Income Protection working together to improve take-up

Income Protection working together to improve take-up A report for Zurich Kyla Malcolm Economics, Policy and Regulation March 2014

Contents Executive summary 3 1 Introduction 5 1.1 Universal credit and other welfare payments 5 1.2 Structure of the report 6 2 Financial benefits for taxpayers and individuals 7 2.1 Financial benefits for taxpayers 7 2.2 Financial benefits for individuals 9 2.3 Coverage at US levels 9 3 Return to work activities 10 4 Segmentation 12 4.1 Low income segment 12 4.2 High income segment 13 5 Incentives to encourage take-up of Income Protection policies 15 5.1 Why may individuals and employers under-purchase Income Protection policies? 15 5.2 What sort of incentives would help encourage take-up? 16 5.3 Conclusion 18 Disclaimer Whilst every effort has been made to ensure the accuracy and completeness of the material in this report, the author gives no warranty in that regard and accepts no liability for any loss or damage incurred through the use of, or reliance upon, this report or the information contained herein. 2 Kyla Malcolm Economics, Policy and Regulation

Executive summary Pressure on the public finances and changes to various aspects of the welfare state mean individuals are increasingly expected to take greater responsibility for their own financial well-being. For those who face disability events, the insurance sector, through the provision of Income Protection policies, can help the Government to achieve some of its aims of protecting these individuals financially as well as helping them back to work at the appropriate time. Income Protection payments mean that the State makes lower welfare payments and receives higher taxes than when this insurance is not in place. Overall the taxpayer gains around 165 million annually from the presence of Group Income Protection policies ( 85 million from lower welfare payments and 80 million from higher income tax and National Insurance Contributions). In addition to these gains for the taxpayer, individuals also gain with incomes higher by 190 million than in the absence of Income Protection. Income Protection policies are less common in the UK than in the US. If the coverage of Income Protection policies reached the same level as that seen in the US, the gains to taxpayers would be around 725 million. As well as bringing benefits while individuals are out of work, insurers also work alongside them and their employers to help them to return to work faster than they otherwise would. The success of rehabilitation depends on a range of complex factors including: the role of employers; the motivation of the individual; and the nature of the disability. While precise impacts from rehabilitation are difficult to identify in all cases, the annual gains from return to work activities are estimated at around 20 million for taxpayers, 5 million for individuals and 15 million for employers. Where Income Protection policies are not in place, these savings are not made representing a deadweight loss for the economy since taxpayers, individuals and employers are all better off by getting people back to work as fast as is appropriate. Table 1: Gains for taxpayers Gains for taxpayers Lower welfare payments Higher income tax and National Insurance Contributions Gains from rehabilitation activities Total 85 million 80 million 20 million 185 million Income Protection policies are unusual in that those who purchase them (employers or individuals) do not receive all of the benefits from them since gains accrue to the combination of taxpayers, employers and individuals. This is likely to lead to under-purchase. Behavioural factors also reduce take-up where purchasers think welfare payments are more generous than they are, are sceptical that claims will be accepted (despite 92% of claims being paid in 2013), and do not understanding the likelihood of being out of work for a sustained length of time. Kyla Malcolm Economics, Policy and Regulation 3

In order to address this under-provision, incentives may be needed to encourage take-up. Such incentives could be targeted at those earning 20,000-60,000 to avoid those segments where Income Protection mainly reduces welfare payments or who would purchase Income Protection policies anyway. Government incentives not only reduce the price of Income Protection policies but can also act as a signal to individuals and employers that a particular product or course of action is a good thing, and in itself this can help to encourage take-up. This can partly address the misbelief that claims will not be accepted or that disability is a low risk to be ignored. Short-lived tax advantages could play a particularly powerful role relying on some of the very behavioural characteristics that hinder take-up. For example, publicising that tax incentives would last for a short period of time (e.g. 3 years), could help to overcome short-run inertia as there is a limited period of time in which individuals and employers would need to act in order to take advantage of the lower prices. Such an approach is also likely to gain from the fact that individuals are generally overly-persuaded by discounts. The subsequent removal of tax incentives may see take-up benefit from a ratchet effect as purchasers value the product more than they used to because of the Government support, or because the value of the product may have been demonstrated to those who have made claims (more likely for employers with multiple employees), or because of inertia where people do not cancel the product once in place. A higher take-up is also likely to bring further gains from rehabilitation where there is still much to be understood in respect of which activities are most successful. Gains in this area bring clear benefits to all stakeholders. Employers could also help to address some of the reasons that employees under-value Income Protection. For example, providing clear statements of the level of income employees would receive if they had to rely on any occupational sick pay could help employees to understand the gap which is, or could be, filled by Income Protection coverage. Finally, it needs to be recognised that the insurance industry can also take action to improve take-up and to overcome some of the difficulties highlighted above. For example, in as far as the similarly-named Payment Protection Insurance causes confusion with Income Protection Insurance and thereby reduces take-up, the names of products are within the industry s control to alter. Transparency regarding the proportion of claims that are paid could also build confidence in the product both among individual consumers as well as their representatives and the media. In addition, insurers could provide clear statements of the value of typical welfare payments that individuals would receive in the absence of Income Protection policies, along with the calculations and precise value of the payment individuals would receive if they made a claim. 4 Kyla Malcolm Economics, Policy and Regulation

