Level Premium Structures - True or False?
Insurance affordability has been a key concern in the last year or so. For many clients we planned ahead for this years ago by selecting Level premium structures but were the assumptions we based this strategy on flawed?
With the significant changes in Income Protection insurance coming at the end of September we are having a very close look at how to move forward with both new and existing customers. Unfortunately, we have very little visibility on where this road leads as insurers have been playing their cards very close to their chest. While we have indicators of what these new products might look like, we simply cant see past September 30 so its difficult to plan past this point with certainty, which is a key role of a risk advisor.
How do you work out a Level Premium?
Level Premiums are based on your age when your insurance policy began. Essentially, your premium is averaged out (typically until age 65) so you pay more now and less later, when you are more likely to claim. Stepped premiums are the standard option and increase with your age and likelihood to claim so while it might be cheap to start with you will eventually get priced out, so if you are young, why not pay a little extra to have cost effective cover when you need it? Sounds good in theory but predicting the future can be tough and while insurers still need to make a profit they also need to be competitive in a harsh marketplace.
There are a lot of assumptions used to price this over 30 or even 40 years. I am certainly no actuary but a few factors that appear to have severely been underestimated are:
Interest rates - The neutral rate is around 6%. It’s been far under that for years now and likely to be for some time. Insurance pools must be held in low risk assets which are seeing neutral or even negative returns.
Rates of claims - Generous terms, more proactive medical systems and more educated and aware clients mean that new claim rates have been increasing. Plus, people on long term claim tend to stay on claim and receive monthly payments for decades.
Reduced new business - Legislative red tape strangling advisers and insurers who design and distribute insurance products have drastically reduced the number of new (and healthy) lives that are joining insurance pools.
I am sure that there are numerous other factors at play here and as an adviser I am not privy to what goes on in Life and Reinsurance offices. I do however see recent pricing increases and note that Level premiums are going up around 20% faster than Stepped premium structures and with the focus on Level premiums and have to seriously wonder if this will ever stop. If you are interested in the most recent increase please follow this link to a Zurich update. Zurich are a very well established and historically stable insurance provider in Australia and these premium increases have been lower than many this year but this is not the first time they have applied this in the last 3 years.
The new reality
Even up to 18 months ago, it was a widely accepted rule of thumb that if it was likely you might need insurance cover for over 12 years, a level premium structure was more cost effective as the cross over for when stepped overtook Level was around 12-14 years away. I ran this calculation on a Doctor in his mid 30s last week and it appear this cross over point is now 22 years away. This calculation does not include any future increases such as described above so its quite possible that paying a level premium has no benefit at all. Quite simply, this throws the shop worn knowledge about level premiums out the window.
What is the outlook?
You can always switch between Stepped and Level premiums at any time. It appears that this option will continue past October 1 but there is still uncertainty there. Its very likely that Level premiums will not be available on new Income protection contracts past this point but existing contracts should be “grandfathered”.
Of course, if you have been paying higher premiums for some time to try and manage future cost this can be tough to walk away from. If this trend does continue its likely that level premiums will quite simply become unaffordable, exactly the same as stepped later in life, its just a matter of when.
If you have held a level premium for a long term, even with these recent increases, switching to stepped may still might increase your premium. You will need a good adviser to assess this for you as each policy and person is different.
As I have said before there is certainly no one size fits all strategy here but it does appear that relying on a cost effective protection strategy based solely on insurance is a thing of the past. Moving to self insurance is down to your unique needs and may take some time to properly establish so while good cover is often essential in the short term, so is reducing debt and building up income producing assets for the longer term.