Restoring the logic to TPD insurance

Col Fullagar suggests that the need for an underlying logic in any risk insurance recommendation, including TPD, is an important component of safe advice.

The debate about the merit or otherwise of total and permanent disability (TPD) insurance started when the product was first introduced in the 1970s and it has continued unabated ever since.

The following arguments are cited as sound reasons to avoid TPD:

• Trauma insurance supersedes the TPD need;
• It is difficult to get a claim paid; and
• Calculating an appropriate benefit amount is similarly difficult.

And yet the trauma insurance need, whilst partially overlapping TPD, in no way replaces it. TPD claims are paid and are paid often, and apparently sound and comprehensive recommendations are being made.

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The real issue may therefore be more subtle, lying somewhere else other than in the need, the claims process or the benefit amount recommended.

The real issue may in fact be a perceived lack of an underlying logic to the TPD needs analysis process.

The TPD need

When questioned about the basis of a generic TPD recommendation, responses vary dramatically, for example:

• Sufficient to cover all debts and an additional amount to cover medical expenses;
• An equivalent amount to death cover; and
• As much as the client can afford.

There can be no doubting that the needs being covered by the above are genuine areas of potential risk exposure for an insured and, when considered in their own right, each is a sound and logical recommendation.

However, whilst the above bases may be typical and even relatively common, it is also accepted that variations are endless, which gives rise to the necessity for an underling logic that will enable all areas of need to be identified so they can either be covered or the client informed where gaps exist.

This logic would not only enable all areas of need to be identified, it would also enable the recommendation to be made in such a way as to engender confidence that a comprehensive solution was being provided.

The challenge, however, is to build a framework which possesses unlimited flexibility so the unique needs of each client can be quantified and presented, thus facilitating the making of an informed decision.

A good place to start to build is to establish the generic need for TPD insurance, recognising that it can exist in both a business and personal situation:

• In a business situation, TPD insurance mitigates the financial impact on the business if the insured is permanently unable to work; and
• In a personal situation, TPD insurance mitigates the financial impact on the insured’s current and future financial security, again if the insured is permanently unable to work.

Of course, TPD is not the only risk insurance protection vehicle available, insofar that business expenses and income protection insurance provide some protection.

Business expenses insurance reimburses fixed business expenses that continue, notwithstanding the insured is unable to work.

Income protection insurance provides protection against the loss of earnings and the subsequent impact on the insured’s lifestyle, and the lifestyle of those dependant on the insured.

Thus, the need for TPD insurance is, more specifically, to protect against the financial impact that arises over and above that covered by these other insurances, which in turn highlights that TPD insurance cannot be considered on its own but should be considered in tandem with them.

Having established the generic business and personal needs, each can be considered in greater detail.

Business need

The generic business need for TPD is to mitigate the financial impact on the business if the insured is permanently unable to work.

This need arises by virtue of the fact that if the insured is permanently unable to work, they will exit the business.

Therefore, the business need is likely to be identical to that arising as a result of the death of the insured, i.e. both events (death and TPD) lead to the insured being totally and permanently removed from the business.

The various business needs for both death and TPD cover a number of areas such as:

• Loan protection;
• Key person; and
• Business succession.

With loan protection, the financial impact is known as it is tied to the amount of the loan, thus the benefit amount recommendation would be all or part of the loan amount.

With key person and business succession, the financial impact is unknown, so the interested parties agree to quantify the impact by way of a pre-set formula – for example, once times turnover or twice time’s net profit.

Therefore in a business situation the benefit amount recommendation can be objectively arrived at because it is either linked to a known loss or, if the loss is unknown, it is linked to an agreed formula.

Further, the range of areas of impact has been identified and documented such that the adviser and the client can be confident all relevant matters have been considered.

Any offset arising as a result of business expenses insurance being in place can also be taken into account.

It would thus be reasonable to say that, in regards to the business TPD need, an underlying logic to the benefit amount recommendation exists.

Business versus personal need

When considering the personal need for TPD insurance, a totally different approach has to be taken.

First, while death will result in the insured exiting the family, as it were, total and permanent disability will not.

Therefore, even if ultimately the benefit amount recommended for death is the same as that for TPD, the logic behind the TPD recommendation will differ.

Second, generally in a business situation the business is not responsible for many of the costs associated with TPD at a personal level; most obviously, the medical costs that may arise as a result of the sickness or injury leading to the insured being TPD.

Third, in a personal situation it is not only necessary to consider the financial impact on the insured of being TPD, but also on others financially reliant on the insured: ie, dependants, and those linked to the insured, for example, a spouse whose ability to work may be impacted by the insured being TPD.

Appreciating the differences between the business and personal TPD need is an important prerequisite to the construction of a logical framework for the personal TPD recommendation.
 

Appreciating the differences between the business and personal TPD need is an important prerequisite to the construction of a logical framework for the personal TPD recommendation.

