FNCE20003 Introductory Personal Finance Lecture 10 PDF

FNCE20003 Introductory Personal Finance Lecture 10 Asset Protection and Insurance Lecturer – Tony Cusack October 2024  Lecture 10 topics Asset protection The nature of insurance Insurance protection Insurance and estate planning Taxation and insu...

FNCE20003 Introductory Personal Finance Lecture 10 Asset Protection and Insurance Lecturer – Tony Cusack October 2024  Lecture 10 topics Asset protection The nature of insurance Insurance protection Insurance and estate planning Taxation and insurance October 2024 FNCE20003 Lecture 10 2  Asset protection fundamentally, the objective of an effective financial plan is to address earning sufficient income to adequately fund living (C) and investment (S), ensuring the latter provides the means for an adequate RIS implicitly, financial plans are prepared assuming a continuing income a risk arising from this assumption is that there is insufficient focus on protecting the means of generating savings – today we are addressing that risk since the most effective way to protect the means of generating savings is via (life and other) insurance arrangements, our focus will be on the features of these risk management products October 2024 FNCE20003 Lecture 10 3  Ownership of assets but before we examine insurance, for completeness it needs to be recognised that some forms of asset protection are more fundamental than insurance the first such element of asset protection consists of an affirmation of ownership or control of assets – i.e. ensuring appropriate legal title is held issues arising here relate to assets purchased in other names, e.g. a building held in the business name, investment assets in spouse name, etc. – legal title gives the owner the right to deal in the assets (e.g. sell them) this concept extends to legal ownership of any asset being insured October 2024 FNCE20003 Lecture 10 4  Ownership of assets other relevant considerations include: i. assets protected by Binding Financial Agreements ii. assets owned as tenants-in-common (vs joint tenants) iii. superannuation assets subject to Binding Death Nominations minor aspects of asset protection that should not be overlooked are: – guarantee periods on purchases of assets or services – retaining records as to proof and date of purchase – guarantee periods on work done by tradespeople – estimate of time to failure October 2024 FNCE20003 Lecture 10 5  Risk and insurance normal activities of daily life carry the risk of losses, even potentially large financial losses many persons are willing to pay a small amount for protection against some risks, because that protection provides valuable peace of mind in its broadest sense, the term insurance can describe any measure taken for protection against risks a technical definition of insurance is: “a risk transfer mechanism that ensures full or partial financial compensation for the loss or damage caused by event(s) beyond the control of the insured party” October 2024 FNCE20003 Lecture 10 6  The nature of insurance in insurance, parties that transfer specified risks to the insurer are exchanging a potentially large uncertain loss for a relatively smaller certain payment (the premium) insurers are willing to accept transferred risks in circumstances when they are able to pool such risks – risk pooling is the sharing of total losses among a group effective risk pooling is accomplished by combining a group of similar ‘objects’ for which the aggregate losses across the group become predictable within narrow limits insurers charge clients (the insureds) based on that expected loss + margin October 2024 FNCE20003 Lecture 10 7  Risk pooling example an insurance company has 5,000 car insurance customers who have each transferred the risk of an accident that causes damage to their car based on historical incidences of car accidents, along with other relevant industry and demographic factors, the insurer forecasts that for every 1,000 cars insured, there will be 16 accidents causing material damage ranging in value from $2,000 to $75,000 – with an average (loss) value of $28,000 so, the insurer is facing an expected payout of $28,000 x 16 x 5 = $2.24 million to break even, they would need to charge $2.24m / 5,000 = $448 per customer, which means that the premium charged will be above that amount (i.e. to cover costs and return on insurance business risk) October 2024 FNCE20003 Lecture 10 8  Economically feasible this insurer would charge each customer, say, $480-550 on average most individuals will only take out insurance if it is economically feasible, meaning (1) the maximum possible loss must be relatively large, and (2) the premium is not excessive – the potential loss (e.g. destroyed car) must justify the cost of the premium insurers must always charge more for their service than the expected value of a loss – or else they would earn no margin – but not too much more this means that insureds are willing to pay more to avoid a loss than the true expected value (EV) of that loss (in the above example, EV = $448) indeed, if it were not for this phenomenon, insurance could not exist October 2024 FNCE20003 Lecture 10 9  Insurance policies insurance takes the form of a contract that is known as an insurance policy – in Australia, insurance policies are subject to requirements in statutes, administrative agency regulations, and court decisions under an insurance policy, one party (the insurer) indemnifies the other party (the insured) against a specified amount of loss, occurring from specified eventualities within a specified period accordingly, insurance provides necessary funds to cover financial losses or reinstate lost assets the losses that are covered by insurance arise as a result of perils, which arise due to hazards October 2024 FNCE20003 Lecture 10 10  Principle of indemnity a general definition of indemnity is “security or protection against a loss or other financial