Level pricing in an uneven landscape

Here is a slightly vexed but worthy question for financial advisers: is there still a place for level premiums in a client’s insurance portfolio given recent (and not so recent) premium increases in that market?

As a brief recap, level premiums were designed to take the large “steps” out of stepped premium policies as the risk of claim increased due to the age of the client. Level premiums promised to provide lock in for the insurer (because once a client has held level premiums for a number of years, the client can’t find equivalent cover for the same price) and certainty for clients that policy premiums were not going to suddenly become unaffordable when they needed the cover the most.

The premise behind level premiums is that the total cost of cover to age 65 or 70 is divided by the term of the policy – thus flattening the premium shape for the policy holder. In addition, on the assumption that the cost of cover to the insurer in the early years of a policy is lower than the premium they receive, and the insurer gets to invest the “prepaid” premiums, this helps to lower the total cost of cover in comparison with a stepped premium shape where there is no pre-payment.

The traditional cumulative premium crossover period for level premiums was 10-14 years. This made them attractive to cover long-term risks.

The assumptions of the rate of return the insurer can gain on the premiums invested (in mandated low risk – think lower return – assets) and the cost of claims determine how stable the premiums are.  If one or the other or both assumptions prove to be incorrect, then premiums need to be adjusted.

From 2014 to just nine months ago, interest rates, and thus the return on cash and fixed interest investments, have been very low. Coupled with higher claims rates and not so sustainable product design, this meant that insurers faced heavy losses unless premiums increased. This has led to major increases in the cost of level (and stepped) premiums for new and existing policy holders. Such increases have extended the cumulative breakeven point for level premiums with their stepped counterparts to between 18 and 24 years in some instances. This, along with a loss of faith in insurers to accurately price, has led to a huge reduction in the amount of level premiums being recommended by advisers to their clients.

By now, I trust you can see why I used the word ‘vexed’ to describe this complexity of pricing and inter-related inputs like cash rates, claims experience and product design. However, despite the challenges of level premium products, such products still have their place. Sometimes.

Yes, 20-plus years is a long time to be paying premiums at a higher (cumulative) rate before the client sees a financial advantage. Many aspects of their lives could have changed during this time, meaning that the cover originally recommended is no longer wholly appropriate. However, one of the main advantages of level premiums is that if they are affordable at the outset, they will tend to remain reasonably affordable when the client hits their late 40’s and early 50’s. When you consider that the average age of PPS Mutual’s trauma claimants is 45, this seems like a good time to be able to keep cover in force!

I hold insurance with one of the largest insurers in the market (unfortunately I’m ineligible for PPS Mutual) and I have level premium income protection. Like many other policy holders, I have received double-digit premium increase notices for each of the last 3 years. However, when I price up the same levels of cover now, I still can’t beat my 7-year-old level premiums in terms of year 1 premium. Yes, the increases have pushed out my total break-even period beyond original projections, however, the cover is still competitively priced and above all affordable.

In terms of keeping cover as affordable as possible at the key moments in a client’s life, level premiums still have a part to play. Many advisers are choosing to split the cover between level and stepped premium shapes. This makes cover more affordable in the first instance and means that if any reductions in premium are required later in life, they can be reduced from the stepped portion of cover.

Advisers I have spoken to find this works especially well for lump sum covers. There will usually be a “base amount” of cover that a client needs to repay a mortgage or for home upgrades in the case of severe disability. These amounts can be locked in on level premium with any top-up for income replacement or other debt reduction to be covered by stepped premiums. As clients age, kids leave home and debt is (hopefully) reduced, the stepped premium cover can be wound back providing the client with much needed premium relief.

So, my conclusion? I believe that although insurers need to be accountable in how they calculate price and promote level premium products, the premise of keeping cover more affordable through the very expensive stages of cover is still an attractive one. As always, the most certain aspect of this discussion is the need for clients to access high-quality advice to structure the best available product solutions in their very best interest.

Richard Hopwood, state manager QLD, PPS Mutual