Facing up to asset realisation

Advisers are faced with a number of challenges when it comes to protecting the investment side of a financial plan, including:

~ what areas of the plan are at risk if the investment process is unexpectedly interrupted by the death, sickness or injury of the client;

~ to what extent is the plan at risk;

~ how can the risk be mitigated by putting in place some form of insurance;

~ what type of insurance should be put in place; and

~ deciding what carrier should be used to supply the insurance.

Over-insurance

However, the main challenge seems to be how to calculate the amount of insurance required.

While this challenge may appear daunting for total and permanent disability insurance, trauma insurance and the like, it has long been held that at least the calculation is simple when it comes to income protection insurance (that is, always go for the maximum 75 per cent of income, 30-day waiting period, benefit period to age 65).

Unfortunately, this relatively simple solution, even if correct, comes unstuck when the client has a reasonable asset base.

When it comes to income protection insurance, the primary concern of insurers is unnecessary or over-insurance, and the impact of these on the client’s motivation to return to work after recovering from a sickness or injury.

Statistics show that, at all income levels, if a client can receive the same level of earnings by not working as they would if they worked, the frequency and duration of claims ends up exceeding that which was assumed when premium rates were calculated.

Going further, insurers believe income protection insurance should protect the ‘reasonable’ lifestyle of a client rather than their luxury lifestyle.

Finally, insurers feel a high-net-worth client could, in the event of being unable to continue working because of a sickness or injury, simply realise some of their assets, shore up their unearned income and continue their current lifestyle unabated.

Advisers and clients on the other hand respond by saying that while they understand and may be sympathetic to this theory, the reality for many clients bears no resemblance to the simplistic, generalised guidelines promoted by insurers.

There is therefore a need to develop a basis of recommendation for income protection insurance where the client has a reasonable level of net worth, such that the position of the client is acknowledged and the concerns of the insurer are addressed.

Asset realisation

The first problem in regards to the treatment of assets is that, net of the family home, insurers tend to treat them all the same (that is, as something that can be realised in order to provide a capital sum that in turn would be invested so the client has an unearned income to fund their lifestyle).

The reality is quite different.

The financial nature of assets differ and these differences should be considered:

~ does the asset have a capital value and what is a realistic estimate of that value?;

~ is the capital value appreciating, depreciating or is it static?;

~ how liquid is the asset?; and

~ is an ongoing financial commitment required in order to maintain the asset?

In addition, if a client realised they would be totally disabled in the long-term, their attitude to their assets would differ depending on the asset and the prevailing circumstances.

This also needs to be considered. For convenience, the client’s attitude to assets can be divided into three categories.

(i) If the client was long-term totally disabled, those assets that the client would be prepared, or have no choice, to realise in the short-term (eg, one or two years).

These would most likely be assets for which the client has only a mild emotional attachment (eg, a boat or a property that is rarely used, or for which the client is still making a net financial commitment).

If a client was long-term, totally disabled, it may not be realistically possible for them to continue with such financial commitments, even if income protection insurance could be obtained.

If assets are to be realised, it would advantageous for the client to have some financial breathing space in which to realise the assets so that a ‘fire sale’ situation can be avoided.

A reasonable period of breathing space for assets that are likely to be realised in the short-term might be one or two years.

Protection of the maintenance costs of these assets could be achieved with an income protection insurance policy, 30-day waiting period and a one or two-year benefit period.

The benefit amount would be the maintenance costs (that is, the net, ongoing financial commitment necessary to retain the assets).

Following on from this, if these assets were realised one or two years after disability commenced, the net capital value could be invested so that non-generated income would be increased.

With the assistance of the client, the adviser should be able to make an approximation of the level of non-generated income that would ensue and when it would ensue.

(ii) If the client was long-term totally disabled, those assets that the client would be prepared, or have no choice, to realise in the medium term (eg, two to five years).

The client may have leased an investment property that, net of expenses, provides a non-generated income to them. While the property might have a reasonable capital value, the client believes the potential for capital gain in the medium-term is such that they would be loathe to realise it before then.

Alternatively, the client may be accumulating a collection of art or wine. If they were totally disabled long-term, they may eventually look to realise some or all of their collection, but, again, it is only something they would consider if their disability was ongoing.

Protection of these assets could be achieved with an income protection insurance policy, 30-day waiting period, two or five-year benefit period.

The benefit amount would be the net, ongoing financial commitment necessary to retain the assets.

Once again, if these assets were realised, the net capital value could be invested so that additional non-generated income would ensue.

(iii) Even if the client was long-term totally disabled, those that the client would be highly reluctant to realise.

In this category would be things such as the family home, car and so on, or an asset for which the client had a strong emotional or financial attachment.

Even if there was an ongoing financial commitment needed to support these items, the client would do everything they could in order to retain them.

Protection of these assets could be achieved with an income protection insurance policy, 30-day waiting period and a benefit period to age 65.

The benefit amount would be the net, ongoing financial commitment necessary to retain the assets.

As the client would be loathe to part with these assets, it could be assumed that no capital value would be realised and, following on from this, no additional non-generated income would ensue.

Lump sum benefit

However, an optional benefit has recently been made available that would be well suited to assist a client in this situation.

The CommInsure TPD Cover option under the income protection insurance product enables the client to commute part of the benefit amount and receive a tax-free lump sum in return.

Thus, if a client aged 45 had earmarked $1,000 a month of income protection insurance to make the repayments on an investment property with an outstanding debt of $130,000, the $1,000 could be commuted in return for a lump sum of $1,000 x 12 x 11 = $132,000.

The actual multiple varies in line with the age of the life insured.

This would enable the debt to be repaid and the client’s need for an income payment reduced by $1,000.

This facility would be particularly valuable if interest rates were relatively high, for example, if interest rates were 7 per cent, in order to achieve an equivalent return to retiring debt, the client would need to earn a pre-tax interest rate of 11.4 per cent (assuming an average tax rate of 39 per cent).

While this may seem ‘over-the-top’ when compared to the relatively simple solution of recommending 75 per cent of income, the problem is that once a client accumulates a reasonable amount of net worth, the insurer is less likely to provide cover in line with the 75 per cent guideline.

Therefore, if an adviser wants to have the position of their client acknowledged such that appropriate cover can be put in place, a compelling, alternative position may have to be developed and provided to the insurer.

So, while the above is certainly more complex, for the adviser who wants access to income protection insurance to protect the needs of clients with a high level of assets, complex is a far better alternative to the simple alternative, that is, no cover at all.

Col Fullagar is a risk manager at Genesys Wealth Advisers .