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Risk Pooling
What is life insurance?
The four types of life insurance
• Term Life insurance
• Total and Permanent Disability (TPD) insurance
• Income Protection (IP) insurance
• Trauma insurance
Summary
Level vs stepped premiums
Risk Pooling
Before we get started, it’s important to understand the concept of risk pooling, which was explained in the previous article.
The need for insurance exists due for a need to pool risk with a large group.
Let’s say that in any one year, there was a 1 in 1,000 chance of having your partner die or becoming disabled and being left unable to ever work again and being left to financially support yourself and your family (as well as pay off the mortgage, maintain basic living expenses and quality of life expenses, and saving for retirement). If the lost income for the remainder of their years totalled a million dollars, then mathematically, your risk is $1,000,000 x 1/1,000 = $1,000.
Unless you were able to save up a million dollars to self-insure, that could wipe you out financially, and self-insuring by putting away $1,000 each year won’t cover you in the event of the risk showing up.
This is where pooling (or sharing) the risk comes in. If a thousand people each contribute $1,000, and one in those 1,000 people died or became permanently disabled, they would be covered financially by those where the risk did not occur. The times where the risk occurs is compensated from the pool. Pooling is what insurance companies do.
If you have a small chance of a catastrophic event occurring that you cannot recover from financially, pooling provides a safety net that cannot be met on your own.
What is life insurance?
Your biggest asset is you and your ability to generate income over the course of your life. If that gets damaged and you don’t have insurance to replace that income, you’ll be up the creek without a paddle
Life insurance is what we call the group of insurances that are payable on an event of death, disability, and illness.
If you or your spouse were never able to earn an income again, and you or your family would not be able to support yourselves financially, including paying off debts and funding your retirement, you need life insurance. Not having insurance for these kinds of high-impact events is a mistake equivalent to a doctor or lawyer not having malpractice insurance. These types of mistakes can cripple you financially in a way that you cannot recover from.
The four types of life insurance
There are four types of life insurance that each protect you from different events that could occur.
| 1. Term Life | ||
| In case you die (if you have financial dependents or debt, this is important) | ||
| 2. Total and Permanent Disability (TPD) | ||
| Important for anyone who is not yet financially independent and therefore cannot rely entirely on their existing assets for the rest of their life. | ||
| 3. Income Protection (IP) | ||
| Important for what does not fit into the TPD category (i.e., it is for partial, or temporary disability). You need income to meet your ongoing financial obligations. | ||
| 4. Trauma | ||
| Covers serious illnesses that hopefully you will recover from, such as cancer and cardiac arrest, but also serious injuries like a major head injury or stroke. | ||
None of these have an accumulated value, meaning they’re purely insurance with no investment. If the policy lapses or is cancelled, there’s no ‘surrender’ value received when giving up the policy. They are all renewed yearly and are often ‘guaranteed renewable’, meaning that as long as you pay your premium on time, you can continue to be insured, even where you are older or have new health issues and wouldn’t be insurable when applying for a new policy.
You may not need all of these. For instance, a young adult with no family or debt may not need term life insurance. A person approaching retirement age with healthy retirement savings may have the financial capacity to forego trauma insurance through self-insurance.
1. Term Life insurance
Term Life insurance pays a lump sum in the event of the death.
When you need it
If you were to die and those that depend on you financially cannot maintain their standard of living and meet their financial commitments now and into the future, including paying the mortgage, other personal debt, and children’s care and education costs, you need term life insurance. Generally, you want term life insurance until you are financially independent. When you have enough assets to live on for the rest of your life, you no longer need term life insurance. If you die, your dependants can live off those assets.
Life insurance is the cheapest of the four life insurances because it has the lowest payout ratio.
Most term life insurance policies pay 12-24 months before death for terminal illness if you provide proof from a doctor.
A note on the name ‘term life’ insurance
In case you are wondering why it’s called “Term Life insurance”, that’s because you have the life insurance for the “term” of the policy, which is typically one year, until you pay your premium for the following year and get a new term life policy. There is another type of life insurance called ‘Permanent Life insurance’, which covers you for your entire life (or until you surrender the policy) and continues under the same policy provided you continue paying your premiums.
The main type of permanent life insurance is “Whole of Life” insurance, which bundles retirement savings and life insurance together for the whole of your life (or until you either die or give up the insurance at which time it is paid out). These were common before superannuation came in, but after that, it became popular to add pure insurance policies separately because they were much cheaper, and we already had retirement savings through super.
