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Determining the sum insured

Overview

The core purpose of insurance is, as accurately as possible, to put the clients back in the position they were in prior to an insured event occurring. This requires a solid grounding in the core steps of risk advising: detailed fact finding, calculating an accurate and realistic sum insured, and ensuring a reasonable basis for the final advice provided.

Although advisers should not rely on blanket numerical ‘formulae’ when calculating the sum insured for term, TPD and trauma policies, following an established ‘calculator’ in conjunction with client specific data and research, is a useful tool to determine the sum insured.

Learning objectives

After reading this article you should be able to:

> Conduct a detailed needs analysis to determine the client’s financial wants and needs should death (or disablement) occur

> Use a calculator to record the results of the needs analysis, determine a comprehensive sum insured and ensure a reasonable basis for the advice provided

> Assess the real cost of suffering a specified trauma event when determining the sum insured on a trauma policy

To give advice on the product(s) referred to in this article you must be licensed or accredited by your licensee and operating in accordance with the terms of your/their licence.

Knowledge areas

This article is relevant to the following knowledge areas:

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May 2007 Page 2 of 9

Role of insurance in a financial plan

The role of an investment adviser is to use a client’s income (net of expenses and the cost of investing), to accumulate wealth so they can achieve financial security and independence both at the present time and into the future (with consideration given to their risk profile). Many wealth creation strategies will typically require ongoing income to successfully implement, continue and complete those strategies.

There is a risk, however, that an unforeseen event may occur to disrupt the client’s ability to generate income, either temporarily or permanently, through death, illness, injury or a major medical trauma. Protecting the income is therefore a critical prerequisite for ensuring that the implementation of investment strategies can proceed as planned.

The role of the financial adviser is to objectively assess the potential impact of unforeseen events on the client’s financial position and use insurance to minimise the impact of those events. In doing so, the adviser must determine the correct sum insured under different types of insurance policies, such as term, total and permanent disability (TPD), trauma and income protection, to ensure the client is protected in unforeseen eventualities.

The danger of not having adequate insurance in place is that in an extreme situation, a family may not be able to survive financially if a primary income earner dies or is unable to continue working due to illness or injury.

How to calculate the sum insured

When addressing a client’s insurance needs, an adviser must ensure they are providing a

‘reasonable basis for advice’. Completing a detailed needs analysis, asking the probing questions in the client interview and using this to then calculate an appropriate level of cover will ensure the client is getting the advice they need.

The need to calculate an appropriate level of cover arises from the practical question: ‘What happens the day after I die or become disabled?’ A common mistaken belief is that this question can be achieved by applying a general formula or a set number (e.g. a set multiple of 15 or 20 times income for term insurance), without any additional analysis or investigation into the client’s situation - this is not the case. While general formulae can be useful in the process of deciding the benefit amount, they should not be the sole basis for the final advice.

Standard formulae involving set multiples do not take into account what the client would want or need for themselves or their dependants in the case of their death, total and permanent disability (TPD) or major medical trauma, to support their lifestyle and financial plan on an ongoing basis. Asking the client a series of questions to ascertain their needs in these situations can provide a better basis for advice than simply using a set multiple of their annual income.

After completing the detailed fact-finding and needs analysis required, advisers need to take this information and use it to decide on an appropriate benefit amount. This demands that a client-specific, structured calculation be used, which is then kept on record. This can be a somewhat daunting task and not necessarily well catered for in financial planning software. The insurance calculator provided below will assist advisers in developing their own methodology in this area.

The insurance calculator

A basic life insurance calculation sheet is included to assist advisers when determining their client’s need for cover across all products. This calculator is based around the requirements for term insurance, but can also be used for TPD, income protection and as a basis for highlighting any need for trauma.

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May 2007 Page 3 of 9

Figure 1: Terms in the calculator Immediate needs

Home mortgage/home provision outstanding debts, loans, business liabilities

If clients choose to clear these items following death/disability, then insert the total amount from the fact finder.

Taxes, CGT, income From facts gleaned from data regarding assets (and potential sale on death) make an estimate of likely CGT liabilities, if any.

Income and other taxes which may be outstanding can also be determined.

Education funding For illustrative purposes only, $7,500 is a suggested per annum cost per child. Case-specific figures should be used where available.

Emergency income Based on monthly income of the deceased, as a buffer; which allows for the claim settlement period. Replacement items/anticipated

purchases

This will not be in most fact finders – so determine this with the client in the interview. For example, if a company car is a family vehicle, does the company retain it on death of the employee? Determine whether a new car would need to be purchased to replace this. Fees: Legal, accounting, appraisal,

admin Known or estimated costs of planned disposal of assets. Final expenses: Funeral execution,

probate This will not be in most fact finders – so determine with the client in the interview. Ongoing income needs

Income – for surviving family to live on post-death

Determine post-death budget requirements, collate with other necessary data to arrive at an annual need. Apply an assumed, conservative earning rate which will assist in determining the capital sum needed to generate the income required.