1 Introduction Pressure on public finances and changes to various aspects of the welfare state mean individuals are increasingly expected to take greater responsibility for their own financial well-being. For those who face disability events, the insurance sector, through the provision of Income Protection policies, can help the Government to achieve some of its aims of protecting these individuals financially as well as helping them back to work at the appropriate time. This report examines the situation after a disability event for an individual with, and without, Group Income Protection. 1 The presence of Income Protection payments means that the State makes lower welfare payments and receives higher taxes, while the individual gains a higher overall income. The report also examines the impact on rehabilitation activities which help the individual to return to work faster than they otherwise would. 1.1 Universal credit and other welfare payments The calculations and modelling conducted for this report are based on Universal Credit which is in the process of replacing six other welfare payments. 2 The maximum payment which households can receive under Universal Credit depends on the family structure (number of adults and children), any limited capability for work and housing costs. As well as Universal Credit, households may also be entitled to Child Benefit, Council Tax Reduction, and Personal Independence Payments (PIP) where they face serious disabilities as shown in Figure 1 below. Figure 1 Components of Universal Credit and other welfare payments Joint Single LCWRA LCW Two children One Child Mortgage Social housing Council tax reduction Enhanced Living, Enhanced Mobility Standard Living, Enhanced Mobility Enhanced Living, Standard Mobility Standard Living, Standard Mobility Monthly benefits ( ) 1000 900 800 700 600 500 400 300 200 100 0 Basic allowance (ESA) Limited capability Child element Universal Credit Childcare costs Housing Child benefit Council tax reduction Personal Independence Payments 1 Readers should also take note of the full details of the various assumptions and caveats which apply to the modelling. These can be found in the separate appendix to the report. 2 Universal Credit replaces: Income-based Jobseeker s Allowance; Income-based Employment and Support Allowance; Income Support; Working Tax Credit; Child Tax Credit; and Housing Benefit. Sources: DWP, Benefit and pension rates, April 2013; https://www.gov.uk/pip/what-youll-get; and DWP Housing Benefit and Council Tax Benefit caseload summary statistics: February 2013. Note ESA relates to the Employment and Support Allowance and is equivalent to the single person s basic allowance under Universal Credit; LCW refers to limited capability for work; and LCWRA refers to limited capability for work related activity. Figure 1 shows the maximum amounts individuals may be entitled to the appendix provides details of the values used in the modelling. Kyla Malcolm Economics, Policy and Regulation 5

The components set out in Figure 1 can be combined in a variety of ways to give the resulting welfare entitlement. In addition, households have an earnings disregard which represents the level each household can earn before Universal Credit entitlements are reduced. Above this level, a 65% withdrawal rate of Universal Credit applies against net earnings. Finally, Universal Credit entitlements are reduced for households with savings of 6,000-16,000 and those with savings above 16,000 are not entitled to any Universal Credit payment. 1.2 Structure of the report The rest of the report is structured as following: Chapter 2 sets out calculations regarding the size of the benefits to the taxpayer and to individuals covered by Income Protection policies; Chapter 3 provides estimates of the impact of rehabilitation activities to help individuals back to work; Chapter 4 examines different segments of the population; and Chapter 5 explains why there may currently be under-provision of Income Protection and sets out potential policies which could overcome barriers to take-up. 6 Kyla Malcolm Economics, Policy and Regulation

