Say What Wednesdays: Insurance – how it works, what to look for, and how much you need

Welcome to Finance and Fury’s ‘Say What Wednesday’ edition, where every week we answer questions from you guys. This week the question comes from Effy;

“I am a Chinese migrant living in Melbourne.

I do not recall if your podcast has covered insurance, such as life/accidental insurances. After some online research, I noticed that the variety and content of the insurances vary geographically. I am aware that many main land Chinese purchase insurance policies in Hong Kong as it is much more attractive. What is your understanding of the Australian insurance industry and what are the must-haves for everyday Australians?

I am trying to improve my financial intelligence by upgrading my skills to increase my earning capacity and learning to use financial products (property, shares, etc) to sustain and generate more passive income. It is not easy work, I have certainly made several mistakes and I feel I need more guidance.

Can you share some of your personal experiences on how you come to where you are today?

Looking forward to hearing anything from you and learning from you.

Sincerely, Effy”

Awesome question!

Insurance – What is it?

• Simply an arrangement where a company, or the state, provides a guarantee of compensation for specified loss, illness, or death, in return for payment of a specified premium. It’s a contract that allows you to pass your liability (loss potential/risk) to a third party for a price (called a premium).

Personal (wealth) protection

• Insurance differs from country to country, including the types of covers available.
• Mainland China has been going through massive push on insurances lately. Most insurance companies are actually state/party owned (in part), with the industry still considered in its infancy stage.
• When it comes to insurance, you should look for a reputable provider regarding payout rates and levels

Investment policies – the main objective of these policies is to facilitate the growth of capital by regular or single premiums. These are common in the U.S., China, RSA, and Australia 30 years ago, and referred to as “whole of life”. They have both an insurance component and an investment component (or, ‘surrender value’).

The cash value refers to the refund you’d receive for a portion of your paid premiums, paid as a lump sum if you cancelled your policy. However, because Whole Life includes both an insurance and cash value component it has become too expensive for many customers and was thus replaced with Term Life. Whole of Life Insurance is no longer available in Australia though it was really popular until 1991 when superannuation came into existence and started replacing the cover.

Protection policies – the most common form of insurance in Australia, protection policies are designed to provide a benefit, typically a lump sum payment, in the event of a specified occurrence. Typically called ‘term insurance’ in professional circles, they have as the name suggests, a term limit to them.

• Example – Total and Permanent Disability (TPD) policy is designed to provide lump sum if you’re unable to ever work again. These typically expire between age 60-65 depending on the policy – as this is ‘retirement’ age – and the term of the policy.

Core questions when looking at insurance

What type of policy do you need? That is to say, what events would you need to cover? For example, home insurance covers a house fire. But if you get hit by a car and are unable to work for 6 months what type of cover do you need?

The other question is, how much will you need if the event were to occur?

• Depends on event type and duration of the impact
• Your financial situation
• Will you be able to ever go back to work? If not, how does this impact your future financial security

When trying to determine what types of covers you may need, consider the four common occurrences that might put you out of work or create financial stress in your life. These tend to be referred to in insurance contracts as ‘Conditions of payment’;

1. Passing away (the most obvious one) – Life Insurance covers this. A lump sum is paid to your beneficiaries.
2. Becoming disabled (permanently) – Total Permanent Disability (TPD) Insurance covers this.
   • Breaking a foot doesn’t make you permanently disabled
   • There are different types of cover definitions
     • ADL – Permanently unable to perform two of the ‘Activities of Daily Living’: Bathing and showering, Dressing and undressing, Eating and drinking, Using a toilet
     • ‘Any’ occupation – defined by likelihood to return to any form of full-time work for which you are reasonably trained. You may be injured enough to never work, even if you don’t meet the ADL definition.
     • ‘Own’ Occupation – can look at insuring your specific occupation which is typically something specialised.

3. Being injured – This is considered temporary disability. So, if you break your foot you might make you eligible here (only if it puts you out of work) – Income Protection covers this.
   • Income protection provides replacement of lost income due to illness or injury. You generally have to exhaust the waiting period (including sometimes your existing employer sick leave) and is paid up until benefit period expires.
4. Suffering from an illness – Trauma insurance.
   • Trauma Insurance is designed primarily as a lump sum to assist in covering the medical costs of a significant medical event in addition to providing a level of capital to cover lost incomes. Trauma Insurance policies can offer as little as 5 critical illness events and on average cover around 40 critical events such as cancers, heart attacks, strokes, loss of limbs and adult onset diabetes. Typically, lower levels of cover as there are fairly high costs. Designed to cover medical costs and maybe 1 to 2 years of income (if you don’t have income protection)

Do you need the funds now, or do you need them ongoing?

