Chapter 15: Insurance Income Protection, Health and General

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1 Questions with Guided Answers by Sharon Taylor 2013 Reed International Books Australia Pty Limited trading as LexisNexis. Permission to download and make copies for classroom use is granted. Reproducing or distributing any material from this website for any other purpose requires written permission from the Publisher. Chapter 15: Insurance Income Protection, Health and General 1 Discuss the elements of the risk management process and the techniques that can be used to mitigate against risk. The first step in the risk management process is to determine the objectives of the client, deciding precisely what the desired outcome of a risk management plan is. This step is often overlooked, with the result that the risk management program is less effective than it could be. Obviously, before anything can be done about the risks, the individual must be aware of them. It is difficult to generalise about the risks a person is likely to face, because differences in circumstances and conditions give rise to different risks. Some risks are relatively obvious, while there are many that can be, and often are, overlooked. To reduce the possibility of overlooking important risks, individuals need to use some systematic approach to the problem of risk identification. A few of their more important tools include insurance policy checklists, risk analysis questionnaires, flowcharts, and analysis of financial statements. Once identified, the risks must be evaluated. This means measuring the potential size of the loss and the probability that it is likely to occur. The evaluation requires some ranking of priorities. Certain risks, because of the severity of the possible loss they would entail, will demand attention prior to others, and in most instances there will be a number of exposures that are equally demanding. Any exposure with the potential for a loss that would represent a financial catastrophe ranks in the same category as any other exposure equally dangerous, and there is no distinction among risks in this class. It makes little difference if bankruptcy results from a liability loss, a flood, or an uninsured fire loss. Risk management recognises two broad approaches to dealing with risks facing an individual: risk control and risk financing. Risk control focuses on minimising the risk of loss to which the client is exposed, and includes the techniques of avoidance and Financial Planning in Australia 5e Questions: Ch 15 Page 1

2 reduction. Risk financing concentrates on arranging the availability of funds to meet losses arising from those risks that remain after application of the risk-control techniques, and includes the tools of retention and transfer. Although risk control and risk financing are alternative approaches to dealing with risk, they are not mutually exclusive. Risk control and risk financing are alternatives, but they are also complementary approaches to dealing with risk. More often than not, they are used in combination. In fact, it is the process of combining the application of risk control and risk financing techniques that represents the art and science of risk management. Before turning to the consideration of selecting the techniques used to deal with risks, let us briefly review the four basic techniques subsumed under the broad approaches of risk control and risk financing: 1 avoidance; 2 reduction; 3 retention; and 4 transfer. Avoidance Risk is avoided when the individual or organisation refuses to accept a risk even temporarily. The most common approach to risk avoidance, both by individuals and by organisations, is by not engaging in a hazardous activity. You can avoid the risk of being killed when your bungee cord snaps by finding another recreational activity. A manufacturer can avoid the risk of liability associated with hazardous products by picking another product line. The prerequisite to risk avoidance is recognising the hazards in an activity so the activity can be avoided. Reduction Risk reduction includes all measures other than avoidance designed to reduce the frequency, severity, or unpredictability of losses. One of the pivotal events in the development of risk management was the recognition by some insurance buyers that actions aimed at minimising risk, if effective, could be more cost effective than obtaining insurance to indemnify the organisation against losses. This led to an increased focus on techniques that reduce the likelihood or potential severity of those losses that occur. It is common to distinguish those efforts aimed at preventing the occurrence of loss from those aimed at minimising the severity of losses that do occur, referring to them respectively as loss prevention and loss control. Prohibition against smoking in areas where flammables are present is a loss prevention measure. A sprinkler system is a loss control measure. Other methods of controlling severity include segregation or dispersion of assets and salvage efforts. Dispersion of assets will not reduce the Financial Planning in Australia 5e Questions: Ch 15 Page 2

