When planning your financial future, it’s exciting to focus on savings, investments, and wealth creation. However, it’s equally important to consider how you will protect yourself and your loved ones from unexpected events.
A comprehensive financial plan should include strategies to mitigate risks when life doesn’t go as planned. One crucial element of this risk mitigation strategy is Life Insurance.
If you have financial dependents that are reliant on you to cover living costs, Life Insurance is a key component of your family’s financial security and estate plan.
Surprisingly, many people insure their homes, cars, and even pets, but overlook insuring their most important asset – their life and the financial security it provides for their loved ones!
In this article, we’ll explore Life Insurance to help you understand what it is and how it works.
What is Life Insurance?
Life Insurance, also known as ‘Death cover’, is a policy that provides a lump sum payment to your beneficiaries if you pass away or are diagnosed with a terminal illness. You might wonder, “Isn’t that what funeral insurance is for?” There is a significant difference between the two.
Funeral insurance typically offers a much smaller benefit, intended only to cover funeral expenses. Life Insurance, on the other hand, provides a much larger sum that can help your family maintain your lifestyle, pay off debts, replace income and cover funeral expenses for your family.
The primary components of a Life Insurance policy are the sum insured, premium structure, and policy term. Let’s examine each of these components in detail.
Sum Insured
The sum insured is the amount of money that will be paid out to your beneficiaries in the event of a claim. This is the core component of your Life Insurance policy.
Your sum insured should be based on a Risk Needs Analysis. This calculation is individual to everyone’s specific circumstances and considers how much cover your financial dependents would need in the event you were to pass away.
It is common to get a default level of Life Insurance provided when a superannuation fund is established. However, this may not be enough to cover your needs, and the premium may be above market rates. It is important you review the default cover and replace it with a tailored policy if needed. We discuss group vs retail insurance later.
Calculating your level of Life Insurance
When considering your Risk Needs Analysis, you should take into account the following:
- Debts to be repaid;
- Income to be replaced;
- Expenses to be covered; and
- Gifts.
You can offset the amount of cover you need by the existing assets you have. For instance, superannuation is paid out in the event you are to pass away and therefore you may decide to offset the amount of cover you need, with your superannuation balance.
Where the policy is funded outside of superannuation, there is no tax payable on the benefit. Where the policy is funded inside superannuation, it can generally be paid to a financial dependent tax-free. If not paid to a financial dependent, there will be tax implications which may need to be factored into your Risk Needs Analysis. See Payment of death benefits from superannuation for more details.
Premium Structure
Life Insurance premiums can be structured as either stepped or level premiums. Stepped premiums start lower but increase with age, reflecting the rising risk to the insurer. Level premiums start higher but remain relatively stable over time, increasing only with inflation or changes to the insurer’s rates.
The choice between stepped and level premiums depends on your personal circumstances and how long you expect to need coverage. Stepped premiums may be more cost-effective for short-term needs, while level premiums can be beneficial for long-term coverage.
Typically, we do not recommend level premiums as insurance is there to fill a short-term need. As your net asset position grows and your children become older, you should require less cover. This strategy of reducing your cover as your wealth grows, goes against the reasoning behind locking in a level premium.
There are some Life insurance policies where the premium remains the same, but the level of cover automatically reduces as you get older. This is common in the default insurance policies offered by industry super funds. Our preference is that the policy owner remains in-charge of the sum insured so it can remain appropriate for their needs.
Policy Term
The policy term determines the duration of your Life Insurance coverage. Many policies offer coverage up to a certain age, often 99, but you can elect to reduce or cancel the cover at any time.
Structuring your Life Insurance
You have the option to structure your Life Insurance inside superannuation or outside of superannuation.
If you choose to structure your Life Insurance inside super, the premiums will be paid from your superannuation fund. If you structure it outside super, you’ll pay the premiums personally.
It is important to note that when structuring Life insurance through superannuation, you are not limited to the default cover offered by your super fund. You can shop the cover around and have the premium funded via an enduring rollover.
Superannuation ownership helps reduce the impact of premiums on your cashflow. In addition, your super fund will be eligible to claim a tax deduction for paying the premium. By paying the premium via rollover, the tax deduction will be given upfront, and only the net cost of cover will be rolled over.
However, premiums deducted from your superannuation fund balance will have an eroding effect on your retirement savings and any additional super contributions will count towards your contributions cap. Any premium paid outside of superannuation will have a negative impact on your personal cash flow.
The right choice depends on your individual circumstances, including your cashflow, superannuation balance, beneficiaries and overall financial strategy.
How much does cover cost?
The cost of Life Insurance varies depending on several factors including age, gender, health status, smoking status, and the amount of cover.
All insurers price their policies slightly differently, so it’s important to compare options to find the best deal for your situation.
Applying for cover
There are two main ways to obtain Life Insurance: through group insurance (often via superannuation) or retail insurance. While group insurance can be convenient, retail insurance often offers more comprehensive and tailored coverage.
Retail Life Insurance policies are medically underwritten at the time of application. This means you’ll need to provide detailed information about your health and lifestyle. While this process takes longer, it provides greater certainty at claim time because any pre-existing conditions have already been assessed.
To get a retail policy, consider speaking with a Financial Adviser. Advisers have access to a wide range of insurance products and can provide guidance on how much cover you need and how to structure it effectively. If you would like our assistance, please visit Personal Insurance where you can get the process started.
The underwriting process
The underwriting process involves answering questions about your medical history, usually either with your adviser or directly with the insurer via a telephone interview.
Depending on your medical history and the amount of cover you’re applying for, you may need to undergo medical tests or provide reports from your doctor. This helps the insurer accurately assess the risk of insuring you.
If you have pre-existing medical conditions, the insurer may apply a loading (increased premium) or exclusion (specific conditions that aren’t covered) to your policy. For example, if you have a history of heart problems, the insurer might exclude claims related to heart conditions.
It’s generally easier to obtain comprehensive cover when you’re younger and healthier, before developing any significant health issues. This is why we recommend considering Life Insurance early in your career.
The Guided Investor approach
Life Insurance is a crucial part of a comprehensive financial plan. We include personal insurances in the ‘financial housekeeping’ of Phase 1 of Wealth Creation. It is an essential part of building a solid financial foundation.
Covering yourself under a Life Insurance policy is not going to help you. It is a selfless act that will help your loved ones – those that are financially dependent on you. It provides peace of mind, should the worse happen. You don’t want to add on financial stress when emotional stress is high.
