Risk in Practice (5-Feb-2004): Work out the ‘what-ifs’ for life risk insurance

New Australian Financial Services Licences (AFSL) are flying out of the Australian Securities and Investments Commission’s (ASIC) door at the moment, and there are significant consequences for licensees, particularly the ‘traditional’ financial planning firms that have applied for and been granted authority to advise and deal in life risk insurance products.

These licensees will in turn be authorising representatives to advise and deal in this product category. Their new Financial Service Guides (FSG) will also specifically list the life risk insurance product category.

This action generates a very real obligation, on the part of the adviser, to address risk in the same way they address all the other areas for which they are authorised. This is a not-so-subtle shift from the common practice to date (with exceptions, of course) of allowing risk issues to sit on the fringes of the planning process.

As this effect dawns on licensees and advisers alike, I am seeing a common thread emerge in my dealings with them. They are expressing angst around the methodology of calculating sums insured for the lump sum range of products — life, total and permanent disability (TPD), and trauma — because it is recognised now that this methodology must be robust enough to satisfy the ‘reasonable basis for advice’ requirement that is now enshrined in legislation.

Supporting a lump sum product advice outcome in the context of a ‘reasonable basis for advice’ demands that a client-specific, structured calculation be used, and then kept on record. It seems that this presents as a somewhat daunting task, which is not necessarily well catered for in software modelling programs. If advisers have difficulty grasping this new ‘skill’, the simplest way to hone it is to apply the principles to their own circumstances and use themselves as a learning exercise.

The principle of insurance has always been to place the insured back into the situation they were in prior to the event, to the greatest practical extent. This applies whether it is the theft of a TV and DVD player, or the loss of a family breadwinner. If this is borne in mind, in the case of each client who is the subject of the planning process, it is difficult to go wrong (provided the fact-finding process is thorough enough).

This sounds all too basic, yet my experience clearly indicates that an air of mystery and complexity still pervades the risk insurance area for non-traditional risk writers.

So as basic as it seems, let’s walk through the elements of the life needs analysis process. More on TPD and trauma next month.

Before I do that, think on this: The new year saw me scuba diving out of a remote Papuan village, where the majority of the small population are pretty much subsisting. It struck me that without a material element in their lives, and without an income-earner in the family, this places them at the very end of the spectrum of insurance need. There is nothing to replace, so there is nothing to insure.

Compare this to average financial planning clients, who stand to lose a small or vast variety of ‘wealth’, of one form or another, should any of a large number of events befall them. By compromising on the job of appropriately calculating needs, an adviser is artificially and irresponsibly pushing their client down the spectrum.

Doing the sums

The formula for calculating need arises from the practical consideration of “what happens the day after I die” (or become disabled, and so on) and literally walking through the real implications, as they would arise client by client.

This cannot be achieved by applying a general formula. The days of recommending 10 times salary, with no basis in reality, are over. Thank goodness. Similarly, I was asked recently if a ‘standard $200,000 for anyone’ was okay for trauma.

Work out the client’s lump sum needs first and remember that this by its nature has to be a theoretical, what-if, exercise — that does not mean it is not realistic. Allow the client to think about and provide his/her own figures.

The initial issues to arise may be:

Funeral and associated costs;

Cash to cover day-to-day costs if an income will stop (life claims over $50,000 are subject to probate — consider a small separate policy for immediate cash needs);

Cash to cover any probable calls on debt (watch for tax bills);

Cash to clear any accrued medical costs — these are never totally covered by health insurance;

If the family car is an arm’s length company vehicle, will there need to be a new car purchased?

Relief of debt may be called for by allowing for a lump sum to be paid after death, for loans, mortgages, credit cards and leases. Watch for forgotten bank guarantees. Allow for capital gains tax on expected asset sales.

Where there are dependent children, it may be that the client will choose to put aside a lump sum for total expected future education costs, rather than having them come out of the family’s future income stream. Give the client the choice to add this amount, rather than include the regular costs of schooling in the next step of the calculation, which is the need for income flow.

Then check on any special needs currently being met out of income — a disabled child with lifetime needs or aged parents who will still need to be supported.

Next, talk through the ‘post-death’ family budget in recognition of the debts that have been planned to be removed, and in the context of any lifestyle changes that may be warranted in the what-if scenario.

Be careful to question any responses you might perceive to be illogical, and listen for any hidden clues. These may come, for example, from a wife who really would not want to return to work but the husband has assumed she would. This will significantly alter the income needs calculation. The last thing an adviser wants is for the wife to say she indicated something which wasn’t taken into account. It’s too late after the event.

Remember to calculate gross income needs — the tax still needs to come from somewhere!

Discussing and deciding on an assumed rate of return on the capital sum will be the most challenging task. It’s obvious that the more conservative that assumption, the higher the insured amount, but it is important nevertheless to be realistic.

The last and easiest step is to question which of the client’s assets they are happy to use as ‘self-insurance’. The value of these would be deducted from the final sum insured arrived at after the above steps. If there is a shared business, there may be cash from the value of the business if buy/sell insurance has been installed properly.

Existing insurance (in or out of super) will, of course, be acknowledged in the advice, if it is to be maintained, as will the current balance of the retirement nest-egg, if appropriate.

Next month, I will also look at applying this exercise to some less regularly encountered risk client scenarios — pre-retirees and single people, for example.

The principle of ‘rubbish in, rubbish out’ applies to the needs analysis processes. Manage the fact-finding well, allow sufficient time for the right information to be drawn out, analyse it logically to the advice conclusion, and feel comfortable that a reasonable basis for advice has been established.

Sue Laing is principal of Laing Advisory Services.