Risk research: developing a new model

In the 1980s, the life insurance industry was largely operating under an agency system where those providing insurance advice to clients were agents of the insurer rather than representatives of the client.

Also, many advisers were ‘tied agents’ of a particular company and as such could only represent the products of that company. In this environment, there was little need for risk insurance analysis that would compare the relative merit or otherwise of the policies of different companies.

Because contract comparisons were rarely undertaken, the terms and conditions of the contracts themselves tended to be restrictive when compared to those available today.

For example, income protection insurance required the life insured to be completely unable to perform their occupation if they were to be deemed totally disabled, and, in many cases, partial disability benefits were not available.

Wording of policies

Policy wording was drafted in a legalistic style such that even if the client or adviser read the contracts, they had little hope of understanding them.

With the evolution of multi-agents — that is, advisers who were able to represent the products, albeit on an agent basis of more than one insurer — the need for product comparisons started to become apparent.

Product comparisons

Advisers used various ad-hoc comparison systems. However, the introduction of Life Research by Life Support in 1991 was the first to receive widespread acceptance.

Sue Laing, one of the principals of Life Support, recalls: “The system was developed by John Butterworth and built around the philosophy that the easier it was for the insured to claim, the better was the contract. In other words, generosity of policy terms and conditions was the primary rating driver.”

This generosity-based methodology has essentially continued through to today. In the early 1990s, when terms and conditions were relatively restrictive, the philosophy worked well.

As advisers became increasingly aware of the impact policy wording could have at the time of claim and the negative impact on their business if clients encountered claim problems, the advisers in turn began to demand that insurers make contractual improvements.

Product and sales managers in a desperate attempt to gain ‘market share at any price’ increased the momentum of liberalisation of policy wording to the point where there was a virtual feeding frenzy of policy upgrades and premium reductions.

Unfortunately, the need for a prudent balance between the rights of the insurer and the client was ignored, and contracts became too generous.

The impact of generous terms

The inevitable crash came in the late 1990s, when the number and duration of claims experienced by insurers started to far exceed what had been allowed for when the premium rates were calculated. Frightening losses for both insurers and reinsurers resulted.

There were two possible ways out of the dilemma; either reverse some of the liberalisation of policy terms and conditions such that there was a better balance of the position of the insurer and the insured, or dramatically increase premium rates.

Those who have been representing risk insurance products over the past few years will know that, by and large, the latter course of action has been taken, with the only exception being term insurance, where rates have decreased because of improvements in mortality.

Because contracts were still rated by the various research houses on a generosity basis, a pullback of the terms and conditions would reflect adversely on product ratings, which in turn could have a negative impact on sales. No life office was prepared to take the risk.

Today’s dilemma

This brings us to today, where the life industry is faced with a dilemma — many of the contracts available still have terms and conditions that are overly generous — that is, they potentially provide compensation well in excess of the loss an insured will suffer if the insured event occurs.

As a result, premiums are higher than need be as insurers seek to combat the anti-selection problem created when clients can profit by claiming. This is turn leads to premiums or appropriate levels of cover being outside the reach of many clients.

No doubt this is one reason for the high level of underinsurance in the market that has been receiving reasonable coverage of late.

The solution, as is often the case, lies in the hands of the advisers. In the same way they rightfully called for improvements in contractual wording back in the early 1990s, they now need to call for wordings to be pared back to a more sensible position; where the rights (and needs for that matter) of the client and the insurer are in balance.

Price sustainability

The by-product of equity in policy wording is predictability and sustainability of policy pricing — if contracts are too restrictive, market pressure will drive changes but, on the other hand, if contracts are overly generous, claims pressure will drive premium increases. The outcome of this fundamental shift would be more realistic and affordable premiums.

The aim of the changes to Genesys risk research is to replace a generosity-based product rating structure with an equity-based rating structure.

Other guiding statements were also agreed upon so we could ensure the final product would have a clear focus. These included:

~ risk research should have a similar high-level logic to investment research;

~ the adviser, and in turn the client, should understand the research methodology;

~ the research should be easy to develop, easy to maintain and not require huge amounts of information technology support.

In simple terms, when an adviser is assessing what investment products to recommend for a client, the adviser will ask the client questions in order to identify the client’s risk profile — for instance, does the client have a high, medium or low risk focus?

When this has been done, the adviser will go to a recommended list of products that are in line with the client’s risk profile.

For example, if the client is looking for a medium risk investment vehicle, the adviser will review products that have medium risk investment strategies. Products with high and low risk strategies will not be considered.

Giving risk advice

Unfortunately, the position is quite different for risk insurance.

An adviser may identify that a client needs risk insurance. The adviser then goes to one of the various research tools where all contracts are essentially compared against each other.

In broad terms, the one with the most points — the most liberal and with the most ancillary benefits — is deemed the best product and is the one that is recommended. (Note — the aim of this simplistic description is to highlight a general process and should not be taken as a reflection of the extensive analysis undertaken by most advisers.)

This process assumes all clients want and can get the same style of contract — that is, the best. This is not the case.

Most clients, with the assistance of an adviser, can make high-level decisions about their risk insurance needs.

For example, they realise they need income protection insurance, and following on from this they may also be able to recognise whether they would prefer a basic contract, with few if any ancillary benefits, or a comprehensive contract that is full of ancillary benefits.

Finally, they may look to choose an indemnity or an agreed value contract based on their employment status, such as employed or self-employed.

