Chapter 02 – Key Concepts in Life Insurance

Insurance is like a bet

In many ways, insurance is like a bet. But it is an unusual bet: it is a bet you hope you lose!

The idea of insurance is that you pay a relatively small amount each year. This is the amount that you bet. If the ‘insured event’ occurs, you then ‘win the bet’ and receive a payment. This payment reimburses you or your loved ones for the financial consequences of the insured event. 

For example: Think about life cover. Life cover is an insurance policy that pays a benefit if you die. Life cover is generally taken out by people who are financially responsible for someone else. Mums and dads who are raising families are the most common buyers of life cover. If a mum or a dad were to die, then there would be less income to raise the kids. So, mums and dads pay a relatively small premium to an insurer, and if the ‘insured event’ happens (that is, if mum or dad die) the insurer pays a larger amount to beneficiary of the policy.

The premium is the bet. Staying alive means losing the bet – you do not get your money back. This is why life insurance is a bet we hope we will lose. 

The Premium

The premium is the amount that you pay when you buy an insurance policy. There are two main types of premium. A stepped premium is one that changes each year.  The amount of the premium changes each year as the probability of the insured event changes. This usually means an increase. For example, once we reach a certain age, for every year older we be come, the chances of dying increase. So, for life cover, a stepped premium will usually increase each year. The insurer needs more money from us each year to account for the increased chance that they will need to pay out on the policy.

The other type of premium is a level premium. As the name suggests, in a level premium the amount paid each year does not change (other than to adjust for inflation). With this kind of policy, the premium is usually higher in the early years of the policy. But because it does not rise each year, at some point the level premium often falls below what would be paid with a stepped premium. 

Whether you prefer a stepped or level premium is something to discuss with your adviser. Generally, stepped premiums are lower in the early years of a policy, and many people like them for this reason. The lower initial premium allows the client to use the money saved for other purposes, such as paying off a mortgage or educating the children. But level premiums give you certainty: you know exactly how much you will pay in the future. They can also have the benefit of being cheaper in the future – so people who know that their living costs will rise often prefer a level premium.

You can read more about stepped and level premiums on the ASIC website here

Underwriting

When you apply for a life insurance policy, the insurance company undertakes a process known as ‘under-writing.’ Basically, the under-writing process determines how likely it is that the thing being insured against will happen.

For example, if the insurance is for life cover, the under-writing process works out how likely it is that you will die during the life of your policy. To do that, the under-writer will look at things like your lifestyle (recreational activities like hot-air ballooning and parachuting are considered more risky), your health history (especially whether you smoke), your age, etc.

The insurer can only work in probabilities, of course. They cannot determine exactly whether the insured event will happen. But they can determine how likely it is to happen.

Once the under-writer has made their assessment, they can do one of four things.

The first is to accept the policy. From this point forward, you simply pay the premium and the insurer will make a payment if the insured event occurs.

The second is to accept the policy but to place an ‘exclusion’ on the policy. An exclusion is a term of the policy that excludes one or more causes of injury, trauma or death. For example, where a person engages in risky activities like sky diving, the insurer might exclude death or injury experienced while skydiving. If the insured person is hurt or dies while skydiving, there is no benefit payable. If the insured person is hurt or dies due to some other cause, a benefit would be paid.

The third course of action is for the insurer to adjust the premium upwards to reflect the heightened prospect of a claim. This is known as a ‘loading.’ The principle is simple: the insured person is asked to pay an increased amount that reflects the fact that the chances of a claim are higher than normal.

The fourth course of action is where the under-writer decides that the likelihood of the insured event occurring during a policy is too high. In this case, the insurer will decline to provide insurance. An example of this might be where a person with terminal cancer applies for life insurance. In this case, the insurer will almost certainly have to make a payment. So, they decline to offer a policy.

Factors that affect under-writing and the premium

There are various factors that the under-writers consider. These include:

Age. By and large, younger people pay less for life insurances. (Very young men can sometimes pay higher premiums, basically because they drive their cars faster than they should). The reason for this is probably obvious: younger people get sick less and die less than older people. Therefore, the risk of the insured event occurring is less for younger people.

