Enhancing TPD sustainability in Australia

The sustainability of total and permanent disability (TPD) insurance has emerged as an important issue in Australia's financial landscape. Amid mounting financial pressures, the relevance and viability of TPD benefits is currently under scrutiny. As work environments change, medical advancements continue, and economic conditions shift, we should carefully analyse whether the current TPD benefit amounts are truly serving their intended purpose at the time of claim.

Key regulatory and industry bodies such as the Australian Prudential Regulation Authority (APRA),¹ the Australian Securities and Investment Commission (ASIC),² the Actuaries Institute,³ and the Australasian Life Underwriting and Claims Association (ALUCA)⁴ have stressed the importance of robust financial controls in maintaining the viability of TPD insurance.

This article explores the central role that financial controls play in ensuring that TPD benefits remain relevant and sustainable, drawing on insights and recommendations from these leading institutions.

The Sustainability Challenge of TPD in Australia

Since the 1960s, TPD insurance has been a cornerstone of Australia's financial safety net, providing crucial support to individuals unable to work due to severe disabilities. Traditionally, TPD benefits are designed to provide a lump sum which can be used at the recipient's discretion. The retail TPD insurance amounts are calculated based on estimated future income loss and are intended to cover expenses such as debt, living costs, home modifications, and rehabilitation.

A primary concern in TPD insurance today is the provision of benefits that exceed the necessary replacement of estimated future income loss. In 2022, the industry recorded its first loss for individual lump sum payments in many years.⁵

APRA has been actively reviewing TPD insurance to address sustainability issues within the industry.⁶ Similarly, ASIC has highlighted ongoing gaps, despite the progress in strengthening the TPD safety net.⁷ The Actuaries Institute's Disability Insurance Taskforce has also urged life insurers to consider the interaction between lump sum and income protection benefits.⁸

In July 2024, ALUCA published a consultation paper addressing the ongoing sustainability of TPD insurance. This paper identifies five key challenges:

1. the attraction and finality of a large lump sum;
2. over-insurance especially when combined with other solutions;
3. the subjectivity and difficulty in determining the permanency of a condition;
4. management of occupation;
5. and the constraints on TPD product evolution.⁹

Excessive benefits play a major role in the sustainability issues facing TPD insurance. This requires a comprehensive re-evaluation of the current benefit structures to secure the long-term viability of TPD insurance within the financial system.

Decoding Today's TPD Benefit Calculations

TPD policies typically align with the policyholder's working life, usually up to the age of 65, resulting in a policy term ranging from 20 to 40 years, depending on when the policy is taken out. The underwriting formula for calculating the appropriate amount of TPD cover primarily relies on an age-dependent multiple of the insured's gross annual income.

The rationale behind determining the suitable income multiple is straightforward: it considers the future earning potential based on the number of active working years remaining and assumes that the individual's income will remain stable. Most insurers further consider any mortgage and future educational expenses for dependent children. The TPD cover is further adjusted for inflation and added as an optional rider to the policy. Generally, the TPD benefit is calculated using gross annual income, without accounting for personal income tax.

While this method is generally well-founded, it has some potential gaps. The following example underscores the shortcomings of current financial underwriting methods.

Let's examine a case study of a 35-year-old applicant with an annual income of AUD 80,000 seeking TPD insurance. Table 1 outlines the underwriting calculation for TPD.