The benefit of income
Income protection specialists FMI has recently announced the launch of its new Life benefit. In what is being hailed as a first for South Africa, the Life benefit will provide both a lump sum payment and an on- going income benefit on the death of the Lif
FMI marketing actuary, Paul McKillen explains that there are many theories why income protection benefits might be better than lump sum benefits on death. “When it comes to disability many people buy a combination of lump sum benefits to settle on- off debts, and income protection benefits to protect their future income stream. The same logic should apply when people buy life cover. Part of the reason why people buy life cover is to protect their dependants in the event that they can no longer earn an income and support them into the future,” he says. “For instance, the client may want to provide for his spouse for a period of 20 or 30 years. That same client might also want to provide for his children to make sure they receive a sound education and are taken care of until they become financially independent, or reach a certain age. Therefore, part of the client’s life cover planning is preparation to replace the income stream he would have earned, for the benefit of his dependants and their different circumstances,” McKillen continues. FMI sees the disability and the life markets as being similar in terms of need. In both cases, the client is insuring against the risk of no longer being able to earn an income. While the cover may be for different risk events, the outcome is essentially the same.
Timing is everything
While there have been a number of insurers who have offered some manner of income benefit in the past, FMI still considers its product unique in a life cover market that traditionally offers only lump sum cover. There are a number of reasons for the company’s claim. McKillen points out that FMI took advantage of a recent major change in the industry, “In the past, and up until March of next year, premiums on disability products have been tax- exempt while the life cover market had no such advantage. Any income benefit that was paid out for life cover was defined as an annuity and this benefit was taxed. The client didn't enjoy the advantage of any kind of premium deduction so essentially they were paying the full price premium and receiving less of the benefit,” he says. This made income- based life benefits tax-inefficient. From March 2015, however, the proceeds from all life policies will pay out taxfree, regardless of whether they are lump sum or income benefits. “This means that you will get more value for your premium. That is the sort of paradigm shift that has opened up this market,” McKillen explains. The other reason that the rest of the life insurance industry may have been slow to adopt this approach is a more difficult one, according to McKillen. “The fact is that insurers
don't have much data regarding longevity, which means that pricing a benefit that pays out an income for life is difficult. This may be part of the reason why insurers have shied away from this solution in the past,” says McKillen. In contrast, lump sums have been much easier to price. “Whenever your client dies, you pay the required amount, and your responsibility to the client is met without the need to factor in unknowns, like how long the client will live or how future economic factors will affect the ultimate cost of the benefit,” McKillen continues. “We are not the first to provide an income benefit, but what we have done is to expand that universe. What you could buy in the past was a very limited subset of the range of customisable options that we are now offering clients. In this regard, we are definitely ahead of the pack,” he says.
Choosing lump sum or income
McKillen is quick to point out that lump sum and income protection cover are not mutually exclusive options. “It is still very much up to the needs of the individual client. Lump sum benefits will always be the best option if there are home loans or large liabilities to be settled. And there is no point in using an income benefit when you actually require a few million in cash right away,” he explains. However, when part of the client’s requirements is to provide for their spouse, children, or other dependants, an income benefit can be most beneficial. There are also certain business applications where it would be more beneficial for the business to receive continuing income rather than a lump sum, and an income benefit would be better suited to that. “I would say that there is a definite space on almost all our clients’ portfolios for some kind of an income benefit,” McKillen adds. The solution according to McKillen, will almost always be a combination of the two options.
The benefit of income
McKillen argues that there are substantial advantages to taking out a life income policy. The first of these occurs when setting up the cover in the first place. “As soon as you try to use a lump sum to cover your future income liabilities, you need to calculate how much lump sum cover you are going to have to provide your beneficiaries with to meet those costs. This calculation requires numerous assumptions about future inflation, investment returns, and longevity,” he starts. With a monthly income benefit, the client decides how much they want their beneficiaries to receive every month. This can either be for a set time or for the rest of the beneficiaries’ lives. “We can work that out without introducing the uncertainty of converting that income stream into a lump sum amount,” McKillen adds. “Using a lump sum to provide for dependants also introduces risks to the beneficiaries at the time of the pay- out as they now need to reinvest that lump sum on the terms available in the market at the time. “They will also have to manage longevity and inflation risks themselves. In effect, a lump sum pay out transfers risk from the insurer to the beneficiary. With an income benefit, upfront, there is a much more intuitive match between the client’s needs and the solution that the cover provides,” McKillen explains. According to McKillen, many clients do not understand the risks involved in life cover planning. “With good financial advice there is no doubt that these risks can be managed, but what we’re saying is that an income benefit presents a much lower risk and a much neater solution. Especially when opposed to rolling the dice with lump sum where the life insured takes on a number of serious risks,” he says. FMI’s Life product is still quite new, having only been introduced in April this year, “This is definitely what we call phase one, so we certainly have the intention to evolve this product annually going forward. We've already had some very good feedback from the market about options and features that are not included in our initial product but that are really good ideas. As time goes on, we will be able to better define our pricing models and I think, will be able to offer more options to the market. I cannot predict the future but I suspect that this product will evolve substantially over the next five years,” McKillen states. What is not likely to change, according to McKillen, is FMI’s philosophy on the subject. “We believe that if you face an income- based liability then you should be looking for an income- based solution,” he concludes.