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Life Insurance 101

I don't need insurance!!!
- Try telling this to a person who has just been diagnosed with cancer, or terminal illness.
- Try telling this to a family who just lost their breadwinner.

Many financial planners are insurance agents, multi-agents or brokers for life insurance. This means they can advise on life insurance, trauma insurance, total permanent disablement insurance, income protection and business expenses insurance.

Other forms of insurance, including property insurance, professional indemnity insurance, car insurance, professional indemnity insurance, workers compensation and various other products go under the banner of general insurance. Usually these other forms of insurance are handled by general insurance brokers and agents, sometimes financial planners deal in this... but not usually. At least for now I won't discuss general insurance, financial planners are more tied up with life products (those that do insurance anyway) so I'll confine this article to discussion of life products.

Health insurance deserves to be under a semi-separate category. It is more akin to a general insurance product, and is not usually sold by life advisers. Sometimes general insurance brokers deal with it, but often health insurance specialists, including many pharmacists who have entered the business as a sideline. Occasionally financial planners can write health insurance.

Life insurance

Life insurance is one of the oldest forms of personal protection insurance, and it is fairly simple really: the policy owner gets money if the insured dies. There are many reasons why one would want to take out life insurance, to pay out loans, to buy a full share of business if your business partner dies (this is called key man insurance), to pay for your funeral and to support your family after you have gone.

There are many different options available with various packages, all will (or should!) pay if you die, nearly all will exclude suicide and self harm as payable events (for the first 13 months of the policy anyway), some pay extra for violent death and some even pay for certain non-lethal events. For example there is an accident benefit paid out on Zurich Term Life policies, for certain serious accidents that lead to loss of limbs and eyesight you can get a payout of up to 100% of your life cover, even if you don't die. There are other examples of extras like this, Australia has a surprisingly large number of life companies, believe it or not Australian life insurance is a surprisingly competitive industry. There are also sometimes optional extras that pay a little more for certain death events, like extra money if you die from a violent, external cause. Most life insurers will pay up to 100% of the life insured amount when you are diagnosed as having a terminal illness and less than 12 months to live. This is paid out when a doctor approved by the insurer is able to confirm the diagnosis, which is very handy if you end up surviving your illness after all since once paid it cannot be refunded, provided the claim was not fraudulent.

Unfortunately, the overwhelming majority of people, particularly the young, are hugely under-insured. While you should guard against over-insuring and you need to be able to afford what you are buying, most people do not carry enough insurance.

For example (and this is not hypothetical, it is in fact the situation of a young couple I met this afternoon):

Husband: salary $35,000

Wife: salary $20,000

One child (aged one), another planned but not yet on the way.

Mortgage: $85,000

Other debts: about another $15,000

Superannuation: each have about $15,000

Together we concluded that regardless of which partner died, the survivor would have to cut back their working hours to look after the kid(s), we estimated that the income either could earn at this part-time work would be around $15,000 a year. So if either partner died, they would need about $40,000 a year to make up for the loss financially since this couple needed both incomes to survive. The loss of the wife would cause a financial problem disproportionate to her income, the husband would need to reduce his work load to look after the kid(s) or otherwise he would need to bring in extra help for childcare. In all it wouldn't have mattered which partner died, they would incur extra expenses for child minding and the survivor would probably earn less.

On top of that you can add probably $20,000 funeral, estate and medical costs.

How much insurance did these two need? There are various formula you can use, none of them particularly scientific, but they all lead to some big numbers! Just quickly though, as a back of the envelope sum:

Pay off all debts and final costs, $120,000.

Repay the salary for at least 10 years, $400,000.

Minus the deceased's superannuation.

This is over half a million dollars in insurance, we aren't even getting started with fancy formulae or figuring out the amount necessary to provide a lifetime pension. If either partner died tomorrow the survivor would be forced to either remarry or accept a rather pitiful lifestyle after about 10 years or so. Half a million dollars worth would not leave the surviving partner rolling in riches for the rest of his or her life, the money would last only until their daughter turned 10 or so, after which they would have to revert to a "single parent" type lifestyle. Kids aren't cheap, clearly half a million in insurance is not excessive by any stretch of the imagination, in fact one could even get wild and crazy and buy a million in insurance, provided the premiums are affordable. These numbers may seem huge up front, but I am sure if you think about it, in ten years time that money will be all gone.

If I was going to do this "properly", I would estimate the costs of raising their child to the age of 18 (or 21), paying for the kid's university education and giving them enough extra money that they can compensate for half a lifetime of lost salary from the departed spouse. We aren't trying to make instant multi-millionaires, but if you multiply your salary by 20, 30 or 40 you will see how much income you would have earned if you hadn't died. The shortfall will need to be compensated for, either by sale of assets or a huge cut in quality of life.

