Navigating the insurance minefield

Why should you consider each type of insurance and what do you need in a good policy? Liam Shorte and Richard Livingston explain.

Key Points

  • Why you might want income protection, life, TPD or trauma insurance
  • The core policy features that you can't do without
  • Benefits to holding insurance through super

Insurance policies come in all shapes and sizes and can offer many different features, benefits and prices. They can be scaled back to be low cost or scaled up to offer more comprehensive cover, so it’s vital to shop carefully and read the policy documents – especially the exclusions.

A fundamental requirement of any policy is that it meet your needs; don't sign on the dotted line until it does. Whilst we would recommend talking to an adviser to be certain that you understand the coverage and the long-term costs, this article (and the series to follow) is intended to guide you on what to look for if you go it alone.

So how do you compare one cover against another and choose a decent policy?

You need to focus on the features of each policy. For most types of insurance, there are some essential (core) benefits, which should be non-negotiable, some benefits that are nice to have and others that add the bells and whistles. In this article we will outline the  ‘core’ features for each type of cover. In a series of articles to follow, we’ll cover some of the particular issues and bells and whistles specific to each type of insurance.

Let’s turn first to income protection.

Income Protection (IP)

When you ask someone what insurance policies they have, the most common answers are home and motor insurance. Why? Because the bank providing your mortgage insists on the former and the latter is often compulsory.  In any event, we’ve become conditioned to taking them out.

But it is your ability to work and earn an income that is your main asset (your human capital) and which allows you to own and maintain those other assets. Without an income, it would be hard for many of us to keep our house and cars while still providing for the other living expenses of our families.

The prospect of long-term disability, causing inability to work, is so frightening that many people simply choose to put it in the ‘too hard basket’. It’s human nature to hope that, ‘nothing will happen to me’ but relying on hope to protect your future earning power is, for some, not going to stand up to the test of reality. Instead, you should consider a decent income protection (IP) or salary continuance policy that provides enough replacement income to enable you and your family to continue your current lifestyle, or maintain a basic one, if you can no longer work.

Note there’s a personal choice to be made here. Some people won’t want their current living standards affected whilst others will accept much lower living standards in the event of the unexpected and are simply looking to be able to pay the bills. The trade-off is lower premiums.

In Table 1 we’ve set out the core features of an IP policy and the standard of features a good one should provide. A good policy will be very clear about what is covered and you should be careful of those that sound good but are relatively cheap. These often have a sting in the tail with ‘pre-existing illness’ or ‘injury exclusions’ that are so broad the policy becomes useless.

The duties-based definition is the industry standard and works best for PAYG employees. The criteria used are based on your ability to perform the normal duties of your occupation. Once this criteria is met, the partial disability payment is based upon an income-based formula:
(Pre-disability income – post-disability income) / (pre-disability income x monthly benefit).

Core features What will a good policy offer?
Table 1: The core features of a good income protection (IP) policy
‘Own occupation’ vs ‘any occupation’  ‘Own occupation’ cover option.
With ‘own occupation’, the policy pays out if you are unable to do your own job. With ‘any occupation’ the policy will only pay out if you can meet a stricter definition, meaning you cannot continue any form of work for which you could reasonably be expected to do because of your education, training and experience. Insurance companies group occupations into classes based on the risk of being unable to work. If you are in riskier occupations some insurers may only offer you a less generous definition of ‘any occupation’ disability. In fact there are some occupations where there are very few providers who will offer you cover at all. In coming articles we will discuss options for those who are in difficult to insure occupations or are struggling to get approved. Sometimes it’s a matter of knowing which insurer to go to or using a specialist broker.
Three-tier disability definition for the best claims outcome Three pay-out scenarios (a valid claim can be made under any one)
Because there are such a wide range of disabilities you need cover that offers a ‘three-tier’ disability definition, which gives you more flexibility and the best possible outcome at claim time. Duties-based definition
The duties-based definition is the industry standard and works best for PAYG employees, The criteria used are based on your ability to perform the normal duties of your occupation. Once this criteria is met, the partial disability payment is based upon an income-based formula:

