Level of cover: How much is enough? Part 2: TPD and trauma

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1 Level of cover: How much is enough? Part 2: TPD and trauma 10 December 2010 In the second part of this strategy series, we continue the discussion on appropriate levels of personal insurance cover, specifically for Total and Permanent Disability (TPD) and trauma cover. TPD cover The calculation of TPD cover should follow similar methodology to that of calculating term life cover, with some major differences. Term life is the easiest cover to obtain from an underwriting perspective, followed by trauma cover, then income protection and finally TPD cover. The main difference between term life and TPD is that the latter is a living benefit and therefore its interaction with income protection is paramount in establishing the level of cover. As we know, income protection generally ceases at age 65, with the exception of some cover provided by insurers that can extend this term to age 70 and beyond (with major restrictions). TPD cover can usually extend up to age 80, but generally is restricted to a loss of independent existence (activities of daily living) definition after the age of 65. Therefore, the level of TPD cover depends on three income protection questions: home duties) or working part-time, or can only get a reduced income protection benefit period, such as five years, the level of TPD cover must compensate for this shortfall. In this regard, the recommended TPD level of cover may indeed be higher than the level of cover recommended in the event of death. This has become possible since the relatively recent introduction of stand-alone TPD. Previously, there was no option to provide TPD cover that was higher than the term life component, as TPD was only available as a rider to a term life policy. If there is no income protection whatsoever, an appropriate level of TPD cover would not only need to cover capital items such as repayment of debt, education funding and medical/lifestyle costs, but also provide for the care of dependent children and possibly around the clock care for the life insured. Repayment of debt The approach is similar to that of death cover. It is conceivable to repay all non-deductible debt, in particular the balance of an outstanding mortgage. This is particularly so if the insured does not have income protection. It may be prudent to cover only 50 per cent of the debt for a non-income producing spouse or a partner who is on a lower income. 1. Is there existing income protection cover (or is it being recommended)? 2. What is the level of cover (i.e. monthly benefit)? 3. How long is the benefit period (two years, five years, to age 60 or age 65)? In the situation where there is existing income protection with a monthly benefit of 75 per cent of the insured s income and a benefit period up to age 65, the required income component of a TPD calculation will generally be limited to 25 per cent of the client s current income being the gap not covered by income protection. If there is no income protection, because the prospective insured is not working in a defined occupation (performing Contents TPD cover 1 Emergency funds 2 Homemaker TPD 3 Trauma cover 4 Debt repayment 4 Summary 5

2 THE STRATEGY SERIES 2 Medical and lifestyle costs As a general rule, the greater of $50,000 or 100 per cent of the major earner s annual income is a reasonable amount for this purpose. However, it is important to discuss this with the client. Medicare and private health insurance will never totally cover these costs. It is worth discussing with the client whether it is reasonable for a family living in a three-storey home to relocate to a single-level residence. Lifestyle costs would include wheelchair ramps and household adjustments, such as bathroom modifications. If the family lives in a two-storey house, the requirement for the lifestyle costs could easily be between $100,000 and $200,000. Recovery income If the client chooses to extinguish debt, this may be zero. These tend to be longer term expenses in addition to the lump sum generated for medical/lifestyle costs. A reasonable amount for this would be 50 per cent of the major earner s annual income. Emergency funds As for recovery income, this would be calculated based on a per cent age of the major earner s income, but may be reduced to zero if debt has been repaid, and if this debt forms a substantial portion of the client s expenditure. Education funding This would be treated on the same basis as education funding under term life insurance requirements, in consultation with the client. Required income As mentioned above, the requirement for ongoing income would depend on whether the client has or is going to take income protection cover. Under an income protection policy linked to increases to inflation, if the client is on claim, only 25 per cent of the client s income would need to be provided by TPD cover, generally until the age of 65. If income protection is unavailable, the amount of TPD cover should be increased to compensate. If both are unavailable, the adviser should look at recommending trauma to cover part of this shortfall. In the latter scenario, it would make sense to provide a sum insured to cover capital items, such as debt repayment and education funding. There are a number of reasons why the requirement for ongoing income would cease at the normal retirement age of 65, rather than the life expectancy of the client. These include: A TPD claimant can still contribute to super until the age of 65 and therefore may provide for an income stream in retirement It is likely that a TPD claimant will have a reduced life expectancy The required income in retirement would probably be substantially reduced as compared to pre-retirement income requirements. Therefore, our examples will assume that the ongoing income is required until age 65. Steve (aged 38) and Emily Cooper (aged 35) are a married couple with three children, aged nine, six and four. Steve is a sales account executive on $90,000 salary (with nine per cent employer contributions), and no FBT packaged items. Emily is a stay at home mum. The Coopers have a $250,000 mortgage and no other debts, which they would like to extinguish in the event of TPD. Steve is eligible for income protection, and you are recommending he take a monthly benefit of $5,625, as well as cover 100 per cent of his super contributions of $675 per month. There is no requirement for education funding for the children. You have recommended in your statement of advice that Steve be covered for the entire debt of $250,000 and an amount of $90,000 (annual income of major earner) be allocated to cover medical/lifestyle expenses. Twenty five per cent of Steve s income is $22,500. We should look at insuring this gap until Steve turns 65 (for 27 years). The calculation is the same as required income for term life cover, but without a separate calculation for dependent children until they are no longer dependants. The Excel formula for this is: 1.04*(1-(1.04)^(27*(-1)))/0.04 All occurrences of four in the above formula refer to the real rate of return (discount rate), and the number 27 refers to the number of years the income is required. The resulting factor is then multiplied by the annual income required. The above formula produces a factor of , which is multiplied by $22,500 to produce a lump sum of $382,112. If income protection is unavailable, the amount of TPD cover should be increased to compensate.