3 number of fires or explosions that may occur, but it can limit the potential severity of the losses that do occur. Salvage operations after a loss has occurred can minimise the resulting costs of the loss. A final way of classifying risk reduction measures is by the timing of their application, which may be prior to the loss event, at the time of the event, or after the loss event. Safety inspections and drivers' training classes illustrate measures that are designed to prevent the occurrence before losses happen. Seat belts and air bags are designed to minimise the amount of damage at the time an accident occurs. Postevent loss prevention measures related to auto accidents include negotiating with injured persons for an out-of-court settlement or a stern defence in litigation. Retention When an individual or organisation does not take positive action to avoid, reduce, or transfer a risk, that risk is retained. This retention may be conscious or unconscious, and it may be voluntary or involuntary. In addition to the distinctions between conscious and unconscious retention and voluntary and involuntary retention, another distinction may be drawn between funded retention and an unfunded semiliquid form against the possible losses that are retained. The need for segregated assets to fund the retention program will depend on the firm's cash flow and the size of the losses that may result from the retained exposure. Transfer Transfer may be accomplished through contractual arrangements. The most formal transfer technique, and by far the most common, is the purchase of insurance. The purpose of risk management is to minimise the role of insurance in dealing with risk. 2 Why is it important to consider life insurance as part of a financial plan? What are the consequences of not having adequate life cover? Why is insurance important in financial planning? Life insurance provides cover against the risks of premature death and disability. To be in a position to make provision for these possible occurrences, it is necessary to know the consequences of these events should they occur. Who would be affected? To what financial extent would they be affected? And what insurance cover could be used to provide for the financial cost of such an occurrence? If life insurance was not considered as part of the financial plan and premature death or disability occurred, the plan would dissolve the assets sold to meet ongoing daily expenses. If the only income earner were to die, this could leave a family destitute and unable to meet their obligations. Beyond the immediate consequences of death, provision for the dependants must be considered. It must also be borne in mind that these needs change over time. To provide for the consequences of premature death and Financial Planning in Australia 5e Questions: Ch 15 Page 3

4 disability, it is necessary to establish: who will be affected by the premature death or disability; and the degree of dependency. To illustrate the importance of insurance in financial planning, imagine the following scenario: You are in your early 30s and married for five years, and your spouse is also in her early 30s. You have a son who is five years old. You both are doing very well: household income of $200,000, house worth $600,000 and mortgage of $450,000. You have a car financed with $25,000 in loans. You both have Registered Retirement Savings Plans (RRSPs), each worth $200,000 and a Registered Education Savings Plan (RESP) now worth $15,000. Your plan is to have at least $1.5 million each in your RRSP and fully pay for your son s education and give him some money after graduation; you estimated about $85,000 will do. You have great investments and a top investment adviser; you save aggressively on monthly bases; and can reach your goal in about 20 years. You have the perfect financial plan. Now, you find out that you have some type of cancer and cannot work for at least 18 months, if you get the treatment right away. The only way you can get the treatment quickly is if you go to the west coast to a private clinic. I will not go much further with the illustration, but what are some costs associated with this illness now? Treatment, loss of income, withdrawal from RRSP (you pay tax and loss on earnings), and travel and accommodation costs are just a few costs that come to mind. This will throw your perfect financial plan out of the window; all the great hopes you have are diminished and may not be possible anymore. The point here is that one unexpected event can cause the best financial plan, without insurance, to be worthless. If you had critical illness insurance, you would not feel the major financial impact, as you would have received a tax-free lump sum. 3 In relation to total and permanent disablement insurance, what is the difference between the definitions of own occupation and any occupation? There are two types of definitions with TPD insurance: the first definition is the more superior definition and is called own occupation TPD and is paid if it is unlikely that you can ever perform the duties of your own occupation ever again. The second definition is any occupation TPD and is paid if it is unlikely that you can ever work any occupation ever again. The own occupation definition is generally only available for specific occupations, and a financial planner should do whatever they can to ensure clients get the best definition available to them. Premiums are generally not tax deductible and therefore are not taxable. Premiums may be tax deductible only if the insurance is held inside of the superannuation environment, much like life insurance. Financial Planning in Australia 5e Questions: Ch 15 Page 4

