Income protection: Why taxable losses are not the right advice

JP, I find your article confusing and feel I must respond. I disagree entirely with much of what you say.

Your position seems to assume agreed value will always pay more on claim than loss of earnings. This is not true, in cases where ACC is paid for example, typical agreed value may pay nil (it is fully offset by the ACC payment) while the loss of earnings policy would still pay something (75% of the difference between income lost and ACC received). Even without offsets and after tax, the difference in net benefit received, all other things being equal, depends on the customers average rate of tax while (on reduced income) on claim.

As far as deducting the loss of earnings premiums go, this is much easier for PAYE only taxpayers these days and the deduction is not entirely outweighed, as you seem to suggest, by the difference in premium payable, creating little or no benefit to the customer. Yes, the sum insured for agreed value is typically lower than that for loss of earnings, but the premium rate for agreed value is higher, so the actual differential in premium is typically quite small, certainly significantly less than even the lowest marginal tax rate in the several quotes I have just done. (Incidentally, the full income cover premium is deductible, not just the $100 differential in your example.)

For all clients, the savings made by being able to deduct premiums can contribute to affordability, more clients having it, and, can amount to many thousands of dollars, even tens of thousands of dollars, over their working life, particularly for those on 30%, 33% and 38% marginal rates. It is only those clients disabled for longer periods of time who might find that the additional net benefits received on claim under agreed value exceed the value of the working-life benefit of the deduction from tax. Unfortunately, no one knows who will make a disability claim during their lifetime so tax benefits on claim are uncertain at best. We do however know that every customer must pay premiums, so the tax benefits of deducting premiums are certain (ignoring a tax law change of course) and available immediately.

To suggest advisers are complicit in ‘harming the economy’ for recommending loss of earnings, is plain wrong and unjustified. Equally unjustified is your view that the only reason advisers recommend loss of earnings is higher commission and less work (which is arguable anyway).

Taking a categoric approach to what is acceptable advice, as you seem to do in this article, is not the right way to go about giving advice. There are instances where agreed value is more appropriate for the customer on balance and others where loss of earnings is more appropriate on balance, depending on many factors, including the customers tax rates and income types and levels.

JP - you are normally articulate and a voice of reason. However I think you have lost yourself here to make a point.

Customers have different needs and you do rightly point out that AV contracts work differently than indemnity style such as LoE.

Tash rightly points out the differences are not just tax but benefit levels for both full and partial. In addition customers may often be on a higher rate of marginal tax when they pay premiums (say 39%) than when they may be under a claim.

Furthermore the underlying pricing assumptions used by insurance companies may be different between AV and indemnity. If you ask a friendly actuary (not oxymoronic) I am sure they will be able to tell you the likelihood, reverse of the termination rate, of a return to work is different between AV and indemnity style contracts. From memory claims termination rates may be lower historically for AV so as a result AV contracts have tougher pricing if insurers are allowing for this in pricing. SO potentially by placing a client with AV you are placing your client in a pool of higher risk customers.

Of course it is complex and like everything it depends on the client circumstances.

I am surprised how one could say that advisers push indemnity style over AV to gain more commission.

Nice, I expected some "what are you smoking?" And this is what debate is about.

I agree Agreed Value Loss of Earnings(LOE+) is a stronger position, at the same time it is also more expensive. Indemnity(IV)/Loss of Earnings(LOE), Agreed Value(AV), then LOE+ in the scale of premiums. So middle ground non-taxable AV is the balancing act of premium vs certainty, with the LOE+ calculation giving you the best of both worlds.

And I did state above that there are situations that dictate an LOE approach would be better, typically LOE+, with an agreed value component. It's about the starting point and the motivation behind that starting point. It's now client first remember.

As to the comment about IV over AV for commissions, having been a BDM for 10 years with advisers agreeing on AV is better than continuing to sell IV, yeah, it's hard to come to any other conclusion. It's also human nature, less work for more money. It's also been told to me by more than a few advisers, once I became an adviser, so yes, this is a behaviour out there in adviser land.

However, when you look at this from an initial advice perspective without claims, I get the views stated. When you take into account the claimed reality for clients it becomes quite different. And with 20 years of IP claims management with some very difficult claims, the reality is selling IP on a tax-deductible LOE/IV basis fails the claim test for clients.

