Life cover: an income-based solution makes sense

In a heavily constricted market, an increasingly innovative approach to product development is seeing some insurers reaching out to previously under-served consumers. In addition, in a market where consumers are monitoring their spending habits more closely than ever, every cent counts.

This means that insurers must also respond to client requests for cover that will fit their individual needs, rather than just offering a one-size-fits-all solution. When it comes to life cover, income based solutions are finding their place alongside traditional lump sum offerings.

The lump sum challenge

While the life insured’s responsibilities as a provider are the focus of life cover, research shows that using a lump sum-only approach brings with it a number of risks for beneficiaries. This is concerning, as one of the purposes of life cover is to provide beneficiaries with a future income.

Some of the risks associated with lump sum life cover include:

- Beneficiary behaviour: Commonly known as the ‘lotto-winner-effect’ where the beneficiary feels that they have much more money than they actually do and spend large portions of the capital amount. There is no guarantee that the beneficiary of a lump sum pay-out will invest that amount appropriately to provide an income, or that they will be disciplined in the long-term with respect to the sustainable rate of draw-down. Needless to say, in the absence of sound financial advice, which may or may not be sought out, it is doubtful that most recipients of large lump sums have the financial knowledge necessary to create a sustainable long-term plan.

- Reinvestment risks: If beneficiaries are wise enough to invest their lump sum pay-out, there are no guarantees as to the rate of investment return and whether it will prove sufficient to provide for the inflation-adjusted income needs of beneficiaries over an unknown future period. Even with a sound financial plan, real returns can be impacted by factors such as market volatility, unpredictable inflation rates, and timing risks.

- Longevity risks: People are living longer than ever before. This makes it difficult to know the period for which an income will be required and the correct draw-down rate on a lump sum investment that is supposed to provide a beneficiary with a long-term income stream. This is especially concerning in cases where beneficiaries are elderly parents, dependent on a monthly income for the rest of their lives.

Innovating with income

Income based benefits are not new in the disability market. Here, the ideal portfolio includes a combination of a lump sum, to settle debt obligations and other once-off expenses, and income benefits, to provide a regular income stream covering living expenses for the duration of the disability.

While some advisers are hesitant to move away from the tried and trusted lump sum scenario, the same thinking can be applied to the life cover market, with great benefit to beneficiaries.

Monthly income benefits remove the lump sum risks discussed above. Instead, with an income benefit, they receive an inflation-linked guaranteed income stream that pays out for a specified term, irrespective of the external economic environment. This means that behavioural, reinvestment and longevity risks are retained by the insurer rather than being transferred to the beneficiary.

The life insured can set the terms of the pay-out (how much, to which beneficiary and for how long), and the beneficiary will receive an income as intended, rather than being burdened with the decisions and risks of a lump sum pay-out.

Adopting the best approach

As with disability, in most cases, a combined approach is best. Income benefits can be used to provide a guaranteed minimum income stream for the required period whilst a lump sum can be used to pay once-off expenses such as bond or funeral costs.

Alternatively, a portion of the lump sum could be favourably invested, increasing the likelihood of achieving a long-term financial target.