5 4 Explain the differences between a stepped premium and a level premium and under what circumstances each would be recommended. When considering to take out a life insurance, income protection or trauma insurance policy, you have the choice of how you would like to structure your insurance premiums, either through stepped or level premiums. Stepped premiums the insurance premium is calculated on your age, meaning the younger you are the cheaper the cost. Level premiums the insurance premium is calculated on an average premium, meaning you might pay more when younger but you pay a lot less when you get older. Initially, when we see insurance premiums, we can be misled in thinking the cheaper stepped premium option is the better. But when looking deeper, level premium cover provides a greater long-term saving and in many cases can save you up to 50% of the total amount of insurance cover paid over your lifetime. 5 Trauma cover has become very popular in Australia. Describe the features of trauma cover and any limitations you believe exist in this sort of cover. Trauma cover Trauma cover pays a lump sum if you survive for 14 days after suffering from one of the specified major diseases or injuries covered, such as a heart attack, stroke, cancer or loss of limbs or sight. Trauma cover has been designed to cover medical and rehabilitation costs, to provide for your family and help with lifestyle and employment changes. Trauma cover is available in a package with life care, life care and TPD cover, TPD cover, or as a stand-alone policy. Limitations are costs and conditions excluded in policies. See the example below. Financial Planning in Australia 5e Questions: Ch 15 Page 5

6 Trauma Cover Trauma Cover pays a lump sum if you suffer from one of the specified major diseases or injuries covered such as a heart attack, stroke, cancer or blindness. It has been designed to provide a benefit to help you cover medical and rehabilitation costs, and to help with lifestyle and employment changes. Trauma Cover is a component of Total Care Plan and Life Protection. It is available either in a package with Life Care or on its own. Cover options are as follows: Trauma Cover Packaging Options Trauma Cover Trauma Cover & TPD Cover Life Care & Trauma Cover & TPD Cover Life Care & Trauma Cover Trauma Cover pays a lump sum if you meet the policy conditions and survive for 14 days. You must suffer from a specified medical condition there are 48 specified conditions covered in Trauma and ten additional conditions covered under Trauma Cover Plus Trauma Cover Conditions Heart Disorders Heart Attack Out of hospital cardiac arrest Coronary artery disease requiring by-pass surgery Coronary artery angioplasty* Coronary artery angioplasty triple vessel Repair and replacement of a heart valve Surgery of the aorta Cardiomyopathy Primary pulmonary hypertension Open heart surgery Nervous System Disorders Stroke Major Head Trauma Motor Neurone Disease Multiple Sclerosis Multiple Sclerosis of limited extent* Muscular Dystrophy Paraplegia Quadriplegia Hemiplegia Diplegia Tetraplegia Dementia and Alzheimer's Disease Coma Encephalitis Parkinson's Disease Bacterial meningitis Subacute sclerosing panencephalitis Additional Events Covered under Trauma Plus Cover Option Diabetes Complication* Carcinoma in situ of the Cervix Uteri* Carcinoma in situ of the Vulva or Perineum of limited extent* Carcinoma in situ of the Vagina* Chronic Lymphocytic Leukaemia* Hydatidiform Mole* Melanoma* Partial Blindness* Partial Loss of Hearing* Severe Osteoporosis* In addition to the core Trauma Cover benefit, other benefits and features are also available: Trauma Cover Benefits Benefit/Feature Description Trauma Benefit Pays a lump sum if a specified medical condition or medical event occurs. Partial Trauma Cover Benefit Pays a partial benefit for a range of specific conditions; for example, if you are placed on a waiting list for a major organ transplant. Severe Hardship Booster Benefit Pays a higher Trauma Cover benefit for certain medical conditions. (Not available under Life Protection Personal Statement Part A) Financial Planning in Australia 5e Questions: Ch 15 Page 6

