At first glance, the recent run of reported profits in the individual disability income insurance (IDII) market looks promising for an industry that has been plagued by sustainability issues, notes the Australian Prudential Regulatory Authority (APRA) in a statement.
The industry reported net profits after tax (NPAT) for five consecutive quarters from mid-2021 to September 2022.
Life insurance companies have sold this product for decades, providing policyholders with an income when they cannot work for prolonged periods due to injury or illness. However, in recent years, the product’s future has become much less certain.
Intense competition, higher claims and lower insurance affordability resulted in a prolonged period of losses that significantly challenged the sustainability of the IDII product, calling into question its continued availability to meet the needs of the community.
In the five years to 2019, for example, the collective losses from IDII totalled A$3.4bn ($2.3bn). This included significant increases in reserves for future payments for claims materially exceeding original expectations. Exacerbating the situation, life insurers were reluctant to risk competitive disadvantage by being the first mover to redesign their products to make them more sustainable since this would involve either reductions in benefits provided or increases in price – or both.
To address these concerns, APRA intervened in 2019 by implementing a series of measures, including additional capital requirements, that encouraged life insurers to address flaws in IDII product design and pricing, and to strengthen capabilities in risk governance and data quality.
Financial turnaround
To understand what the recent turnaround in financial results mean for the future sustainability of IDII, it is worth taking a closer look at what’s been driving reported profits of late.
As background, insurers hold reserves for current and expected claims and expenses. When these reserves exceed future premiums, it means the insurer expects to make future losses. Insurers are required to recognise these losses immediately and hold additional capital to ensure they can meet the expected claims. The losses accumulated in relation to IDII to 2020 were therefore, in many cases, a reflection of the fact that insurers expected to make losses on that business in the future.
Analysis
Analysis of the industry’s results show three key drivers contributed to the recent profit turnaround: bond yields, repricing and releases of COVID-19 reserves.
Bond yields
Insurers typically rely on the stable and predictable returns from government bonds to help manage financial risk and meet their obligations arising from insurance claims.
As government bond yields increase, the future liabilities of insurers are discounted at a higher rate leading to a reduction in their value. This downward revaluation of liabilities makes a positive contribution to an insurer’s profit.
Increasing bond yields will also affect bonds held by insurers as they are also discounted at a higher rate, leading to a reduction in their value. As a result, life insurers experience unrealised losses on the bonds that they hold, which negatively impacts profitability.
Many insurers aim to match the investments with the expected claims. However, changing credit spreads or differences in duration of liabilities and bonds can result in the two not being perfectly matched, so the profits that have emerged from the reduction in liabilities will not always be totally offset by the investment losses on the assets. This has been a main driver behind the improvement in IDII in recent quarters. However, there are also other components positively impacting liabilities and therefore profits, such as COVID-19 reserve releases and repricing.
Insurers should be prepared for a reversal of this trend, with the potential for the 10-year bond yield to return to a lower level over the next few years. For example, the liability valuation benefits experienced from interest rate movements began to reduce in the September quarter as the rate increased at a slower speed.
Repricing activities are expected to continue
Premiums are key to an insurer’s profitability, so repricing is another factor that contributed to the improved financial results. A life company that is holding reserves for expected future losses can make releases from those reserves when it reprices.
The continued increase in average premiums due to various repricing activities across the industry contributed to the reduction in cumulative losses and expected improved future profitability for most insurers.
Repricing is expected to continue as many insurers still expect future losses from their current IDII portfolio to rise. While repricing of existing policies is necessary for insurers to meet the increasing level of claims, it has produced poor outcomes for consumers. APRA expects insurers to balance the need for premium increases with providing affordable and fit for purpose cover for policyholders. Looking forward, the new IDII products launched following APRA’s IDII intervention should have much more stable premiums over the long term than the pre-intervention products.
COVID-19 reserves
During the early stages of the pandemic, insurers set aside increased reserves to meet potential liabilities arising from an anticipated spike in claim costs related to COVID-19.
To date, the industry has experienced a lower level of COVID-related claims owing to strict lockdowns, government support measures and high vaccination rates as well as lower impact than forecast on the younger, insured population. Most insurers have released parts of their COVID-19 reserves as a result, which further incrementally boosted reported profits during the year.
Residual risks from mental health, long-COVID conditions and the economic downturn remain. Mental health outcomes have been adversely impacted by the pandemic and it is unclear how long they will last. Long-COVID conditions, such as joint pain, fatigue and memory difficulties, could result in a further increase in IDII claims. APRA encourages insurers to carefully consider the unknown impacts of COVID-19 to ensure policyholders are protected and supported in this journey.
Looking ahead
The sustainability challenges with IDII have been well documented, and the premium increases that have been necessary given escalating claims costs have been very challenging for policyholders. APRA’s IDII measures are intended to help bring the product back from the brink and ensure that these problems don’t recur in the future.
The return to profitability for IDII is a positive sign for sustainability of the product. However, since the net gains from improved bond yields and the COVID-19 reserve releases that have contributed to recent profits are cyclical events, that could reduce or reverse. While further premium increases can be imposed to respond to a future deterioration in profitability, this reduces affordability and leads to poor consumer outcomes. This will be further exacerbated by the lower household income and spending in a high inflation environment.
Overall, the industry continues to forecast future losses (albeit less than previously), showing that there is still some way to go before anyone should conclude that IDII has returned to a sustainable state. As such, it is important that the industry remains disciplined with its product design and pricing to strike the right balance between sustainability and profitability.