3 THE STRATEGY SERIES 3 The total TPD recommendation for Steve Cooper is therefore: Medical/life style requirements $90,000 Required income to cover 25 per cent income protection gap until age 65 $382,112 Total TPD requirement $722,112 Homemaker TPD From your fact find, you have determined that the Coopers would require the equivalent of an additional $40,000 per annum for 30 years until Emily turned 65, in the event she became totally and permanently disabled and unable to care for the children and look after the household. This is the income required after all debts have been repaid. This amount would enable Steve to keep working and hire a housekeeper and carer for the children and allocate some funds to provide care for Emily, should this be necessary. The Excel calculation would be: Calc=1.04*(1-(1.04)^(30(-1)))/0.04 The above formula produces a factor of , which is multiplied by $40,000 to produce a lump sum of $719,349. The total TPD recommendation for Emily Cooper is therefore: Medical/lifestyle $90,000 $40,000 until age 65 for Emily $719,349 Total TPD requirement $1,059,349 Tailoring TPD cover For some occupations, insurers restrict income protection cover to a maximum benefit period of five years, whilst offering any occupation TPD cover. Let s assume Steve is a licensed floor tiler rather than a sales executive, and he fits the above criteria. He is still earning $90,000 per annum, but is selfemployed and so looks after his own superannuation requirements. He is applying for an income protection monthly benefit of $5,625. So how much TPD cover does he require? Steve still requires repayment of his mortgage ($250,000), and an amount to cover medical/lifestyle costs based on one year s annual income ($90,000). He also needs to cover the 25 per cent gap between his annual income and the income protection cover. Once their mortgage is paid off, Steve and Emily believe they can maintain their lifestyle after expiry of the income protection five-year benefit period based on 75 per cent of Steve s pre-disability income. The calculation for the required income is therefore: 1.04*(1-(1.04)^(5(-1)))/0.04 The above formula produces a factor of , which is multiplied by $22,500 to produce a lump sum of $104,173. We then require a further $67,500 per annum (75 per cent of $90,000) of ongoing income at a real rate of return of four per cent, beginning five years in the future, for a further 22 years, when Steve turns 65. The Excel formula is this: (1.04^-5)*1.04*(1-(1.04)^(22*(-1)))/0.04 The above formula produces a factor of , which is multiplied by $67,500 to produce a lump sum of $833,819. In the above calculation, all instances of four refer to the real rate of return (four per cent), five refers to the number of years in the future, and 22 refers to the number of years the income is required. The calculation of Steve s TPD cover now looks like this: Medical/lifestyle $90,000 Most insurers set a maximum allowable sum insured of around $1,000,000 for non-working spouses or partners, though this may be exceeded upon consideration of individual circumstances. Though advisers should not rely on underwriting considerations in their recommendations, they should bear this in mind when discussing a client s needs and objectives. Required income for 25 per cent IP gap $104,173 Required income five years in future for 22 yrs $833,819 Total TPD requirement $1,277,992