Recommended lists

Therefore, in the same way there were specialist recommended lists for investment advice, there needed to be specialist recommended lists for risk advice. So for income protection insurance we initially set up four recommended lists for contracts that were:

~ basic agreed value;

~ basic indemnity;

~ comprehensive agreed value; and

~ comprehensive indemnity.

We also set up a miscellaneous list for things such as cancellable policies. If a client is only able to obtain a cancellable policy, they should not be made to feel they are only getting second-class insurance.

The need to distinguish between contract types is not the same for term, total and permanent disability, trauma and business expenses insurance, so a single recommended list has been set up for each of them.

Ancillary benefits

A major complication, and red herring for that matter, in risk insurance research is the comparative rating of ancillary benefits, particularly within income protection insurance contracts.

Approximately 20 per cent of the risk premium for income protection insurance is tied up in ancillary benefits.

Contracts contain on average around 10 of these benefits, which means, again on average, around 2 per cent of the premium goes towards each, which in turn roughly equates to 2 per cent of the total chance of a claim being made against a particular ancillary benefit.

When these benefits are analysed, three or four separate components of the benefit are reviewed, so again this equates to around 0.5 per cent of the total risk for each.

An adviser would hardly make a recommendation based on such a minute fraction of risk when compared to the 80 per cent premium component that supports the major policy benefits and features.

But there is another compelling point. We listed all the ancillary benefits for several different income protection insurance contracts and assessed the maximum possible payout for each benefit under each contract, assuming a fixed benefit amount of $5,000 a month. The amounts were compared across companies and also the total possible payout for each company was compared.

The results

The results are set out in table 1. It can be seen, for example, that while Company A may be more generous in some areas, the other companies are more generous in other areas. So no one company is more generous in all benefits.

When the totals are compared, there is less than 10 per cent difference all up.

Finally, the amounts of money involved are, by and large, not overly great.

In other words, it would be very difficult for an adviser to make a clear and certain recommendation based on the merit or otherwise of ancillary benefits.

Also, if a loss did occur, it would be of a low comparative magnitude (remember, the amounts listed in the table are the maximum potential payout) when considered against the main policy benefits.

Based on these results, the decision was taken not to assess or rate ancillary benefits within contracts. Suddenly, the analysis required to set up and maintain risk research was dramatically reduced and the ability of the adviser and the client to understand the research was dramatically increased.

Best versus most appropriate

All too often when a risk policy for a client is being assessed the focus is on finding the best, with the attention on the policy rather than the client.

A policy itself is neither good nor bad. It only becomes such when the policy is not appropriate for a particular client.

So, for example, a cancellable policy when recommended for an accident-prone explosives handler may be considered ‘gold’ by that client. If recommended for a healthy accountant, the same would not apply.

In line with this, we did not feel policies should be rated as better or worse than each other. Instead, we rated them against a consistent benchmark. In this way, we are able to ensure that all contracts on our recommended lists are of a certain quality.

We also only concerned ourselves with the most critical aspects of the policy when setting up the benchmark. So for income protection we looked at:

~ the total disability definition and benefit;

~ the partial disability definition and benefit;

~ the definition of pre-disability earnings;

~ offsets;

~ exclusions; and

~ the rights the insurer had to terminate the policy.

A similar philosophy was followed with each of the other risk insurance types.

Thus, an adviser can be confident that if a policy appears on our recommended list, it has a certain underlying quality. The adviser is familiar with the nature of that quality because they are in turn familiar with the benchmark that has been set.

Objective versus subjective

Naturally, an adviser not only needs to know that a contract meets the benchmarks set, but they also need to know where and how the contract is better than the benchmark.

So the next step is simply to set out the areas where a policy on the recommended list differs from the benchmark.

But, again, differences were not rated as better or otherwise. It is up to the adviser to overlay the risk research with their knowledge of the client and the client’s needs and resources.

So, for a particular client, an adviser may recommend a policy where partial disability requires a 14-day qualifying period because that client has sufficient liquid net worth to carry them through less severe disability situations.

This increases the amount of adviser discretion in the recommendation process, which may initially appear to be a concern, but safety in a recommendation lies less in the nature of what is recommended and more in the process of the basis of the recommendation.

So in fact, by giving the adviser the facility to apply a skill-based discretion, the well-qualified adviser is in a better position to make a sound recommendation and deflect any potential future criticism of the recommendation.

Notwithstanding this, it also enables the adviser to better demonstrate their skill and justify any remuneration they receive as a result of the advice.

And finally, and not unimportantly, it enables the adviser to bring some ‘theatre’ back into the advice process.

This may initially concern some regulators, but if the underinsurance issue is to be addressed, the marketing components of advice and, dare I say it, selling, need to be reconsidered and rediscovered.

Other research criteria

Further developments planned for the research include:

~ integration of the C-Map Claims Management rating, which will also include a measure of premium sustainability; and

~ rating of the policy’s adherence to the components of ‘plain English’. Is the policy presented in such a way as to encourage the client to pick it up and read it? Is it written in such a way that the client is able to understand it, and is the policy clear of errors, ambiguities and omissions?

The devil is always in the detail and this article does not enable too much of the detail to be revealed. Suffice to say, independent legal sign-off of the process has been obtained.

We have worked closely with the insurers and our advisers to ensure these changes to how the appropriateness of risk insurance products for our clients are researched brings benefits to all parties.

We believe the logic behind these changes to be such that it will provide a strategic advantage to those using it.

Genesys, on the other hand, has not sought to retain ownership of the process. Any adviser or dealer group is able to duplicate what has been produced. The need for change is too important for any one dealer group to seek to gain an economic or intellectual monopoly from it.

Col Fullagar is a risk manager at Genesys Wealth Advisers .