The reason I was seeing this couple was because they had asked me to shop around for cheaper life cover for them. It had turned out that I could offer them the same cover as what they had already for just over half the price that they were paying. Even better, I could offer them two and a half times as much insurance for the same premium. (Take note of this: shop around, the calculation methods used by each insurer differ greatly. In this case a certain insurer was incredibly cheap for them, while others were expensive. For someone of a different age, or a smoker, or someone of a different gender the cheapest insurer could have been someone else: no one insurer is the cheapest at any particular time, you need to get a dozen quotes. Next year the insurers will all be changing their rates again, the best deal could be with a different insurer again).

Previously, they had about $85,000 in cover each. For the same price I presented an illustration from a different insurer offering $200,000 in cover. They thought this excessive until I did the quick calculation above. They immediately agreed that $200,000 was not excessive, though did not feel they had the cash for a million dollar policy. As this pair were only in their mid-20s and were non-smokers, the cover was cheap. Including a certain amount of trauma cover it was about $300 a year to cover them both. Later on they will have lower debts and greater savings, the kid(s) will be old enough to look after themselves while mum or dad are at work so this pair can reduce their cover. I still felt they were under-insured, and they agreed, but $200,000 is certainly better than $85,000 and they agreed that at a future review of their case I should calculate their needs accurately for them and they will consider increasing their cover. In case you are wondering, no, the new policy was not worse than the old in terms of benefits, in fact it was much better! You must shop around extensively.

This is a fairly typical case, the sums calculated are invariably huge and invariably people balk at the figures, thinking they are excessive. On closer inspection though, people realise that their partner really will need all that money just to stay afloat for a few years. What a pity then that most of the people I meet have only really enough insurance to pay their mortgage. Premiums can be expensive, but if you can't afford the premiums then how on Earth could your family afford your death???

Young people are often the ones that need huge amounts of insurance cover, older people need much less as typically they have paid their house off and the kids are gone. It is ironic therefore that usually only older people want insurance, the young don't think they need it. Well of course the young are less likely to die than the old, but the young need greater levels of cover. This works out nicely in fact, for the young who need insurance the most but have the least chance of making a claim, cover is cheap. A couple of hundred dollars a year has you covered for a huge benefit. For the old, who are less likely to need as much cover but make more claims cover is expensive, often a few thousand dollars a year. You can actually get a premium freeze on many policies, where your premiums stay exactly the same year after year but the amount of cover decreases. This is a fairly popular option for many people.

Life insurance can be held through a superannuation policy. In this case the premiums become tax deductible just the same as superannuation itself. Which means that to a self-employed person they are fully tax deductible (up to the MDC limit). For an employed person they are not tax deductible, but they are tax deductible for an employer, meaning life insurance can be salary sacrificed just like super itself. For a spouse earning less than a certain threshold, presently around $11,000 or so (I won't give the exact figure since it will change yearly, and I don't want to have to go upgrading this page all the time!), you can buy life insurance through superannuation and claim a tax rebate (NOT a deduction), the rebate is calculated with a formula but is up to 18% of the contribution. These rebates and deductions are the same as for super in general, nothing special about insurance.

The only complication with superannuation life insurance is that the payment could exceed your reasonable benefits limit, which has tax implications. There is also a legislative problem with binding death nominations.

Apart from super, life premiums are not generally tax deductible, though the payout is not taxed either. The exceptions are when taking out life policies on people for business purposes. The premiums are tax deductible if you are taking out a policy on your business partner (key man insurance), but if you get paid you will be taxed on the money.

Premiums vary for smokers and non-smokers, with your age and with your gender. Some very hazardous occupations can lead to loadings or declined cover, however usually your occupation has no effect on the premiums.

Trauma Insurance

Life insurance sure is important, but it many ways it is obsolete! These days people don't die quickly. Thanks to the miracles of modern medicine, these days far more often people languish for several years with some horrible injury, and die a slow, undignified death. Noticing this, Dr Marius Barnard (famous heart surgeon, and brother of even more famous heart surgeon, Dr Christian Barnard, first to perform a human heart transplant) proposed what he called "dread illness" insurance. Barnard had noticed that while he, and his colleagues were becoming very good at prolonging life, this only led to the financial destruction of his patients. Not only were the patients incurring medical bills, but they were keeping healthy family members from working or simply not working themselves. Dr Marius Barnard, who I had a chance to meet a short time ago (he himself is dying of cancer, by the way - I sure hope he has trauma insurance!), said that in many cases he could see that the best financial advice he could give to his patients, and the family of the patient, was to hope for a quick death so the life insurance would pay out.

