Topic 8 – Risk Management & Insurance

Topic 8 – Risk Management & Insurance BAFI 1016 Personal Wealth Management

Introduction • A financial plan must take into account the possibility of risks such as disability and premature death may occur and aim to: • Eliminate them, or • Minimise their effect • A systematic approach should be taken to identify and manage these risks

Risk Speculative risk • Arises where there is a chance of a loss or a gain • Examples: • Gambling; Once the bet is placed, there can only be a win or a loss • Setting up a business; The business will succeed or fail

Risk continued Pure risk • Arises where there is only a possibility of loss or no loss • Categories of pure risk • Personal • Property and (see next slide)

Risk continued • Liability • Common law – e.g. negligence • Statute law – e.g. faulty product • Contract – e.g. construction

Risk Management Risk management process can be divided into 3 broad steps: 1. Identification and evaluation of potential risks • Identify possible losses and their costs

Risk Management continued 2. Management of identified risks • Seek to avoid and minimise risks 3. Program review • Regularly reassess to ensure ongoing protection

Personal Risk Management 1. Identification • Premature death • Prolonged illness or injury • Medical costs • Business risks

Personal Risk Management continued 2. Evaluation of personal risks a. Lump sum costs in the event of premature death include: • Burial and associated expenses • Estate administration costs • Final medical and associated care • Debt clearing • Adjustment expenses

Personal Risk Management continued b. Provision for dependents • The multiple approach - Relatively simple to calculate - Ignores individual resources and commitments - Assumes constant resources and inflation

Personal Risk Management continued • The needs approach - Requires relatively detailed dynamic budgeted information necessitating reassessment from time to time c. Disablement costs can include: • Medical expenses • Other costs associated with the disability • Provision of an income to support any dependants

Personal Risk Management continued 3. Control measures • Lifestyle factors such as fitness, diet, smoking and alcohol. 4. Financing measures • Retention: losses met from individual’s own resources or via insurance excess • Transfer: financial responsibility passed to another party – typically via insurance

House and Contents Risk Management 1. Identification • e.g. fire, storm, water damage, burglary, impact by vehicles and earthquake 2. Evaluation • Value only considered for building and contents as land will always remain 3. Control measures • Smoke detectors, burglar alarms, deadlocks etc

House and Contents Risk Management continued 4. Financing measures • Adequate insurance • Replacement value • Indemnity value • Consider value of contents • Consider impacts of a ‘co-insurance or average clause’ which seeks to pass on some of the financial impacts of underinsurance to insured

House and Contents Risk Management continued • Example of underinsurance: • the full value of a house is $300 000 but it is insured for only $160 000. The house sustains partial damage amounting to $150 000. The calculation is as follows: • insurance company would only cover $100 000 of the $150 000 loss, leaving the owners of the house with an amount of $50 000 to cover from their own resources. • Keep in mind that some insurers do not use this clause...

Motor Vehicle Risk Management Identification and evaluation • Damage to the vehicle itself • Limited to amount of the repairs • Loss or damage to third parties or their property • May be extremely large in cases of serious bodily injury

Motor Vehicle Risk Management continued Control and financing measures • Control via car alarms, safety devices and improved driving skills • Financing via insurance policies

Liability Risk Management Identification and evaluation • Liability at personal level is increasing. • Rise in number of negligence actions Control and financing measures • Take steps to minimise chance of loss in relation to potential identified situations

Liability Risk Management continued • e.g. Financial planning office: use a check list of procedures to help ensure nothing has been overlooked in gathering information in order to advise client • AFSL holders must have adequate PI insurance cover

The Insurance Marketplace • Insurers • Life, General and Health • Intermediaries • Financial Services Reform Act • Clients • Insurance Contracts Act 1984 • General Insurance Codes of Practice

The Insurance Marketplace continued • Regulators • APRA via prudential regulation • ASIC via consumer-oriented matters

Principle of Utmost Good Faith • Principle underlies contractual relationship between insurer and the insured • Highest degree of honesty imposed on both parties • Duty of disclosure of all ‘material facts’

Principle of Utmost Good Faith continued • Absence of disclosure of a material fact by applicant may result in contract becoming voidable at the option of the insurer, or • Reduction in insurer liability upon a subsequent claim

Principle of Utmost Good Faith continued • Misrepresentation of information provided to insured may be categorised as being either • Innocent, or • Fraudulent • Different contractual outcomes arise from the categorisation made

Insurance Policies • Insurance is a central part of risk financing measures • Policies include: • Life insurance policies • Disability policies (TPD) • Trauma policies • Health insurance policies • General insurance policies

Life Policies • Most common life policy is term life with whole-of-life policies much less frequently used today • Term Policy features • Sum insured payable on death • Terminal illness benefit reducing subsequent sum insured • Indexed sum insured

