Final report Prepared For: Unum Group 2211 Congress Street Portland, ME 04122 Milton Court Dorking Surrey RH4 3LZ Economic analysis of disability insurance products in the UK Prepared by: Kyla Malcolm and Chiara Atzeni 99 Bishopsgate London EC2M 3XD Date:
DISCLAIMER The conclusions set forth herein are based on independent research and publicly available material. The views expressed herein are the views and opinions of the authors and do not reflect or represent the views of or any of the organizations with which the authors are affiliated. Any opinion expressed herein shall not amount to any form of guarantee that the authors or has determined or predicted future events or circumstances and no such reliance may be inferred or implied. The authors and accept no duty of care or liability of any kind whatsoever to any party, and no responsibility for damages, if any, suffered by any party as a result of decisions made, or not made, or actions taken, or not taken, based on this study. Detailed information about, a registered trade name of CRA International, Inc. is available at www.crai.com Page i
TABLE OF CONTENTS EXECUTIVE SUMMARY...1 1. INTRODUCTION...2 2. OUTCOMES WITH, AND WITHOUT, INCOME PROTECTION...3 3. OVERALL UK RESULTS...7 4. CONCLUSION...10 Page ii
EXECUTIVE SUMMARY The recent credit crisis and the current economic climate have brought government finances under considerable strain with substantial reductions in spending planned over the next few years. The welfare budget in particular is facing pressure having increased by 45% in real terms over the last decade prompting the Government to announce fundamental reform through the Universal Credit. We have conducted detailed modelling on the benefits to individuals from the presence of income protection policies as well as capturing the savings for taxpayers in terms of the reduced expenditure on state benefits. For the median earner with pre-disability employment income of 28,000, the potential income gain from holding an income protection policy is nearly 5,000 while the saving for taxpayers would be nearly 7,300. Individuals as a whole gain an income advantage of 0.5-1.0 billion. Overall we estimate that the presence of income protection policies leads to annual savings for the taxpayer of some 0.3-0.5 billion per year. However, the penetration rate of income protection policies in the UK is less than half that in the US. Expanding the prevalence of income protection policies therefore has the potential to bring savings for the taxpayer of up to 1.2 billion per year. For individuals and families, however, the monetary difference in income does not capture the full value of benefits that they receive from holding income protection policies. Individuals are typically risk averse, preferring to avoid financial shocks and insurance policies bring great benefits because of this. We have conducted welfare analysis which takes into account the typical cost of paying insurance premiums and the risk aversion of individuals. We estimate that the consumer welfare benefit from income protection is worth around 4.4-7.5 billion. Should penetration rates reach those of the US this could increase up to around 18 billion. Furthermore, we have not included benefits from potential behavioural change arising from the actions of insurers to help return individuals to work rather than see them move from short-term sick pay to long-term disability payments. Neither have we included gains to the taxpayer from increased tax revenues where income protection policies pay out. Both of these issues would add to the overall gains to the taxpayer from the presence of income protection policies and would therefore arise in addition to those taxpayer savings which we calculate. Overall, the benefits of income protection for both individuals and taxpayers are clear and the potential to expand the use of such policies in the UK is significant. Market based solutions can bring benefits both to individuals and also to the taxpayer - benefits which are particularly valuable at a time of pressure on government expenditure. Page 1
1. INTRODUCTION (CRA) was commissioned by Unum to assess the economic value of income protection policies in the UK. Such policies can play an important role in helping families to maintain income levels in the event of a disability and in limiting the extent to which they fall back on state support. 1 In order to assess the benefit of income protection policies, it is first important to consider the details of the UK benefit system which provides a number of state benefits some of which are aimed specifically at the disabled and others of which are available irrespective of disability. The analysis conducted takes into account the following state benefits: Benefits related to disability including Employment and Support Allowance (ESA) and Disability Living Allowance (DLA); and Benefits available to people irrespective of disabilities, focusing on tax credits, housing benefit, council tax benefit and child benefit. 