burden” in insurance, the effect of indemnity is that it seeks to restore insureds to their position that existed prior to a loss this principle ensures that an insured may not collect more than the actual loss in the event of damage caused by an insured peril – this serves to control moral hazards that might otherwise exist (see next), and therefore the likelihood of intentional loss is greatly reduced it is an important principle in insurance, ensuring that no profit can be made from a loss event October 2024 FNCE20003 Lecture 10 11  Peril and hazard despite their common interpretations, technically speaking the terms ‘peril’ and ‘hazard’ should not be confused as being the same as ‘risk’ – however, they are both closely related to risk peril may be defined as the cause of a loss: – e.g. if a house burns because of a fire, the peril, or cause of, loss, is the fire – e.g. 2: if a car is destroyed in an accident, the accident (collision) is the peril, as it is the cause of loss some other common perils that result in losses include fire, cyclone, storm, flood, lightning, earthquakes, malicious damage, theft and burglary only these possible events – perils – can be insured against October 2024 FNCE20003 Lecture 10 12  Hazard a hazard is a condition that creates or increases the chance of a loss – i.e. a hazard increases the chance of a peril event the relevant literature often recognises three major types of hazards (but there are variations): physical, moral and morale hazard – some sources distinguish between the latter two, whilst others don’t a physical hazard is a physical condition that increases the chance of loss – e.g. a business owns an older building that has defective wiring – this is a physical hazard that increases the chance of a fire (the peril) – i.e. any loss is not directly as a result of the hazard (defective wiring), but as a result of the peril (fire) October 2024 FNCE20003 Lecture 10 13  Moral hazard moral hazard is a situation in which an insured party actively gets involved in a risky event to cause a loss, knowing that it is protected against the risk and the other party will incur the cost – will occur when the insurance payoff is > insured asset value so, moral hazard involves unethical or immoral behaviour by an insured person seeking to gain at the expense of insurers and other policy owners it arises when both the parties have incomplete information about each other, in the sense that insurers aren’t aware of what the insured will do moral hazard is potentially present in all forms of insurance, and it can be difficult to control October 2024 FNCE20003 Lecture 10 14  Moral hazard example consider a business that is overstocked with inventories because of a severe business recession, and it is unable to sell them if the warehouse and inventory are insured, the owner of the firm may decide to deliberately burn the warehouse to collect money from the insurer in this example, the unsold inventory has effectively been sold to the insurer by way of the deliberate loss it is observed that in practice, many fires are due to arson, which is a clear example of moral hazard – not always related to insurance claims, though October 2024 FNCE20003 Lecture 10 15  Morale hazard morale hazard differs from moral hazard in that it arises due to carelessness or indifference to a loss because of the existence of insurance i.e. the presence of insurance causes an insured to be careless about protecting their property, and the chance of loss is thereby increased – e.g. motorists know their cars are insured and, consequently, some are not too concerned about the possibility of loss through theft – their lack of concern will lead them to leave their cars unlocked, so the chance of a loss by theft is thereby increased because of the existence of insurance so, moral and morale hazard differ on the basis of the intent of the insured (but can result in the same outcome for the insurer) October 2024 FNCE20003 Lecture 10 16  Principle of utmost good faith the principle of utmost good faith is applicable to all contracts of insurance it may be defined as: “A positive duty to disclose voluntarily, accurately and fully, all facts material to the risk being proposed, whether requested or not” the implication of this principle is that a higher standard of honesty is imposed on parties to an insurance agreement than is imposed through ordinary commercial contracts this casts a different light on the interpretation of insurance agreements relative to general business contracts (consider “entire agreement” clauses) October 2024 FNCE20003 Lecture 10 17  Types of insurance there are various types of insurance including: – life and health – property – public liability – business interruption – fire, burglary and theft insurance – marine insurance – motor vehicle insurance – workers compensation October 2024 FNCE20003 Lecture 10 18  Insurance protection for individuals protection against loss of income on death is provided by life insurance, either permanent plan or term life protection against loss of income because of permanent or temporary disablement is provided by income protection policies both life and income protection policies may have a trauma insurance ‘add- on’ key person insurance can typically be used to alleviate financial loss to a business arising from premature death or disability of a key employee however, be aware that it is not possible to provide protection against (job) redundancy by use of an insurance policy October 2024 FNCE20003 Lecture 10 19  Life insurance life insurance operates to reduce the financial impact of death or other serious contingencies affecting the capacity to provide income to cater for dependents i.e. if the family income earner dies or is permanently incapacitated, the financial stability of any dependants can be retained by appropriate life insurance evidence points to underinsurance in Australia – i.e. on average, individuals