Beware the taxman cometh
As of 1 March 2015, premiums paid by natural person(s) are no longer tax deductible and when a benefit pays out, it is tax free.
As a result of this, it is important to consider the implications of tax on income disability products to adapt to accommodate this when advising clients.
A Impact on a claim
To explain the tax implications this change will have on clients, an example would be where a client earns R100 000 per month and he or she opted for a temporary income protection policy of R100 000 with the assumption that his or her replacement ratio was 100%.
If one allows for the deduction of 30% tax, the net income for the client is R70 000. The net benefit the client receives from the pay-out will also be R70 000. This means that his or her net replacement ratio is 100%. This is an important principle because of the intention of the policy, which is to put the client in the same position that he or she was prior to experiencing a disability event. Therefore, the aim of the policy is not to enrich a client but to target the 100% replacement ratio.
This client will then receive R70 000 in his or her pocket as a result of the claim payment for the month of January and February 2015 and assuming this is not a permanent disability, it is expected this client will return to work at some point. With the new tax legislation that came into effect on 1 March 2015, an insurer will no longer hold back the taxable portion of the claim but pay the entire R100 000 over to the client. So, what happens to the client’s replacement ratio?
The insurer takes the R100 000 benefit and divides this by the client’s net income and this gives one a replacement ratio of 142.8%. Based on this, do you think this client has the same incentive to return to work than what he or she had prior to this change in tax legislation? Obviously not.
Therefore, this client will return to work in the future and in all likelihood this scenario will increase the insurer’s claim costs because it might be making these payments for a much longer period than before.
Next logical steps
How can we then deal with situations like these from a product perspective? There are four possible options:
Option 1 - Reduce the benefit amount for your current clients based on an existing, standard clause in insurance contracts that allow insurers to make contractual changes in accordance with changes that occur in the tax regime;
Option 2 - For any current client that submits a claim in future, one could apply a net income definition to calculate the loss of income. This means going back to the client’s current contract and changing the definition of gross income to a definition that involves net income. This is thus also a contractual change that would have to be applied;
Option 3 - Insurers can simply increase the premiums for all clients that fall outside of the guaranteed period, thus conducting a general premium review across the risk pool; or
Option 4 - Increase new business rates.
Looking at the big picture
Going forward, target clients net replacement ratios by moving from a gross income definition to a net income definition. Either by using an average tax rate of 30% across the board, incorporating the income tax tables into your quotation packages or, having a pragmatic approach in creating a tax table based on income categories and using this table to limit maximum benefit amounts in future.
Most clients, specifically from an income and temporary income protection perspective, without considering lump sum disability, do not have maximum replacement ratios. This means that for you as a financial adviser there are ample opportunities to ensure that your clients are adequately covered when you take your clients through the changes in the new tax tables.
