CHAPTER 14
Insurance – Life, Income and Other
OVERVIEW
There are four ways to manage risk: avoid, reduce, retain or transfer.
Life, TPD, and trauma insurances are ways to transfer unavoidable risks.
Death and disability can have devastating consequences for individuals, families
and businesses.
Professional advice helps to accurately determine the levels of cover required.
A range of insurance policies and premiums is available to meet the needs.
Facing Up to Insurance Needs
• There can be a reluctance to face up to the
need to insure oneself and one’s family
against the financial losses associated with
death, disability and incapacity.
• The reasons range from personal denial to a
strong focus on long-term saving goals (for
example, superannuation) which obscures the
need for insurance in the present.
Facing Up to Insurance Needs
• Yet despite all of these ‘reasons’ for underinsuring, the most important thing a financial
adviser can do for his or her clients is provide
appropriate and affordable insurance cover.
• Any financial plan can be brought undone by
the intervention of unexpected events.
• Premature death, disability, and loss or
damage to property can all result in a financial
plan not being achieved as essential parts of
the plan can no longer be funded.
Risk Management
Process
• Identification of risks
• Quantification of risks
• Strategies for handling the risks —
1. Reduce or eliminate the risk
2. Provide financing to meet the
consequence
• Transfer the risk (insure)
• Retain the risk (self-insure)
• Implement the program
• Review the program
Life Insurance
• Life insurance provides protection against the risks of
premature death and disability.
• Often more than one person benefits from the
generation of income, particularly within families.
• Consideration is needed of the consequences of an
income prematurely ceasing.
– Who would be affected?
– To what financial extent will they be affected?
– What insurance cover could be used to cushion those
financial consequences?
Causes of Death
• Death and disability are not predictable
events. From time to time stories surface of a
person dropping dead who was very fit, who
exercised daily, and who was last person one
would expect to die prematurely.
• Prediction of premature death is not possible.
Causes of Death
Principal causes of death
• Cancer
• Heart attack
Accidents are a much less common
cause of death than illness
Life Expectancy
Immediate Consequences of Death
• In providing for the consequences of a client’s
death two separate matters need to be
considered:
– What amount is needed to take care of immediate
expenses including clearing any outstanding
debts?
– What amount needs to be set aside to take care of
the dependants into the future?
Immediate expenses
These expenses can be summarised as:
• funeral and associated expenses;
• final medical expenses;
• mortgages;
• other debts;
• emergency funds;
• taxes; and
• other items particular to the
circumstances.
Consequences of Death or Disability on
Dependants
To provide for the consequences of
premature death and disability it is
necessary to establish:
• who will be affected by the premature
death or disability; and
• the degree of dependency.
Insurance needs change throughout life
• Young Adult
– Limited needs on death
– A long future if permanently disabled
• Young Family
– Often catastrophic consequences from
• Death of income earner
• Death of homemaker
• Permanent disablement
• Mature Family
– Children self-supporting
– Health, disability considerations
– Existing assets
Calculation of the Needs
The multiple approach
Calculates the capital sum required to replace an
earned income with investment returns
1. Decide what salary would need to be replaced
Example: $70,000
2. Nominate an achievable investment interest rate
Example: 7%
3. Divide one hundred by that rate and round up
Example: 100 / 7% = 14.28 = 15 (rounded up)
4. Multiply the salary to be replaced by the multiple
Example: $70,000 X 15 = $1,050,000
This amount, invested at 7%, produces $73,500. The tax
liability on this amount should be no more than the
tax paid pre-death.
Shortcomings of this approach
• It does not take account of any other
resources that may exist.
• It does not specifically investigate whether
the dependents need the amount of income
that results from the calculation.
• Depending on whether nominal or real
investment returns are used for step two, this
method may not provide inflation protection
for the income generated.
The Needs Approach
The needs approach uses three steps:
• Calculate the amount needed for the dependants
to maintain their standard of living.
• Calculate the resources the dependants would
have to meet those needs.
• The difference between those two sums is the
amount for which life insurance needs to be
effected.
The Dependants
• The immediate dependants in a family would be the
partner and children. The partner needs to be provided
for over a lifetime or, if there was a superannuation
plan, until the superannuation benefits commence.
• The children would need to be provided for throughout
the period of their dependency.
• For each of the dependants it would be necessary to
establish their age and the length of their dependency.
The Living Expenses
• The amount required for living expenses would
be derived from amounts currently incurred.
• In ascertaining costs the full amount of the
family’s expenditure needs to be brought into
account.
• When considering living expenses in relation to
children, consider costs at different stages of
their lives. As they get older, the costs will
increase.
Current Resources
After calculating the amount needed by the
dependants, the next step is to ascertain
what funds may be available to meet the
calculated amount, including:
– the personal exertion or investment income of
surviving family members
– any available government benefits
– where death or disability arises from a motor
vehicle or workplace accident, a benefit that
may be payable under the state scheme
providing benefits for those situations
– proceeds of a superannuation plan.