Gender. Gender is another factor that impacts on the premium. On average, women live longer. This makes them less likely to die at a younger age and this usually means a lowered premium for a woman.

Health. Again, the healthier a person is, the lower the premium is likely to be. And again, the reason is obvious: healthy people tend to die later and become ill or injured less.

Smoking. Smokers pay higher life insurance premiums. The reason is obvious: smokers get sick and die more easily than non-smokers. This provides yet another way that giving up smoking saves you money – not only will you spend less on cigarettes, but (if you stay off the ciggies) you will pay less in life insurance as well. Higher insurance premiums are one of the hidden costs of smoking.

Occupation. While most occupations do not have an impact, there are a few occupations that will attract higher premiums or even see insurance declined. Neil Armstrong, for example, could not get life insurance before he flew to the moon, and had to come up with a novel way to provide for his family in the (fairly significant) chance that he did not make it back safe and sound. 

Your Duty of Disclosure

People applying for insurance cover must disclose all relevant information to the insurer. This is known as a duty of ‘utmost good faith.’

Most insurance policies state that the contract for insurance may be voided (ie be ignored by the insurer) if the insured person did not tell the insurer something that is ‘material’ to the underwriting decision. ‘Material’ means that the insurer may have made a different underwriting decision had they had the information.

The general point is that you should always give the insurer honest answers to every question that they ask. If you don’t, there is not much point in having insurance in the first place. 

Affordability

For most people, affordability is the biggest issue that determines whether and how much they insure themselves for. Premiums are not cheap, and spending money on a bet that you want to lose can sometimes be written off as a low priority.

Because of this, it is crucial that life insurances be as affordable as possible. There are various ways to make insurances more affordable. These include:

  • Using superannuation benefits to pay for those insurances that are available within superannuation. This usually means life cover, TPD and a limited amount of income protection. Paying these amounts out of superannuation does not necessarily make them cheaper. But because you are using money that is not accessible to you anyway, it reduces the effect of insurance on your day-to-day cash flow. 
  • Claiming tax deductions wherever possible. Premiums for some life insurances, in particular income protection, are typically tax deductible. Some life cover and TPD, especially for self-employed people, is also effectively tax deductible. This is because the superannuation contribution that you make to finance the insurance premium reduces your taxable income.
  • Accepting a degree of under-insurance. Under-insurance is where the amount for which you are insured is less than would normally be recommended. Don’t get us wrong here: we think people should always be insured for an appropriate amount. But if you simply cannot afford the premium for the recommended level of insurance, then taking out a lower level of insurance is better than having no insurance at all.
  • Accepting some of the risk of the insured event yourself. Here, you insure yourself against some of the risk of things going wrong. For example, you might decide that you could ‘get by’ for a year if you become too unwell to work. You could then choose an income protection policy that has a one year waiting period. Very few people are sick for more than a year. This means that the premiums for this kind of policy are much lower than for policies with a shorter waiting period, such as a 30 day waiting period. If you get sick for a period of less than a year, you will be out of pocket. But the sickness that goes on for more than a year is the one that would be financially ruinous – and you are insured against that. 
  • Get multiple quotes and don’t be loyal to any one insurer. Your adviser can easily do this for you and there can be substantial amounts of money saved by choosing the best-value insurance policy. 

Your financial adviser will know other ways to ensure that your premium is as affordable as possible. Make sure you emphasise the importance of affordability when you talk to them. 

Continuity

If you are contemplating changing your insurer, make sure that your cover continues from one policy to the next. Your adviser can help you here. You want to make sure that there are no gap periods in your cover – the last thing you want is for the insured event to occur after you have cancelled one policy but before the next one has kicked in.

Tell people you have the policy

When you take out a life insurance policy, tell trusted people about it. This should include at a minimum the executor of your estate, but also your partner and some good friends or relatives. The reason is simple: if you have an insurance policy that no one knows about, and the insured event happens and stops you telling anyone about it, they may not know to make a claim. Think about life cover: after you die, you can’t come back to tell anyone that you had an insurance policy.

The Dover Group