An ASIC review has found significant industry-wide problems with the design of total and permanent disability insurance and the claims handling process.
The regulator said the problems means the over millions of Australian workers who pay for the cover can't rely on it when they need it the most.
"Over 12 million Australian workers automatically pay for TPD cover through their superannuation to provide financial protection when they are so sick or injured that they can never work again. ASIC expects industry to make prompt changes to ensure this cover provides real value," ASIC said.
The review found that nearly half a million Australians mostly casually employed or in high-risk occupations, are covered by a very narrow TDP policy definition which "only pays out in the most catastrophic circumstances".
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"Three out of five of the claims assessed under this narrow cover are declines. This is five times high than the average decline claim for all other TPD claims," the report said.
ASIC also warned that poor claims handling processes contributed to some consumers withdrawing their claims and insurers lacked clear key claims data to help them effectively manage the risk of consumer harm.
ASIC Commissioner Sean Hughes said the regulator found it alarmingly that three TPD claims a day are assessed under the restrictive 'activities of daily living' definition, which has a "concerningly high" decline rate.
"People that hold this type of automatic cover through superannuation are typically paying the same premium - for what is essentially junk insurance - as people who can access less restrictive definitions under general TPD cover."
ASIC has called on insurers to invest in data resources and improve the quality of their data, by collecting data on outcomes for different types of TPD cover including claims assessed under restrictive definitions such as Activities of Daily Living.
In response to the report the Financial Services Council said the regulator relied on 2016/17 data and therefore the report fails to highlight the significant positive reforms the industry has initiated since.
"The 2018 data tells a very different story and ASIC's report serves to highlight the substantial progress the life insurance industry has made in the last couple of years. KPMG on behalf of the FSC collect TPD claims data every six months and we know this data collection initiative is unsurpassed anywhere else in the world, both for its granularity and timeliness," FSC chief executive Sally Loane said.
"Data to the end of 2018 shows 88% of TPD claims are paid in the first instance and higher at 91% for mental health TPD claims. This includes claims against all definitions, including activities of daily living."