The idea took a little while to catch on, in fact Marius Barnard ran around to a great many insurers trying to get someone interested in his idea, but today it is one of the fastest growing risk products around the world. The overwhelming majority of claims made are for the big four traumas, cancer, heart attack, coronary bypass surgery and stroke. These four account for more than 80% of claims, however if you read an insurance Customer Information Brochure (the insurance equivalent of a prospectus), most insurers cover more than 30 specific trauma events, such as severe burns, head trauma, paralysis, multiple sclerosis, kidney failure, altzheimers disease, angioplasty and even "loss of independent living".

Trauma insurance pays a lump sum. If you survive the trauma, a linked policy that includes trauma and life insurance together will pay the trauma amount but reduce the life cover by the amount paid. If the policy has a buyback clause, then after a period, ranging from one year through to several years, you can buy life insurance for the amount you had before the trauma. Accelerated buyback options reduce the waiting time before life cover can be fully reinstated, though this costs extra. A stand-alone trauma policy usually only covers you for the trauma event, and will not pay on death. The fine print varies but usually you have to survive for a minimum of 14 days before the claim is considered a trauma event. If you die after only a week, a stand-alone trauma policy possibly won't pay out at all. If it is a linked policy and you die of the trauma event, usually you get paid the life insurance sum. You hit the jackpot of course (or your family does) if you have a heart attack, get paid the trauma amount, with your buyback get the full life cover reinstated and die after that, then you get paid twice.

Why get trauma cover? Because life insurance does not pay you at all if you suffer a long, lingering death, not until you die anyway. A stroke that leaves you paralysed will stop you ever working again, and screw you up financially, but a life policy won't pay you a cent. This is a shame if you end up so poor you can't afford to pay for your life premiums any more. A lot of people do end up in this situation, they have a pretty humiliating and miserable last few years, leaving only debts behind for their family.

Trauma cover can not be effected through superannuation. Some funds will offer cheap group rates on insurance as a loyalty bonus, but they are a separate product, not run under your super. Hence the premiums are not tax generally tax deductible, though the benefits are not taxed either.

Premiums vary with your demographics, just like life insurance. They assess you based on factors applicable to the whole population of guys (or girls) like you.

How much trauma insurance do you need? If you have a buyback clause then I'd suggest you set your life insurance up as I did for the young couple above, buy enough trauma insurance to pay your way for a couple of years so the family isn't financially ruined while they wait for you to die. (Sounds kinda harsh, I know, but that's how it goes).

Total and Permanent Disablement Insurance (TPD)

TPD insurance covers you for disability that stops you ever working again. It is a lump sum payout that you get when a doctor is able to pronounce you so severely disabled that you can not ever work again. There are two levels of cover. "Own occupation" is where you are insured on the basis that the doctor has to proclaim you unable ever to perform your own job again. This is handy if you are in a heavy, manual job, since it is somewhat easier to make a claim if a doctor pronounces you unable to ever lift big weights again. If you are in a clerical/office type job then you have to satisfy the insurer, or at least their doctors, that you won't be able to ever push a pen around again... kind of hard unless you got really screwed up. "Any occupation" is where they must proclaim you unable to ever work again, in any job for which you might be reasonably suited by education and ability. In other words, this second type of cover may give the insurer the right to test you for other suitable employment. A bad back might put you out of the removalist business but it won't stop you from taking a desk job. Naturally the second form of cover is much cheaper, since the insurers pay out less often.

TPD can be taken out through a super fund, just like life insurance. The reason why you can get TPD through super, but not trauma, is that if you are truly totally, permanently disabled, then you can apply to have access to your super early. If you have a coronary bypass operation you will be paid for trauma insurance but not necessarily end up disabled and unable to work again. The crucial difference is that trauma pays you for suffering a medical emergency, regardless of how well you survive the incident, whereas you only really qualify for TPD if you are unable ever to work again.

Factors affecting TPD premiums are the clients health, demographics and smoking habits, as well as occupation. It is far cheaper for an office worker to get TPD insurance than a heavy labourer. In fact for certain occupations it may be impossible to get TPD cover at a reasonable price (ie removalists, professional athletes), or cover is only available with an "any occupation" rule.

Income Protection Insurance (IP)

To replace your wage/salary if you are unable to work.

These policies only cover you for disability and sickness - not to replace lost income if you become unemployed. "Unemployment benefits" for Income Protection are where the insurer agrees to keep the policy going after you become unemployed while you look for work. If you come down with a horrible disease while looking for work you can claim under an IP policy. If you want something to cover mortgages against unemployment, consider credit insurance, which is not the same as the mortgage insurance that banks make you take out when getting a big loan. Talk to a general insurance broker about these types of insurance if you are into negative gearing, or simply have a huge house mortgage.