Other income sources Determine any known payable amounts (e.g. pension income that may be payable to a survivor following death such as Allocated Pension income) and offset against the above income figure prior to calculating the capital sum required.

Expected return Determine a conservative rate of return acceptable to the client.

Taxation Don’t forget to calculate gross needs, pre-tax Estate assets

Personal assets Include only realistically saleable items. Note that in many superannuation funds the accumulation value is included in the death benefit shown.

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May 2007 Page 4 of 9

Life insurance Any ordinary life insurance policies. Business assets Transferable to the estate under buy/sell

arrangements. Figure 2: The insurance calculator

Immediate needs

Home mortgage/rent $

Outstanding debts $

Business liabilities (personal guarantees) $

Taxes (CGT, income) $

Education funding $

Emergency income (one month worth of income) $

Replacement items, e.g. car $

Fees: Legal, accounting $

Final expenses: Funeral, probate $

Subtotal (A) $

Ongoing income needs

Required income following the insured event $

Less non-discretionary income/pension $

Subtotal $

Converted to a capital sum based on an assumed earning rate of

5% (B) $

Estate assets

Personal assets (super, shares, property, investments) $

Life insurance (current cover) $

Business assets (secured by funded arrangements) $

Sub-total (C) $

Cover required

Immediate needs (A) $

Ongoing Income needs (B) $

Equals total estate required $

Less available estate assets (C) $

Equals the estate shortfall $

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May 2007 Page 5 of 9

Sum insured tips and traps

There are, of course, varying needs for each client that must be considered when conducting the needs analysis and entering amounts into calculators such as the one provided above. Some tips, traps and sample questions relating to circumstances that advisers may face are provided below:

> Allow for any accrued/excess medical costs which are not fully covered by private health insurance cover.

> Allow for immediate cash costs – e.g. day-to-day living expenses, funeral expenses, legal fees, probate costs and outstanding medical expenses, etc.

> If there is a personal guarantee in place, the institution must be advised of the death of the insured. The guarantee will most likely be ‘called in’, so it’s better that this is funded by an insurance policy.

> Allow for approximate capital gains tax on any mortgage discharged on, and the sale of an investment property.

> Remember to calculate gross income needs.

> Remember debt relief – mortgage, credit cards and personal loans. Other items simply missed are current or imminent tax liabilities, car lease payouts, or director’s loans on account.

> Include any child support for minor children from previous marriages in income needs.

> Check for any ongoing special needs included in the current income expenses, such as a disabled child requiring lifetime care or aged parents requiring support.

> Discussing, and deciding upon, an assumed rate of return on the capital sum is one of the most challenging tasks. The more conservative the assumption, the higher the insured amount; but it is important to be realistic.

> Does the client have assets they are prepared to use as ‘self insurance’? The value of these assets would reduce the sum insured that is determined by the rest of the needs analysis.

> Life policies held through superannuation will need to be determined by the trustee, which will mean delay. Similarly, life policies over $50,000 owned by the insured (or jointly) must go through probate, also causing a delay. It is worth considering a separate $50,000 policy held solely by the spouse, ensuring the proceeds are paid quickly and directly to the spouse which will provide instant short term funds where they are needed. The only delay in

processing this claim would be if there was a delay producing the death certificate.

Calculating trauma lump sums

Trauma insurance is perhaps one of the more underutilised insurance products. This could be because advisers may not be asking clients the right questions in order to establish why the client might need trauma insurance as well as income protection, TPD and term insurance.

The purpose of trauma insurance is twofold:

> to provide a lump sum, thus enabling a client to gain access to the best possible medical care and rehabilitation, and

to provide the funds to enable a change in lifestyle if that is desired.

The statistical likelihood and impact of events covered by a trauma insurance policy are much harder to quantify than for term or TPD, where there is a more absolute result. This is because trauma insurance covers between 40 and 50 insured events, some of which have a significant number of sub-events. For instance, while cancer is an insured event, there are 300 different types of cancers listed as sub-events. With a multitude of insured events, each with a different statistical

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May 2007 Page 6 of 9

likelihood and impact, it can become very difficult to work out the appropriate sum insured for the client.

In calculating this amount, it is logical to focus on the insured events most likely to happen rather than try to determine all the possible eventualities. With trauma insurance, the three most likely insured events to occur are:

> cancer

> heart attack, and

> stroke,

irrespective of family history.

The next step is to understand the lifetime cost of having one of these insured events occur, including the cost of the initial consultation and diagnosis, together with the ongoing treatment required to bring the situation to a point of stabilisation.