2 Financial benefits for taxpayers and individuals This Chapter sets out the advantages for taxpayers and for individuals from the presence of Income Protection policies. 2.1 Financial benefits for taxpayers Financial benefits for taxpayers arise from two main sources: Lower welfare payments Universal Credit, Council Tax Reduction and Child Benefit (for those on high incomes only) are all lower in the presence of Income Protection payments; and Higher tax revenues income tax, employee National Insurance Contributions and employer National Insurance Contributions are all higher in the presence of Income Protection payments. Figure 2 provides an illustration of the level of financial benefits that the taxpayer receives through the presence of Income Protection policies for one particular household structure. Figure 2 Financial benefits for Government Lower welfare payments Higher tax/nic revenues Couple, 2 children Annual benefits for taxpayers per individual ( ) 45,000 40,000 35,000 20,000 25,000 20,000 15,000 10,000 5,000 0 IP still replaces UC to an increasing extent, but the average assets of households increase which reduces the original UC entitlement IP replaces UC payments to an increasing extent Child benefit reduces and then falls to zero adding to the savings for tax payers 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000 50,000 55,000 60,000 65,000 70,000 75,000 80,000 85,000 90,000 95,000 100,000 Pre-disability annual gross income ( ) Source: Results from modelling. Note: UC represents Universal Credit; IP represents Income Protection; NIC represents National Insurance Contributions. The illustration is based on the individual receiving contributory Employment and Support Allowance (ESA); entitlement to the Limited Capability to Work component; social housing; and no childcare costs. The illustration also weights the households by average assets for each level of income. 3 A 1% disability rate is much lower than the proportion of the population receiving welfare payments associated to disability such as Incapacity Benefit and Employment and Support Allowance. 8.5% of the population with Income Protection is based on data from Swiss Re Group Watch 2013 and HMRC data regarding the size of the taxpayer population under State Pension Age. Figure 2 above illustrates the benefits to the taxpayer for individuals with different levels of income for a particular household structure (a couple and two children). In order to calculate the overall level of financial benefit for the taxpayer, it is necessary to combine information for different household types, different welfare payment entitlements and the proportion of individuals who are covered by Income Protection policies. The calculations are based on a disability rate of 1% and the proportion of the working age taxpayer population who have Group Income Protection policies which is around 8.5%. 3 Kyla Malcolm Economics, Policy and Regulation 7

Lower welfare payments Income Protection policies provide an income stream which means that individuals receive lower welfare payments that they would in the absence of Income Protection payments. There are some scenarios in which taxpayers make little, or no, savings in welfare payments despite the presence of Income Protection payments. In particular, where households have assets of more than 16,000 they are not entitled to any Universal Credit payments. In this scenario, an individual would not receive Universal Credit irrespective of whether there is any Income Protection payment and therefore taxpayers make no saving from the presence of Income Protection (although individuals are substantially better off see section 2.2). Overall, the taxpayer saves around 85 million in welfare payments each year from the presence of Income Protection policies. In addition to this, the presence of Income Protection payments may mean some individuals do not make any welfare claim even though they are entitled to do so. The value of this effect could be around 15 million annually although it represents a direct transfer from the individual to taxpayers. Higher tax revenues Group Income Protection payments also ensure that the taxpayer continues to receive tax revenues on these payments as well as receiving National Insurance Contributions from both employees and employers. Overall, the taxpayer gains around 80 million as highlighted in Table 2 below. Table 2: Higher tax revenues Income tax Employee National Insurance Employer National Insurance Total Gains for taxpayers 35 million 20 million 25 million 80 million Source: Results from modelling. 8 Kyla Malcolm Economics, Policy and Regulation

