Indexation of coverage values and limits is a common practice in the insurance industry. It adjusts a customer’s cover to a measure of inflation or value, with the intent that the policy value or limit will continue to align with the customer’s asset value or its repair or replacement cost over time.
This benefits customers because it helps to ensure that they remain fully insured when values and costs increase over time for assets such as homes and other buildings, while also helping to ensure that they do not pay for cover they do not need for assets with a declining value, such as motor cars.
Insurers typically offer indexation as an option to customers who would like to ensure that their insurance cover keeps pace with inflation (i.e. to prevent customers from becoming underinsured as inflation erodes the value of their cover) and they may insist upon it where assets are expected to decline in value.
Indexation is tied to a measure of inflation or deflation which is typically specified in the insurance policy. A common measure is the consumer price index (CPI). If the insurer commits or promises to indexing its policies using the CPI, it is bound to adjust the customer’s cover at the same rate as the CPI. The insurer may also adjust the customer’s premiums accordingly.
Customers tend to view indexation as a purely mechanical process and trust insurers to carry out the necessary calculations correctly. Perhaps surprisingly, a number of insurers have realised recently that they have calculated their indexation in a way that does not accord with what they have told their customers.
So, what happens when insurers get indexation wrong?
We look by way of an example of issues recently uncovered by Cigna Life Insurance New Zealand Limited and the consequences of those issues. Cigna are, however, but one of several insurers to have identified issues of this nature.
When do customers suffer?
Inaccurate indexation adjustments may result in customers becoming either overinsured or underinsured, at least compared with their expectations, if not their asset values and risks. Customers become overinsured when the insurer uses an index rate that exceeds the applicable measure. Customers suffer a loss when they are overinsured because they pay higher premiums than they would otherwise have, had their cover been adjusted for inflation accurately. As the proceedings against Cigna demonstrate, the FMA takes a dim view of this and is prepared to take enforcement action to ensure that customers are not overcharged for cover.
What happened to Cigna?
The FMA issued court proceedings against Cigna for false or misleading statements about the indexation of some of its life insurance policies, in breach of section 22 of the Financial Markets Conduct Act 2013. Cigna admitted to having increased customers’ premiums and cover under a series of life insurance policies, using indexation rates which exceeded the CPI. This was not consistent with the relevant policies, which required Cigna to adjust cover in accordance with the CPI. As a result, Cigna charged customers approximately NZD13.5 million in additional premiums for the extra cover that it provided over the relevant period.
The case will proceed to a penalties hearing in the Wellington High Court. However, Cigna has voluntarily commenced a remediation programme, and as at 10 August 2022 it had refunded over NZD10.7 million (including interest) to customers that it had overcharged.
The case, like all such circumstances, raises some interesting conceptual issues. On one view, customers did not suffer a loss at all, because they received the cover they paid for. It was just that they bought slightly more cover than they anticipated buying. Even then, they will have known just how much cover they were buying, because the annual renewal forms will have specified it. The indices are never more than an approximation of what is required for cover to remain broadly the same in real terms, because they do not typically reflect actual increases in values or costs for the particular risk insured. Where the insured asset is a building, for instance, a broad CPI index may not reflect a real world increase in building costs.
Some customers who suffered a loss may have benefited in a very real sense because they may have been fully insured – or less underinsured – than would otherwise have been the case. The issue is therefore a subtle one – customers who believed their cover was increasing by the specified index were in fact sold slightly more (or perhaps less) than they expected.
Customers may become underinsured when the insurer uses an index rate that falls below the applicable measure. Contrary to the position when a customer is overinsured, underinsured customers often gain because they pay lower premiums, provided they do not suffer a loss. However, those customers suffer a theoretical loss because, had they made a claim, their cover would have fallen short of the amount they thought they had purchased. Therefore, the mere fact that customers have been underinsured for a period of time is problematic.
The FMA has made its position with respect to such inchoate losses known in a previous case. The FMA views those customers as having suffered a detriment, as in Financial Markets Authority v ANZ Bank New Zealand Limited [2021] NZHC 399, where the FMA took the view that customers suffered detriment when they were unintentionally uninsured (because they exceeded a maximum age), notwithstanding that in fact the insurer would not have declined their claims on the relevant basis.
What should insurers be concerned about?
Remediating losses suffered by customers because of inaccurate indexing can be a complex undertaking, and therefore expensive. Identifying which customers have suffered a loss can be difficult, particularly if different insurance policies are indexed to different measures of inflation and/or if some customers have signed-up for indexation and others have not. Calculating adjustments for thousands of individual policies is also a mathematically complex exercise and is one that many insurance firms would not be equipped to complete in-house.
"Remediating losses suffered by customers because of inaccurate indexing can be a complex undertaking, and therefore expensive."
Refunding customers for overpaid insurance premiums is not only mathematically complex, but also complex administratively. Some customers will likely be former or historic customers, and others might be very difficult to contact. Calculating refunds for each customer, together with interest payable on those refunds, is a costly exercise that insurers would ideally avoid. Again, depending on the scale of the adjustment error, even large insurers might struggle to complete the refund exercise without external assistance.
Remediating underinsurance is normally easier, as customers have underpaid, rather than overpaid. Ordinarily, the remediation will involve identifying any customers who have suffered a loss and who have been underpaid as a result and compensating them. They will normally comprise only a small proportion of affected customers.
What should insurers do?
Firstly, insurers should take care when making representations about indexation. For example, if an insurer represents that a particular policy is indexed to the CPI, the insurer must ensure that its internal processes support that representation. Insurers should have robust processes in place to identify which of their policies are indexed and to ensure that customer’s premiums and cover are recalculated at the relevant frequency, which is typically specified in the policy.
Secondly, insurers must make accurate adjustments to premiums and cover. For example, if a particular policy is indexed to the CPI, the insurer must accurately adjust cover and premiums for all policy holders in accordance with the CPI. Even minor adjustment errors can be significant if that same error is made for thousands of policyholders. The scale of any adjustment error will increase if the error is systemic and is repeated on multiple occasions. Regular audits of inflation adjustments are therefore encouraged.
One possibility that could assist in protecting against future errors may be for insurers to be less specific about how they are calculating adjustments. Insurers who adjust policies to reflect general changes in building costs do this already – they are normally careful to make clear that they do not promise that the figure they use will in fact reflect relevant real world building cost increases, which are difficult to predict. Similar language could be used in relation to other indices. For instance, instead of promising CPI increases, insurers could advise customers that they intend to offer increase at their discretion, which may reflect CPI increases but may be adjusted or otherwise differ from CPI. Such language would be less likely to be misleading in case of error.
This article was co-authored by Jamie Hofer, a Solicitor in our Litigation and Dispute Resolution team.