2 The appendix to this report provides the specific details of the various benefits and, where relevant, sets out which rates have been used. This report focuses on the results of the analysis conducted and sets out the following issues: Section 2 provides the results of the analysis in terms of the differential incomes that different types of households earning different levels of income would receive and the impact on the taxpayer depending on the presence or absence of income protection policies; and Section 3 scales up the results to reflect the UK working population presenting results on the overall income benefits to both households and the taxpayer from the presence of income protection. It concludes with a welfare analysis of these policies that also captures the impact of the cost of insurance and the impact of risk aversion. It is worth noting that the modelling focuses on the benefits to individuals from the presence of income protection policies as well as capturing the savings for taxpayers in terms of the reduced expenditure on state benefits. However, these do not represent the full benefits that can arise from the use of income protection policies. In particular we do not take into account: 1 Further details regarding the modelling conducted can be found in Economic analysis of disability insurance products in the UK appendix,. In addition, details of the of the welfare analysis cited in section3 can be found in the appendices to Financial Security for Working Americans: An Economic Analysis of Insurance Products in Workplace Benefit Programs,. 2 The Government has proposed replacing many of the state benefits considered in our analysis with Universal Credit. It is anticipated that Universal Credit will improve incentives for individuals to work and will remove distortions in the benefits system. Our analysis considers those who are unable to work and, assuming that Universal Credit provides a similar level of total benefits compared to today, the benefits described from the use of income protection policies would be expected to be of a similar magnitude to those set out in the report. Page 2
The potential behavioural change that would result from using private sector insurance companies such as reducing the number of individuals who move from receiving short-term sick pay to long-term disability payments; or The potential gains to the taxpayer from increased tax revenues where income protection policies are paid. Both of these issues would add to the overall gains to the taxpayer from the presence of income protection policies and would therefore arise in addition to those taxpayer savings which we calculate. The complexity of the UK benefits system and the extent to which benefits are dependent on the exact characteristics of individuals and households makes modelling the expected impact of income protection challenging. Given this complexity it is therefore necessary to make a number of simplifying assumptions in order for this to be a manageable exercise. It is important to recognise that, as with all models, the results of the modelling are therefore dependent on the simplifications and the assumptions that have been made. 2. OUTCOMES WITH, AND WITHOUT, INCOME PROTECTION In this section we first explain the different household structures and scenarios that we consider for analysis before focusing on the results of the analysis in terms of the incomes received by different households and the impact on the taxpayer. Households and scenarios Throughout the analysis in order to establish the benefits that people are entitled to it is necessary to consider different household structures since many benefits, such as housing benefit and tax credits are dependant on assumptions made about this. We consider four family types: single person; couple; couple with one child; and couple with two children. We assume that half of households with couples have both partners in paid employment and half of households have one partner in employment. Where only one of the partners is in paid employment we assume that this is this individual who becomes disabled. For all household types we examine employment incomes in the range 8,000 to 84,000 per year. Where both partners are in paid employment, for simplification we assume that the household income is equally split between the two partners. In the event of disability, such a household would therefore lose only half of the employment income of the household. It is important to note that this assumption results in the non-disabled partner s income being almost perfectly correlated to the payouts from income protection policies and therefore has the effect of mirroring much of the impact of income protection. The broad conclusion that the income of the non-disabled partner can help to prevent a household from falling on to state benefits is reasonable. However, the extent to which this arises in the model is exacerbated by the simplified assumptions that are made and therefore the Page 3
