Navigating the insurance minefield

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).

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).

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.

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.

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.

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.