Each type of event will require different forms of payments due to duration of events and also, what you may need to cover.

• Now – Lump Sum Payments.
  • Life, TPD, Trauma – All based around the sum insured (the level you tell the insurance company you need). This might be a default amount if automatically established within superannuation.
• Into the future – Ongoing insurance funds to cover your future costs
  • Income protection payments are generally a monthly benefit that pays you up to 75% of your income and covers you for accidents, illnesses or major traumas.
  • It pays you up until you return to work (after your waiting period), or if you can’t return, pays up until the benefit period ends.
  • The ‘waiting period’ is the time between becoming unable to work and receiving your first income protection payment – you can generally choose a waiting period from fourteen days and two years with a shorter waiting period usually meaning a higher premium.
  • The benefit period is the period during which you receive your income protection payments. You can generally choose between a two- or five-year benefit period or up to age 70 for some occupations.

How much insurance do you need?

The goal of life insurance is to provide a measure of financial security for your family if something happens. So, consider your financial situation and the standard of living you need to insure for in each event.

1. Passing away
   • Do you have dependents?
   • Mortgage, funeral costs, education funds – any lump sum expenses
2. Becoming permanently disabled (TPD)
   • Medical bills, rehab, reno costs or costs to modify your home
   • Would your family have to relocate?
   • Will there be adequate funds for future or ongoing expenses such as daily living expenses, day-care, mortgage payments and education for kids? You’ll need something to provide an income if you can’t
3. Ongoing Income Replacement
   • If you’re considered totally and permanently disabled it would provide a benefit to you long term, or if you’re simply injured, it will provide a benefit short term until you return to work. If you pass away this insurance would not provide a benefit payment.
   • Ongoing income of up to 75% of your pre-disability income (this is taxable, but the premiums are tax deductible if paid personally)
   • Income is one of the biggest wealth building tools and the present value of all future income is huge. As an example, we’ll look at the difference in foregone earnings for an individual aged 30 on an income of $80,000 per annum, who becomes disabled. If they have a Benefit Period of 2 years, they’ll receive around $120,000 (75% of $80,000 over 2 years) … but having a Benefit Period to Age 65, the present value is worth $1,289,233.
   • How much income do you need? Can you live off 25% of your current income? Just insure that. Or, what if you work out that 75% of income isn’t enough? Or what if you pass away and the income is lost to dependents? This is where lumps sum covers come in.
4. Lump sum covers – Life or TPD Cover.
   • Work out the income you need – and additional sums to provide this
     • Invest the funds; How much would need to be invested to provide adequate funding/drawdown for dependents?
     • For example – you have an insurance payout/benefit of $1M. You have no debt so the $1M can be invested. This could generate $50k ongoing passive income without drawing down on the capital. An alternative scenario may be that your spouse needs more – $94k of income can be drawn down if it is drawn down over 20 years (capital sold for income)

The Elephant in the room – Insurance Premiums

• Nobody like paying for insurance and we try to get our premiums down as low as possible without sacrificing the level of cover

Why it is important to not be over insured

• Over insurance is having too much cover and paying too much – Insurance is not meant to be something you want to have to claim on – what factors will affect your premiums
• What other things effect premiums – they’re calculated based around a range of factors
  • The level of insurance – get the right level so you’re not over insured
  • Age – if you’re young you have a high chance to claim. Between 28-35 years = lower chance, from 40 years onwards premiums increase
  • Occupations – riskier jobs, more chance of claim, higher premiums
  • Premium structures – Stepped v Level – Increases each year with your birthday (or pay more now for smaller increases)
    • It is a question of how long covers will be in place, and how will the premium grow?
    • Takes 10-20 years to reach breakeven on premiums – even if premiums are level, we’ve seen some like MLC +15% premium increase (out of cycle increases)
  • Insurance type specific
    • IP – Wait and benefit period
    • TPD – Type of definition – ADL, Any, Own (about 30% more than ‘Any’ occupation)
  • Underwriting – loadings for health and lifestyle risk factors
• Strategies
  • Life / TPD inside super
  • IP – Can insure 75% – but how much would you need?
  • Waiting period increase on IP to 60 or 90 days if you have emergency funds

Some things to think about

1. Types of covers
   • Will you need lump sums? Death/TPD
   • Income Replacement
2. How much cover you need?
   • Lump Sums – debts, etc.
   • Ongoing – insure your income to the amount of your expenses,
3. Where it should be owned
   • Super or personal – based around tax efficiency, cashflows, and also accessibility

Thanks for the Question Effy! If anyone else has a question you’d like answered on the podcast, go to financeandfury.com.au and hit us up on the contact page.