Critical Illness - the details

Introduction

Critical illness policies are a relative newcomer to the UK market, the first such product having been launched in the UK in 1986, although the product had already been popular in other countries such as the United States and South Africa. Relatively speaking, market penetration remains low. 

In its simplest form a critical illness policy (which is also sometimes referred to as 'dread disease' cover) will provide a lump sum payment on diagnosis of a specific critical illness covered by the policy.  The need for such policies is well established, bearing in mind that due to advances in medical care many people who suffer major life-threatening illnesses, such as a heart-attack or a stroke, may well, these days, survive for a relatively long period after the illness.Over the years considerable product development has taken place, which has tended to increase the scope of cover and introduce new policy types and packages offering a combination of critical illness and other types of cover, such as life cover or permanent health insurance. These issues are considered in more detail below.

Product development

Whereas in its most straightforward form a critical illness policy will simply provide a lump sum payment on diagnosis of predefined conditions, in an attempt to differentiate from other products, product providers have gone to considerable lengths in developing new products.  The trends in product development include increasing the scope of cover, different policy structures, variations in the level of benefits depending on the relevant medical conditions, offering preferred lives underwriting and combining the cover with other types of cover including income protection insurance (sometimes known as permanent health insurance), life cover and long-term care. In a separate strand of development, group policies have been introduced as well as individual ones.

Illnesses covered

Early product development concentrated on introducing increased cover for a variety of illnesses and, indeed, it has been considered that the proliferation of critical illnesses covered under policies has been one of the problems of this product,with the public generally being confused by the number and variety of terminology.

To combat this, a list of six core conditions was drawn up by the IFA Association in conjunction with key providers in the market.  This core conditions list was used by all the serious players in the critical illness market.  The list included: heart attack, cancer, stroke, kidney failure, major organ transplant and coronary artery by-pass surgery.  In addition to this various providers did include other conditions such as multiple sclerosis, Alzheimer's disease, Parkinson's disease,motor neurone disease and others.  Many policies, in addition to covering critical illnesses, also include cover for total permanent disability (e.g. resulting from an accident).  HIV infection is normally excluded but some offices offer cover for accidental HIV infection for medical staff, subject to certain conditions.

A number of offices also now include terminal illness in their scope of cover, generally defined as illness, whether it falls within the categories otherwise defined or not, resulting in a life expectancy of less than 12 months.

The ABI has now laid down standard definitions of various conditions through its Statement of Best Practice for Critical Illness Cover – see later in this section.

Policy types

The most straightforward type of critical illness policy provides a lump sum payment on diagnosis of critical illness within the term of the policy, or in many cases on the survival of an individual for a specified period, typically between 14 and 30 days, following the diagnosis.  This is to ensure that the cover is not confused with death cover, which will not be provided under this type of policy.

As well as being sold as a separate stand-alone contract, critical illness cover has been offered as an addition to a, usually, whole of life unit-linked policy, i.e. as a separate benefit, in addition to or as an alternative to the life cover within the contract.

Any of the following combination's can now be found in the market:

• Stand-alone critical illness on a term basis

• Stand-alone critical illness on a whole of life basis

• A combination of life and critical illness cover, paying out either on death or on earlier critical illness

• A combination of critical illness and life cover under an endowment policy

• A combination of life and critical illness cover with benefits payable at a specified level on both occasions.

The most straightforward policies, i.e. the 'stand-alone' policies, provide for payment of a lump sum benefit only on critical illness, (or on survival for a period between 14 and 30 days after the diagnosis).  If the life assured dies within the waiting period, no benefit is payable though historically some offices would pay a nominal death benefit (e.g. a refund of some premiums) in these circumstances to ensure that the contract qualified as a life policy to avoid a potential capital gains tax liability.  HM Revenue & Customs subsequently confirmed that provision of a nominal death benefit in these circumstances was not necessary to make the policy a life policy. 

Where the policy provides combined death and critical illness cover, as indicated above this can be on an 'either/or' basis on both events.  If the cover is provided on an 'either/or' basis, this will mean that the whole sum assured would be payable on critical illness or on earlier death. If a claim is made on critical illness and the whole sum assured is paid, the policy would terminate. A more recent development adding further flexibility to this concept has been to give an option to choose the level of benefit on either death or critical illness, with the possibility, for example, of choosing a payment of 50% of the sum assured on critical illness with any balance being payable on death (or in any proportions that the life assured may choose).  While such flexibility may well be desirable from the client's standpoint, it may have unforeseen (and undesirable) consequences with regard to the taxation of benefits under such policies - see 'Critical illness policies - taxation issues') and 'Critical illness policies and trusts'.