The vast majority of claims do not have an ACC component, Gen Re's stats have this at 25% for females and white-collar workers with blue-collar workers significantly underrepresented in being covered by disability cover, typically because of premium costs. And the problematic claims I have seen and managed have either not had ACC involved or have become a real issue once ACC backs away. And these problematic claims have all been IV, not AV. You just don't get these lack of response issues with AV products.

Add to that as advisers we advise on loss, so an offset for ACC or not having "top-up" of the 20% is intrinsic in the design of these products, it may be desirable to have this covered, but even the vaunted LOE approach is still 75% if there is no ACC.

However, the bigger issue is certainty, that is what clients are really lacking with the advice around income protection. This is reflected in the FSCL income protection complaint GR covered this morning 6/8/21, the advice was ruled to be fine in the situation and the documentation could have been better, what the client was really complaining about the lack of response and certainty from the policy they had. And that is more my point.

As to the tax deductibility, some advisers may manage this well, however, I am yet to come across an employed IV/LOE/LOE+ policyholder that has consistently claimed their tax dedictions, if they don't need to do a tax return for other reasons, they forget about it as life is busy. Yes, that challenges my IRD funding insurers comment, at the same time there are plenty that are taking the deduction and have far less certainty at claim time.

If you use LOE+ style of products, good, that's agreed. But, and there is a big but. Offsets which is where all of this falls apart for many claims.

The claim reality, and this is where almost every problematic claim I have seen has fallen apart, is the client had indemnity style coverage. The issue is ongoing and passive incomes, under an indemnity and LOE calculation these get offset, and sometimes to the point that they result in little to no claim being paid.

One of the realities for Kiwi's is we move from employment to contracting or self-employment and back again on a regular basis. I have one client that has change from employment to contracting and back again every year for the last 5 years, which makes it very challenging if there was an indemnity/LOE style claim as income has wildly varied too.

And the point here is the difference in treatment AV has over IV, where AV offsets exertion earned income and IV offsets all income with the exception of investment income. (in general terms as this is a provider agnostic discussion)

So where there is ongoing income from a company where the owner is disabled but management still manages to produce an income, there may be no loss with a LOE calculation, however, as the income is not exertion based, the AV claim continues to pay.

Where the insured has subsequently developed an increased passive income that's not considered investment income, as an overall loss the loss of income may be very small. Yes, an LOE here may be useful and at underwriting time if this passive income exists AV is likely to result in little to no insurable benefit. So it is very much situational, which I also stated.

More my point, the majority of people out there buying IP are better off in the hand on an AV product. Sure an LOE+ may advantage some situations, more the point is about certainty and IV/LOE is not the solution for certainty and that was what the article was about.

The reality is IV/LOE as a lead is not the place to start, as I stated above. IV/LOE is lazy advice that increases the IRD funding insurance companies bottom line while advisers get paid more for taking the easy route with clients less secure at claim time, not declaring their claim and paying tax on it. That's the frank reality. The IRD pays more for IP deductions than it collects in tax on taxable claims.

It very much is a case of what is appropriate for the client situation, and I stand by what I have said.
As to what prompted this article in the first place, yes that adviser reviewing my client prompted me to write this at that point in time, but this has been an article in my head and I have written about and talked about for a very long time. There are versions on my own website from 2014 to 2016.

Good debate over a complex issue and especially good comments by Tash.

JP’s initial article raised some interesting points but showed the problem with make judgements based on a single case.

I think JP has pulled backed from saying it is essentially (his word) higher commissions that drive people away from AV by saying it is about the particular client situation. But he then tries to have a bob each way by saying he stands by what he said.

Thanks for raising JP and get your argument but Tash is right in that it depends on the client circumstances.

Cheers JP and a good reply for Tash.

We all get wound up when faced with having to address someone not being clear to clients with the underlying motive to move.

Care needs to be taken though In extrapolating individual cases where AV is better to generalised statements for all clients.

At least we can have this debate in NZ.

It is interesting that the Australian regulator, APRA, has instructed the AU life insurers to cease the sale of new Agreed Value income protection / disability income policies.