7 Financial Planning Benefit Helps cover the cost of financial planning Advice for you or your loved ones after a Life Care, Trauma Cover or Total & Permanent Disability Cover benefit is paid. Loyalty Bonus Benefit Rewards you for keeping your cover by paying 5% more Trauma Cover benefit. Life Care Buy Back Benefit Allows Life Care to be reinstated after 12 months if it is reduced due to a Trauma Cover claim. Trauma Cover Buy Back Benefit Allows Trauma Cover to be reinstated 12 months after a full Trauma Cover claim. Applies to Trauma Cover selected on its own. Accommodation Benefit Helps cover the cost of accommodating a family member who has to be away from home to be near you if you are confined to bed and away from home. Indexation Increases your cover each year in line with inflation. Interim Accident Cover Covers you for accidents while we are processing your application. There are also optional benefits that you can choose to shape your Trauma Cover to suit your needs Trauma Cover Option Option Description Evidence of Severity Option A premium discount in return for some restrictions to Trauma Cover. Guaranteed Insurability Option Personal Events 2 Allows you to increase Life Care without further evidence on specific occasions. Guaranteed Insurability Option Business Events 2 Allows you to increase your Trauma Cover in line with your death cover without further medical evidence if you increase your business loan, if the value of a key person grows, the value of your financial interest in a business grows or if your business increases in value. Business Safe Cover Option This option is similar to Guaranteed Insurability Option (Business Events), where on application we assess you for three times your chosen amount of cover, so that you can increase your cover without any further medical evidence when the relevant business event occurs. Child Cover Option Child Cover pays a lump sum equal to the amount for which you insure your child, if your child dies or suffers from one of the 38 Child Trauma Cover conditions. Trauma Cover Plus A partial Trauma Cover Benefit will be payable for an additional 10 Trauma Conditions Financial Planning in Australia 5e Questions: Ch 15 Page 7

8 6 Discuss the features of both the multiple income and needs approaches to calculating the appropriate level of cover. The multiple approach method takes current income as the starting point and uses a multiple of that income to arrive at the amount needed. The idea is that this amount, when invested, will produce an annual income similar to the pre-death income. The gross income is used, as tax must be paid on the income generated from the invested capital. The needs approach overcomes many of the problems associated with the multiple approach by aiming to calculate a more precise amount as the sum insured. The major drawback is that the calculations are more involved.the needs approach uses three steps: 1 Calculate the amount needed for the dependants to maintain their standard of living. 2 Calculate the resources the dependants have to meet those needs. 3 The difference between those two sums is the amount for which life insurance needs to be effected. 7 Discuss the benefits of having life insurance within superannuation Insurance inside super versus outside super Deciding whether to have your insurance within superannuation or outside it can be a complex decision. All insurances can be done outside your superannuation. Only three insurances can be done inside super: life, TPD any occupation, and income protection. TPD own occupation and trauma insurance are not permitted within superannuation. There are pros and cons of personal insurance placed inside or outside superannuation. Insurance within super pros and cons: You pay premiums with pre-tax dollars, so they are cheaper. There is automatic acceptance up to certain amounts, with no need for a medical history check. However: You may not be able to access the benefits until retirement (payments are treated as superannuation moneys). Financial Planning in Australia 5e Questions: Ch 15 Page 8

9 Death benefits may be taxed, depending on to whom the benefit is paid. There is significant taxation of TPD benefits, particularly for younger people. You cannot insure for TPD own occupation. You must pay extra for insurance outside super and there may be extra taxation; however, the biggest benefit to having insurance outside super is portability. If you have insurance inside super and you change employers, you will have to apply for new insurance. A new insurer may look at your health history and you may not get it or it may cost you more. Insurance outside super will mean you can be insured no matter where you work. If you are planning on changing employers, or especially if you are working overseas, insurance outside super may be the better option. In addition: You get relatively immediate access because any benefits are paid directly to the policy owner. Life and TPD insurance are not taxed. You can insure a TPD own occupation. 8 Explain to a client why the review process is so important when it comes to giving advice on insurance. Reviewing the insurance plan You and your planner should: agree on who will monitor and evaluate whether your plan is helping you progress toward your goals; also review your risk-management plan. Insurance is an important part of the overall plan. If your planner is in charge of the process, your planner should: periodically contact you to review the progress of the insurance plan and make adjustments to the recommendations required to help you achieve your needs. This review should include: a review and evaluation of the impact of changing tax laws and economic circumstances, as well as changes in your life circumstances (eg, ill health, disability etc); a review of your life circumstances and an adjustment of the recommendations, if needed, as those circumstances change through life events, such as birth, illness, marriage, retirement, redundancies, inheritances etc. Financial Planning in Australia 5e Questions: Ch 15 Page 9