
• The policy owner has the right to renew for further periods not exceeding five years without a medical review, but with a financial and occupation review, on the terms and conditions then applicable to new contracts.

Hopefully, new contracts will not include pre-existing conditions exclusons.

(iv) Benefit period

“If the risks associated with long benefit periods are not managed appropriately, they can detract from claimants' motivation to return to work and have an adverse impact on claim duration.

“With effect from 1 July, 2021, APRA expects that life companies have effective controls in place to manage the risks associated with long benefit periods e.g. having a stricter disability definition for longer benefit periods…”

In regard to each of the above, APRA feedback questions are asked which immediately gives the impression that, whilst the designations and timeframes are being made, a degree of prudential care may be lacking or to put it another way, has APRA moved outside its area of expertise?

It is also relevant that, much of what is being pilloried was introduced to the DII market around 40 years ago. Surely, insurers and reinsurers have not gone without their profits for all that time which begs the questions, could the current financial woes be due to something else, for example, poor management, use of out of date data or even deficiencies in staffing numbers and expertise? 

Few would deny that change is required in the DII arena but maybe a different approach with a better outcome is possible – refer “Gun, Trigger, Bullet” (Money Management, 12 February, 2018).

Initiatives might include:

• An elevation of the training regime for claims assessors to the equivalent of a degree or TAFE qualification with salaries to increase accordingly – hey, if it’s good enough for financial advisers maybe it is for claims assessors too; 
• Encouraging adviser-informed participation in the claims management process with regular claims reports being provided in preference to the current mind-numbing periodic progress claim forms; and most importantly
• Insurers appreciating that there are ways in which to compelling promote a DII policy on factors other than “generosity”, for example, the value of a balance between insurer and insured protection. If management of insurance companies do not understand this, then get someone on board who does.  

The efforts of APRA in identifying, highlighting and seeking to correct sustainability issues are acknowledged and applauded with the codicil that APRA does not send the DII product back to the 1970’s, something that would, without any doubt, have a severe and adverse impact on the lives of countless policyholders and their families, and further damage the reputation of the Australian life insurance industry.  

Col Fullagar is principal of Integrity Resolutions.