calculation of the savings to taxpayers from the presence of income protection may be underestimated. We also analyse three scenarios: pre-disability; post-disability without income protection; and post-disability with income protection. In the scenario in which the individual has income protection, we have based the expected income on the characteristics of a typical policy. This sets income as 75% of the pre-disability employment income minus the single person contributory ESA rate. Figure 1 below provides an illustration of this for a single person with employment income of 20,000 pre-disability. Figure 1: Illustrative sources of income for a single person Employment Income Income protection Council Tax Housing DLA ESA 24,000 20,000 Total income = 20,000 Income advantage: 19,117-16,439 = 2,678 Total income = 19,117 Total income per year ( ) 16,000 12,000 8,000 20,000 Total income = 16,439 7,543 3,679 Tax savings: 16,439-8,870 = 7,569 4,753 3,679 438 4,000 4,390 10,247 0 Pre disability 827 Post disability - no income protection Post disability- income protection Source: CRA calculations. Note that this chart is based on the case where the individual is entitled to contributory ESA. As seen in Figure 1 above, post disability the individual would be better off with income protection with an overall income benefit of 2,678. At the same time, the payments from the income protection policy means that lower state benefits are required bringing a saving of 7,569 to the taxpayer. Replacement rates The approach illustrated in Figure 1 is then applied for different family structures and across the income spectrum. We present this in Figure 2 below which shows the replacement rate in the post-disability scenarios. We define the replacement rate as the post-disability income divided by the pre-disability income expressed as a percentage. Page 4
Figure 2: Replacement rate with and without income protection one partner working Single with Income Protection Couple with Income Protection Couple with 1 child with Income Protection Couple with 2 children with Income Protection Single without Income Protection Couple without Income Protection Couple with 1 child without Income Protection Couple with 2 children without Income Protection 160% 140% 120% Replacement rate 100% 80% 60% 40% 20% 0% 8,000 12,000 16,000 20,000 24,000 28,000 32,000 36,000 40,000 44,000 48,000 52,000 56,000 60,000 64,000 68,000 72,000 76,000 80,000 84,000 Employment income pre-disability ( ) Source: CRA calculations. Dotted lines show the replacement rate without Income Protection and solid lines show the replacement rate with Income Protection. Note that this is based on the case where the individual is entitled to contributory ESA (and may also be entitled to income-related ESA depending on the income situation under consideration). Figure 2 shows that individuals are always better off with income protection in the postdisability world (the replacement rate is always higher for the solid line compared to the relevant dotted lines). It is also clear from this that the benefit of income protection (the gap between the continuous line and the dotted line) is greater the higher the predisability income. This is due to the structure of income protection policies which pay out a particular percentage (75%) of the pre-disability employment income. There are variations in the income without income protection between different family structures. The differences reflect the additional benefits provided where there are children in the household as well as the implicit assumption that within a couple the nondisabled partner should be able to seek employment and receive an income. (Figure 2 only illustrates the households with one partner working.) Slightly surprisingly, some replacement rates are found to be above 100% which implies that post-disability income is higher than pre-disability income. For single people without income protection, this is the case for incomes up to around 18,000. The main drivers of this are DLA and ESA. However, it should be noted that part of the reason for DLA is that those who are disabled face additional costs compared to others hence these individuals should not be considered better off post-disability. Furthermore, even where replacement rates are over 100% without income protection, income protection nonetheless leads to a higher income compared to its absence. Page 5
Savings to the taxpayer Income paid through income protection policies reduces the extent to which individuals need means-tested state benefits and we consider below the impact of income protection policies on the cost to the taxpayer. Figure 3 below provides a summary of the savings to the taxpayer from the presence of income protection policies for the different household structures. Figure 3: Savings to the taxpayer due to income protection one partner working State benefits savings due to income protection ( ) 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 Single Couple with 1 child Couple with 1 child - child benefit reform Couple Couple with 2 children Couple with 2 children - child benefit reform 0 8,000 12,000 16,000 20,000 24,000 28,000 32,000 36,000 40,000 44,000 48,000 52,000 56,000 60,000 64,000 Yearly employment income pre-disability ( ) 68,000 72,000 76,000 80,000 84,000 Source: CRA calculations. Dotted lines show the impact of child benefit reform. Note that this is based on the case where the individual is entitled to contributory ESA (and may also be entitled to income-related ESA depending on the income situation under consideration). It is clear from this that even where individuals are on relatively modest incomes there are considerable savings for the state from the presence of income protection. Savings for taxpayers continue to increase as pre-disability incomes increase even up to quite a high level of pre-disability income. 3 We also illustrate the impact of the proposed child benefit reform and Figure 3 shows that these reforms would bring additional taxpayer savings in the presence of income protection policies. 4 3 Between 8,000 and 22,000 of pre-disability employment income this mainly reflects the withdrawal of housing and council tax benefit. Between 28,000 and 42,000 of pre-disability employment income there is an increase in the savings for the state for couples with one or two children, which mainly reflects the reduction of child tax credit. 4 Individuals whose pre-disability income is above 64,837 would receive an income protection payment of above 43,875 (the higher rate tax threshold) and therefore would no longer be entitled to child benefit payments. Page 6
