Say you're looking at your income protection policy and wondering why it only covers 70% of your income. Or maybe you're holding one of the old policies, the kind that locked in your benefit years ago, and wondering if it's actually worth what you think it's worth.
Either way, you've bumped into something insurers call moral hazard. It's not the insurer being sneaky. The real story is a fair bit more interesting than that, and it's the reason every policy you own is built the way it is.
What is moral hazard, and why is it built into every policy you own?
Moral hazard is insurance changing your behaviour, simply because you no longer carry the full cost of the risk. Nobody's being dishonest. People are just less careful with something they can't really lose.
In life insurance, this shows up hardest at claim time. If a claim pays more than your job does, the incentive to recover, retrain or return to work starts to fade. Claims run longer, the cost of the whole pool goes up, and everyone's premiums rise with it. These clauses aren't the insurer versus you. They're the insurer versus the version of the product that becomes unaffordable for everybody.
So what does that mean for you? Every cap, offset and waiting period in your policy exists to keep the product sustainable enough to still be there when you actually need it.
Why doesn't personal insurance work like car insurance?
Car and home insurance run on indemnity: the insurer restores you to where you were, never better. You can't insure a $500,000 house and cash in $2 million.
Life, TPD (total and permanent disability) and trauma cover don't work that way. These are benefit contracts, meaning you agree on a lump sum upfront and that's what gets paid, regardless of your actual loss. Income protection sits in the middle, and for a long time in Australia, it drifted a long way toward the benefit-contract end. That drift is exactly what got expensive.
So what's the actual risk? The further a product drifts from restoring you to rewarding you, the more it costs everyone, including you, to keep it running.
What actually happened with old agreed value policies?
Older income protection, known as agreed value, locked in your benefit at whatever you were earning when you applied. If your income dropped later, say you went part-time or started a business, your benefit didn't move. Some people ended up better off on claim than they were at work.
Multiplied across the country, that turned into a genuine crisis. Life insurers collectively lost around $3.4 billion over five years selling this kind of cover, and no single insurer wanted to be first to pull back and lose customers to a competitor still offering the generous terms. APRA eve
ntually had to step in.
So what's the actual cost of assuming your old policy is junk, or gold? Agreed value contracts can no longer be bought at any price, so yours might genuinely be worth keeping. But premiums on them can climb sharply, and once you cancel one, it's gone for good. Get advice before you touch it.
How do insurers manage moral hazard in today's policies?
New income protection is built differently. Your benefit is capped at up to 90% of your income for the first six months, dropping to a maximum of 70% after that, so there's always a reason to get back to work. Offset clauses reduce your payment if you're also receiving workers' compensation or certain other income protection benefits. Waiting periods work like an excess on your car insurance, the longer you wait before your benefit kicks in, the cheaper your cover. And your claim is now assessed against what you actually earned in the 12 months before you claim, not what you were earning years ago.
So what does that cost you? A lower headline payout than the old-style policies, but a product that's actually still standing in twenty years.
Does TPD cover have the same problem?
It's starting to. Own occupation TPD, which pays out if you can't do your specific job, is priced assuming it costs about 50% more than broader "any occupation" cover. The real cost has been running closer to double. People in their 30s, often carrying the most cover because of a mortgage and a young family, are the highest-risk group for it. Some insurers are already bringing in narrower definitions and caps on how much TPD you can hold.
So what's the actual risk? If you haven't had your TPD reviewed in a few years, particularly in your 30s or 40s, you might be holding a definition that's already showing cracks.
Frequently asked questions
Why is income protection capped at 70%?
So there's still a financial incentive to return to work, and so claims don't outpace what the whole insurance pool can sustainably cover.
What's the difference between agreed value and indemnity income protection?
Agreed value locks in your benefit at application time, regardless of what you're earning later. Indemnity value is based on your actual income in the 12 months before you claim.
Should I cancel my old agreed value income protection policy?
Not without advice. These policies can't be bought any more, so they can be genuinely valuable, but they're not automatically worth keeping either.
Is moral hazard the same as insurance fraud?
No. It's a behavioural shift that happens even among honest people, simply because the full cost of the risk isn't sitting with them. It's a design problem for insurers to manage, not a character flaw in policyholders.
Does TPD cover have the same problems as old income protection?
Similar signs are showing. Own occupation TPD is proving more expensive than insurers priced for, and people in their 30s are the highest-risk group holding the most cover.
This is general information only and doesn't account for your personal circumstances. If you're not sure what you're actually holding, book a chat with a Skye adviser and bring your policy documents; working out where the moral hazard clauses sit in your cover is exactly what we do.
Prefer to watch this one? Catch the full Deep Dive on moral hazard with Aimee Cowling.