Another more recent development is to provide different levels of benefit for different conditions. This appears to be as a result of claims experience where most claims apparently arise from cancer. This would indicate that greater levels of benefit for the same premium could be provided for those conditions that do not have a similar claims experience.

Another recent development is a combination of critical illness and permanent health insurance(PHI) cover.  The subject of PHI policies is covered separately under 'Permanent health insurance'.  It is clear that when an individual becomes critically ill, a lump sum may well be a solution to pay for capital expenses resulting from the illness (e.g. conversion of the house or a long holiday to aid recuperation etc). However, if the incapacity is likely to be prolonged, the primary need will be in the area of income replacement. Of course, although a lump sum can be used to provide income, if the main consideration is the provision of income, then a policy designed to do that may well be more appropriate. This is where PHI policies become relevant and a recent innovation in CI product development has been a product combining critical illness cover with a PHI benefit.  In one particular case, on the individual becoming critically ill, the policy will pay out a lump sum and if after a specified number of years the individual is still unable to return to work, the PHI part of the policy will start paying out PHI benefits.  Such a combination of CI and PHI benefits may well be more cost effective then effecting two separate policies, a PHI policy which will come into payment after a (comparatively) short deferred period and a critical illness policy.  This is because, under a combination policy, the PHI benefits will only commence after a much longer deferred period on the basis that the immediate cash needs will have been satisfied from the lump sum payable under the CI part of the cover.  Of course, comparable costs may be attainable if two separate policies are effected with a longer deferment period on the separate PHI policy.

Problems with premium rates

The key issue to address with regard to the development of critical illness products is the limited claims experience although clearly this is changing over time.  Some companies offer preferred lives rates, for example, based on alcohol consumption levels, smoking habits, height and weight. Other offices have offered moratoria on claims within specified periods.  For example, a policy condition may provide that no claim in respect of cancer will be admitted within a specified period,say 12 months, after effecting the policy.  This is to prevent policies being effected by those who suspect having cancer but where no evidence of that exists at the time the proposal for the policy is made.

Medical developments are having a serious impact on critical illness rates and product design.

Around the end of 2002 there were substantial increases to the critical illness rates offered by some major providers reflecting higher than expected claims experience. Two of the main reinsurers withdrew their guaranteed rates from the market. Costs also rose with market contraction. The number of guaranteed rate policies fell and one leading reinsurance company estimated that 80% of insurers had switched to reviewable premium rates by the end of 2003. Since 2004, more reinsurance capacity has become available and so more insurers now offer guaranteed rates. But such rates are higher than they were before and some illness definitions have been tightened.

Group critical illness cover

While the main product development in the critical illness area has been through individual policies, group cover, historically, has been somewhat neglected although this has now largely been rectified.  Interestingly, a joint survey of 2,000 members of the Confederation of British Industry by Swiss Life and the CBI in 1995 found that just 7% of employers provided critical illness cover for their staff. In contrast nearly 100% offered group life cover while 85% offered private medical insurance and 65% offered permanent health insurance.  Clearly then great scope existed for product development in this area. In order to make products profitable for the provider there is normally a requirement for a minimum number of lives, which typically might be 50.  In return for achieving the minimum number the provider will normally provide benefits up to a specified level with more generous underwriting. Apart from policies being offered on a corporate basis, i.e. one policy effected by the employer on the lives of all of the employees, with benefits being paid directly to the employee on diagnosis of critical illness, another development is to offer discounted premiums where individuals effect policies for their own benefit but sufficient numbers of individuals are involved to enable premium discounts to be offered. 

Critical illness cover and viatical settlements

The term 'viatical settlement' is used to describe a payment under a life assurance policy to an individual who is terminally ill.  The practice originated in the United States with some life offices offering terms to pay out an accelerated death benefit where an individual has been diagnosed as being terminally ill. Clearly such an arrangement would appeal to individuals who are terminally ill but have no dependants and who would therefore benefit from the cash payment before death. In normal circumstances a discounted sum assured would be paid depending on the medical condition and the expected survival period.  This concept marked the beginning of the market in viatical settlements whereby a terminally ill individual can sell his policy and secure a cash lump sum to use during whatever remains of his or her lifetime.  This would be relevant where the policy in question does not provide for accelerated payment of the death benefit and the life office itself does not offer viatical settlements.

