In our opinion in all situations Agreed Value is. Yes, there are some clever tricks you can play with tax and claims on indemnity or loss of earnings, but the vast majority of claims just don't work out like that at claim time.
In my experience when it comes to Income Protection claims, indemnity claims cause the most headaches. In my time as a manager looking after advisers and as an adviser myself, the only problematic claims I have had were indemnity claims. Agreed Value never had the drama and hassle.
Indemnity Income Protection is an easy policy to put in place. It's a product that is easily sold, where Agreed Value while having a sales aspect also has a significant advice requirement.
Think about it, if I came to you and said, If you were disabled, how much money would you need? And you said ’My income of $75,000.’ It's relatively easy for me to put a policy in place that would pay $6,200 per month before tax. There might be some problems with your disclosure as you'd have to disclose an income of $100,000 to make it work at application, but this wouldn't have to be proven until claim time. Relatively easy from a sales perspective to achieve, problem is you would only receive $4,687 per month at claim if you were only able to prove $75,000 per annum and you would have to arrange to pay tax on it too.
The Agreed Value approach would go like this.
- 'What do you earn?' You say '$75,000'. I say I can insure you for $3,906 per month.'. You say that's not enough.
- Ok there are a couple of things to be aware of. Agreed Value is not tax assessable, so this is paid in your hand. The policy you have insuring you for $75,000 per annum won't work at the level you think, because you can't prove $100,000. Once you have proven the loss at $75,000, received your $4,687 per month and taken tax out, you'll have about $3,500 in your hand.
- So do you want to pay for a policy at $6,200 per month that pays you $3,500 or do you want one that pays you $3,906 per month and you pay a premium for $3,906 per month with the confidence that it will pay at that level?
Sound a little far fetched? Actually, as an adviser reviewing Income Protection, this is the scenario I come across on a regular basis. The past adviser has often taken the easy sale on indemnity cover and will worry about the fall out, if and when there's a claim. The harsh fact is humans respond to incentives, advisers are humans and they have to do less work and earn more when they advise you to take indemnity and loss of earnings policies. So, if you have an indemnity policy and agreed value wasn't discussed or there were not good reasons to take that path, a review should be seriously considered.
You're paying good premium on cover that is potentially over insuring you and also creating additional risk for you at claim time. There are many things at work with an Income Protection claim, a changed situation from the original application being one of the most common. Agreed Value protects you from adverse changes and situations that indemnity doesn't.
For example, one of the most common, employee working for a corporate, $100,000 income, insured under indemnity Income Protection. When you chuck that in to start your own business, or go contracting, your indemnity cover is probably going to be ok for 2 years, as you can prove a loss including your corporate salary.
The challenge arises in year 3 - 4 and onwards, if you have a disability. Because you have been in business for awhile and your Accountant does a good job, your taxable income is now only $50,000 though your turnover may be several hundred thousand. Because of the time that has passed you can no longer rely on your past salary to prove loss. In this situation your indemnity Income Protection is only going to provide 75% of $50,000 not the 75% of $100,000 you were insured for. Meaning you're effectively over insured for a benefit you can't claim. Which is worse than being over insured with say life or trauma, at least if something happens you can claim the lot.
If you had an agreed value cover, proving a loss for your total disability claim value isn't required, you have an agreed value. So what you are insured for, is what you will receive, once your claim is accepted and the wait period has passed. This is regardless of the earnings you have had.
If your earnings have been lower, then at this stage there's nothing to worry about, you're over insured and you'll be paid at this higher insured rate. If your earnings have been higher, then yes potentially you're underinsured, but this also applies to indemnity too.
In the first couple of years self-employed, insurance companies will generally only offer indemnity personal Income Protection. This may be the only option to top up your cover if your business goes really well. You can have both agreed value and indemnity Income Protection together, they will work if you can prove the total loss required for the total insured income. Once you have 2-3 years of accounts, provided they're at the level needed, you can convert the indemnity to agreed value generally without any medical disclosures. The same goes for indemnity only with most insurers, once you have financials available.
This is why you review your insurance planning on a regular basis, to make sure it aligns with your risk situation. Both with increased and decreasing risk.
What about partial disability claims?
When it comes to partial disability, which is where you're able to do some work but you’re not fully back at work yet, you're going to be better off with agreed value here too. For a couple of reasons.
The first is a biggie. Indemnity and loss of earnings, by their very nature, take any earnings into account. Which means in certain situations indemnity won’t pay anything and agreed value will pay a full claim.
Why is this?
Because of how exertion based earnings is treated.
Most indemnity polices look at the continuing income from a business and offset the lot. This is regardless of the reason or the person creating the income. So if it's your employees or replacement creating the income, it will get offset. With agreed value it's about your own exertion earnings. If you're working and creating an income, this is what will be used for offsets. If it's your employees creating the income, typically it won't be offset.
The second point; often agreed value policies have dual approaches to partial disability claims. One calculation that looks at what you are earning and takes this away from your claim and the second which looks at what you were earning prior to claim and what you're earning on a partial claim and uses this as a ratio of your monthly benefit.
The first works well for those who's earnings have been less than their insured income and the latter where their pre-disability earnings were higher than their insured income. As a client generally you get to choose which, but you often only get to choose once. So you do need to work through the scenarios with your adviser.
Other things to keep in mind.
Income Protection does have some limitations. If your potential loss of earnings relative to your passive income is a low ratio at the point of application, then you may not be able to get agreed value, this also translates to loss of earnings and indemnity value too.
What this means is, say your income was $120,000 with $60,000 earned with your job and another $60,000 through other business activities but you're not directly involved with it. The insurance company will look at what will stop and what won't when you are disabled. They will then look at the possible loss and insure a portion of this possible loss. Which means you won't receive as much as you might expect if you are just looking to your earned income.
If you have agreed value before passive earnings start to build or the passive earnings are low when you take cover, then this is often a much stronger solution as the agreed value cover has already taken passive earnings into account and shouldn’t offset them again at claim time. Which is especially important if they are expected to increase substantially as a relative ratio, as the indemnity and loss of earnings offsets will increase.
Where loss of earnings does have application is where the high ratio of passive earnings is already present and relatively stable, and you have tax losses you can attribute to your exertion earnings that would remain available if you were disabled. Then the tax assessable loss of earnings approach will generally deliver more at claim time, though having an agreed value flavour of loss of earnings or tax assessable agreed value is desirable at this stage to mitigate future increases in passive earnings offsets.
Where indemnity has its advantage is typically when it comes to some of the ancillary benefits, like a specific injury or traumatic condition, same applies to the agreed loss of earnings and tas assessible agreed value too. As the monthly insured amount is higher, because of the tax aspect, then the specific injury to traumatic condition claim would be higher.
The vast majority of people taking Income Protection don’t have a problem with passive earnings considerations, but needs consideration by your adviser for your current and future situations.
Hopefully you've got my point, there is more to Income Protection than rocking up to a website and buying a policy. If you want something simple and cheap then it's likely to be nasty too.
If you want real advice about what's best for your situation, talk to us. We'll explain it as plainly as we can, because Income Protection can be complex for your situation. Understanding the complexities means we can advise you about benefits that will work.