Lifetime costs of medical trauma

According to research by Genesys Wealth Advisers, the cost of an average heart attack is between $10,000 and $15,000, while the average lifetime cost of suffering a stroke is around $50,000. If an adviser is recommending a policy to cover the medical and rehabilitation costs of having a stroke or heart attack, a reasonable recommendation could be a sum insured of $50,000, as this is the higher of the two costs.

Determining the lifetime cost of having cancer is far more complex because there are more than 300 different types of cancer. Genesys analysed the most common types of cancer to occur: for men this was found to be prostate cancer, colorectal, melanoma and lung cancer; and for women, it was breast cancer, colorectal, melanoma and lung cancer. Together, these account for around 60-65% of all incidences of cancer. Lymphoma and leukaemia were also included in the research as the next most likely cancers to occur.

The lifetime costs for these cancers varied considerably, according to Genesys’ research,

depending on whether there are robust early detection procedures in place. The research revealed that the average lifetime cost of a melanoma was around $3,500, while breast, prostate and lung cancers were around $15,000. The average lifetime cost of colorectal cancer was around $20,000, lymphoma was around $30,000 and leukaemia was most expensive, costing on average around $60,000.

This data can then provide advisers with a more logical basis for their recommendations. For example, a base amount of $60,000 of cover on a trauma policy could be explained to the client as providing cover for the average lifetime costs for cancer, heart attack and stroke, if any one of these traumatic events were to occur.

Other interesting findings from the research are that in the case of paraplegia and quadriplegia, the lifetime costs are between $5 and $10 million – which is outside the scope of trauma insurance. A sum insured of $2 million, however, would cover the costs of all insured events covered by trauma insurance (apart from quadriplegia and paraplegia). This research (and any other research of a similar nature) effectively provides a numeric basis for recommendations in respect of medical expenses and ongoing care and rehabilitation.

Dementia on the increase

With an ageing population, dementia is a medical condition with an increasing likelihood of occurring to clients. Compared with trauma events such as heart attack, stroke or cancer, dementia carries a relatively low upfront cost, but this increases markedly as the condition progresses.

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May 2007 Page 7 of 9

During the first half of the average dementia period, which is 10 - 12 years, a person with dementia will usually be able to stay at home and access home care services, but for the second half of this period, the person will almost inevitably have to move into institutional care. While government services are available, having this illness covered by an insurance policy offers the sufferer and their family increased choices regarding their care options.

The lifetime cost of dementia, according to Genesys’ research, is around $25,000 per year – so for an average of six years in institutional care, it would cost around $150,000. However, many aged care facilities also require payment of an accommodation bond or charge, which can range considerably, from approximately $100,000 to over $400,000. While it is recommended that the adviser make some enquiries to get a better picture of what may be required in terms of a bond in the client’s local area, this upfront payment could in fact bring the total benefit amount required to comprehensively cover costs associated with dementia to around $500,000.

Using trauma to fund income

Covering change of lifestyle

The other purpose of trauma insurance is to fund a change of lifestyle for the client if desired. This can mean different things for different people, but can include retiring debt such as paying off mortgages, taking a recuperative holiday, pre-funding retirement, pre-funding children’s education, or providing a lump sum to invest in order to provide 25% of income to top up the 75% provided by an income protection policy.

Once the adviser has determined the client’s needs and desires in this regard, the amount of cover required is easier to calculate. This also provides the adviser with tangible examples regarding what will have to be sacrificed if the client cannot afford the recommended sum insured. For example, if after a recommendation is made, the client can only afford a certain premium, which would provide a benefit amount of say $100,000 (which is less than the recommended amount), the explanation that could be provided to the client is that if an insured event did occur, that amount would probably cover average costs relating to a heart attack, stroke or cancer, with some money left over for a holiday perhaps, but there would be no opportunity for debt reduction or to top up income protection products. By providing this explanation to the client, if the insured event occurs and the claim payment is made, the reasonable expectations of the client are met and the chance of any dispute or the advice being challenged are considerably minimised. Another approach to securing an income

An alternative approach to calculating the appropriate sum insured for trauma insurance is to first secure 100% of the client’s income. While income protection insurance can provide up to 75% of the income, some clients may express a desire to ensure they have access to the full amount of their income on an ongoing basis if they become disabled.

Trauma insurance can then be used in conjunction with income protection insurance, firstly to make up the 25% shortfall through the investment of a lump sum, with retiring debt (particularly non-deductible debt) or providing income for capital and medical expenses being secondary considerations.

For example, if a client wants to secure 100% of their income and pay off their mortgage if they suffer a medical trauma, the sum insured could cover these two requirements. While there is no provision for medical expenses in the benefit amount, income earmarked for regular mortgage payments could then be used to pay these costs.

