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ombudsman news

issue 52

April 2006

insurance - assessing the amount of benefit paid out under income protection policies

In some of the disputes we see involving income protection policies, policyholders are unhappy with the amount of benefit they receive after they have successfully submitted a claim. The problem often stems from the policyholder’s misunderstanding about how the policy works. But sometimes the firm has calculated the benefit incorrectly.

This article:

  • examines some of the assessments firms make when calculating the benefits payable in individual claims
  • looks at the types of complaints that may arise as a result; and
  • provides some recent case studies.

the limitation of benefit clause

This affects the maximum amount of benefit the policyholder can get under the policy. The limit is linked to the policyholder’s earnings before they became incapacitated. So policyholders who do not fully understand this – and whose earnings are too low to entitle them to the maximum amount of benefit for which they were insured – may be disappointed by the level of benefit they receive. Disappointment can also result if the maximum benefit payable under the policy is lower than the amount the policyholder was earning before becoming incapacitated.

When looking into complaints referred to us, we will examine the policy and check whether the firm calculated the benefit correctly, in accordance with the policy. If we are satisfied the calculation is correct, we may examine the advice the firm gave at the time it sold the policy. We do not assume that simply because the insurance does not currently meet the policyholder’s needs, it must have been mis-sold originally.

We will look, in particular, at whether the policyholder was over- or under-insured. We will also examine any fact find or other document relating to the policyholder’s financial circumstances, demands and needs at the time of the sale. And we will look at any policy brochures and marketing information given to the policyholder before they took out the insurance. For instance, where the insured benefit is subject to options that could increase it, then if there is any ambiguity in the policy about how the increases operate, we may consider what the firm told the policyholder at the time they entered into the contract.

definition of earnings for employed/self-employed

Invariably, policy definitions of pre-disability earnings will distinguish between employed and self-employed policyholders. Generally, when calculating benefit, the firm will consider pre-tax earnings for employed policyholders, and net profit for those who are self-employed.

Disputes can sometimes arise if a self-employed policyholder believes that – in basing its assessment on net profit rather than on some other factor, such as turnover – the firm has calculated benefit incorrectly. In such cases we will always examine the policy in question. The status of elements such as benefits-in-kind, bonuses, commission, ‘drawings’ and dividend payments can vary considerably between policies.

Income protection policies are designed to replace lost income. So we will not consider it unfair for a firm to take into account any income that a self-employed policyholder continues to receive from their business during a period of incapacity (even if this results in no benefit being payable) so long as the policy clearly allows the firm to do this.

basis of assessment

A policyholder’s earnings are usually assessed on the basis of their average income over the 12 months before they became incapacitated. But this can sometimes produce harsh results. For example, we may know from medical evidence that the policyholder’s condition worsened progressively over a period of time, during which they struggled to continue working. In such cases their average income over the previous 12 months may not be a true reflection of their income when in good health.

A harsh result can also arise where a policyholder’s income fluctuates, for example when their earnings depend on commission. If such a policyholder becomes incapacitated during an economic downturn, their earnings over the 12 months before they became incapacitated may be much lower than normal. So a fair and reasonable approach would be to take an average of their earnings over a longer period (for example, three years) unless the policy clearly restricts this.

proportionate/rehabilitation benefit

Own occupation policies often have clauses allowing the firm to pay a reduced benefit if, after a period of total disability, the policyholder returns to work in a reduced capacity or a different occupation – and can demonstrate a reduction in their earnings.

In general, however, if a policyholder does not return to work, no proportional or rehabilitation benefit is payable. The requirement to return to work can be onerous for policyholders if:

  • the failure of their business prevents them from performing their occupation part-time; and
  • their disability makes them unfit for any similar occupation.
In our view, it may not be an appropriate response for the firm to either:
  • make no benefit payments; or
  • continue with full benefit.

So depending on the terms of the policy, we will consider whether good industry practice suggests the best solution would be for the firm to make some part-payment of benefit.

deductions for other insurance

When calculating the amount of benefit payable, some policies deduct any income the policyholder receives from other insurances. So the policyholder may not realise, until they make a claim, that they have been paying for a policy that provides very little – if any – benefit.

In such cases, we look at the circumstances surrounding the other policy or policies (often a form of payment protection insurance). This may help us establish if the policyholder (or indeed the firm or intermediary) was aware that the risk was already wholly or partially covered by another policy.

We will also check whether the income protection policy makes it clear that the firm will make the deduction. Our approach, in line with well-established legal principles, is to interpret any ambiguity in the policy wording in favour of the policyholder. So unless the policy clearly shows what other types of insurance payments will be deducted from the benefit, we will not interpret any clause purporting to deduct income from other ‘similar’ policies as including payment protection policies.

case studies

insurance – financial assessment in income protection policies

income protection – calculation of benefit where earnings unaffected by disability

Mr G, a self-employed IT consultant, took out an income protection insurance policy. The policy had a limitation of benefit clause restricting the amount of benefit he could be paid to 75% of his normal earnings.