Whole-of-life insurance is an atrocious product, often the type of predatory insurance you hear about from the old days with door-to-door insurance salesmen. The reason it’s so bad is that, firstly, it had exorbitant fees, and secondly, the investment within it were invested very conservatively to make sure there were always funds available to pay for the insurance. As a result of the high fees and low returns, people ended up with a shockingly low nest egg to live off after a lifetime of contributions. Whole-of-life insurance is still offered in many countries, including the US, and many of the terrible insurance stories you read from outside Australia telling you to avoid it are about whole-of-life insurance. Thankfully, we don’t really have them here any more except for a few legacy policies.
The name “term life insurance” is almost always shortened to “life insurance”, but it’s often ambiguous as to whether it is referring to term life insurance or all four life insurances collectively, which are also called ‘life insurance’. In super, term life insurance is often called “death insurance” or “death cover”, which is much clearer.
Who can it be paid out to
If life insurance is held outside super, it is be paid out to whoever the policyholder puts down as the beneficiary.
If life insurance is held inside super, the policy is owned by the trustee of the super fund on your behalf, which means that the insurer pays the lump sum into your super account, and your super will be paid to your nominated beneficiary upon death (or if you haven’t nominated a beneficiary, the trustee will decide who to pay it to based on the trust deed). If you want to ensure your super (and any possible life insurance) goes to who you want it to go to, make sure you have a binding death nomination with your super fund and that it meets the conditions of being valid!
Super paid out to others upon death is called ‘superannuation death benefits’, and superannuation death benefits can only be paid out to a dependent under superannuation law (the SIS Act), or to your estate (your ‘estate’ means the collection of your assets after you die, and that can be paid to anyone under the direction of your will).
There are two slightly different definitions of a dependent, but it is important to understand the difference:
- The definition under tax law dictates the taxable nature, and
- The definition under superannuation law dictates whether your super can be paid to them when you die. If it can’t, your super can be paid to your estate.
| Beneficiary | Superannuation dependent |
Tax dependent |
|---|---|---|
| Spouse — married/de facto | Yes | Yes |
| Interdependent | Yes | Yes |
| Financially dependent | Yes | Yes |
| Child — under 18 | Yes | Yes |
| Child — over 18 | Yes | No |
| Estate | Yes | No |
Tax
If life insurance is held outside super:
- premiums are not tax deductible
- benefits (payouts) are not taxed.
If life insurance is held inside super:
- premiums are tax deductible (to your super fund), making the premiums cheaper for the equivalent insurance outside super
- benefits are typically not taxed if paid out to a dependent under tax law, but may be subject to tax if paid to a non-dependent under tax law (as shown in the table above).
2. Total and Permanent Disability (TPD) insurance
TPD insurance pays a lump sum in the event of becoming totally and permanently incapacitated through injury or illness.
When you need it
If you become totally and permanently disabled and don’t have the means to meet your financial needs for the rest of your life (including retirement funding), and if you don’t have the means to meet the financial needs of those that depend on you (including paying off the mortgage and paying for children’s care and education). Basically, anyone who isn’t financially independent with assets that can provide for them for the rest of their life needs this.
TPD is more expensive than life insurance because the definition to satisfy is more difficult in the event of a claim (it is easy to show you are dead, but you need a lot more proof that you are unable to work ever again). It is also more expensive than life insurance because it has a higher payout ratio (more people will get sick or injured than die during their working lives).
TPD insurance definitions
There are two definitions to the type of cover you can take out with TPD insurance – any occupation and own occupation.
- Any occupation – unable to perform the duties of any occupation
- Own occupation – unable to perform the duties of your own occupation.
Own occupation TPD insurance covers your where you are unable to perform the duties of your own occupation – generally, the job you are currently working in. This means you can make claim on your policy even if you were able to work in another occupation. For instance, if a surgeon had an accident which resulted in nerve damage in their hand so that they were unable to perform surgeries, but could continue to be a GP, they could still claim on their TPD policy.
Any occupation TPD insurance covers you only where you are unable to perform the duties of any occupation. This means that if you were unable to perform your own occupation’s duties, you may not be paid out if you are able to work in ‘any other job or role that is suited to your education and experience’.. In the above example, a surgeon who was no longer able to perform surgeries but was able to become a GP is unlikely to be paid out under an ‘any occupation’ TPD policy.
Own occupation is more expensive than any occupation because the definition to satisfy is easier in the event of a claim.
From 2014, TPD insurance in super can only be ‘any occupation’ due to the fact that anything defined within the ‘own occupation’ but outside the ‘any occupation’ definition may not qualify to be released from super under the superannuation (SIS) law’s permanent incapacitation definition. This is to avoid having benefits paid out by the insurance company but being trapped in super.
As a result, many insurance companies that offer TPD directly (i.e., not the default insurance you get from your super fund*) now offer ‘split policies’ where you pay for the ‘any occupation’ part through super (for the tax deduction) and the remaining outside super so that you are covered in both cases.
