A Financial Advisor’s Guide to Life Insurance – What you Need to Know

What is Life Insurance?

Life Insurance helps protect against certain risks if something were to go wrong. You essentially pay an insurance company a certain amount (usually a monthly ‘premium’) for them to pay you an amount if you need to make a claim. This can be for your car, home, health and even life. For example, most people have home insurance, where an insurance company will pay a certain amount if something happens to your home, such as a fire that destroys it.

How does it work?

Insurance is a risk management strategy – you pay a monthly amount to an insurance agent for the ability to make a claim and have money paid in the event of something happening. Normally we take out insurances on things that we can’t fund ourselves, such as needing to rebuild your home in the case of a fire.

The way it works is usually like this: you take out an insurance policy with a company for a certain amount and to cover you against certain things happening (they might call these ‘events’) and pay a monthly or yearly cost to the insurance company in return for them agreeing to pay you a certain amount in the future if you need to make a claim.

Eg: You want to cover the cost of rebuilding your home if it is destroyed by flood, fire or hurricanes. You estimate it will cost $500,000 to do this so take out insurance to cover that amount. The cost of this is $1,000 per year, which you pay to the insurance company. You don’t get this back if you don’t make a claim, however you have the peace of mind that if something happens you can claim and the insurance provider will pay you out $500,000 to rebuild your home.

Types of cover – Life Insurance, TPD, Trauma & Income Protection

As financial planners we look at insurances as part of an overall risk management strategy. This strategy includes having an emergency fund, protecting things like your home, car & health, and then making sure that you are covered financially if you were to pass away or unable to work. These last types of cover fall into the ‘Life Insurance’ basket and are predominantly made up of the following:

Life Insurance: Pays you a certain amount of money (usually as a one off) if you pass away. The money will go to the people you nominate as your ‘beneficiaries’ (normally your partner and/or kids) and is usually used to pay off any outstanding loans, cover funeral expenses and provide some financial comfort for the family.

Total & Permanent Disability (TPD): This also pays you a one-off amount, but in this case if you are so seriously injured or unwell that you are unable to ever work again. This can get specific on when it will be paid out so it’s best to do your research or get some help, but the main idea is that if you can’t work anymore, for example due to a car accident or major illness, you will get a payout which can be used to clear any outstanding loans, help with medical & rehab costs, and provide some financial comfort to you and your family. There are 2 types of cover here:

Any occupation cover – this will pay out if you are unlikely to work again in any occupation that you are reasonably suited for based on training, qualifications and experience. It is slightly harder to claim under this option, however is slightly lower cost as a result.

Own occupation cover – this will pay out if you are unlikely to ever work again in your current occupation. It is easier to claim on this however is slightly more expenses, but in our opinion worth it!

Trauma/Critical Illness Insurance: This also pays out a one-off amount, but this is specifically if you suffer a serious illness, such as cancer, a heart attack or stroke. This type of cover is to help with your recovery and to pay for things like medical & rehab costs and some financial support while you are on the mend.

Income Protection: This pays part of your income if you’re unable to work because of a disability caused by illness or injury. It can help pay the bills so you can focus on getting better. It usually kicks in after 1-3 months of being sick, so isn’t necessarily to cover time off for things like colds. Income Protection can pay you for a certain amount of time (such as 2 years) or until you are back at work, whichever is the earliest.

Payout options: Most options pay you 70% of your income if you can’t work, however this amount can differ a little bit so is worthwhile getting help on your options. There is also what is known as a ‘benefit period’, which is basically how long you are paid for. You pre-select a timeframe that would be the maximum amount of time your get paid, such as 2 years, 5 years or until you are 65 years old. If you are able to go back to work within that timeframe then the payments will end as well, however if you are unable to go back to work after the benefit period ends you will need to look at other funding sources, such as the Disability Pension.

Waiting Periods: This is how long you wait until your income protection starts paying you once you make a claim. It is not like private health cover, which may have a 12 month waiting period before you can claim on certain items – most policies allow you to claim as soon as it is in place, however there are options have the monthly payout start 30-90 days after you are first sick/injured. The benefits of the longer ‘waiting period’ is a lower cost of insurance, however you need to make sure you have enough savings and/or sick leave to cover that period.

Payment options

These types of insurances can usually be paid either out of your bank account/credit card, like car & home insurances, or from your super fund. You may have some insurances inside your super fund already, however there are some restrictions on what types of insurance can be held within super, as well as the benefits payable and access of these. We usually like a mix of paying for insurances inside super and personally to get an ideal blend of affordability, tax benefits (for example income protection is usually tax deductible) and simplicity at claim time.

Our Insurance Philosophy

We look at insurances as part of an overall risk management strategy. This strategy includes having an emergency fund, protecting things like your home, car & health, and then making sure that you are covered financially if you were to pass away or unable to work. As a rule of thumb, we believe around 3% of your total household income is appropriate to spend on the ‘life insurance’ category, and around 5% of your income on total insurances (including car, home & health). This leaves you with 95% of your income to pay your mortgage & bills, save, invest & spend.

Our insurance philosophy is built around the idea that insurances are needed to put you back into the financial position that you would have been in if the event that occurred never happened. For example, what financial position would you & your family be in if you didn’t have to have time off work, or were diagnosed with cancer, or worst case passed away? This is largely based on the financial blueprint that we put together for people, however as a rule of thumb covers against the following:

• If you pass away – leaving your family with enough to be debt free (the financial blueprint always aims to be debt free within a certain period) and support themselves for a few years
• If you can’t ever work again – having enough to pay out your mortgage and any other debts and cover the medical, rehab & any other costs incurred due to the injury / illness.
• If you suffer a serious illness – covering the medical, rehab & other costs associated with the illness.
• Income Protection – covering your income while you are off work and recovering. This income is still needed to pay the bills, and there may be other medical expenses due to the injury or illness that need to be paid for as well.
• Financial comfort – we usually look at some money to provide financial comfort & support on top of the above, so people don’t have to worry about money and can focus fully on recovering. Studies have shown that money-related stress can slow down the recovery of injury & illness, so we want to alleviate that as much as possible.