(Pre-disability income – post-disability income) / (pre-disability income x monthly benefit).
  Hours-based definition
The criteria used are based upon the number of hours you can spend at your place of employment. Many definitions include a ‘10-hour clause’ that will allow you to return to work for up to 10 hours and still receive a full total disability benefit. Works best for self-employed individuals who may have an inconsistent earnings pattern, where income may be received later for a job that was performed prior to the disability.
Income-based definition
This definition is often important to self-employed individuals who may be performing some administrative tasks, but are unable to perform more strenuous physical tasks associated with their occupation due to illness or injury, and thus are notearning an income. Under this definition, regardless of how many hours the client works or how many duties they can perform, as long as they are still suffering an injury or illness and there has been a reduction in their income, then they are entitled to a benefit. You are often allowed to earn up to 20% of your pre-disability income while on full benefit.
Stepped vs level premium rates   The choice between stepped and level
Level premiums are premiums agreed when you start the policy and will apply throughout the term of the policy without review (unless you change the term of the policy or the benefits such as increasing cover annually using indexing). Stepped premiums are based on age and increase dramatically over your working life. Stepped premiums could be suitable in some circumstances (such as cover for a limited time period when you are managing a large loan) but for those planning on holding a policy over the long term, level is usually the best option. A quote will typically include a comparison of stepped and level premiums over 10-20 years and you can see the breakeven point to decide your preference.
Agreed value vs indemnity  A choice between agreed value and indemnity
Agreed value is where you establish the benefit amount at the outset of the policy. In order to establish the amount of benefit your policy will pay, you need to provide evidence of earnings and any other sources of income up front. An indemnity policy will only pay out based on your earnings immediately before your claim.  A good policy will allow the choice on when the financial underwriting can be done – either when you take out the plan or when you make a claim. If for any reason you feel you may make a career change that would result in lower earnings (for instance, accountant to farmer) then it may be wiser to lock in the agreed cover now when you can show regular income rather than hope that you have not had a bad year before a claim on an indemnity based policy. However if you are pursuing a steady career then indemnity cover with indexation is likely to be sufficient.
Waiver of premium Automatic inclusion
Ensures that if you have a claim and are unable to work due to illness or disability your insurance premiums are waived and cover continues without you having to fund the premiums. Waiver of premium should be included automatically, or at least be an option. 
Benefit flexibility The ability to increase or decrease the benefit
The option to increase or decrease the amount of the benefit if your circumstances change with minimal additional paperwork. You should be allowed to both increase and decrease the benefit amount. If you increase the benefit, you may have to provide additional medical evidence but a good policy will allow some standard ‘hassle free’ increases for life events such as taking on a new mortgage, marriage or having a child without the need for a new underwriting process.
Indexation Option to index
The ability to have your cover (benefit amount) increase each year in line with an index (such as the consumer price index) or a fixed percentage, so your benefit maintains its buying power as time passes. This reduces the effects of inflation on your cover amount. A good policy will allow you to decline the indexation for a number of years but still retain the option to accept it in following years. However some will only let you decline the option once and then never offer it again.
Exclusions and restrictions: Options to avoid exclusions/restrictions
A policy should clearly state what is excluded and what restrictions are on the cover offered. This will enable you to see what is and is not covered under the plan as well as enabling you to compare alternatives. A good policy will offer an option to provide further details or to undergo a medical examination or tests to remove exclusions, loading or restrictions. Some insurers will offer to review your exclusions in 18-24 months and if you do receive a loading or exclusion you should ask the circumstances under which they would be removed.

It’s also crucial to choose a policy to suit your occupation and circumstances. ‘Own occupation’ cover may be essential for a mechanic or plumber who dreads the idea of having to take a desk job, but ‘any occupation’ cover may be sufficient for an office administrator. Circumstances can change, so you want a policy that can be flexible and that is updated to suit your needs as you progress through your career and family life cycle. Some insurers now offer guaranteed upgrades where their existing policies are automatically upgraded for new additions as the insurance market develops (so you avoid being left with an inferior policy).