Companies have developed, which specialise in the viatical market, who will purchase such policies and continue to pay premiums so that on the death of the life assured the purchaser of the policy will be able to cash in the policy and claim the benefits. While there may be some ethical questions about third parties trading in this way, there is no doubt that in certain circumstances viatical settlements provide a considerable benefit to individuals who are terminally ill and who, thanks to such arrangements, are able to benefit from a cash injection during the last stages of their life.  However, there is also an apparent trend for life offices to offer terminal illness payments as part of the policy conditions so that the individual does not need to sell the policy on the viatical market. 

Critical illness policies and trusts

In most cases where critical illness benefit is provided under a policy, it would be clear that the individual would want to receive the critical illness benefit for himself/herself. However, when considering a policy which provides both substantial death and critical illness benefits, whether on both occasions or on an 'either/or' basis, it may well be desirable for any death benefit to be payable to beneficiaries outside of the taxable estate of the deceased and without the need for probate, while ensuring that any critical illness benefit that may become payable is paid direct to the critically ill policyholder.  In such cases a trust may be suitable to achieve this objective. 

A trust is a means of holding an asset, such as a life assurance policy, for the benefit of certain persons called beneficiaries.  The policy itself is legally owned by the trustees but it is held for the benefit of individuals who are either named or indicated in some way in the trust. The subject of trusts of life assurance is fully covered in 'Life policy trusts'. In the case of a critical illness policy that also provides death cover, as stated above only death cover would need to be held subject to trust for others. For legal reasons (the inability to assign part of a 'chose in action') it is not possible to make only some of the benefits under the policy subject to trust. It is however possible to have a trust under which the CI benefit would be held for the benefit of the critically ill policyholder and the death benefit held by trustees for the benefit of other beneficiaries.  Such a trust is often referred to as a 'split trust'.  Indeed such packaged plans involving policies and trusts have been one of the ways of promoting critical illness policies as a tax effective arrangement. It must be noted however that because of the reservation of benefit legislation in connection with inheritance tax, care is needed if it is intended to create a trust under which the settlor can benefit and yet will continue to be effective for inheritance tax purposes. This is further considered in 'Critical illness policies - taxation issues' and 'Critical illness policies and trusts'. 

However, even ignoring the inheritance tax issue, and particularly for those individuals where inheritance tax is not a problem because of the size of their estate, a trust which provides for a split of the beneficial interests in benefits in the manner described above may well be advantageous because it will ensure that, in the event of death, a payment is made by the life office without the need to wait for probate or letters of administration, thus ensuring speedy claim settlement,while also ensuring that on critical illness any payment is made directly to the policyholder. A trust can also include provisions to ensure that there are no delays in making a payment to the critically ill policyholder where, because of his condition (e.g. being in a coma following an accident) he is unable to deal with his affairs personally.  If a policy is held subject to trust, the trustees can then deal with the life office and ensure that the payment is used for the benefit of the critically ill life assured.  Special consideration is necessary in the context of business assurance.

Critical illness policies and business assurance

Where CI policies are used in business assurance arrangements, such as keyperson cover or share purchase arrangements between partners or shareholders in private trading companies, a special business trust will often be appropriate to ensure that the payment is made to the co-partners or co-shareholders (this excludes straightforward policies on a life of another basis for the purpose of keyperson cover effected by companies).  For details of such business trusts see 'Partnership share purchase' and 'Share purchase for directors'.  It is important to remember that the same business trust should be used in respect of both life cover and critical illness cover to ensure that in the event of either critical illness or death the funds are available in the hands of the other partners or shareholders.  Should a 'split trust' of the kind described above be used, and the payment on critical illness be made directly to the critically ill director or a partner extinguishing or reducing the level of death cover then, in the event of subsequent death, the co-partners/shareholders will have no (or reduced) funds to carry out share purchase or replace lost profits as a result of eventual death.  Accordingly, in many business assurance cases where the purpose of the cover is to ensure that funds are paid to continuing partners/shareholders on the death/critical illness of the insured a 'split trust' will rarely be appropriate. A business trust under which all policy benefits are held for the benefit of co-partners would usually be suitable.