do not carry sufficient insurance to meet financial needs of dependents how is the appropriate level of life insurance determined? October 2024 FNCE20003 Lecture 10 20  Life insurance regulation the life insurance industry is subject to considerable regulation, as follows: – the Corporations Act – the ASIC Act – Insurance Contracts Act 1984 – Life Insurance Act 1995 – Privacy Amendment (Private Sector) Act a key part of regulation of the industry is that providers of life insurance must hold a proper licence under the Life Insurance Act (list – there are currently only 24 licensed providers) October 2024 FNCE20003 Lecture 10 21  Life insurance providers some key providers in this industry are: – AIA Australia Limited (Suncorp) – Allianz Australia Limited – AMP Limited (now fully owned by Resolution Life Australasia Limited) – Challenger Life Company Limited – MLC Limited – Munich Reinsurance Company of Australasia Limited – The National Mutual Life Association of Australasia Limited – Zurich Australia Limited the ‘big 4’ banks (ANZ, CBA, NAB and Westpac) also hold licences October 2024 FNCE20003 Lecture 10 22  Parties to a contract of life insurance 1. owner of the policy 2. the insured life 3. the beneficiary(ies) 4. the ‘Life Office’, i.e. Life insurance company there is a difference between the policy owner and the insured life, although the owner and the insured can be (and is often) the same person – e.g. a person who buys a policy on his own life is both the owner of the policy and the insured life – if the wife of that person was the buyer of the policy on his life, she is the policy owner, and he is the insured life October 2024 FNCE20003 Lecture 10 23  Parties to a contract of life insurance the policy owner is the one who pays for the policy, and also acts as the guarantor (i.e. that premiums will be paid) the beneficiary receives policy proceeds upon the insured person’s death the policy owner designates the beneficiary, but the beneficiary is not a direct party to the policy – the owner can change the beneficiary, unless the policy has an irrevocable beneficiary designation the life insurance company is the provider of the insurance, and charges a premium based on pooling and risk assessment considerations October 2024 FNCE20003 Lecture 10 24  Parties to a contract of life insurance October 2024 FNCE20003 Lecture 10 25  Life insurance premiums as previously illustrated, insurance premiums are based on risk pooling accomplished by combining a group of similar objects (i.e. lives) for which the aggregate losses across the group are predictable for life insurance, this prediction is actuarially determined, based on: i. life expectations experience (usually based a mortality table, with appropriate specific adjustments for individuals); and ii. a (market) rate of interest – actuarial maths is beyond the scope of this course there are numerous variations of life insurance policies available in the market, depending upon the term, nature and level of cover sought October 2024 FNCE20003 Lecture 10 26  Life insurance policies life-based policies fall into two major categories: 1. (term) protection policies – designed to provide a benefit in the event of specified event, typically a lump sum payment – the most common form of this policy is term life insurance (TLI) 2. investment policies – the main objective is to facilitate the growth of capital by regular premiums – usual forms are whole life and endowment policies – these policies were traditionally prevalent, but in recent years they have been phased out and replaced by term protection products this is due to the growth of investment alternatives that are more attractive October 2024 FNCE20003 Lecture 10 27  Term life insurance (TLI) TLI provides a lump sum payment on death of the insured to the policy owner or nominated beneficiaries – the amount of the lump sum is specified in the policy, and drives the premium – in the event of diagnosis of a terminal illness with less than 12 months life expectancy, the policy will often allow an advance payment of total sum insured the level of cover will be based on considerations including required income stream for dependents, children’s education, mortgage and other debt outstanding, etc. as noted, TLI is the most common form of life insurance in Australia, since whole life and endowment policies are generally no longer available October 2024 FNCE20003 Lecture 10 28  TLI example it’s simple to get a quote online from one of the many well-known insurers assume the following: – person to be insured: John A. Student – date of birth: 1 Sept 2003 – amount of cover desired: $500,000 – cover types: Life, Critical illness, Permanently Unable to Work as discussed, in each case the level of cover will be based on assessing the immediate and ongoing needs of dependents (usually it is set to cover mortgage and other debts, family and other living expenses for a period) – varying the level of cover will obviously change the premium October 2024 FNCE20003 Lecture 10 29  Life insurance in estate planning life insurance has several uses in estate planning, such as: – key person insurance – buy-sell agreements – provision for self (income maintenance) in case of disability or trauma – equalising bequests to different beneficiaries the first two are examples of how life insurance can be used in Business Succession Planning a key issue is who is the beneficiary of the life insurance policy – e.g. testator, spouse, business partner, trust October 2024 FNCE20003 Lecture 10 30  Key person insurance essentially a form of life insurance, key person insurance is typically used to alleviate financial loss to a business arising from premature death, disability or incapacitation of a key employee such financial loss might arise due to: – immediate loss of expertise – potential sales loss – reduced profitability – time and cost of finding a suitable replacement – loss of goodwill / customers it is paid for and owned by the business October 2024 FNCE20003 Lecture 10 31  Buy-Sell agreement a Buy-Sell agreement is a contract usually entered into between business partners, pursuant to which the remaining partners are compelled to buy out the other partner’s interest in the business should a specific event occur specific events that may trigger a Buy-Sell agreement include death, divorce, long-term disability, retirement or bankruptcy should any of these events occur, the remaining business partners would be disadvantaged because in most cases another party (i.e. the beneficiaries) would have acquired an ownership interest in the business the main risk is that the beneficiaries wish to cash out their interest at market value, but the remaining partners can’t fund such purchase October 2024 FNCE20003 Lecture 10 32  Buy-Sell agreement it makes sense to have an arrangement that facilitates a transfer of the ownership interest to existing owners when a trigger event occurs the effect of a Buy-Sell agreement is to ensure that, e.g. in the case of death, the purchase of the business interest is funded by proceeds of a policy of life insurance, paid to the estate of the deceased owner these insurance proceeds are not subject to income tax or CGT when paid to the estate or directly to beneficiaries – however, a subsequent sale of the equity may give rise to CGT (note that there might be a problem with these agreements in SMSFs) October 2024 FNCE20003 Lecture 10 33  Accidental death cover accidental death is a limited life insurance, designed to cover the insured should they die due to an accident accidents include anything from an injury and upwards, but do not typically cover deaths resulting from health problems or suicide – Q: is suicide an automatic disqualification from claiming on life insurance? because they only cover accidents, these policies are much less expensive than other life insurance policies (surprisingly?) accidental death insurance is not often paid out, as death by accident is relatively uncommon October 2024 FNCE20003 Lecture 10 34  Personal income protection policies these policies are designed to provide an income stream to the insured should the person become totally or partially disabled and thus unable to earn income after a waiting period (typically 90 days), benefits are payable for a predetermined period (which could be the whole of life) under this insurance, up to 75% of the life insured’s earned income may be insured – paid in the same way as a regular salary like any insurance policy, there are crucial definitions to determine, such as income and disability October 2024 FNCE20003 Lecture 10 35  Personal income protection policies the definition of ‘income’ differs between self-employed and salaried: – self-employed: total income earned in the conduct of business due to the insured’s personal exertion, less their share of business expenses necessarily incurred – salaried (employees): salary, fees, commissions, etc. which comprise the insured’s total remuneration package Total disability comprises three tiers, or types: duties-based, income-based and hours (or time)-based ‘duties-based’ is the most common and usually the best, as any claim will be linked to your inability to perform income producing duties October 2024 FNCE20003 Lecture 10 36  Total and permanent disablement total and permanent disablement (TPD) insurance provides for payment of sum insured if life becomes totally and permanently incapacitated through injury or illness in addition, such policies will also put a sum on loss of limbs, loss of sight, etc. there are three types of occupation defined for TPD and each requires that the life insured be unable to perform any work for six consecutive months they are: Standard (or Any), Own and Homemaker – Standard / Any – unable to perform duties of any occupation for which he/she is reasonably suited by education, training or experience – Own – unable to perform the duties of their own occupation October 2024 FNCE20003 Lecture 10 37  Trauma insurance trauma insurance provides financial cover in the event of a specified medical catastrophe, including the conditions listed earlier (Alzheimer’s, stroke, etc.) although this list can be long, 92% of all trauma claims arise from heart attack, stroke, cancer and heart surgery it can be packaged with TPD or as a stand-alone note that the inability to work is a prerequisite for TPD insurance claims, but here is no such requirement for claims under trauma insurance October 2024 FNCE20003 Lecture 10 38  Other types of insurance other common types of insurance taken out by individuals include: – motor vehicle – private property, especially real estate – landlords’ – recreational (e.g. holiday) – business expense – professional indemnity – private/public liability October 2024 FNCE20003 Lecture 10 39  Motor vehicle insurance the main category of motor vehicle insurance relates to accidental damage to or by a vehicle, but there can be insurance against losses arising from other perils, such as fire and theft; the main types are: – CTP: compulsory third party; for third party personal injury (this does not insure against third person property damage) – TPPD: third party property damage – TPPDF&T: third party property damage, fire and theft – Comprehensive note: these are separate policies, requiring payment of separate premiums October 2024 FNCE20003 Lecture 10 40  Issues for financial planners there are good reasons as to why FPs should understand and advise in relation to insurance: – it is part of a complete financial plan – to save clients financial loss – to avoid litigation – to protect the adviser’s client base – to ensure the adviser himself has adequate professional and personal cover it is important that FPs protect themselves by maintaining records, e.g. of client-specified exclusions when advice is given, and recommendations made October 2024 FNCE20003 Lecture 10 41