Types of risk that can affect your ability to earn an income and derail your financial plan

Unemployment

There isn’t any type of insurance that can protect against this. Instead we like to build cash reserves to utilise in these instances (3-6 months of living expenses), plus make sure you are always employable by improving your skills & training.

Accident/Illness or other Health issues

Short term (0-24 Months) – Ways to Get ready for short term:

• Cash buffer (3-6 months living expense)
• Sick leave
• Insurances that pay out if you can’t get to your own job for a few months

Long term (24 Months & Beyond)

• Insurance that will take away some big-ticket financial pressure e.g. debt, major medical and kids expense if you cant get back to your own job even after 2 years, as your current debt & Kids education plans is based on the income you generate in your current job, not based on a job an occupation therapist from the future, paid by an insurance company says you can do.
• Insurances that pay out if you can’t get to any job for the foreseeable future

Having insurances Inside super vs Outside super – best of both worlds?

Some insurances can be held within your super fund, such as Life, TPD & Income Protection Covers. This can help with affordability of insurances, however some of the covers aren’t as good when held within super due to legislation requirements at claim time. For insurances held within super, they must meet the ‘Superannuation Industry Supervision Act’ (also known as ‘SIS’). In a nutshell, even though the insurance might pay out because you have made a claim, the super fund may not pay the money to you because you haven’t met one of the requirements to be paid. All insurances owned through super get ‘released’ (paid) to the super fund first – this is something most people don’t realise and is a little quirk of the system. So it is very important to make sure you will be able to get your money when you need it.

For each of the main covers:

• Life insurance – This is usually ok to be held within super because at claim time it’s fairly straightforward (when you’re dead you’re dead!). If paid to your spouse or someone who is financially dependent on you the payout will be a tax-free lump sum regardless of if it’s through super or outside, and there isn’t any trouble with the super fund paying the money to your family as death is one way that you can access money from your super. The main downside when holding Life Cover through super is there are only certain people can be nominated as a beneficiary – essentially immediate family or someone who is dependent on you – and adult children may be taxed on the payout.
• TPD – Here is where things start to get tricky. With TPD through super you can only make a claim if you are unable to work in any occupation that you have training, experience or qualifications in. When holding it outside you are able to have it set to claim on your own occupation, which means it is easier to claim. Because TPD cover is usually linked to Life cover though, it is usually easier to have it through super with life cover. So we generally like to ‘link’ the TPD inside super & outside to help with affordability and get the better claim ability at the same time.
• Trauma – this cannot be held within super due to legislation, so is only able to be held and paid for personally.
• Income Protection – Like TPD, things can get a bit murky here. There have been a lot of changes with Income Protection legislation recently and there are so many nuances within different policies now. They are all fairly streamlined in being able to claim a maximum of 70% of your income, however some policy can drop that amount depending on how long you are paid for. You can hold Income Protection through super, however we generally recommend that it is held outside because it is tax deductible, and it is a bit quicker at claim time because you get paid directly. For those that have affordability issues we as a minimum recommended the ‘linking’ of the Income Protection inside super and outside, like the TPD.

Paying for cover through super

For cover that you hold through super (usually life insurance & TPD), the cost will be taken from your super balance. For small amounts this may not be too much of an issue, however over time it can add up to large amounts and deplete your super balance. Due to this we like to recommend adding some extra to super to cover some or all of the costs. For example, this can be done by salary sacrifice, which also reduces the amount of tax you pay, or in a way where you qualify for a Government Co-Contribution if eligible, which can help pay some of the costs.

‘Super linking in more detail’

What is Super linking?

• This is the ability to ‘link’ certain insurances (specifically TPD & Income Protection) inside super and outside. The reason people do this is to help pay for the insurances through super, whilst getting the better claim definitions outside super.

What is the benefit?

• What is the SIS act’s condition of release – this is the techinal term for when your super fund can pay you your money and or insurances. By law super is to fund your retirement, so normally cannot be accessed until a certain age (currently at least 60) and also needing to be retired if you want to access your money between 60 & 65. There are a handful of other ways to access super early, with 2 of the main ones being death and permanent disability. If you have these insurances within super you will be assessed by both the insurance company on whether the claim is successful, and after that from the super fund on whether they are able to release the money from your fund. The insurance provider will have to pay the claim to your super fund, who will then decide whether they are allowed to pay you based on the laws of super access.
• Legislative risk – there is a small risk of the insurance company paying a claim and the super fund deciding not to release the funds. Usually the risk is more that the insurer will deny the claim, especially in the case of the ‘any occupation’ TPD cover noted previously. A lot of super funds have this as standard; we generally recommend having the better ‘own occupation’ definition so increase the likelihood of the claim being successful.
• Chance of claim – there is a better chance that you will be able to claim on the ‘Own occupation’ TPD definition, as it will kick in if you can’t work in your current job, not just any job you are qualified to do. Because of this we prefer this option and have built it into our insurance philosophy. Most super funds do not off er this option directly though, which is why it is important to look into the right provider and not just take the standard insurance that is offered through super.

Conclusion

Life insurance & the other types of cover can provide a great safety net for you, however we believe they are part of an overal risk management & financial plan. We aim to get the right blend of required cover, affordability & tax benefits with all the insurances that we look at.