Premiums are affected by your age, smoking habits and gender just like with other insurances, but is also heavily influenced by your career choice. In addition it is cheaper to insure a small proportion of your salary than a large proportion. In addition changing the waiting period or the benefit period affect premiums greatly.

Basically, in this type of insurance, your premiums are affected by your health, and how much incentive you have to stay on benefits or go back to work. When looking at your occupation, the insurers are looking at more than just the physical demands of the job, also your training features in their assessment. A professional engineer and a secretary probably have similar risk exposure while at work. Both work in an office all day. The difference is that an engineer has had to go to uni and spend at least 4 years studying a very challenging topic, followed by numerous professional development upgrades and perpetual study. A secretary (no offense intended to secretaries!), has no where near this level of commitment to his or her career, and might not necessarily be as keen to get back to work. The engineer may well wish to get back to work as soon as he is healed up enough to be stretchered in to the office, but the secretary possibly won't be so keen. For an engineer to walk away from his or her profession purely because of an injury could well be a great personal tragedy, considering the effort expended to get that job in the first place.

Secondly, the insurer looks at how much of your income is being replaced. There is a ceiling of 75%. You cannot write a policy that replaces more than 75% of your income. If you earn $1,000 a week (gross), you can write a policy for $750. The rates are often cheaper for someone insuring 50% of their income rather than 75%. For example someone earning $5,000 a month could take out a policy that will pay $2,500 in benefits. This may be cheaper than someone that earns $3,333 taking out $2,500 in cover. The insurer figures the first one will be rather more keen to get back to earning their regular salary, as the recuperation period is costing them more money. This is purely earned income, you cannot insure passive income, like share dividends or rent, because presumably your shares won't go bust simply because you were ill.

A waiting period is a time during which the insurance company won't pay you, only when you have been sick for the whole time can you make a claim. There are a variety of waiting periods available, the shortest is usually 14 days. This means that if you broke your arm on the first day of the month, the insurer won't pay you anything until the 15th. The insurer does not then make a back-dated payment for the waiting period. Other wait periods are 30 days, 60 days, 90 days, a year, two years... it all varies, different insurers have different choices. Naturally cover gets cheaper with long wait periods. Insurers pay out all the time with 14-day wait periods, with moderate frequency when the wait is 30 days, and only rarely pay when the wait period is a year or more. The price difference between a 14-day period and a 30-day period can be as much as double, so the majority of policies in force have a 30-day wait period.

Benefit periods also vary and have an impact on the premium. The shorter periods available pay for one or two years, after which the insurance contract expires and if you are still sick you go on Centrelink payments. More commonly, people buy insurance that will pay for 5 years, but a better choice is cover to age 65. You may be quote surprised to see how similar the premiums often are with 5-year payment periods and payment to age 65. If the insurer allows payment to age 65 in your occupation, you should always go for the long pay period, extending the wait period if necessary. In most cases it would be cheaper to take out a policy with a 30 day wait period and payment to age 65 instead of a policy with a 14 day wait that pays for 5 years. Provided you can live for that extra two week wait I feel that the long payment period is far more desirable. For cost cutting I think it is always better to go for a longer wait period than a shorter benefit period. Other pay periods available for some occupations with some insurers include payment to age 60 and even a lifetime payment, meaning they continue to pay right into your old age.

An option to look at that I personally feel is essential is indexing of the benefit to inflation. It is all very well to insure 75% of today's income is insured until age 65, but 20 years down the track it will get harder and harder to pay the bills when inflation devalues your payouts. Known as "escalation options" or "indexing of benefits", this feature, which may be standard for comprehensive cover or optional for budget policies at an extra price is well worth the money. I really don't see what the point of a lifetime policy is if this option is not selected, even with a rather tame 4% inflation rate your benefits will effectively halve every 18 years, thus pulling the safety blanket right out from under you.

There are a variety of options available with an IP policy, some of which may interest people, others which may or may not be worth the extra premiums. There are wait period waivers for certain injuries, these things start to pay immediately for certain unfakeable injuries (like leg fractures and severe burns), rehabilitation benefits where they pay a little extra for house modification (installation of handrails in the shower and wheelchair ramps, etc.) Also sometimes a bit of free life insurance is chucked in (ie three months payments) and retraining benefits, where the insurer will help pay for you to take an educational course to learn a new trade.

IP premiums are tax deductible, the money you receive is taxable income. When you do your tax return the insurance benefits are treated just as you would treat your regular wages.

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