Typical benefits Having calculated the potential impacts of income protection for different households and different incomes, we then calculate the results taking into account the overall household composition and income distribution. For the purpose of illustration, we set out below the information for the average household with a pre-disability income of 28,000. This represents the median employment income. The results presented in Table 1 below represent the weighted average benefits across all of the household types, i.e. the four different household structure as well as the different assumptions regarding whether only one partner in a couple is in paid work or whether both are in paid work. Table 1: Representative benefits of income protection ( ) Pre-disability Post-disability Benefits of income protection Employment income Total income without income protection with income protection Savings for taxpayer Income benefit 28,000 29,128 21,070 25,838 7,253 4,768 Source: CRA calculations based on: Household structure in the EU, University of Essex, April 2010; and Elisabeth Finn Care website. It is clear from Table 1 above that for the median income, individuals with income protection would receive over 4,700 more income overall compared to those without income protection. At the same time, the taxpayer would also make savings of over 7,200. Using a slightly higher employment income, which may be more representative of those who hold income protection policies would generate even higher benefits for individuals and the taxpayer alike. 3. OVERALL UK RESULTS In this section we scale up the results from the different scenarios in order to capture the overall results for the UK working population. We conclude with details of the welfare analysis of these policies that also captures the impact of the cost of insurance and the impact of risk aversion. Current benefits from income protection policies In order to determine the overall benefits of income protection policies, it is necessary to consider both the number of income protection policies that are held and the disability rate (i.e. the proportion of individuals who are disabled): According to data from the Association of British Insurers (ABI) there are around 3.6 million income protection policies in force; and Page 7
We use disability rates of 1% and 2%. These rates are conservative compared to those implied by DLA (5%) or ESA and its predecessor Incapacity Benefit (4.8%) although many DLA recipients will be in work and there are concerns that more people claimed Incapacity Benefit than were expected. We understand that using 1-2% is reasonable on the basis of the claimant experience of income protection policies. By using this information, we are able to calculate the current tax savings generated by existing income protection policies and the income advantage for holders of income protection policies for the UK as a whole. The results are reported in Table 2. 5 Table 2: Current income advantage for income protection holders and tax savings Disability rate Income advantage ( billion) Tax savings ( billion) Source: CRA calculations 1% 0.5 0.3 2% 1.0 0.5 As is clear from Table 2 above, the benefits of income protection policies are quite considerable with individuals gaining an income advantage of 0.5-1.0 billion and taxpayers saving around 0.3-0.5 billion. However, it is worth noting that the potential savings are even greater. The penetration rate of income protection policies in the UK is considerably lower than that of the US. If the penetration rate in the UK reached similar levels to that of the US, this would increase the number of policies from 3.6 million to 8.6 million policies. Table 3 sets out the potential savings that would result if 8.6 million policies were in place in the UK. Table 3: Potential income advantage for income protection holders and tax savings Disability rate Income advantage ( billion) Tax savings ( billion) Source: CRA calculations 1% 1.1 0.6 2% 2.3 1.2 It is clear from Table 3 above that an increase in the prevalence of income protection policies could lead to up to 1.2 billion of savings for taxpayers and an income advantage of up to 2.3 billion for families. 6 5 These results are based on assuming that the 3.1 million income protection policies currently held are all held by individuals with incomes over 20,000. In turn, this figure is based on the level at which the replacement rate post-disability without income protection is around 100%. Using the whole income distribution would suggest an income advantage of 0.4-0.8 billion and tax payer savings of 0.2-0.5 billion. Page 8