Life Policies continued • Special sum insured increase • Guaranteed renewable • Multiple lives • Policy duration - Stepped premiums - Level premiums • Convertibility • Optional benefits

Life Policies continued • Term Policy exclusions • Suicide • Other • War, terrorist attacks • Pre-existing conditions • Taxation of Term insurance policies • If regular premium payments can be claimed as a tax deduction, policy proceeds are taxable

Life Policies continued • Other life company products • Whole-of-life policies • Endowment policies • Life insurance cover in a superannuation fund

Life Policies continued • Policy ownership • A life policy can be in the name of: • The life insured • A person or company on the life insured • The life insured with a named beneficiary

Disability Policies • Total and permanent disablement insurance (TPD) - critical aspect relates to definition of total and permanent disablement - more restrictive definition typically provides for lower premiums but less chance of making a successful policy claim

Disability Policies continued • Trauma insurance - lump sum benefit - can be purchased separately or as an extension of another life policy • Combined life, trauma and TPD policies - Linked policies - Combined policies

Disability Policies continued • Income protection insurance - benefit - waiting period - guaranteed renewal - total disablement lump sum benefit - partial disablement lump sum benefit - Additional benefits • Business overheads insurance

Health Insurance Policies • Health insurance via Medicare provided to all Australian residents as a government service • Medicare • Available to all Australian residents. • Medical benefits • Hospital benefits • Pays up to 85% of the scheduled fee

Health Insurance Policies continued • Public pay for Medicare by a levy assessed on taxable income • Levy surcharge if resident does not have private health hospital cover and taxable income beyond a family threshold level

Health Insurance Policies continued • Private health insurance • Available to those who purchase it from a licensed health insurer at an additional cost to the Medicare levy • Government supports private health cover by way of a subsidy • Provides greater flexibility in where and by whom a person is treated

Arranging Insurance Through a Superannuation Fund • Some personal risk policies such as term life insurance can be arranged via the individual’s superannuation fund • Premiums will be substantially less within a superannuation fund as opposed to a retail environment • Necessary to have a binding death nomination to overcome the issue of trustee discretion…

Arranging Insurance Through a Superannuation Fund • Potential problems arranging TPD within superannuation… • If the TPD is ‘own occupation’ it is unlikely to be a deductible expense to the super fund and the fund will need to charge a higher premium to the superannuant • If the individual suffers from a disability which qualifies from the insurer to the fund but it does not satisfy a condition of release of the fund, proceeds can be locked in the fund until preservation age…

Arranging Insurance Through a Superannuation Fund • Income protection • Such policies must cover a period of temporary disability of at least two years. Then the contributions will be a deductible expense to the fund • The individual must also satisfy the SIS ‘temporary conditions of release’ for benefits under the policy to pass to the individual • Premium savings by taking income insurance through superannuation

Group Underwriting • Insurance policies can either be underwritten individually or as a group of employees • Group policies are available for Term Life, TPD and Income Protection • Group cover does not take into account higher risk individuals so it a good way for such individuals to obtain cover at a reasonable price – funds need to implement strategies to overcome the risk of adverse selection

General Insurance House and contents • Policies may cover all risks and damage or specify the list to be covered or loss or damage to valuables only • Flood damage often not covered although some cover ‘flash flood’ • Policies will generally have exclusions • Public liability insurance usually included in policy

General Insurance continued • Contents insurance normally provided on a replacement value basis (‘new for old’) • May also cover credit card fraud, food spoilage, fusion of electric motors (to an age limit)

General Insurance continued Motor Vehicles: • Compulsory Third Party Insurance (CTP) • Insurance covers legal liability personal injury arising from a motor vehicle accident and is required by law • Nature of cover varies from state to state – e.g. Vic has a no fault scheme whereas NSW had a fault based scheme (i.e. the injured person is covered so long the accident is not their fault)

General Insurance continued Motor vehicle insurance • Comprehensive motor insurance - Covers all vehicle costs of insured and any other party to accident - Market value vs. agreed value - Common exclusions such as drink driving apply

General Insurance continued • Fire, theft and third party property damage • Third party property cover only • Uninsured motorists extension

General Insurance continued Sickness and accident insurance • Restricted form of an income protection policy provided by life insurers • Consumer credit insurance • Provides protection for those who have entered into any type of consumer finance contract requiring regular payments

General Insurance continued • Travel insurance • Includes luggage and personal effects, medical expenses and personal liability

Implementation and Review • Identification and evaluation of potential risks • possible losses and their costs • Management of identified risks • avoidance and minimisation • Program review • to ensure ongoing protection

Summary • The risk management process is a systematic approach to the identification and management of risks faced by individuals • Key stages in the process are: • Identification • Evaluation • Control • Financing

Summarycontinued • Insurance is the principal means of providing for serious losses • Insurance contracts are based on the principle of ‘utmost good faith’ between the relevant parties

Topic 8 – Risk Management & Insurance