Late last year, we conducted research into people’s perceptions and attitudes towards life insurance. One of the recurring themes we discovered was just how confusing life insurance can be for customers. 

One question in particular that sparked my interest was the question around how much life insurance you need. 

When we asked people what level of life insurance cover they think is recommended: 

• 30 per cent selected ‘over 10 times a year’s salary’, which is the amount recommended by the Investment and Financial Services Association (IFSA);

• 34 per cent selected ‘between five and 10 times a year’s salary’;

• 22 per cent selected ‘between two and five times a year’s salary’;

• 9 per cent selected ‘between one and two times a year’s salary’; and 

• 5 per cent selected ‘one year’s salary’.

The answer to this question isn’t exactly intuitive, so you might expect these sorts of responses from people who didn’t have life insurance. But the results for people with and without life insurance were almost identical, suggesting that even those who have life insurance aren’t sure how much they need.

How much life insurance do people have?

Our average retail sums insured are as follows:

Considering the average wage in Australia is now $60,658 per annum, according to the Australian Bureau of Statistics, it seems our customers aren’t far off 10 times their income on average, probably because they have been fortunate enough to receive financial advice.

But how reliable is the ‘10 times income’ formula? Do we as an industry even agree on the best way to calculate a sum insured?

How do you calculate sums insured?

There are probably dozens of different methods advisers use to calculate sums insured, but I’m going to take a look at the pros and cons of the three most popular.

The first is the multiple of income formula, as mentioned above. 

The best thing about this formula is that it’s simple. Simple to calculate, simple to explain, and it correlates directly to an insurer’s underwriting rules.

What it doesn’t consider is an individual’s personal circumstances, such as their age, dependants and debt levels, which are obviously important things when it comes to their future financial needs.

As a result, the multiple of income formula can easily lead to over or underinsurance.

Another method is using your client’s salary, multiplied by the number of years to retirement. Again, it’s pretty simple to calculate and explain. But it still doesn’t consider a number of individual factors.

The third formula takes your client’s ongoing income needs, adds the cost of debt elimination, adds a hypothetical figure for expenses associated with a disability, and subtracts assets that will be converted to cash.

The good thing about this formula is that it takes into account an individual’s circumstances. It also provides a logical conversation you can have with your clients that takes into account future expenses as well as current ones.

The downside is that it’s almost impossible to accurately estimate the costs associated with hypothetical medical conditions.

Of the three formulas, I believe the last one offers the best way to calculate your client’s sum insured. But even then there are a number of other important considerations for advisers.

Inside or outside super?

While insurance through super can be a tax-effective way to pay premiums, there may be tax implications when your client tries to access the insurance proceeds from the super fund, or when the benefits are paid upon death.

With death cover for example, lump sum benefits paid to beneficiaries from policies held outside super are tax-free, regardless of who receives it.

However, when death cover is held inside super, only dependants — which could be a spouse, a child under 18, or anyone shown to be financially dependent on the deceased — can receive the benefit tax-free. If the lump sum benefit is paid to anyone else, including 

an adult or a non-dependent child, it will be taxed at 16.5 per cent.

This means clients who are taking insurance inside super, and who have non-dependent beneficiaries, may need to take out a higher level of cover to achieve the same result.

While this can make insurance inside super less attractive for some clients, it may still be possible to do it at a lower cost to the client.

Considering investment income

Investment income may be used to subsidise the loss of personal exertion income if your client can’t work. 

As a result, if they earn a significant proportion of their income from investments, this may be offset against normal income for the purposes of income protection benefits.

But as the events of the past year have demonstrated, there’s a definite need for caution when estimating the sustainability of this investment income.

It’s also possible your client may need to access some of the capital that’s driving this income due to unforseen medical expenses and/or lifestyle changes, further diminishing their earning potential.

How do you ensure sums insured remain relevant?

Whichever way you calculate the sums insured for your clients, you know insurance is not a set-and-forget strategy. 

The appropriate level of cover for an individual can increase with any number of life events, such as a pay rise, an increase in the size of the mortgage, or an addition to the family.

Likewise, your client’s required level of cover can decrease as they age and their future income needs reduce, their investment income increases, or as their children become less dependent.

By ensuring your client’s level of cover remains appropriate, you can help reduce lapse rates, and improve client retention. 

Reviewing your client’s insurance also gives you a chance to discuss changes in their personal circumstances, making it an important part of the review process for all advisers. 

Gerard Kerr is head of products, marketing, and reinsurance, life risk division,ING.