Tax
Tax is similar to life insurance, except that benefits from a TPD policy held inside super may be taxable where you are under 60.
If TPD insurance is held outside super:
- premiums are not tax deductible
- benefits (payouts) are not taxed.
If TPD insurance is held inside super:
- premiums are tax deductible (to your super fund), making the premiums cheaper for the equivalent insurance outside super
- benefits may be taxable where the lump sum is paid to an individual under 60.
3. Income Protection (IP) insurance
Income Protection insurance provides replacement income if temporarily unable to work due to illness or injury, which TPD insurance does not. However, it also pays out in the case of permanent disability up to benefit period you selected.
Unlike Term Life and TPD, Income Protection insurance is temporary and paid out as a regular income, not a lump sum.
To encourage returning to work, insurers cap the amount, usually at 70% or 75% of gross salary.
When you need it
If you don’t have the means to meet your expenses and the expenses of those that depend on you financially in the event of being temporarily unable to work due to illness or injury. Basically, anyone who isn’t financially independent needs this.
Income Protection insurance is more expensive than either term life or TPD insurance because it is far more common to have a temporary loss of income than a permanent disability or death, so there are many more claims.
Tax
For Income Protection insurance held both inside and outside super:
- premiums are tax deductible (to you personally if held outside super, or to your super fund if held inside super)
- benefits (payouts) are taxed.
Since benefits are taxed (unlike term life and TPD insurance), and premiums are normally tax-deductible regardless of whether it is held in super or not, it is often better for those on high marginal tax rates to hold it outside super as the tax deduction will be at your marginal tax rate which is often higher than the 15% super tax rate. You can fund it through super and make a tax-deductible super contribution to cover the cost which gives the same tax outcome, but this uses up your concessional contribution cap which could have been used to increase your retirement savings.
Premium structures
Waiting period
For income protection policies, there is a waiting period before benefit payments start. The longer the waiting period you select, the cheaper the premium. Waiting period can be 3 months, 6 months, 12 months, or 2 years (most insurers won’t offer all of those).
A longer waiting period is a form of partial self-insurance available if you have sufficient savings or other assets to cover the waiting period. This enables you to lower the cost of insurance while still covering you for major events that you cannot afford without insurance.
Be aware that benefits are often paid at the end of the month in arrears, so a 3-month waiting period would get its first payment at the end of the 4th month.
Benefit period
The benefit period (i.e., when you start to get paid your regular income) that you select starts at the end of the waiting period and is generally 2 years or 5 years or until a specific age (e.g., 55, 60, 65, or 70). The longer you choose, the more expensive it will be.
Agreed value vs indemnity
In Australia, this is no longer an option for new insurance as ‘agreed value’ cover is no longer issued. Instead, the benefit is based on your gross income at the time of the claim, and is calculated on the average income leading up to the claim (generally 12-24 months). Legacy agreed-value premiums have gone through the roof with the changes to the insurance industry in 2021, so if you have one of these and are having trouble with the cost, seek advice on your options.
Recent changes to income protection insurance
There have been significant changes in income protection over recent years as the regulator (APRA) found that insurance companies have been bleeding money through claim payments. Insurers were also found to be subsidising income protection claims from premiums paid for other life insurances, such as term life insurance, which is paid out less frequently.
To avoid the risk that the Australian insurance industry failed and could not meet claim payments, the regulator, stepped in and laid out new requirements, which effectively resulted in significant price increases to ensure the insurance industry was operating in a sustainable way.
These significant industry-wide hikes have left a lot of people disillusioned with the idea of insurance, especially those who purchased level premiums to avoid having their insurance costs increase with age, but did not envision that it would still be able to rise so much.
Income protection costs were hit particularly hard, and to keep costs manageable, many advisers now put forward to their clients the option of income protection insurance with a benefit of only 2 or 5 years (rather than to 65), based on the idea that most of the time, if an income protection claim lasts longer than five years, you will fall into the definition of being totally and permanently disabled and so they use more TPD insurance instead which is significantly cheaper.
This isn’t a perfect solution because there are some situations that don’t fall under the definition of being totally and permanently disabled, but last longer than five years, but for those where the cost of insurance is too high as a result of the changes, this offers a compromise.
4. Trauma insurance
Trauma insurance, often called “critical illness” cover, pays out a lump sum in the event of a critical illness. It covers a range of conditions, such as coma, organ failure, blindness, and dementia, but 90% of claims relate to one of the four major trauma events: cancer, stroke, cardiac arrest, and bypass surgery.
The lump sum payout from Trauma insurance is is used to help recover and to cover out-of-pocket medical expenses not funded by Medicare and private health insurance.
When you need it
Trauma insurance is used in case you are diagnosed with a critical illness and you wanted funds for additional medical expenses (if you didn’t want to go with the excellent public health system), or if you wanted extended leave from work for your partner during recovery, or to help with home or vehicle modifications.