2.2 Financial benefits for individuals Financial benefits for individuals arise from Income Protection payments which are set as 75% of pre-disability income minus the single person Employment and Support Allowance (ESA). Hence the financial benefits for individuals increase with the pre-disability income of the individual. The overall benefits reflect the proportion of the population with incomes of different levels resulting in the income gains shown in Figure 3 below. Figure 3 Higher income for individuals Higher income for individuals 5,000,000 4,500,000 4,000,000 3,500,000 2,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000 0 10,000 15,000 20,000 25,000 30,000 35,000 40,000 Annual value of increased income for individuals ( ) 45,000 50,000 55,000 60,000 65,000 70,000 75,000 80,000 85,000 90,000 95,000 100,000 Pre-disability annual gross income ( ) Source: Results from modelling. Overall, the annualised benefits of Income Protection policies are calculated as around 190 million. 2.3 Coverage at US levels The calculations above are based on the roughly 2 million people covered by Group Income Protection policies in the UK. However, coverage of Income Protection is much lower in the UK than in the US. If Group Income Protection coverage grew to US levels (implying around 8.6 million people would be covered), taxpayer savings would increase to around 725 million ( 370 million from lower welfare payments and 355 million from higher income tax and National Insurance Contributions); higher incomes for individuals would increase to around 820 million. Kyla Malcolm Economics, Policy and Regulation 9

3 Return to work activities In addition to providing an income to individuals who are off work due to disability, insurers also work alongside employers and individuals to help them to return to work faster than they otherwise would. Hence Income Protection can bring benefits beyond the static comparison set out in Chapter 2. Helping individuals to return to work is also one of the key advantages for employers from Income Protection policies. Employers are able to draw on the skills and knowledge of a third party with relevant rehabilitation experience, face less disruption from absent staff, and lower associated costs such as overtime for other staff, reduced production due to lower staffing and maintain intellectual capital within the firm. Whilst there are cases where returning to work will not be possible, for most people this will be beneficial, not just financially, but also for their own health, as identified in the Government s review of sickness absence which highlighted that for, individuals with common health conditions (mental health, cardio-respiratory and musculoskeletal condition) consensus holds that for the good of their health they should remain in, or return as soon as possible to, work. 4 It should be acknowledged that it is difficult to prove quantitatively the precise benefits of different types of rehabilitation. The evidence suggests that a range of complex factors interact to determine the success or otherwise of rehabilitation activities including: the role of employers; the motivation of the individual; the nature of the disability; the type of medical interventions that are used; and their likely medical success. Nonetheless, there is evidence that sickness absence and disability management is costeffective and may reduce sickness absence by 20-60%. 5 4 Health at Work an independent review of sickness absence, Dame Carol Black and David Frost CBE, November 2011. 5 Waddell G, A K Burton, N Kendall, Vocational Rehabilitation What works, for whom, and when? 6 By contrast, rehabilitation activities are much less common for cancer cases. 7 The ability of insurance companies to seek private provision of services is also likely to distinguish them from the Government s proposed Health and Work Service which will be able to advise employers but not to fund treatment, although there will be a tax exemption of 500 per year for each employee for medical treatments recommended through the Service or employer-arranged occupational health service. The fact that insurers are increasingly spending money funding rehabilitation activities also adds credibility to the effects of rehabilitation in the absence of an impact of rehabilitation, insurers would neither seek early notification of possible claims nor incur costs funding rehabilitation. Within Zuirch s Group Income Protection schemes, early notification of potential claims typically arises after an employee has been absent for four weeks although for the largest schemes earlier notification may occur. Once notified, Zurich will consider the appropriateness of rehabilitation activities based on the particular nature of the claim. Common rehabilitation activities include access to Cognitive Behavioural Therapy (CBT) sessions for mental health issues, and access to physiotherapy and advice for musculoskeletal issues. 6 In many of these cases, Zurich will facilitate private treatment in order that individuals receive more rapid access, or more frequent access, than can be provided through the NHS. 7 It is also worth noting that in many of the most common cases, interventions are not especially expensive with costs typically around 1,000-1,500 for mental illness and musculoskeletal issues. Whether to pursue rehabilitation activities will also depend on their costs compared to the benefit to insurers from shorter claims. This decision will be based on the combination of factors described above and on the level of Income Protection payments which could be saved. In many ways this is a helpful discipline on the use of rehabilitation since insurers can weigh up the benefits of paying for the intervention compared to its cost. Given the low cost of many of the interventions, the relative salaries of individuals are unlikely to be determinative in the cases where the claim may otherwise prove to be long-term. 8 8 Where rehabilitation is provided through Group schemes, some insurers may be willing to fund rehabilitation services for low income individuals even where this may not make economic sense when considering only that single individual. This would be in order to offer a consistent service to the employer such that all employees are treated equally. 10 Kyla Malcolm Economics, Policy and Regulation

