Risk insurance and client income and assets

Col Fullagar explains the ins and outs of keeping your clients’ income and assets well covered.

When it comes to getting cover for high-net-worth clients, seasoned risk insurance advisers know that the biggest challenge is on the financial side rather than the medical side.

Nowhere is this more evident than when it comes to income protection insurance and the delicate relationship between the desire on the part of the client to obtain maximum protection and the desire on the part of the insurer to avoid anti-selection.

For all clients there is the issue of cover not being available in excess of 75 per cent of earned income, since this would impact on the motivation to return to work – which would in turn impact on the frequency and duration of claims. 

This restriction remains in place until the client has earned incomes of around $250,000.

As earnings increase beyond this figure, the maximum benefit amount is further reduced along the lines of 75 per cent of the first $250,000 of earnings, 50 per cent of the next $150,000 and 25 per cent of any balance.

The stated logic is that the purpose of the insurance is to protect a reasonable – but not luxurious – lifestyle.

At around this point, two further restrictions start to appear, encapsulated in the insurer’s attitude towards unearned income and assets.

The presence of unearned income and assets can quickly lead to a reduction or even elimination of available cover under income protection insurance.

The concern of the insurer is that if cover is made available to a client with significant levels of unearned income and assets, the client might be tempted to feign a disability, convert their assets into investment income and live very nicely off it – along with the income protection benefit payment.

The adviser and the client, however, are likely to see the position quite differently.

As far as they are concerned, earned income, unearned income and assets may all need to be protected if they are underpinning the client’s current and future lifestyle.

One of the great skill-sets of risk insurance advice is being able to identify and obtain the necessary insurance notwithstanding the insurers underwriting guidelines.

Earned income

In regards to the client’s earned income it has already been noted that a sliding scale of available benefits will exist. These scales differ somewhat between insurers. However, the example above is reasonably typical.

If the insurer has an overall maximum monthly benefit amount of $30,000, the insurer is effectively indicating that they are unwilling to insure earned income in excess of $790,000 (ie, ($250,000 x 0.75 + $150,000 x 0.5 + $390,000 x 0.25)/12 = $30,000)

In the absence of any other complications, in the above example, the client would have access to $30,000 a month to age 65 on an agreed value basis.

Some insurers may consider cover in excess of these levels. However, the excess cover would be available only on an indemnity basis with a maximum benefit period of two to five years.

Care should be taken because insurers will likely have an earned income cut-off point. For example, if income exceeds $1 million, cover is not available at all – not even the initial $30,000 a month.

The assumption being made by the insurer is that a client with this level of earned income is almost certainly going to have significant levels of unearned income and assets. This means the client would fall foul of the previously stated concern (ie, they would convert everything into unearned income).

As unlikely as it may seem, however, this is not necessarily the case.

Thus, for example, if a client had earned income in excess of the insurer’s cut-off figure but there was little or no unearned income or few assets, the inability of the client to work because of a sickness or injury would immediately damage their lifestyle.

If the client was in this position, the adviser may be able to make a compelling case to the insurer to put in place cover through to age 65 for at least some of the client’s earned income.

Unearned income

Unearned income is generally considered to be income that is not related to the personal exertion of the client such that, even if the client were sick or injured and unable to work, the unearned income would continue to be received.

The position in regards to reducing available income protection insurance for clients with material levels of unearned income differs between insurers. The position of four was reviewed.

• Insurer 1 indicated that unearned income would be offset when it was more than 10 per cent of earned income;
• Insurer 2 set the figure at 15 per cent; 
• Insurer 3 set the figure at 25 per cent and
• Insurer 4 indicated unearned income would be offset if the monthly benefit amount being applied for was more than $20,000.

Insurers 1, 2 and 3 each applied a similar approach to applying the offset.

The earned and unearned incomes were added together. The maximum benefit amount for the total was calculated from the sliding benefit amount scale and then the unearned income was deducted from the resultant amount.

Insurer 3, however, had a further rule: where unearned income was greater than 75 per cent of earned income or $150,000 (whichever was the lesser), income protection insurance was not available.

Insurer 4 indicated that their approach would depend on individual circumstances.

Insurers appear to take a generalist approach in regards to unearned income (ie, their attitude is driven by the amount of unearned income rather than the source of the unearned income).

Unearned income can be derived from two sources. Firstly, a source for which there are no material maintenance costs, for example:

• Interest and dividends;
• Pensions; and
• Royalties.

Unearned income derived from these sources would not be endangered if the client was disabled and unable to work; thus it does not need protecting by way of income protection insurance.

Secondly, unearned income can be derived from sources for which there are maintenance costs (eg, an investment property for which the maintenance costs might include debt repayments, rates, repairs, etc).

Unearned income derived from these sources will be endangered if the client is disabled and unable to work. The endangerment arises to the extent that the maintenance costs are dependent on the continuation of the client’s earned income.

The risk exposure for the client who has unearned income coming from sources for which there are maintenance costs is that the continuation of the unearned income is dependent on the asset remaining in place, and it is also dependent on the maintenance costs being met.

Thus, if the inability of the client to work would lead to an inability of the client to pay the maintenance costs, then a case could be made that income protection insurance was needed to the extent that the maintenance costs could not be met. This amount would constitute the benefit amount under the policy.

The period of time protection was needed would be driven by the period of time the asset would be retained if the client was disabled and unable to work. Thus, for example, with an investment property, retention might be for a period of five years to enable sale of the property at an optimal time.

The capital realised from the sale might be reinvested but this time it would likely be in an asset that while producing unearned income it did so without the need for maintenance costs.

The above period of time would be reflected in the benefit period under the income protection insurance policy.

Assets

Assets are possessions of the client that have a capital value. However, the following are generally excluded:

• The place of residence;
• Furniture and fittings in the place of residence;
• Motor vehicles except luxury or vintage vehicles; and
• Superannuation.

The underwriting guidelines in regards to assets and income protection insurance differ between insurers, However, most insurers will simply state that if assets, net of those above, exceed a certain amount (eg, $3 million), income protection insurance is not available.

Again, this generalist approach may fail to fit in with the client’s reality.

Assets that generate unearned income to the client have already been considered above.

Assets that do not generate revenue but which may or may not enjoy capital growth need to be considered in a similar way to assets that generate unearned income. 

In other words, if the particular asset does not require the expenditure of maintenance costs, it will not be endangered if the client was disabled and unable to work. Thus it does not need protecting by way of income protection insurance.

If, however, the asset does require the expenditure of maintenance costs, it may be endangered if the client was disabled and unable to work – and thus it may need protecting by way of income protection insurance.

Once again, the way in which protection is needed is that those maintenance costs that rely on the ongoing earned income of the client constitute the benefit amount and the period of time the asset would be retained constitutes the benefit period.

While there is clearly the potential for anti-selection with clients who have high levels of earned and unearned income and large amounts of assets, the position is not necessarily as clear-cut as the insurer’s underwriting guidelines would indicate.

By understanding the reasons behind the insurer’s position and then identifying any actual risk exposure within the client’s financial plan, the adviser is better able to make the case to the insurer such that appropriate cover might be made available.

Col Fullagar is the national manager of risk insurance at RI Advice Group.