Current Resources
Also to be brought into account would be:
– life insurance cover currently in force
– any investment that can be converted into
income-producing assets.
For an example of the calculation see
page 484.
Disablement
Stand-alone policies are available which cover
disablement, or life insurance policies can be
extended to include this type of cover.
In either case, a lump sum amount would be paid in
the event of:
• total and permanent disablement (TPD); and/or
• the consequences of significant illnesses or
accidents (trauma).
• TPD provides for a lump sum amount to
be paid in the event of a situation where
the insured will never work again. In such
a situation many of the needs that exist in
the event of death arise.
• There are two broad categories of
expenses:
– medical and other costs associated with the
disablement;
– ongoing support of the client and their
dependants.
Need for Life Insurance
• The needs that may exist for life and
permanent disability insurance must be
explored thoroughly as the end result
potentially makes provision for a family for
many years, in some cases a lifetime.
• If the amount calculated is not adequate then
it is the client’s family that will suffer the
consequences.
• The sums produced can be high and may result
in the client being inclined to dismiss the
amount as being excessive.
Need for Life Insurance
• Regardless of the reaction the client
should be taken through the
calculations explaining how the amount
was arrived at and the necessity for
each consideration taken into account.
In doing this the client can clearly see
the necessity for cover amounting to
the total amount.
Insurance Policies and Premiums
Applying for insurance
• When a person seeks insurance an insurer is
required to make a Product Disclosure
Statement (PDS) available to the client. The
PDS gives the client a reasonably
comprehensive description of the policy, the
factors associated with establishing the
premium, taxation and other relevant issues.
Duty of Disclosure
• At law the insured has a duty to disclose any
information that can be regarded as material.
Material information refers to any matter that
the client could be reasonably expected to
know is relevant to the insurer’s decision.
• If the information given in the application
form is incorrect in a material way the insurer
may be able to reduce the amount payable or
deny any cover under the policy.
• The duty of disclosure is imposed under the
Insurance Contracts Act 1984 (Cth).
Deciding Whether to Accept the Risk
• When deciding whether to accept the risk
under a life insurance policy, the insurer is
looking for lives that meet certain
requirements in relation to health, occupation
and pastimes.
• Pastimes include not only obviously
dangerous activities undertaken by the client,
such as hang gliding, but also travel.
Types of Premiums
There are two ways in which the premium may be
applied:
• stepped, in which each dollar of insurance cover
becomes more expensive with age; or
• level, in which premiums will only rise if more
insurance is required, as may happen if sums
insured are indexed to inflation.
Types of Policies
Broadly there are three types of policies provided by life
insurers:
• term, in which the premium is set no higher than is
needed to provide the insurance cover required
• whole of life, in which the premium includes an
investment component, enabling a level premium over
the whole of life
• endowment, which operates like whole of life but
maturing at a specified age or at the end of a fixed
term.
Premiums
• Premium rates — vary according to the situation
of the insured as well as cost structures of the
insurers and the type of cover sought.
• Three generic factors influence life insurance
premium rates:
– Sex: fewer females die than males at all ages, so
premiums are cheaper
– Age: with the exception of young adult males the risk
of death increases progressively with age, so
premiums generally increase with age
– Smoking: smokers pay higher premiums.
Business Insurance
There is range of business uses for life, TPD and
trauma policies. Briefly these covers can be used:
• As an employment benefit. Superannuation and
life insurance cover may be provided as part of
the conditions of employment. This may include
TPD and trauma cover.
• As ‘key person’ insurance. The business could
effect a cover on an employee on whom the
business depends for income generation.
If the person were lost to the business through
death or disability then the policy would provide
for the hiring and training costs of a new
employee and any loss of income.
Business Insurance
• As ‘share purchase’ insurance. Where a business
is operated by partners (incorporated or not) on
the death or incapacity of one of those partners
the question arises as to who will acquire the
deceased’s interest in the business, what its
value is, and how the acquisition will be
financed. Often a formal ‘buy/sell’ agreement is
entered into providing options to buy to existing
partners, with funding provided by insurance.
• Business loans can be protected by a life and
disability policy.
Life and TPD Insurance Under Superannuation
• Superannuation funds often provide life
insurance cover for their members. The
nature and extent of cover will vary
between funds. Some will also include
permanent and partial disability cover.
• Trauma insurance is not normally offered
by super funds.
The advantages for an individual in this sort of cover
come from:
• lower effective tax rate producing a lower
premium; the requirements to submit to a
medical examinations tend to be less stringent
• using its bulk buying power a superannuation
fund may be able to achieve premium
concessions from an insurer.
Summary
• There are four ways to manage risk: avoid,
reduce, retain or transfer.
• Life, TPD, and trauma insurances are ways to
transfer unavoidable risks.
• Death and disability can have devastating
consequences for individuals, families and
businesses.
• Professional advice helps to accurately determine
the levels of cover required.
• A range of insurance policies and premiums is
available to meet the needs.