Providing a better basis for advice

Each client will have unique circumstances so each analysis will be different. However, there needs to be a logical basis for any recommendation so that if a challenge is ever mounted, the

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May 2007 Page 8 of 9

adviser is able to reasonably justify the advice. Using calculators, such as the one provided in this article, is an effective method. Check with your dealer group for their requirements and guidance in this area.

In the case of insurance, advisers should be able to justify recommendations such as the amount of insurance cover by explaining the fundamental logic underpinning those recommendations. While this is relatively simple with term and income protection insurance, because of the large amount of variation on insured events covered by trauma insurance, it may be a more difficult task to provide adequate justification.

According to research by Genesys Wealth Advisers, advisers have a range of methods available to calculate the appropriate benefit amount for a client taking out a trauma policy. The lack of a logical approach to these calculations represents a significant area of exposure for advisers.

By using statistical information about the likelihood of certain events occurring thus enabling informed decisions about benefit amounts, as well as being able to demonstrate an understanding of the client’s desired outcomes and expectations, the safety factor for the adviser is considerably improved.

Using the client’s needs and desires as a starting point, determining which insurance products should be employed to meet these needs, and using tools to effectively calculate the final benefit amount, provides a better basis for advice than relying only on predetermined formulae.

Practical considerations

How do other life insurance policy ownership options impact upon the payment of benefits upon death?

> Where a policy is owned by the life insured, i.e. self-owned, unless they have nominated a beneficiary the funds will be paid into their estate and distributed as per the life insured’s Will.

> If the policy proceeds are paid into the estate it is possible the Will may be challenged and the funds will be received by the intended beneficiary.

> When the funds are paid into the estate, the amount may be channelled into a trust which will avoid potential loss of funds to creditors or in accordance with a family law dispute.

> If a beneficiary is nominated, the policy proceeds will be paid directly to that person and the amount bypasses the estate, therefore challenges are not possible and there will be no delays due to probate.

> Policy proceeds are usually received tax-free regardless of whether the beneficiary is a dependant or non-dependant.

> Where the policy owner is not the life insured, the policy proceeds are paid directly to the policy owner, bypassing the estate. This also means the payment cannot be challenged and there will be no delays due to probate. It also means that the ability to channel the proceeds into a testamentary trust have been lost.

> The policy owner (other than the life insured) may nominate a beneficiary, meaning the proceeds could be paid to a person not of the life insured’s choosing.

Why is it important for an adviser not to limit their risk recommendations based on a client’s budget or attitude towards insurance?

> As part of the fact-finding process, an adviser may have determined that the client’s budget does not allow for high levels of insurance. The client may think they already have adequate insurance or resistance towards buying life insurance.

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May 2007 Page 9 of 9

> Despite this, the adviser should not necessarily limit risk recommendations to suit the client’s budget, attitudes or beliefs. An adviser should always, as far as possible, undertake a thorough analysis of the client’s risk exposure and make comprehensive

recommendations.

> The client may not accept all aspects of the recommendation due to their perception of affordability, attitudes or beliefs. Clients must be left to make their own decision to

downgrade the recommendation for any of these reasons, regardless of whether it is in their best interests to do so.

> The adviser’s full recommendation should be recorded in writing and the client’s ultimate decision also recorded. This will ensure there is a documented trail of the decision-making process that led to the insurance cover purchased.

> If the client passes away or becomes disabled and does not buy the recommended

insurance (resulting in them being underinsured), the adviser cannot be held responsible for providing inadequate or inappropriate recommendations.

> If the client declines to discuss certain areas of insurance claiming they already have cover or it is not required, this should also be recorded for the same reasons.

> Files notes can be an important tool in this situation to record what the client said, along with other points such as their demeanour. In the event of a dispute, this will be supporting evidence of the facts of the situation and the recommendations made by the adviser.

For advisers who do not write risk insurance themselves they should, at the very least, discuss the applicable areas with the client and refer them to someone who specialises in this area.

Acknowledgement & thanks

We thank the following people for their contribution to this article:

> Col Fullagar, Risk Manager, Genesys Wealth Advisers

> Sue Laing, Laing Advisory

> Chris Unwin, Director, Training and Consultant Services

DISCLAIMER

This document was prepared by and for Kaplan Education Pty Limited ABN 54 089 002 371. It contains information of a general nature only and is not intended to be used as advice on specific issues. Opinions expressed are subject to change. The information contained in this document is gathered from sources deemed reliable, and we have taken every care in preparing the document. We do not guarantee the document’s accuracy or completeness and Kaplan Education Pty Limited disclaims responsibility for any errors or omissions. Information contained in this document may not be used or reproduced without the written consent of Kaplan Education Pty Limited.

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