Life Insurance

Life insurance protects the future lifestyle of people that are financially dependent on you. If your spouse and children would face financial hardship if you died, life insurance should be a priority. Think about how much your family would need for living expenses each year in the event of your early departure from this world (and the number of years before they can be self sufficient), and purchase enough cover for them to meet those expenses. Factor in the cost of paying off any home mortgage, education costs, clearing credit cards, personal loans and funeral costs, too, as the unexpected items all add up. As with IP, there's a personal choice to be made here. Some people will want the mortgage, for instance, paid off in full, whilst others will just want it paid down to a manageable level.

To calculate your insurance needs you can try using one of the online calculators provided by the likes of OnePath and AMP. Alternatively, you can try the new purpose-built site from the Financial Services Council: Lifewise – Love it. Protect it. Most of these calculators work on the basis of giving your dependents enough to pay off your current debts and cover funeral costs, with enough left over to cover your family’s living expenses until the youngest is over 18 or 21 (so the spouse is not forced back to work).

Policy type How it works Pros and cons Best for
Table 2: Main types of life insurance
Term insurance with fixed or indexed level of cover Your policy is renewed annually and lasts for a set number of years usually to age 75, 70 or nowadays 99 – it pays out if you die during that term. Simple but more expensive than decreasing cover.  Most people with dependants and those with a mortgage, living expenses or debts that they may take many years to reduce or may in fact increase over time.
Decreasing term insurance where the cover decreases as you age (many industry and employer super funds include this cover) Your policy lasts until retirement and it pays out if you die during that term. But for each year that goes by, the benefit payable decreases. Very affordable but less cover as you age. Those with decreasing debts or mortgage whose dependents can manage other expenses on their own.

Table 2 identifies the main types of life insurance policy you’re likely to encounter. The core features required in a good life policy are similar to an IP policy and include:

  • Choice between stepped and level premiums
     
  • Indexation (ability to increase cover to keep step with inflation)
     
  • Benefit flexibility (ability to increase cover when needed, such as for a new mortgage or a new baby)

A feature specific to life insurance is a ‘terminal Illness payment’. This allows you to access the proceeds if diagnosed with a life expectancy of less than 12 months, providing funds to make preparation for your family’s needs or to pay for expensive alternative treatments.

Life insurance inside super Life insurance outside super
Table 3: Life cover inside and outside super
If you take the cover via your superannuation policy or written under a superannuation trust then the insurance is tax deductible to the super fund (reducing the after-tax cost). If the proceeds are meant for anyone other than superannuation dependants then the tax on benefits may be prohibitive unless the cover is grossed up to compensate for the tax payable. Life Insurance is not tax deductible in your own name but the proceeds are in most cases tax free to the beneficiary.
You may be able to salary sacrifice to pay for the cover thereby reducing the after-tax cost of the cover by paying for it with pre-tax dollars. Must be paid in after-tax dollars.
Historically only a choice of stepped premiums via superannuation, but now there are linked polices that can be set up on a level premium basis and paid via the superannuation account of the insured. A choice between level premiums and stepped premiums. For those planning to hold a policy long term then level is usually the best option.

A key question with life insurance is whether to take the cover inside or outside of superannuation. Table 3 highlights some of the key considerations, but the two main reasons why insurance is often held through a superannuation fund are:

  1. Cash flow. Having premiums paid from your superannuation account means you don’t have to fund them from your personal after-tax cash flow. Even if you’re making contributions to cover the premiums (more below) they can often be deducted from your pre-tax pay.
     