The taxation implications of using trusts for critical illness policies are considered in 'Critical illness policies - taxation issues'.

Keyperson critical illness cover

Although most CI policies would be effected on an own life own benefit basis, the need for cover on critical illness has been recognised in business assurance and keyperson CI cover has become popular as an addition to the keyperson cover on death.  In most cases such cover would normally be added to the life cover by using an 'either/or' policy or the issue of two separate policies. The way the policy would be effected would depend on the relationship between the keyperson and the business. In partnerships the policy would normally be effected by the partner on his own life subject to a trust for the benefit of his co-partners in the same way as life cover.  The same principle may apply to arrangements between shareholders in small private companies.  Here, however, there will also be the option for the policy to be effected by the company on the life of the shareholder so that the benefit is paid to the company, which is probably the 'natural' place for the funds to be placed in the event of the critical illness of the keyperson.  In a situation where the keyperson is a non-shareholding employee, the normal way of arranging keyperson CI cover would be for the company to effect a policy on the life of the employee.  For more details of keyperson CI cover arrangements please see 'Keyperson cover-partnerships' and 'Keyperson cover (companies)'. 

ABI Statement of Best Practice for Critical Illness Cover

As stated earlier, in the early years of critical illness insurance many people were unable to make a detailed comparison when trying to choose between critical illness policies. Some policies covered only a few critical illnesses, whilst others catered for about 30 and the way in which illnesses were defined differed markedly.  It is obvious to state that unclear definitions can cause disputes at the claims stage with potentially devastating consequences.

In view of this the Association of British Insurers (ABI) sought to reduce the confusion by initiating moves to standardize products sold by ABI members who account for the vast majority of critical illness sales.  These guidelines were good news for the consumer because under the old-style wordings even financial advisers had difficulty comparing products. The fact that a lot of critical illness cover is linked to protecting a mortgage makes it all the more important that policyholders know exactly the extent of their cover.

Phase one of the standardization was completed in 1999. Under phase one, ABI members now issue key features details to help consumers compare the different products available.  These key features must include, among other things, a list of conditions covered arranged in alphabetical order.

Phase two was the Statement of Best Practice for Critical Illness Cover which was first drafted in 1999 following an Office of Fair Trading report on health insurance. The Statement introduced model definitions and wordings and allowed for a full review every three years, and interim reviews when needed, for example due to changing regulations or legislation.

The key aims of the Statement are to help consumers in three important ways:-

• Security – providing consumers with the safeguard that appropriate minimum standards of cover are used across the industry;
• Comparability – making it easier to compare critical illness insurance from different insurers; and
• Clarity – helping to improve understanding about what each product does and does not do.

In May 2002 the ABI published a revised following extensive consultation within the industry and with other interested bodies.  A further version was published in August 2004 and the current version was published in April 2006.  Insurers had to adopt the changes contained in that Statement as soon as they could but, in any event, by the end of April 2007 at the latest.

Critical illness cover is required by regulations to be described in a Policy Summary document carrying the FSA 'Key Facts' logo or a Key Features document, depending on the underlying product type - for example, whether it is an investment or a pure protection product for the purposes of regulation.

Under the ABI regime all policies must cover cancer, excluding less advanced cases, heart attacks and strokes which result in permanent damage. There are a list of 23 conditions covered, as follows:-

• Alzheimer's disease
• Aorta graft surgery
• Benign brain tumour
• Blindness
• Cancer
• Coma
• Coronary artery by-pass grafts
• Deafness
• Heart attack
• Heart valve replacement or repair
• HIV infection – but only if caught in the UK from a blood transfusion, a physical assault or at work in an eligible occupation
• Kidney failure
• Loss of speech
• Loss of Hands or feet
• Major organ transplant
• Motor neurone disease
• Multiple sclerosis
• Paralysis of limbs
• Parkinson's disease
• Stroke
• Terminal illness
• Third degree burns
• Traumatic head injury

Within each heading there is an extended heading where appropriate and a full definition which sets out the precise nature of the condition.  For example, in the cancer definition, prostate cancer is not covered unless it satisfies certain criteria and skin cancer is not covered unless the cancer is a malignant melanoma.

All ABI member offices must abide by the definitions – although, of course, individual member companies can cover a wider range of conditions than those set out in the Statement.

There is also a list of Model exclusions as follows:-