27th November 2024

Understanding Consumer Duty and the Hidden Costs of Indexation

Consumer Duty requires advisers to actively seek out value for their clients. While this doesn’t necessarily mean selecting the cheapest or so-called “best” plan, value must always consider what provides the greatest benefit in the long run.

One area often overlooked is how insurers handle premium increases for indexation—a critical factor for clients aiming to protect against inflation. While mortgage protection policies typically require level or decreasing cover, other forms of personal and family protection benefit significantly from inflation-proofing. 

The Mechanics of Indexation

All insurers offer indexation options, often linked to the Retail Price Index (RPI) or fixed rates such as 3% or 5%. However, what many advisers may not realise is that insurers charge differently for indexation, and this can greatly impact the overall cost of a policy.

When a policy’s sum insured increases automatically, clients gain the advantage of guaranteed future cover without the need for underwriting. This places additional risk on insurers, as the health of some policyholders may deteriorate over time, making them otherwise uninsurable or subject to higher premiums. 

To compensate for this increased mortality or morbidity risk, insurers apply an “uplift factor” to premiums. For example, if the RPI is 3%, most insurers use a 1.5 uplift factor, resulting in a 4.5% premium increase rather than 3%. However, not all insurers follow this standard, and the differences can add up significantly over a 20-year term or longer. 

Comparing Insurers: The Cumulative Effect

Royal London stands out for using a lower 1.2 uplift factor, which significantly reduces cumulative costs over time. In contrast, other providers, such as Vitality and HSBC, employ alternative calculations that can either raise or lower premiums depending on the plan duration and inflation rate. 

The table below illustrates how these factors impact premiums over a 20-year term for a £250,000 level term policy indexed to RPI:

Example: Male, DOB 01/09/1993, non-smoker, £250,000 level term, RPI linked for 20 years with guaranteed premiums (as of 29/08/24).

What Defines ‘Best Value’? 

Determining the “best value” involves more than just picking the cheapest plan at the outset. Some plans fail to run for the full term, while others may become disproportionately expensive over time.

For some clients, the lowest total cost over 20 years may be the deciding factor. For others, it might be the premium’s affordability in later years. Advisers must use these insights to assess the most appropriate plan for each client and explain the rationale behind their recommendation, including how premium increases will impact the policyholder over time.

By understanding and communicating these nuances, advisers can ensure they are meeting both the letter and the spirit of Consumer Duty, delivering true value to their clients.

Alan Lakey, CI Expert

Protection