  2. Tax effectiveness.In order for you to maintain your superannuation fund balance (but still make insurance premium payments) you can increase your contributions to the fund via salary sacrifice or self-employed contributions. Because these contributions are taken from your pre-tax pay, it lowers the after-tax cost. In effect, it's a way of getting the Government to pay for some of your insurance premium. For example, let's assume that your annual insurance premium is $2,500. If you are on the 38.5% marginal tax rate, and own this insurance policy in your own name, you will have to pay the premium using after-tax income, so you’d need to earn $4,065 pre-tax to pay for it. Instead, by holding the cover through your super fund you could make a pre-tax contribution of $2,500 to cover the premium (which is deductible to the super fund, cancelling out the 15% contributions tax).

Advantage for SMSFs

In addition to the advantages noted above, there is an additional benefit to holding insurance through a SMSF. An SMSF has the ability to claim a once-off tax deduction not practically available in other types of superannuation funds. It is called the Future Service Benefits Deduction, which is available by applying a special formula in the year that a death or disability benefit is paid from the fund holding insurance on a member’s life. This tax deduction (which we’ll cover in more detail in a future article) can produce some significant tax benefits for the SMSF and its members.

Total & Permanent Disability  (TPD)

Due to medical advances and our high standard of healthcare, it’s more likely than ever you will survive a severe illness or injury. But this may not be a good outcome for your family’s finances.

TPD insurance is designed to be your financial back-up plan, as it helps you modify your lifestyle and gives you options if you're left without the ability to work. It provides a one-off payment that can help you:

  1. cover the cost of forced lifestyle changes and modifications to your home and vehicle;
     
  2. cover the cost of long-term care, second opinions or medical treatment expenses;
     
  3. reduce any debts including your mortgage; and
     
  4. fund any shortfall in ongoing family income not covered by income protection

The essential features of good TPD insurance cover are set out in Table 4. We’ll deal with other ancillary benefits that would be desirable in a policy in following articles but for now we’ll just mention that many TPD covers now offer some payments for partial disability.

Core features What will a good policy offer?
Table 4: The core features of a good TPD insurance policy
‘Own occupation’ vs ‘any occupation’  ‘Own occupation’ linked cover option.
With own occupation’ the policy pays out if you are unable to do your own job. With ‘any occupation’ the policy will only payout if you can meet a stricter definition, meaning you cannot continue any form of work for which you could reasonably be expected to do because of your education, training and experience. As with life cover, one of the main options is to hold the cover inside or outside superannuation. The government has now made it less attractive to hold the cover through super as you will only be allowed a tax deduction for the ‘any occupation’ definition within superannuation. Insurers have reacted by developing hybrid policies that will offer ‘any occupation’ under the superannuation policy with a linked non-superannuation policy covering the more extensive ‘own occupation’ definition that only pays out if the any occupation cover is not relevant.
Stepped vs level premiums  The choice between stepped and level
Level premiums are premiums agreed when you start the policy that apply throughout the term of the policy without review (unless you change the term of the policy or the benefits such as increasing cover annually using indexing). Stepped premiums are based on age and increase dramatically over your working life. As with life insurance, stepped premiums could be suitable in some circumstances – for instance, nearing retirement or where you have a large loan that will be repaid in a few years – but for those planning on holding a policy long term then level is usually the best option.
Waiver of premium Automatic inclusion
Ensures that if you have a claim and are deemed to have a partial or total permanent disability your insurance premiums are waived and cover continues without you having to fund the premiums. Waiver of premium should be included automatically, or at least be an option. This is essential to allow you to continue to afford any connected life or other insurances that may be essential for family protection going forward.
Benefit flexibility The ability to increase or decrease the benefit
The option to increase or decrease the amount of the benefit if your circumstances change with minimal additional paperwork. You should be allowed to both increase and decrease the benefit amount. If you increase the benefit, you may have to provide additional medical evidence but a good policy will allow some standard ‘hassle free’ increases for life events such as taking on a new mortgage, marriage or having a child without the need for a new underwriting process.
Indexation  Option to index
The ability to have your cover (benefit amount) increase each year in line with an index (such as the consumer price index) or a fixed percentage, so your benefit maintains its buying power as time passes. This reduces the effects of inflation on your cover amount. A good policy will allow you to decline the indexation for a number of years but still retain the option to accept it in following years. However some will only let you decline the option once and then never offer it again
Exclusions and restrictions Option to avoid exclusions/restrictions
A policy should clearly state what is excluded and what restrictions are on the cover offered. This will enable you to see what is and is not covered under the plan as well as enabling you to compare alternatives A good policy will offer an option to provide further details or to undergo a medical examination or tests to remove exclusions, loading or restrictions. 

