INSURANCE

Income cover comes in several different types. The difference between them centres mainly on how the benefits are calculated on disability, how they are taxed and how much clients can insure.

This is important because the different benefit calculations could result in a big difference in the amount your client receives at claim time. Then again it may make no significant difference; it all depends on the client’s circumstances at claim time. None of us has a reliable crystal ball so this uncertainty makes it tricky sometimes to settle on a recommendation. Don’t be surprised to feel like it’s more a question of selecting the lesser evil.

For these purposes we will concentrate on how the disability benefit is calculated but please be aware some providers may include other differences between the different types of income cover they offer.

Indemnity cover: As the name suggests, indemnity income cover pays benefits based on the client’s income at claim time (predisability income). This pre-disability income is defined in the policy wording and typically (but not always) defined as the average monthly income earned for the best 12 consecutive months during the previous three years. Other definitions include the monthly average for the last year or last three years for example. How the pre-disability income is calculated, along with

what ‘income’ means and what income offsets apply, are important matters, so you should take the time to understand them as they will differ between providers.

The disability benefit formula is typically: 75% of the client’s pre-disability income less any offsets (ACC weekly compensation for example). Offsets will also be provided for in the policy wording). In other words: A x 75% - B (where A is pre-disability income as calculated per the policy definition and B are the permissible offsets).

Assume, for example, the client’s sum insured and pre-disability monthly income is $6,000 and offsets are $4,000. The totally disabled client will receive $500 from their income cover policy ($6,000 x 75% = $4,500 - $4000 = $500).

If the client’s pre-disability income is less than their income cover sum insured their benefit will still be 75% of actual pre-disability income even though this is less than what they have been paying for – this is the nature of ‘indemnity’ insurance, you can be over insured! If the client’s pre-disability income is greater than their income cover sum insured their benefit will be limited to a maximum of their sum insured even though this may be less than 75% of their pre-disability income – this is the nature of insurance. You can never get more than what you pay a premium for – the sum insured!.

Loss-of-earnings cover: This is also an indemnity style product in that benefits are also calculated typically as 75% of the client’s actual pre-disability earnings as defined (so could be less than the sum insured if income has gone down over time) and limited to a maximum of the sum insured. (There is a widely held misconception that loss-of-earnings style products may pay more than the sum insured if incomes have gone up, but I have yet to see policy wordings that allow this!).

The main difference between loss-ofearnings, and let’s call them ‘pure indemnity’ products, is the way offsets are dealt with. If there are no offsets, loss-of-earnings contracts will generally pay the same as Indemnity contracts, namely 75% of pre-disability income.

The disability benefit formula for loss-ofearnings looks something like this: (A-B) x 75% (where A is pre-disability income as calculated per the policy definition and B are the permissible offsets). Using our previous example (client’s sum insured and pre-disability monthly income is $6,000 and offsets are $4,000) the client will receive $1,500 from their income cover policy ($6,000-$4,000=$2,000x75%=$1,500). For this reason, loss-of-earnings contracts are usually a bit more expensive than ‘pure indemnity’ contracts.

Agreed value: As the name suggests, agreed value income cover does not base the disability benefit on actual pre-disability income. The benefit paid on total disability is the sum insured, the ‘agreed benefit’, less offsets (yes, offsets do apply with agreed value income cover contracts too). This means that if the client’s income has gone down and is less than the sum insured when they become disabled, their disability benefit will still be based on the sum insured even though this is higher than their actual pre-disability income. This certainty of benefit is valuable, particularly for people whose incomes fluctuate, like those who are self-employed for instance. Please note that with some agreed value contracts partial disability benefits effectively become ‘indemnity’ in nature.

The tax situation: My understanding of the tax laws and how the IRD interpret them currently is as follows: where primary income cover benefits paid are based on actual earnings at claim time, the benefit is taxable. Accordingly, indemnity and loss-of-earnings disability benefits are taxable. Agreed Value benefits, being based on the ‘agreed’ sum insured, not pre-disability income, are not taxable (and for this reason premiums are not deductible). Advisers must take care to warn their clients on disability claim with indemnity and loss-of-earnings contracts that claim benefits are probably taxable. Insurance companies paying income cover benefits do not deduct the tax due, so clients on disability claim under indemnity and loss-of-earnings policies must make their own arrangements to file a tax return and pay any tax due. Clients who are not accustomed to filing tax returns will be particularly at risk of failing to do this and winding up with a knock at the door from the IRD.

Sums insured limits: To avoid the moral hazard that replacing 100% of income brings, insurers generally allow no more than a proportion of the client’s income to be insured (called the replacement ratio). For indemnity and loss-ofearnings policies this limit is 75% of income. For agreed value, because the benefits paid are not taxed (and to result in a similar ‘after tax’ benefit) the replacement ratio limit is lower, typically around 62.5% and sometimes down to 55% at higher incomes.

Financial justification: Before you start thinking that agreed value must therefore always be the way to go, insurance companies generally require clients to prove continuity of income before they will allow agreed value cover. Proof of income (typically financial accounts for the last three years for selfemployed) will often be required. Best of both worlds? A relatively recent development is income cover that combines the loss-of-earnings approach with agreed value. Clients typically get the benefit calculation which delivers the higher benefit to a maximum of the sum insured. This brings certainty of benefit regardless of pre-disability income but does make the product more expensive. As this income cover type provides a combination loss-of-earning and agreed value benefit, financial justification is required and the benefits appear to be taxable (allowing the insurers to offer a 75% replacement ratio).

Which should you recommend? As with all insurance products, your advice should be based on what is most appropriate for your client and their specific circumstances. All the various pros and cons of the different types, including all the other income cover benefits we haven’t discussed here, inflation indexing, additional critical illness, specific injury, TPD benefits, and so on must all be considered and weighed-up. ✚