Chapter 1 - Replacement Ratio and Over-Insurance

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The Replacement Ratio is defined on this page. I would like to know how this ratio is calculated.

Does it use say expected lifetime being at work and incapicated?

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The notes read:
"Over-insurance refers to a higher than appropriate replacement ratio. There are several ways in which over-insurance can arise:

• over insurance from outset

...."

Does the above bullet point imply that the cover is higher than needed and this will increase the replacement ratio? Also the premiums will be higher for a larger cover and this will reduce the pre-claim income and thus increase the ratio.

 

Can you expand on the product that it's talking about? You may open up your target audiance to those that have taken the exams rather than those that have the notes! (and I'm lazy!!)

 

In a pensions world the replacement ratio is defined as the ratio of Year 1 Pension payment to salary or income in final year of employment (typically gross of tax or living costs). Someone with a final salary pension of 2% pa and 40 years of service will then have a replacement ratio of 80% (assume final salary of 100, year 1 pension will be 80).

I would assume that if you are looking at a disability income type product, a similar formula will apply, replacing retirement pension with disability pension in first year of disability.

In the case of over-insurance, if someone takes out a policy which provides an income benefit of close to or more than 100% of the pre-disability income, this will surely act as a disincentive for the individual to return to work (= prolonged period of benefit payment to insured and higher cost of claims to insurer).

I would venture a guess that most insurers apply some form of underwriting which relates to the level of income of the individual prior to selling a policy... (but check your notes on that as I sat a different set of ST subjects).

 

The replacement ratio isn't calculated by assuming how long someone will work for/be incapacitated for, it's done based on income pre/post incapacity in the year of incapacity. In fact, often it isn't calculated at all - it's set by the insurance company.

So if a person earns £100,000pa and the replacement ratio is 50%, then if that person falls sick then they will receive benefits of £50,000pa. There may be allowances for tax, state benefits etc so that total income post incapacity over total income pre-incapacity is 50%.

Over-insurance might occur if the insurance company promise more than (say) 50% of pre-disability income at the start. I guess this could happen if the individual has other income (eg dividends) that the insurance company hasn't taken into account.

I don't think that pre-disability income nets off outgo (such as the insurance premium paid for the IP cover), so this shouldn't affect the ratio.