Thankfully the insurers in NZ have managed to keep AV going over here in NZ. Next time you see a friendly Chief Underwriter maybe say thanks for their efforts in keeping AV open in NZ.

https://www.apra.gov.au/news-and-publications/apra-resumes-work-to-enhance-sustainability-of-individual-disability-income

Yeah good work to keep AV open. I am sure some of the NZ underwriting peeps would have enjoyed the negotiations with reinsurers & the like and celebrated with a nice dinner and wine.

Do the rules on soft benefits, eg dinners, apply to the relationship between insurers and reinsurers?

Indeed - underwriters have a reputation of being fond of wine - on a case by case basis

@wilf What soft benefits? As an ex Underwriter I got a pen and pad once. Most reinsurance shot callers are also based in Australia dinners I can imagine are few and far between before COVID let alone now.

Thanks for the comments and debate, it is a complex area that limits on article length (yes, I'm listening to the feedback) limit explanation.

Also, it is a contentious issue for some, as the path well-trod is the easy path to follow. And various vested interests and incentives do drive the positions some take.

I'll reiterate my comment in the article; there are cases where indemnity is the approach it is just not the first approach, that is the crux of my point.

I'll be clear: Agreed value cover should be our first point of call, the tax aspect is somewhat situational, but doesn't always go as planned at claim time.

I have seen more taxable claim issues than I have non-taxable claim issues, because of the tax positioning at advice and underwriting. And that's part of the problem we don't know what the client's claim is going to look like when it happens, so we need to be broader in our consideration of what could happen.

Comments elsewhere (social forums) have debated this with good effect too. And that's the point of the article.

Also, a good adviser will consider the options, an insurance salesperson will sell a product, and that is often the distinct determinator of what goes on with product selection.

The large majority of in-force IP covers (mortgage excluded) are indemnity style contracts, some have been there decades and haven't been touched, some can't be changed. Even with my time at Sovereign with the push on AV the company had publically in the majority of its IP discussions, the bulk of IP covers were still indemnity, by a large majority, though that stat I don't recall accurately enough to put numbers to.

The tax implications on higher tax rates, calculated out don't stack up. Even high incomes with 39% tax impact on the income over $180,000 still have an outright advantage on agreed value. And when we get into very large incomes, underwriting limits on amount of cover impact, which makes taking a non-taxable approach even more effective when the limits get imposed as they are amount of cover not tax position of cover

As to U/W'rs, my recall is most enjoyed a good red ;) though the days of that seem to have moved on. Though for some still around you will remember the days of silver service in the executive suite at tea time too :D

JP. Again, I am compelled to respond.
No product or solution should be ‘our first point of call’. Taking categoric positions like that is not conducive to the objectivity necessary for ‘best advice’. No solution should be given a ‘head-start’ over other options (unless of course you really are only selling products). Insurance solutions should be calculated fairly and objectively, without undue favour or prejudice, having regard to appropriate factors and circumstances particular to each client.

What are the ‘taxable claim issues’ you see more of? What do you mean? If you are referring to claims where pre-disability income is insufficient to support the sum insured, that is a feature of an indemnity style product (something the Australian regulator thinks is an important factor for sustainability!) – the taxation thereof is irrelevant.

You say ‘The tax implications on higher tax rates, calculated out don't stack up. Even high incomes with 39% tax impact on the income over $180,000 still have an outright advantage on agreed value.’ WHAT DO YOU MEAN???? Are you saying that after-tax, agreed value claim benefits are higher than they would be with indemnity? If so, that is possibly correct, but it depends on the sum insured taken, how much income at higher levels the provider is prepared to give for agreed value, the claimants other taxable income earned and the deductions available to them, amongst others. At average income levels the tax differential at claim time makes very little difference in terms of cash in hand.

Whatever the case, you can’t simply ignore the benefits of deduction of premiums (very large tax deduction benefit at marginal rates of 38%) that loss of earnings/indemnity contracts could provide for the vast majority who will not make a claim or who will make claims of short duration only.

Incidentally, I am only trying to bring some balance to this article and your comments. I don’t think tax should be the primary determinant of the product solution recommended, but in some cases, it may be a determining factor and it may be important to the client, either when they receive your advice or when they make a complaint!