Trauma/critical illness insurance

‘Trauma’ insurance (also called ‘critical illness’ insurance) policies cover many health conditions and can vary in the cover they offer. Trauma is the policy on which you are most likely to claim but the premiums aren’t tax deductible. This makes them appear very expensive until you consider the statistics:

  • Nearly 80,000 new cases of cancer are diagnosed each year, which equates to an average risk of one in three men, and one in four women, being directly affected by cancer
     
  • One in two men and one in three women will develop coronary heart disease in their life
     
  • Cardiovascular Disease (CVD) claims a life in Australia every 10 minutes
     
  • One out of every five Australians will experience some form of mental illness each year. Three out of every ten of these will be seriously affected.

Table 5 sets out the essential features of a good trauma insurance policy. Trauma cover is a very personal matter, since many people have a different reaction when faced with cancer, stroke or heart disease etc. Some want money to cover any therapy available worldwide, others want just enough to manage say $50,000-$100,000 extra medical costs and then three times the standard 25% shortfall on their IP policy, to ensure the family’s lifestyle is fully maintained for at least 3 years.

Core features What will a good policy offer?
Table 5: The core features of a good trauma insurance policy
Critical illnesses covered Cover for the key illnesses
Any policy should cover you for at least the main areas of concern: cancer, heart attack, stroke, and coronary artery bypass (the ‘big 4’) as well as for multiple sclerosis, and benign brain tumour, because these are the conditions which give rise to most claims. Cover for the illnesses mentioned, plus the numerous other 40 critical illness conditions usually covered by Australian policies. Bear in mind, 85% of claims are for the big 4.
Terminal illness A terminal illness payout at any time during the term of the policy
If you are diagnosed with a terminal illness, which means your life expectancy is no greater than 12 months, you want a policy that will pay out as soon as possible. Terminal illnesses diagnosed within the last few months of a policy (can be as much as 18 months) may not be covered.
Total and permanent disability A payout if you cannot do your own occupation
You want a policy that pays out if you are totally and permanently disabled, regardless of the illness you are suffering from. Others might only pay out if you couldn’t do a suited job or if you fail an ‘activities of daily living’ (ADL) test.
Stepped vs level premiums  The choice between stepped and level 
Level premiums are premiums agreed when you start the policy and will apply throughout the term of the policy without review (unless you change the term of the policy or the benefits such as increasing cover annually using indexing). Stepped premiums are based on age and increase dramatically over your working life. As with life and TPD, a good policy should provide a choice between level premiums and stepped premiums. Stepped premiums can be suitable in some circumstances but for those planning to hold a policy long term then level is usually the best option. The earlier you can take out a policy the lower the level premiums you lock in but if you look at taking a policy out at 45 and plan to retire at 55 you will find that it is hard to break even paying level premiums (it often takes about 10-12 years to reach the breakeven point). But if you plan on holding the policy longer, the savings are very high because the rises in stepped premiums as you age can be 10-15% a year compounded.

What type of insurance do you need?

These are the main insurance options, but it’s important to remember that many people won’t need, or want, them all. If, for instance, you’re a self-funded retiree, you might only want some TPD and trauma insurance to guard against an accident or illness that causes a big jump in your cost-of-living (although some still want life cover). But if you’ve got a job, a large mortgage and a young family, you might want the lot.

In future articles we’ll take a more detailed look at each type of policy, the bells and whistles and the pitfalls, to help you make an informed choice.

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