Overall, around 20% of notifications in Zurich s Group schemes involve rehabilitation activities with many of these notifications not progressing to full claims because individuals return to work before the point at which Income Protection payments would be made. Conclusive evidence on the precise impact of early intervention and rehabilitation is not available and therefore Zurich has made assumptions regarding the impact of rehabilitation which are that: In 10% of claims, rehabilitation reduces duration out of work by one month; In 5% of claims, rehabilitation reduces duration by three months; and In 5% of claims, rehabilitation reduces duration by 18 months. Together these sum to 20% of claims in which rehabilitation occurs. Overall, they are considered to be fairly conservative assumptions as rehabilitation activities would usually arise when a reduction in absence of more than one month is expected. In addition, these assumptions do not give any weight to the small number of cases where individuals would have remained permanently out of the workforce without rehabilitation activities. Since rehabilitation can reduce the duration of claims, this brings benefits in addition to those calculated in Chapter 2: 9 The taxpayer gains from the difference between the combination of welfare payments and tax revenues in the presence of Income Protection and the combination of welfare payments and tax revenues when the individual has returned to work at their pre-disability income level for the length of time by which the claim is reduced; and Individuals gain from the difference between their total income with Income Protection payments compared to their pre-disability total income for the length of time by which the claim is reduced. Overall, the annual gains from return to work activities are estimated as being around 20 million for the taxpayers and 5 million for individuals in addition to the calculations in Chapter 2. 10 Employers also gain from having their employees brought back to work at an earlier stage than otherwise and the financial benefit of this is estimated at around 15 million. Where Income Protection policies are not in place, these savings are not being made. As such this can be seen as a deadweight loss for the economy since taxpayers, individuals and employers are all better off by getting people back to work as fast as is appropriate. 9 The calculations include the potential for gain before Income Protection payments are actually made i.e. in the early months of notification. 10 The relatively modest saving for individuals reflects the fact that work allowance and Universal Credit entitlements increase in the event of disability. Kyla Malcolm Economics, Policy and Regulation 11

4 Segmentation As explained above, the basis of the modelling is to examine the situation in which an individual faces some form of disability event which prevents them from working. A comparison of the situation with, and without, Income Protection, is then undertaken. Within this, Zurich wants to better understand the segmentation of individuals according to: Those for whom purchasing Income Protection policies may not be worthwhile because Income Protection payments would primarily replace welfare payments; Those who will purchase Income Protection policies anyway and who do not need any additional encouragement to help them to do so; and The remaining segment for whom Income Protection policies would be expected to be beneficial but who may need additional encouragement in order to purchase them. Since payments made under Income Protection policies are dependent on the level of pre-disability income, the key determinant for this segmentation is income. 4.1 Low income segment Could Income Protection payments make individuals worse off? When considering the low income segment it is useful to first consider whether any individuals would be worse off through having Income Protection policies. The design of Universal Credit has sought to avoid the situation where welfare payments reduce at a faster rate than any increase in income and the withdrawal rate of Universal Credit is set at 65% of earned income. Due to this, individuals will almost always be better off with Group Income Protection policies than without them. There is, however, one scenario in which individuals could be worse off with Income Protection policies. This arises because mortgage payments are only included within Universal Credit payments when households have zero earnings. Since Group Income Protection payments are typically made through existing payroll systems, these payments would be seen as earnings and therefore individuals would no longer be entitled to mortgage payments. This impacts single households and couples where the insured has a non-working spouse. 11 The maximum mortgage payment allowed under Universal Credit is currently 595 per month based on a 200,000 mortgage and average interest rates. Group Income Protection payments exceed this level when pre-disability annual income is around 15,000. Hence individuals are never worse off post-disability when pre-disability incomes are over 15,000. The combination of circumstances where individuals would be worse off will be relatively rare since few individuals on a salary of less than 15,000 are likely to have mortgages of 200,000. Below what level of income could Income Protection payments replace welfare payments? With the exception of the interaction with mortgage payments, individuals are always better off with Income Protection policies. However, it is useful to also consider the level of income that individuals would need such that Income Protection payments replace all welfare payments (i.e. to assume that individuals rely on the Income Protection payment and claim no welfare payments a strong assumption to make for the purpose of segmentation). 11 Couples with a working spouse would not be entitled to the mortgage payments with, or without, Income Protection policies. 12 Kyla Malcolm Economics, Policy and Regulation