4 THE STRATEGY SERIES 4 Realisable assets This would depend on individual clients. In most cases, clients would probably retain most of their assets that would have been disposed of in the event of death. An exception may be lifestyle assets such as a second motor vehicle, boat or caravan that may no longer be required based on the severity of the permanent disablement. TPD in super: There is a strong argument not to include TPD cover and/or superannuation balances as offsets in calculating the TPD recommended sum insured in the following instances: When recommending own occupation cover outside super: Although the life insured has met the insurer s TPD definition based on his or her own occupation, he or she may not meet the SIS permanent incapacity condition of release. The insured would receive the TPD cover proceeds, but his or her superannuation fund balance could be trapped within the fund until the super fund member meets this or another condition of release When the insured has a homemakers definition of TPD within super which is defined as the inability to perform domestic duties or child rearing and being confined to the home either within a qualification period (three or six months) or sometimes from day one following a severe medical condition he or she may not meet the SIS permanent incapacity condition of release When the insured suffers loss of limbs or sight, which would meet the insurer s definition of TPD, but may not meet the SIS condition of release. Trauma cover Trauma insurance has evolved from its original purpose of providing cover for medical expenses associated with critical illness. Trauma proceeds are now also used to assist with the following: Repayment of debt Medical expenses and lifestyle costs Rehabilitation expenses Required income. The recommended levels of cover for trauma insurance are also influenced by the availability of income protection and TPD cover. If income protection and TPD cover are not available, trauma insurance may cover shortfalls. Debt repayment Debts should be extinguished as directed by client. If income protection and TPD are unavailable, the repayment of total debt should be given serious consideration. Medical and lifestyle costs As for TPD cover, a reasonable amount for this purpose would be the greater of $50,000 or 100 per cent of the major earner s annual income, as agreed with the client. This would provide for out-of-pocket medical expenses not covered by Medicare and private health insurance, as well as lifestyle requirements such as household modifications and adjustments. Recovery income This amount would allow for additional expenses to assist the insured in the recovery and rehabilitation process over and above those provided for under medical and lifestyle costs. A basis of 50 per cent of the major earner s annual income would be reasonable for this purpose. If debt is being fully extinguished, this amount could be reduced to zero, or may be retained if there is no income protection or TPD cover. Emergency funds As for recovery income, this would be calculated based on a per cent age of the major earner s income 50 per cent would be reasonable but may be reduced to zero if debt has been repaid. These funds would be earmarked to provide for shortterm unforeseen expenses. Education funding As the client may still earn an income, there are no minimum requirements for this in calculating the level of trauma cover. However, if income protection and TPD cover are not available, the client may consider this as a separate item if private or tertiary schooling is required. Required income Where the client has adequate income protection or income protection is being recommended, the equivalent of 25 per cent of the client s annual income over a period of five years is reasonable. The rationale behind the five year period is that no one can be certain of how much time the insured will be off work following a trauma event. It may be as little as a few days or weeks or may be permanent, either because of the severity of the event or on doctor s instructions.

5 THE STRATEGY SERIES 5 If the client is working, and income protection is of limited duration or unavailable or if the client does not qualify for TPD cover, it is reasonable to cover 100 per cent of annual income until retirement age. If the client is a non-income producing spouse or partner, a minimum of 50 per cent of regular expenses may be applied. Realisable assets These are assets that the client or clients will be disposing of upon the occurrence of a trauma event. In most cases, clients would likely retain most of their assets that would have been disposed of following death. The total trauma recommendation for Mildred would therefore be: Requirements to repay liabilities $180,000 Medical/lifestyle $80,000 $48,000 until age 65 for Emily $779,854 Total trauma requirement $1,039,854 George (aged 42) and Mildred (aged 40) are a married couple with older children, aged 18 and 14. Mildred is a golf professional, who provides lessons and does some tournament work around the country, and earns around $80,000 per year. As such, she is ineligible for TPD cover or income protection, but will be accepted for trauma cover. George and Mildred have a mortgage of $180,000 but no other debts. How much trauma cover does Mildred require? As Mildred cannot get TPD or income protection cover, she should use trauma cover to make up the shortfall. We need to assume the worst case scenario, namely that Mildred would be totally and permanently disabled as a result of a trauma event. We also need to bear in mind that she may become permanently disabled but not qualify for a trauma benefit; for instance, as a result of mental illness or a chronic back condition. During the fact-find process, you determine that Mildred would require 60 per cent of her income ($48,000) until age 65 if she were disabled and there were no debts. The remainder of the calculations would be similar to TPD requirements. The calculations would be as follows: Summary As Total and Permanent Disability and trauma cover are living benefits, their interaction with income protection is paramount in establishing the appropriate levels of cover. Indeed, a higher level of cover may be required for TPD than for term life cover. TPD requirements may need to be tailored depending on the client s situation; for instance, if the client does not have a paid position, but is responsible for the care of children and maintaining the household. Trauma insurance has evolved from its original purpose of providing for medical expenses associated with critical illness or injury. The amount of cover is greatly influenced by the availability of both income protection and TPD cover. 1.04*(1-(1.04)^(25*(-1)))/0.04 The above formula produces a factor of , which is multiplied by $48,000 to produce a lump sum of $779,854. Important information This information was prepared by The Colonial Mutual Life Assurance Society Limited ABN AFSL (CMLA) which is a wholly owned but non-guaranteed subsidiary of Commonwealth Bank of Australia ABN , for the use of advisers and staff only and is not to be issued, reproduced in whole or in part, or made available to members of the public. Any taxation information, social security information and examples are of a general nature only and should not be regarded as specific advice, and are based on the continuation of present taxation laws, superannuation laws, social security laws, rulings and their interpretation as at the issue date of this article. Advisers should refer to the relevant life company policy documents for further clarification. CommInsure is a registered business name of CMLA.