Benefits to consumer welfare Although we have calculated the increased income that individuals would receive where they hold income protection policies, this does not capture the full value of these policies in terms of consumer welfare. The reason for this is that most individuals prefer to avoid sudden financial shocks to their income. Indeed, the whole principle of insurance is that most individuals are willing to give up a certain amount of income (in the form of their insurance premium) in return for a payout if a particular, but uncertain, event occurs (such as becoming disabled). The utility or welfare which individuals have from receiving another pound of income will vary depending on their starting level of income. For example, being given 10,000 is likely to bring a much greater increase in utility or welfare when an individual has an income of 10,000 compared to when the same individual has an income of 1 million. A similar effect arises with income protection policies. Moving post-disability individuals from relying on state benefits alone, to a position where they receive a payment from income protection is worth more to these individuals than had they been given an equivalent amount of additional income from their pre-disability position. Put another way, giving up a proportion of their income now (on which they gain relatively low levels of utility) is worthwhile in order to receive income post-disability (on which they gain relatively high levels of utility). It is for these reasons that the calculations of the income advantage to households from the presence of income protection would be expected to underestimate the consumer welfare value. Furthermore, some individuals will value this role of insurance to a greater degree than others i.e. some individuals will be more risk averse than others. Put simply this implies that they have a greater dislike of the situation in which they suffer the financial shock of disability. The more that the individual dislikes the financial shock, the more risk averse they are. In order to calculate the consumer welfare value, we have developed a model which captures the effect of this risk aversion, as well as the fact that the provision of insurance involves costs. In this section we highlight the main assumptions and the results. 7 In respect of risk aversion we base the assumptions on a variety of empirical academic research which assess the coefficients of relative risk aversion (CRRA). The academic work is consistent in finding that the CRRA is never below 2 and studies suggest it varies between 4.4 and 6.6 although some studies find it can reach as high as 10. We present results for values of CRRA of 4.5 and 5. 6 The potential benefits of income protection policies using the complete income distribution rather than the truncated distribution would be up to 2.2 billion of income advantage for families and around 1.4 billion of savings for taxpayers. 7 Detailed information on the model and its development can be found in Financial Security for Working Americans: An Economic Analysis of Insurance Products in Workplace Benefit Programs, Charles River Associates. Page 9
We consider costs of insurance, or expense factors, of 10%, 15% and 20% i.e. for every 100 of insurance premiums paid in we expect insurers would pay out 90, 85 or 80 due to disability. We use these estimates along with the information presented earlier in modelling that enables an assessment of the overall welfare impact to be calculated. The results are reported in Table 4 below. Table 4: Welfare value of insurance in the UK ( billion per year) Disability rate 1% Disability rate 2% CRRA\Expense factor 10% 15% 20% 10% 15% 20% 4.5 4.4 4.3 4.3 7.6 7.6 7.5 5.0 5.9 5.8 5.8 9.8 9.8 9.7 Source: CRA calculations In Table 4 we observe that the higher the cost of insurance the lower the welfare value to consumers. However, the differences in the results by this factor show that it is a minor determinant of the welfare value of insurance. By contrast, the major determinants of the welfare value are the degree of risk aversion and the disability rate. It is clear from Table 4 and Table 2 that the consumer welfare value of insurance is greater than the income advantage for the disabled individuals holding income protection. Overall, using a conservative value for the CRRA of 4.5, the value of consumer welfare from holding insurance is 4.4-7.5 billion depending on the disability rate. Should penetration rates of income protection policies increase to those levels seen in the US, the consumer welfare benefits from income protection policies could reach around 18 billion (with the CRRA equal to 4.5). 4. CONCLUSION The analysis provided shows clearly the benefits of income protection policies: Individuals are always better off post disability if they have income protection compared to if they do not; and The cost to taxpayers is always lower where disabled individuals have income protection compared to if they do not. Overall, the benefits of income protection for both individuals and taxpayers are clear and the potential to expand the use of such policies in the UK is significant. Market based solutions can bring benefits both to individuals and also to the taxpayer - benefits which are particularly valuable at a time of pressure on government expenditure. Page 10