As is clear from Figure 1, even for a single adult with no children there is a range of possible combinations of the different components of Universal Credit and therefore it is not straightforward to identify a single figure at which Income Protection payments could replace all welfare payments. The most common types of claims against Income Protection policies involve disabilities which would not lead to the Limited Capability for Work Related Activity (LCWRA) component or to PIP. For an individual with average social housing costs, an income of around 18,000 would be needed before Income Protection payments could replace all welfare payments, whereas for those with the maximum mortgage costs, income of around 21,000 would be needed. Since, individuals are always better off with Income Protection polices once incomes are over 15,000 (to overcome the interaction with mortgage payments), a figure of 20,000 is chosen as the lower bound. There are approximately 13.5 million working age taxpayers with salaries above this level. 4.2 High income segment High income individuals are expected to value the benefits of Income Protection policies to a greater degree than lower income individuals. This is for a variety of different reasons including: Income Protection payments are higher for high income individuals than for those on low incomes; 12 High income individuals are more likely to have higher levels of assets than low income individuals and higher values of assets reduce Universal Credit payments 40% of households with incomes over 52,000 have savings over 16,000 (and would receive no Universal Credit payments) compared to around 15% of households with incomes less than 15,000; 13 and The gap between pre-disability incomes and welfare payments is much greater for those on high incomes than those on low incomes. In as far as stability of income is valued and readjustment hard, this should lead those on high incomes to value Income Protection to a greater degree. In addition to these reasons, employers are also likely to value the presence of Income Protection policies for high earning staff. In as far as high incomes reflect more specialised skills, the cost of absence for employers of high earning employees will be greater than the cost of absence associated to lower earners. Figure 4 below shows the relative take-up of Income Protection policies of different levels of income. 12 The cost of Income Protection will also be higher for higher income individuals than for lower income individuals. 13 DWP, Family Resources Survey 2011-12, Table 2.8. Kyla Malcolm Economics, Policy and Regulation 13

Figure 4 Index of take-up of Income Protection policies 140 Take-up of Income Protection policies 120 100 80 60 40 20 0 10,000 15,000 20,000 25,000 Index of penetration of Income Protection policies 30,000 35,000 40,000 45,000 50,000 55,000 60,000 65,000 70,000 75,000 80,000 85,000 90,000 95,000 Pre-disability annual gross income ( ) Sources: Information from Zurich on take-up rates; and HMRC data for populations with different levels of income. Index of 100 is based on the average take-up for those earning 60,000 or above. The volatility in the figures beyond incomes of 60,000 simply reflects relatively small samples of take-up and the size of the taxpayer segment. As expected, the take-up of Income Protection policies increases with income. However, of more surprise is that take-up plateaus at around 60,000 despite the fact that the benefits of Income Protection policies continue to increase in line with income at even higher levels of income. 14 Figure 4 could suggest that a figure of around 60,000 is the appropriate level above which a given proportion of individuals will purchase Income Protection policies anyway and therefore do not need additional encouragement to help them to do so. However, it is essential to note that this approach assumes that those earning 60,000 and above are making the right decision in terms of their choice to purchase, or not to purchase, Income Protection policies. This is considered further in Chapter 5 which sets out a variety of reasons which lead to under-purchasing of Income Protection policies. 14 It is possible that this reflects individuals with even higher incomes having other sources of assets that they intend to rely on should they face a disability event. 14 Kyla Malcolm Economics, Policy and Regulation