Several years later Mr G made a claim under the policy, on the grounds that repetitive strain injury was affecting his ability to work.

The firm reviewed Mr G’s business accounts to see whether his medical condition had affected his income. It noted that he had not recorded payments he had made to a sub-contractor. It also found that the accounts did not show all of Mr G’s income and expenditure. So it decided the accounts were unreliable. It did, however, agree to pay the claim until it was able to review Mr G’s audited accounts, when it would re-consider the position.

When it examined the audited accounts, the firm compared Mr G’s pre-disability earnings with his net income and ‘drawings’ for the period after he made his claim. It concluded that he had not suffered a loss of income because of his disability, so it stopped his benefit payments.

complaint rejected
When a self-employed policyholder makes a claim, the firm must be satisfied there was an actual loss of income. In this case, Mr G’s audited accounts did not show a loss. Despite his disability, Mr G’s business remained profitable. Indeed, the business had made a significantly higher net profit in the period after his claim than in the year in which his illness began.

Mr G disagreed with the firm’s assessment. He said the accounts showed an artificial profit and that he had been forced to borrow money to remain trading. But the turnover figures suggested that sales sustained profits, rather than just borrowings.

In any event, under the limitation of benefit provision in his policy, Mr G wasn’t entitled to benefit unless his earnings were less than they had been before his disability. Mr G had continued to earn more than he would have been entitled to in benefits. We rejected his complaint.

income protection – calculation of increases in benefit

Mr M took out an income protection policy in October 1991. He selected an option that protected him against the effects of inflation by increasing his benefit by 7.5% each year. This option was subject to an annual increase in premium.

In 1994, Mr M became disabled and made a claim on his policy. The firm wrote to tell him how his benefit would be calculated. The standard policy restricted benefit to two-thirds of the amount the policyholder was earning immediately before becoming disabled. However, because of the option he selected when he took out the policy, Mr M’s benefit payments were more than this.

For several years, Mr M’s benefit payments continued to increase at the rate of 7.5% per year. But then the firm reviewed its policies. It decided the standard policy condition, which limited benefit to two-thirds of the policyholder’s salary, over-rode the increases arising from the inflation-protecting option. When the firm rejected Mr M’s complaint about its subsequent reduction of his benefit, he came to us.

complaint upheld
It was clear from the policy documents that the option Mr M had selected:

  • was intended to offset the effects of inflation; and
  • had been sold to Mr M on this basis.

Neither the policy itself, nor any of the associated promotional literature, made it clear whether the benefit cap applied to the option. We decided it was reasonable for Mr M to have assumed the two-thirds cap would not have applied in his case, since it appeared to apply only to the "standard" policy.

Selecting the option would have been pointless for Mr M if the cap had been applied from the outset of the claim, as the firm said it should have been. At the outset of his claim, Mr M’s benefit was already two-thirds of his pre-disability earnings. So despite paying higher premiums for the option he could never have benefited from the increase it was designed to provide.

The way in which the policy had been sold and/or represented did not make it clear that the benefit cap would limit any increase arising from the option. We decided it would be unfair of the firm to restrict Mr M’s claim to the original benefit limit. We told the firm to reinstate the increases arising from the option and to backdate any payments owing to Mr M, plus interest.

income protection – calculation of benefit against continuing income

Mr J, a self-employed architect, had been unable to work because he was suffering from stress. He made a claim for income replacement benefit under his income protection policy. The firm accepted his claim but said he would not be paid any benefit because he was continuing to receive earnings from his business.

The firm calculated Mr J’s entitlement to benefit in accordance with the policy terms, which required it to take continuing income into account. Mr J’s continuing income from his business was £55,000. This was more than the maximum allowable benefit, calculated as 75% of the first £50,000 of his annual earnings immediately before the start of his disability.

Mr J said that when he arranged the insurance he had provided the firm with copies of his accounts. The firm’s adviser had not based his calculations on Mr J’s annual earnings (including both ‘drawings’ and share of profits) but only on his annual "drawings". So Mr J said the level of earnings that needed replacing (£50,000) had been undervalued at the outset.

complaint rejected
There was no evidence that Mr J had supplied his accounts at the time he took out the policy. And the firm’s adviser had based his calculation of the appropriate level of benefit on Mr J’s gross earnings, as declared on the application form. On this basis, we determined that the income replacement benefit provided was likely to have been appropriate at the time of sale.

Even if this were not the case, the claim was not affected. Mr J had not suffered a sufficient reduction in income to justify a payment of benefit, so we rejected the complaint.

Walter Merricks, chief ombudsman

ombudsman news issue 52 [PDF format]

ombudsman news gives general information on the position at the date of publication. It is not a definitive statement of the law, our approach or our procedure.

The illustrative case studies are based broadly on real-life cases, but are not precedents. Individual cases are decided on their own facts.