As far as maximum levels of cover go, I am unsure of the limits these days but it is my understanding that at least some providers do in fact differentiate between agreed value and indemnity/loss of earnings in terms of the maximum percentage of income they are prepared to allow for sums insured at high income levels. Unless I am mistaken in this regard, and I'm sure your intentions are not to mislead, your comments are misleading.

I’m all for debate but we all have an obligation to be clear, unambiguous, rational, objective, factually accurate and coherent, without parading opinion as fact, especially when debating product issues and advice solutions. If we do not, we risk confusing a great many well-meaning advisers who are trying to improve their knowledge and skills. As David Miliband once famously said… ‘you are entitled to your opinion but not your facts’.

@tash, you seem to have lost your way there. And I think I've been quite clear in an area that is not only complex but nuanced.

As advisers under a client first approach we need to be focused on client's outcomes, that implies that certainty of outcome is desirable for the client and also in the regulators eyes. We will be measured on the suitability of our advice and the outcome resulting at claim time.

On the tax bit it sounds like you need a better tax calculator. Excluding ongoing incomes that favour LOE or offsets of tax for a monment, plain vanilla employee income. Taxable is only net in the hand at claim better below about $42,000 gross taxable income. Above that net of tax benefits are higher in the hand.

When we consider large sums while there are provider nuances about tiers and maximums, they largely work the same where the sum assured is the maximum they go to irrelevant to the tax treatment.

There are aspects where certain cases have an advantage of higher deductibility with a lower taxable claim, these have some merit being an outlier on the cusp of the tax bracket, again as an LOE+ not indemnity.

A recent review for one client in the region of $1.2 mil personal taxable resulted in a LOE+ solution, not because of the tax or the inderwriting, but the employer cover. So yes, individual circumstances have significant consideration.

Another, as I alluded to above, ended up on LOE+ due to a high component of unearned income that already existed. If this didn’t exist already then a typical net of tax AV approach would have been better.

Largely my point is when it comes to IP advice we do what we have always done, and that isn’t necessarily the right approach. Given that indemnity style products have been that approach.

The tax bit is somewhat secondary, while also needing to be considered as the net of tax AV answer has both more certainty and net of tax is usually more in the hand (offsets, tax deductions, and unearned income excluded)

The bit we are assuming with our advice is the situation today is the situation tomorrow, the problem is even in the strongest financial position that can change overnight. Where assets and wealth tools that were assumed literally disappear leaving the claim situation worse than it could/should have been, and I also have several client's in this position as a result of Covid. Thankfully not claims and they have agreed products.

As to the problematic claims, plenty and most involve self-employed or passive income situations.

Sure you could go with the Aussie regulators position, no loss no claim. And sure for the insurer that seems reasonable. Except we work for the client. And a client on finding out that having an agreed value claim would have paid is going to complain. Not might, will. I’ve seen it up close many many times.

It's up to the insurers to build sustainable products. It is our role to utilise the best product (bunch of criteria) available for the client.

The bit that really gets screwy on the LOE bit is long term degenerative claims, MS is a great example. The loss of income can be over many years, so when a claim tested on last 12 months or best 12 of 36 months is lodged the claim benefit bears no resemblance to the income they had and insured. Add self-employed to this one and it becomes a tragic epic. Seen this happen too.

You might now be realising that I’m coming from the claim outcome perspective, an area where many advisers have little to no experience. They are advising based on what their BDM/Manager told them, who typically hasn’t given advice or seen claims either.

I used to get plenty of comments as a BDM about leaving claims alone. Funny thing, when I took care of claim issues my advisers were both more productive and also more supportive. So while the numbers were good and advisers were happy the comments weren’t an issue.

But that didn’t solve everything, as an indemnity cover that couldn't prove a loss was still no payment of a claim.

My final point when giving advice about the present situation without considering the future, you are discounting that Kiwis have a habit of moving in an put of employee/self-emplyed roles.

I have one client that has done that 4 times in the last 5 years, and many of the claims I've seen with issues were initially implemented as employees.

Which means they're screwed when they have a claim in year 1 or 2 of being self-employed with a last 12 month income test, and often in year's 4-6 they still have issues against the levels they have insured.

So yes, I have many many stories of why indemnity as a solution for income protection when agreed is available is a bad idea.

If you want to challenge the perception of disability cover being expensive and difficult to claim, yes, I hear this regularly too, then we need to move aways from it as a preferred solution.