5 Incentives to encourage take-up of Income Protection policies Most products in the economy do not require incentives to encourage individuals or employers to buy them, relying instead on the usual market forces of demand by individuals and supply by firms. However, there are a variety of reasons why the Income Protection market may not work perfectly and, in particular, which may lead to under-purchasing of the product. 5.1 Why may individuals and employers under-purchase Income Protection policies? First, even if the market did work well from the perspective of individuals and employers as the purchasers, it is clear that they would not take into account the gains for the taxpayer when deciding whether to purchase Income Protection policies. Similarly, employers may only take into account the benefits of Income Protection policies for their firm rather than for their employees, and individuals purchasing Income Protection policies are unlikely to take into account the benefits for their employer. Hence, even at a minimum, providing incentives for employers or individuals could be required to account for these various externalities whereby benefits arise to those who do not make the decision to purchase. Second, however, there are a number of reasons that mean that individuals and employers may not purchase Income Protection policies even when it is in their own interest to do so because: 15 The cost of finding out about the product is high due to the complexity of the product, lengthy application forms and complicated eligibility requirements (in the individual market), leading to information overload; They under-value the product which may arise for different reasons: 15 There are various sources of evidence for the different behavioural biases described here but some which provide an overview of the different sources include: Kunreuther H, M Pauly and S McMorrow, Insurance and Behavioral Economics: Improving Decisions in the Most Misunderstood Industry, 2013; and Baicker K, W Congdon, S Mullainathan, Health Insurance Coverage and Take-up: Lessons from Behavioral Economics, The Millbank Quarterly, Vol 90, No 1, 2012; and Financial Conduct Authority, Applying Behavioural Economics at the Financial Conduct Authority, Occasional Paper 1, 2013. 16 ABI press release, Insurers paid out 6 million every day to help families deal with death, serious illness or injury, 3 June 2013. It should also be noted that, as described in Chapter 3, return to work activities also mean that insurers work with employers and employees when potential claims are notified such that some individuals will return to work before the claims payout stage. There is also some anecdotal evidence from advisers that mis-selling of Payment Protection Insurance hinders the sale of Income Protection. They do not understand the level of payments that they will receive in the event of a claim because of issues such as deducting ESA from the payments; They are sceptical that claims will be accepted because of the mis-selling of the similarly-named Payment Protection Insurance, even though insurers paid out 92% of claims in 2013; 16 They over-estimate the welfare payments that they would receive in the absence of Income Protection policies indeed the Money Advice Service notes that welfare payments are much less than many people think ; 17 and They do not understand the likelihood of being out of work for a sustained length of time as individuals often find it difficult to understand the risk associated to low-frequency-high-impact events leading to a view that it won t happen to me. They suffer from inertia whereby they do not get round to purchasing the products which could be due to reasons such as: complexity leading them to put-off decision making as it is difficult to engage with the process; present bias where the cost is incurred now but the benefit comes later; and loss aversion where there is a certain loss in terms of the payment of premiums compared to an uncertain gain in terms of the potential payments if they claim. 17 Money Advice Service at https://www.moneyadviceservice.org.uk/ en/articles/do-you-need-incomeprotection-insurance Kyla Malcolm Economics, Policy and Regulation 15

While many of these reasons are likely to apply to a greater extent for individuals than for employers, combined they are likely to lead to under-purchase. Indeed the consumers association, Which?, states, The one protection product every working adult in the UK should consider is the very one most of us don t have income protection 18 Third, there are also reasons on the supply-side that hinder sales not least of which is the complexity of the welfare system. The benefits of Income Protection policies need to be set in the context of what individuals would receive were they to rely on welfare payments. As is seen from section 1.1, the welfare system is complex and therefore the specific benefits of Income Protection policies are also complex to explain. This complexity adds time and costs to the sales process and may also mean that advisers are unclear about whether individuals should take out Income Protection policies. 19 5.2 What sort of incentives would help encourage take-up? As highlighted above, the Income Protection market is characterised by positive externalities in which those who make the decision to purchase (individuals or employers) do not take into account the full social benefits that arise from having Income Protection policies in place (which accrue to the combination of taxpayers, employers and individuals). Behavioural issues also mean that individuals or employers may not take out Income Protection policies even when it is in their own interest to do so which further strengthens the case for intervention. There is already some incentive in place to assist take-up of Income Protection policies by employers since the cost of this is an allowable business expense. However, other incentives may still be required and tax incentives are an obvious source to consider and they can help reduce the cost of Income Protection to a level that takes into account the size of the externality. In particular, by reducing the effective price of Income Protection policies, tax incentives would be expected to increase the take-up of policies. 20 In order to partly overcome the problem that such incentives reduce the price for people who would buy the product anyway, these incentives could be targeted at those earning 20,000-60,000 as described in Chapter 4. 18 Which? What is income protection, cited from http://www.which.co.uk/ money/insurance/reviews-ns/incomeprotection/what-is-income-protection/ 19 This may also be exacerbated as the individual s circumstances at the point of purchase (in terms of their household structure and any assets they have) may differ from those at the point of claim and there is some suggestion that advisers fear mis-selling claims in relation to this. 20 For pensions, automatic enrolment combined with tax advantages has been used to overcome the different types of barriers to take-up of pensions. The feasibility of this could be explored for Income Protection policies although care would need to be taken to ensure that this did not suffer from adverse selection effects where only those with existing medical issues making them likely to claim take out the policy. The form of the tax incentive will impact understanding of its value. For example, a flat discount or Government contribution may be better understood and therefore be more effective than an incentive based on tax relief. The Government s tax exemption of 500 per year per employee for recommended medical treatments is a useful form of this and will be of help although, as noted above, costs of 1,000-1,500 are more typical than costs of 500. However, it also needs to be acknowledged that many of the reasons that reduce take-up are not to do with price, but other factors and therefore remedies need to be targeted on the nature of the problem that is identified. Tax incentives or Government contributions can nonetheless play a role here since they have advantages beyond simply their impact on price. A tax incentive can act as a signal to individuals and employers that a particular product or course of action is a good thing which the Government is seeking to encourage, and in itself this can help to encourage take-up. This can partly address the misbelief that claims will not be accepted or that disability is a low risk to be ignored. 16 Kyla Malcolm Economics, Policy and Regulation

