Weighing up the benefits of risk insurance

Macquarie Life broke new ground in May 2010 with the launch of Macquarie Active risk insurance product. Col Fullagar examines whether or not it is possible to establish an objective basis for an Active benefit amount.

Several months ago, Money Management discussed some of the pros and cons of the new Macquarie Active risk insurance product.

The verdict was that Active appeared to give the financial adviser access to some unique opportunities in various areas.

However, in the end the article concluded, “it will come down to the adviser’s analysis of the client and the needs of the client”.

And therein lay the problem.

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The unique design of Active made the identification of the client need and the subsequent reasonable benefit amount recommendation somewhat problematic, and thus the reason for this follow-up article, the purpose of which is to explore whether or not it is possible to establish an objective basis for an Active benefit amount.

A specific client is not being considered, so a general approach will be taken.

Term, trauma and total and permanent disability (TPD) –  and their Active equivalents of term and health events cover – is where the challenge lies.

Term insurance

The payment basis of the term insurance component of Active, while also identical to its equivalent traditional product, requires a slight variation of approach because of the structure of term within Active.

Within Active, the term insurance cover can be established in two ways:

Initial cover

Initial cover is the amount of cover that is shared with the health events (trauma/TPD) insurance within the policy.

If the first insured event to occur is the death or terminal illness of the life insured, 100 per cent of the initial cover is payable.

If, however, one or more health event payments occur first, the initial cover will be reduced by the amount paid.

There is no buy-back facility within Active, so the amount that is subsequently paid on death or terminal illness may well be less than what is required.

Additional cover 

Additional death cover can be purchased and this additional cover is not affected by payments under health events cover.

Additional cover may therefore be used if:

• The client needs death cover in excess of the initial cover, in which case additional cover would be the level of extra cover needed; and/or
• The effect of health events payments on the initial cover needs to be offset, in which case additional cover would duplicate the initial cover. The need to duplicate the death cover in this way will increase the premium commitment required.

Trauma insurance

The health events component of Active has a relatively complex set of payment triggers in that:

• Benefit payment amounts differ based on the severity of the insured events; and 
• Multiple payments can be made over the duration of the policy.

These complexities, however, do not preclude establishing an objective basis for a benefit amount recommendation.

The health event cover recommendation within Active can be made to focus on Severity A health events, as it is these events that will have the greatest financial impact on the client.

Traditionally, the initial focus of a trauma insurance recommendation is in the area of the costs associated with medical care and rehabilitations.

Generally, these costs will be severity-based and will be incurred each time a health event occurs; which appears to fit in well with the structure of Active.

A benefit amount recommendation in this area of trauma insurance cover can be arrived at by following a logical progression.

Base cover

Like most trauma insurance products, the number of insured events covered under Active is such that it would not be feasible for financial advisers to individually consider each of these insured events.

It is therefore appropriate to initially consider only those events which are most likely to occur: ie, cancer, heart attack and stroke.

In respect of the medical and rehabilitation costs associated with these conditions, research has shown that the average, gross costs (ie, prior to the impact of any medical insurance rebates) to the individual are as set out below: 

• Cancer: of the more common cancers, the most expensive on average is leukaemia at around $100,000. (Optimising Cancer Care in Australia, National Cancer Control Initiative February 2003. Access Economics – Cost of Cancer in NSW, April 2007.)
• Heart attack: on average, the equivalent costs for a heart attack is $25,000. (Australian Institute of Health and Welfare publication, Health System Costs of Cardiovascular Disease in Australia 1998-99, indexed in line with CPI to 2011.)
• Stroke: because of the higher rehabilitation component associated with a stroke, the equivalent average costs are around $125,000. (Lifetime costs of stroke subtypes in Australia, Melbourne, June 2003, indexed in line with CPI to 2011.)

Thus, if providing general financial advice in regards to the personal medical and rehabilitation costs associated with the most likely-to-occur trauma-insured events, an amount around the higher figure above might be considered appropriate.

Thus, a base cover amount of $125,000 will be assumed.

Above-average health care allowance

The base cover amount above – ie, $125,000 – is an ‘average’ amount. It may therefore be that a particular client would prefer financial access to a higher-than-average level of health care: eg, an additional $75,000.

Provision for this can be enabled simply by increasing the recommended base cover amount to that required. Any increase in this way would effectively be arbitrary, in part driven by client affordability.

Specific health events

Also, a particular client may wish to give a greater focus to specific insured health events than the likelihood of those events occurring would otherwise demand.

Examples might be that the client wants to focus on:

• Paralysis, because the client is young and very active; or
• Dementia or multiple sclerosis because the client has seen the impact this disease has had on others.

If the medical and rehabilitation costs associated with a specific condition are greater than the base amount plus any above-average health care allowance, the difference would be added to the recommendation. 

In the example below, it will be assumed that the client wishes to protect against the personal costs that may arise in the event of Alzheimer’s disease being diagnosed. An allowance of $225,000 has been made.