Personal need

The generic personal need for TPD insurance was established as being to mitigate the financial impact on the insured’s wealth creation process if the insured is permanently unable to work.

The financial impact at a personal level can manifest in two ways; in the form of what will be termed recurring and one-off expenses.

Further, these expenses can be current (ie, current at time of the insured becoming TPD) or new (ie, arising as a result of the insured becoming TPD).

(i) Current expenses

The financial impact in this category would include:

• Recurring expenses such as loan repayments, school fees, general living expenses, etc; and
• One-off expenses such as the provision for depreciation of the personal car and home, provision for holidays, etc.

Because of the inter-relationship between TPD and income protection insurance, simplistically 75 per cent of current expenses would already be covered.

Therefore, TPD insurance would only need to cover the shortfall; again simplistically, the 25 per cent top-up.

This shortfall could be reduced if provision was made within the TPD recommendation for the reduction or removal of actual or contingent debts for which repayments form part of the expenses; for example, home mortgage, future school fees, etc.

The provision of a lump sum TPD payment to cover the remaining shortfall forms the first component of the personal TPD recommendation.

(ii) New expenses

Not only will some current expenses continue, but the insured being TPD will likely give rise to new expenses, recurring and one-off.

New recurring expenses might include medical expenses, nursing expenses, home maintenance expenses, etc.

New one-off expenses might include car and home modification costs or maybe a new car or home, one-off medical expenses, etc.

As these are ‘new’ they will not be covered by income protection insurance, and therefore allowance needs to be made for them by virtue of an invested lump sum.

The provision for new expenses forms the second component of the personal TPD recommendation.

One seemingly insurmountable problem still exists.

Traditionally, it has been difficult, and in fact impossible, to objectively quantify the extent of the new expenses because to do so would require foreknowledge of the particular sickness or injury the insured was going to suffer and also the severity of that sickness or injury.

For example, expenses arising as a result of an electrician losing a hand would be quite different to the financial impact if the same electrician lost both hands or was rendered TPD as a result of contracting multiple sclerosis.

As it is not possible to know claim events and the severity of them in advance, an objective calculation of a recommended benefit amount is impossible to achieve.

One alternative would be for the recommendation of ‘the maximum cover available’, with the possible logic being that by doing this safety of advice is achieved.

Unfortunately, this might result in the recommendation of unrealistically high levels of cover at similarly unrealistically high premiums, which in turn could have an adverse impact on adviser credibility.

Notwithstanding an objective recommendation may be impossible and an extreme one unrealistic, this does not preclude the making of a logical benefit amount recommendation.

Financial advisers have known for ages, despite the protests of some in compliance, that if any part of the risk insurance need cannot be established objectively, the recommendation must be ‘budget-based’.

TPD case study

The confines of space necessitate the pulling of all this together via a case study example involving the provision of a TPD recommendation to a client called Jim:

“Jim, when we met we agreed you were looking to make a total investment of $5,000 a year to meet your overall risk insurance needs.

“I have been able to cover your needs in the areas of term, trauma and income protection for $3,500 a year, which has left $1,500 for the TPD need.

“Of course we cannot know in advance what might render you TPD, so I am setting out below what we can do within the remaining budget. If you want more done, we will need to expand the budget.

“I am making the following recommendation:

• $200,000 to repay your current actual and contingent debts – ie, mortgage and pre-payment of school fees, funding for future holidays etc, thus reducing expenses to 85 per cent of current levels.

The income protection insurance we have in place will account for 75 of the 85 per cent, leaving a shortfall of 10 per cent.

• $200,000 to be invested, which will provide sufficient after-tax revenue to cover the above 10 per cent shortfall.

Therefore, provision of $400,000 has been made to ensure current expenses are covered.

In addition:

• $200,000 to be invested to cover new recurring expenses that may arise, such as home maintenance costs, medical and nursing costs, etc.
• $300,000 to be invested to cover new one-off expenses such as car and home modification costs;

“Therefore, provision of $500,000 has been made to ensure at least some of the new expenses are covered.

“Thus the total personal TPD recommendation made is $900,000.”

Summary

Of course, the purpose of this article is not to imply that the above is the only way to develop an underlying logic for a TPD recommendation.

Nor is it to suggest that the above is the best way.

Each client, each adviser and each adviser practice will be different, and it may well be that a different approach would therefore be more appropriate.

It is, however, the purpose of this article to suggest that the need for an underlying logic in any risk insurance recommendation is an important component of safe advice.

This is even more so the case in regards to what may be seen as the problematic area of the TPD recommendation.

The use of an underlying logic ensures that all areas of need are identified.

The explanation of the logic will engender confidence in the client that a comprehensive solution is being provided.

The presence of the logic will ensure an understanding of the TPD benefit.

Col Fullagar is the principal of Integrity Resolutions Pty Ltd.