Income protection and individual incomes This note provides additional analysis for Unum following on from our main report examining the economic benefits of income protection policies. 1 The report and appendix set out all of the assumptions used in the modelling. The main report presents information on incomes and state benefits on a household basis. In this note we provide information at the level of the individual who becomes disabled rather than at the level of the household. The distinction is only of relevance for households with couples where both partners are in paid employment. Figure 4 of the appendix, reproduced below as Figure 1, shows the post-disability household income with, and without, income protection for a couple with one child and where both partners are in paid employment. Figure 1: Household income post-disability with and without income protection - couple with one child and both partners working 80,000 Income protection & non-disabled partner's employment income State benefits with income protection Total income without income protection Yearly income post-disability ( ) 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 14,000 18,000 22,000 26,000 30,000 34,000 38,000 42,000 46,000 50,000 54,000 58,000 62,000 66,000 70,000 74,000 78,000 82,000 Yearly employment income pre-disability ( ) Source: CRA calculations. Note that this is based on an average of households with contributory ESA and income-related ESA. There are three preliminary observations that need to be made before examining the income at the level of the disabled individual rather than at the household level: The model assumes that where both partners are in employment, they have the same level of income pre-disability. One of the cautions regarding the model is that this means that income 1 Economic analysis of disability insurance products in the UK,,. Page 1
Income protection and individual incomes protection payments (75% of pre-disability income minus contributory ESA) are almost perfectly correlated with the non-disabled partner s income (100% of pre-disability income); Many of the means-tested benefits are based on household income and not on individual income; and The calculations for the income advantage and taxpayer savings are all conducted at a household level (due to the payments of benefits at a household level). When considering the individual income rather than the household income, we need to make assumptions about the state benefits which they may receive. For simplification, in this note we assume that the state benefits related to disability (ESA and DLA) accrue to the disabled partner. We assume that half of other state benefits (tax credit, housing credit, council tax credit, child benefit) also accrue to the disabled partner. This is the same as assuming that the income that accrues to the nondisabled partner is their employment income and half of the non-disability related state benefits. Figure 2 below shows the income for the disabled individual. Post-disability income with and without income protection is shown compared to the pre-disability income. Figure 2: Individual income post-disability with and without income protection - couple with one child and both partners working 80,000 Income protection State benefits with income protection State benefits without income protection 70,000 60,000 Yearly income post-disability ( ) 50,000 40,000 30,000 20,000 10,000 0 7,000 9,000 11,000 13,000 15,000 17,000 19,000 21,000 23,000 25,000 27,000 29,000 31,000 33,000 35,000 37,000 39,000 41,000 Yearly individual employment income pre-disability ( ) Source: CRA calculations. Note that this is based on an average of households with contributory ESA and income-related ESA. Considering income on an individual basis with the assumptions described above results in Figure 2. This shows that without income protection the income of the disabled individual post-disability falls as the individual s pre-disability income increases towards around 26,000. This occurs because of the impact of the non-disabled partner s income as the non-disabled partner s income rises (in line with the disabled partner s pre-disability income), state benefits are withdrawn. State benefits for the household are withdrawn at a slower rate than the increase in income from income protection policies Page 2
Income protection and individual incomes hence the total household income rises as pre-disability income rises (as seen in Figure 1). 2 However, because most of the state benefits accrue to the disabled partner, the income for the disabled partner falls until the point at which no state benefits are received for the household. A similar effect would also result if all of the state benefits accrued to the disabled partner, but the starting income would be somewhat higher and the rate of decline somewhat greater. In addition Figure 2 suggests that for individual incomes up to 14,000, post-disability income falls for those with income protection. Again this is a function of the withdrawal of benefits due to the increase in the non-disabled partner s income. For pre-disability incomes above 14,000, post-disability income rises for the disabled individual reflecting the income protection payments. Overall, presenting information at the level of the individual helps to show the effect on the disabled individual of the withdrawal of state benefits at the household level. 2 It should be noted that different scales are used for the x-axis (pre-disability income) in the Figure 1 and Figure 2 reflecting the different levels of household income (in Figure 1) and individual income (in Figure 2). Page 3