Health insurance rebate

The total of the above amounts, however, may be adjusted downwards by any amounts likely to be received through health insurance rebates.

It is not the place of this article to mandate a specific adjustment, bearing in mind that it is unknown what health insurance cover a particular client will have in place.

In the example below, however, a rebate amount of $50,000 will be assumed. 

Lifestyle changes

Having considered the medical and rehabilitation costs associated with the trauma insurance recommendation, this amount may need to be supplemented if the client wishes to overlay some lifestyle changes. 

Whilst medical and rehabilitation costs might be severity-based and recurring, the costs associated with so-called lifestyle changes are generally not.

For example, the following traditional lifestyle costs are neither severity-based nor do they recur:

• Debt reduction;
• Pre-fund children’s education costs;
• Pre-fund early retirement; and
• Discretionary home improvements.

On the other hand, the following traditional costs are not severity-based but may recur:

• Holiday;
• Hire home-carer or cleaner;
• Top up the 25 per cent income protection insurance shortfall; and
• Time off work.

Therefore, in the area of lifestyle changes, Active, while equally as effective as traditional trauma insurance, is not as appropriately designed as it is in the area of medical care and rehabilitation.

As the cost of each of the lifestyle items is capable of being objectively estimated, the amount needed to implement the required lifestyle changes is simply the total cost of those changes required.

In the example below, it will be assumed that the client wishes to make provision of $150,000, being the total cost of the following lifestyle changes:

• Debt reduction – $130,000, and
• An overseas holiday in Italy – $20,000.

Thus, in regards to the trauma insurance component of the Active health events recommendation, the following flow can be followed: base cover, plus above-average health care allowance, plus specific health events, less health insurance rebate, plus lifestyle changes.

TPD provision

Total permanent disability (TPD) insurance makes funds available to provide for the needs and costs that arise as a result of the total and permanent inability of the life insured to work in their own occupation or an occupation for which the life insured is reasonably suited by training, education and experience.

‘Needs’ can be defined as the financial outgoings that were previously provided for by the earnings of the life insured.

If revenue needs such as the payment of debt instalments are covered under income protection insurance, additional cover under Active is not required.

Capital needs would include:

• Debt repayment or reduction; and
• Pre-payment of school fees

If capital needs are covered under the lifestyle changes component of trauma insurance, additional cover under the TPD component is not required.

‘Costs’ can be defined as the financial outgoings that arise as a result of the life insured’s sickness or injury.

 Revenue costs would include:

• Cost of home maintenance;
• Transport to medical facilities; and
• Ongoing medical costs associated with the treatment of the sickness or injury.

Capital costs would include:

• Home and car modifications or even a new, more suitable home or car; and
• One-off medical expenses.

The ‘costs’ component is driven to a large extent by the nature and severity of the sickness or injury, which again aligns this component with the structure of Active.

However, as the nature and severity are not known when the financial advice is given, it is in fact not possible for an objective benefit amount recommendation to be arrived at. 

Bearing this in mind, a financial adviser may make a recommendation in regards to this component in the following way:

“You indicated that, were you to be permanently unable to work, you would like provision to be made for the following:

• • $150,000 to cover any possible home or car modification costs or one-off medical expenses not covered under your private health fund; and
  • $300,000, that could be invested to cover ongoing medical and home maintenance costs, for a total of $450,000.”

Affordability will play a large part in capping the upper limits of the recommendation, and within this capped range the financial adviser can split the recommended benefit amount and provide objective purposes for each part of the total.

Personal insurance

In regards to the personal insurance needs, a basis for arriving at an Active benefit amount can (using the figures noted above) be seen in Figure 1.

Business insurance

Each of the business insurance needs has some things in common:

• The financial impact is dictated by an agreed, theoretical formula;
• The financial impact does not include any medical or rehabilitation costs;
• The financial impact is linked to the total loss of the life insured to the business, not the partial loss; and
• The financial correction mechanism will be handled in line with a signed agreement.

Because benefit payments under the health events component of Active are geared to periodic, severity-based payments which can have the effect of dissipating any final payment, this component of Active is less suited to cover business insurance needs.

Summary

There are acknowledged limitations to the above approach, for example:

• The product design does not enable the one-off lifestyle provision to be separated and thus only paid once, therefore in making provision for them in the benefit amount there will be some potential for duplication of cover; and
• If payment is made under a severity level lower than A, only a portion of the lifestyle provision will be paid – for example, 80 per cent or 65 per cent, etc – which will result in an inability to effect the full lifestyle change.

Notwithstanding these limitations and the fact that some financial advisers may approach the benefit amount calculation in a completely different way, the important thing is that whatever basis is used for arriving at a recommendation, it must possess objectivity such that, if necessary, it can be actively explained and defended.

Col Fullagar is the national manager, risk insurance at RI Advice Group.