If your client is responsible for others, he/she needs life insurance. This ensures that when they die, their beneficiaries will be financially protected.
Traditionally, life policies pay out lump sum amounts on the life insured’s death. This money has a two-fold purpose: to settle large expenses, such as a bond, and to replace the future income stream the policyholder is no longer able to provide. While a lump sum amount will allow beneficiaries to pay off immediate expenses, not enough attention is paid to the difficulties in using this amount to replace a future income stream.
How much is enough?
The lump sum provided in traditional life policies is determined with a FNA tool, which uses assumptions about the future to convert recurring monthly expenses into a lump sum amount. This way of determining how much a family will need to survive is concerning as it is based on inflation, interest, and annuity assumptions that may change over time.
It is especially risky when used to replace a future income stream. At the date of death, if any of these assumptions turns out to be different than initially thought, the lump sum will either be too high or too low. At best, the recommended amount is a good estimate on the day it is taken out.
Even with regular reviews, the policyholder runs the risk of not having the correct levels of life cover in place. This means that the beneficiaries might end up without the necessary payout to continue living as they did before the policyholder died.
How does this put beneficiaries at risk?
Even when they receive an adequate payout, beneficiaries might not have the skills to make sure that they use the lump sum as intended.
Many beneficiaries are not used to handling seemingly large sums of money. Seeing millions in their bank accounts could lead to the lottery winner effect, where beneficiaries think they have more money than they do and use it, rather than investing it. Not investing the money can quickly lead to financial devastation.
Those beneficiaries that realise they need to re-invest the lump sum in order to provide a future income stream face a number of critical financial decisions if they truly want to generate an income that will match their needs going into the future.
There is no guarantee that their investments will generate the required returns to sustain their lifestyle. On what terms will they be able to re-invest? And, if actual investment returns or annuity rates on the reinvestment date are lower or higher than those assumed when performing the FNA, then the lump sum recommended will similarly be either too low or too high.
Using a lump sum to match an income liability introduces a number of risks that many clients may not have considered, including timing, investment return, interest rate, and longevity risks, the beneficiary may live longer than expected and the money might run out before they die. The truth is that the use of lump sum benefits to match recurring liabilities transfer risk from the insurer’s balance sheet to the client’s.
What is the solution?
Lump sum payouts are suitable for settling once off, immediate expenses but are far less suitable for dealing with recurring expenses. This is because the traditional method relies on future assumptions based on today’s reality. Even with regular review of current cover, this approach encourages over or under insurance.
A far more effective solution would be to purchase an insurance product that exactly matches the future recurring liability. This means a combination of monthly income replacement benefits, to replace a future income stream, and a lump sum to settle outstanding debt.
This approach to life cover will ensure that risk is retained on the life balance sheet, rather than transferred to your client’s beneficiaries.
Get the latest issue of FAnews