Furthermore, short-lived tax advantages could play a particularly powerful role relying on some of the very behavioural characteristics that hinder take-up. For example, if it were to be well-publicised that tax incentives for Income Protection policies would last for a short period of time (e.g. 3 years), this could help to overcome short-run inertia as there is a limited period of time in which individuals and employers would need to act in order to take advantage of the lower prices. 21 Such an approach is also likely to gain from the fact that individuals are generally overly-persuaded by discounts due to framing effects. A higher take-up of policies is also likely to reduce the average cost of policies particularly with respect to rehabilitation activities since there are expected to be economies of scale associated to both networks of vocational rehabilitation consultants and to learning about the types of rehabilitation that are, and are not, successful in different circumstances. This is likely to be especially valuable given the current position where there is still much to be understood in respect of successful rehabilitation activities In addition, once the tax incentive is removed, many purchasers will continue holding Income Protection policies. This could arise where purchasers value the product more than they used to because of the Government support, or because the value of the product may have been demonstrated to those who have made claims (more likely for employers with multiple employees). It may also arise because of subsequent inertia where people do not cancel the product once in place. Such a ratchet effect appears to have been the result of short-lived tax incentives for Private Medical Insurance in the 1990s where the removal of tax relief did not cause take-up to fall back to pre-tax-relief levels. Employers could also help to address some of the reasons that employees under-value Income Protection. For example, providing clear statements of the level of income employees would receive if they had to rely on any occupational sick pay could help employees to understand the gap which is, or could be, filled by Income Protection coverage. Finally, it needs to be recognised that the insurance industry can also take action to improve take-up and to overcome some of the difficulties highlighted above. For example, the industry may not have helped itself in respect of scepticism of claims being paid since the similarity of the names of Payment Protection Insurance and Income Protection Insurance is within their control to alter 22. Transparency regarding the proportion of claims that are paid could also build confidence in the product both among individual consumers as well as their representatives and the media. In addition, insurers could provide clear statements of the value of typical welfare payments that individuals would receive in the absence of Income Protection policies, along with the calculations and precise value of the payment individuals would receive if they made a claim. 21 It would be appropriate to ensure that tax incentives only applied for regular premium Income Protection policies so as to prevent the use of single premium products in the run-up to the removal of tax incentives. 22 Confusion regarding the names is likely to impact individuals or small firms to a greater extent than large firms. Kyla Malcolm Economics, Policy and Regulation 17

5.3 Conclusion Overall it is clear that Income Protection policies can bring benefits for individuals, employers and the taxpayer. Yet the very fact that the policies benefit a range of stakeholders is one of the reasons that may lead these policies to be under-purchased as those purchasing the product do not take into account the benefits to others. There is considerable potential for the market to grow with millions of individuals who could potentially benefit from the presence of Income Protection policies. Reflecting the fact that many stakeholders gain from Income Protection policies, there is also more that each of these stakeholders can do to ensure that the market reaches its potential. 18 Kyla Malcolm Economics, Policy and Regulation

Kyla Malcolm Economics, Policy and Regulation 19

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