Trauma premiums are the most expensive of the four life insurances because the conditions are statistically much more likely and therefore have the highest level of claims (particularly in the 50+ age group where it is very high).
Many (but not all) of these conditions will put you out no more than 50-75k. Another 50-75k could be useful for mortgage repayments and potential costs for modifications to your vehicle/house.
If you have sufficient savings or liquid assets, income protection insurance, and can fund medical expenses (our public healthcare system is among the best in the world), self-insuring is an option. Otherwise, you can take out Trauma insurance, but may want to avoid over-insuring due to the high cost of this type of insurance.
From time to time I read of people whose combined life insurance premiums cost them $10,000 per year or more asking if anyone knows of a way to lower such a high cost. I always ask how much trauma cover they have, and it often turns out their adviser recommended $300,000-$600,000 worth of Trauma cover because advisers are still allowed to get commissions on insurance policies due to ASIC bowing to the insurance lobby rather than protecting the public.
Tax
Trauma insurance – just like ‘own occupation’ TPD insurance – cannot be held within super because with trauma insurance, the conditions that you are paid out for do not meet with a condition of release from super. This is to avoid having the benefits trapped in super.
For Trauma insurance, which is only available outside super:
- Premiums are not tax-deductible.
- Benefits are tax-free.
Summary
| Outside Super | Inside Super | |||||
|---|---|---|---|---|---|---|
| Type | Purpose | How it is paid | Premium tax deductible |
Benefit taxed | Premium tax deductible |
Benefit taxed |
| Life insurance | In case of death, for that depend on you financially. | Lump Sum | No | No | Yes [1] | No [2] |
| TPD insurance | In case of total and permanently disability. | Lump Sum | No | No | Yes [1] | No [3] |
| IP insurance | Replacement income if unable to work due to illness or injury. | Income | Yes | Yes | Yes [1] | Yes |
| Trauma insurance | Cover out-of-pocket medical expenses in case of a critical illness. | Lump Sum | No | No | N/A [4] | N/A [4] |
[1] Premiums through super are tax deductible to the super fund (not to yourself personally). However, if you contributed concessionally, as most people do, you paid only 15% tax on contribution instead of your marginal tax rate, and that 15% tax withheld by the super fund is deductible by the super fund when paying for life insurance, making the premiums essentially tax free to you.
[2] Life insurance benefits may be subject to tax if paid to a non-dependent under tax law (typically, children over 18 or paid out to the estate to be distributed to non-dependents).
[3]] TPD insurance benefits may be subject to tax where the lump sum is paid to an individual under 60.
[4]] Trauma insurance is not available through super as benefits would be trapped in super due to not meeting a condition of release.
Level vs stepped premiums
Life insurances tend to get more expensive as you get older because as you age, health issues begin, particularly from about middle age, and there is an increased risk of the events you are insuring for.
There are two premium structures you can choose from:
- Stepped premiums – Start cheaper and increase with age. Moderate increases until about middle age, then rise more steeply. This is better for short period coverage.
- Level premiums – Initially higher than stepped but won’t rise based on age. This is often considered better for the long-term coverage.
Since insurance premiums increase as you age, particularly from about middle age, if you are looking for long term insurance, starting early enough on a level premium is something to consider.
However, as mentioned above, for term life and TPD insurance, your insurance needs are likely to be decreasing as you amass more assets over time and get closer to the point of being financially independent. Therefore, you are likely to need less coverage as you get older. One option is to have multiple policies. For instance, one for the long-term using a level policy, and one for a shorter period using a stepped policy so that after, say, 10 years, having amassed more assets and having lower insurance needs, you may end the stepped policy before the point where it starts stepping up aggressively.
The case against level premiums (which are typically for the long-term), is that you may be pigeon-holing yourself to that insurer because switching when you are older is likely to cost you a lot more in premiums based on the fact that when you are older, you are generally less healthy and have more pre-existing health-related events that you are obligated to disclose. Pigeon-holing yourself means you cannot shop around for a better price.
Also, if you look at projections of premiums, it can take a very long time for the cumulative higher initial cost of level premiums to become cheaper overall than using stepped premiums – often over 20 years. This also pigeon-holes you to the insurer, who may not have the cheapest coverage after the time you took the premium out.
Also, while level premiums don’t increase based on age, level premiums can still increase where the insurer changes premium rates for all their level premium policies. For instance, they might need to increase premiums if they are paying more claims than they expected, or if economic conditions change. This occurred significantly in 2021, 2022, and 2023, and has caused most people (policyholders and advisers) to question level premiums for the long term.
* We will explain the difference between default insurance policies in super and other policies in an article coming up soon.