Income protection is an important offering provided by a number of insurers in the Australia market. The purpose of income protection is to provide assistance financially at a client’s time of need if they’re unable to work due to sickness or injury.
Statistics tell us that in Australia, working adults have a 1 in 3 chance of becoming disabled through sickness or injury for more than 3 months before we turn age 65. For 70% of those affected, this disablement will actually be caused by an illness rather than an injury. (1) We all think that it won’t happen to us but if you look left and right, we all know someone who’s been impacted – illness and injury does not discriminate.
While the type of income protection cover available in the market varies slightly, the fundamental nature of income protection cover is to be able to provide someone with an ongoing income stream while they’re unable to work either totally or partially.
With slightly varied policy definitions of ‘income’ available in the Australian market, the one thing all insurers share is that they will insure you for your personal exertion or ‘earned’ income.
So the next obvious question you may have is …
What’s the real difference between personal exertion VS unearned / passive income in life insurance?
Earned / Personal exertion income:
Earned / personal exertion income can be summarised as a reward paid for your time, skills & personal effort in providing a good or service.
- A local football league player, they will be paid for every football game they play;
- A high schooler working at McDonalds getting paid an hourly rate for flipping burgers;
- A teacher who teaches primary school children. They are generally paid a salary based on their experience & tenure;
All three individuals above work in varying roles however what they share in common is that they are using their times, skills & personal effort to produce goods & services that can attract monetary benefit.
Unearned / passive income:
Unearned / passive income can be summarised as monetary benefit received through zero to minimal effort – In laymen’s terms, you’re effectively get paid for putting your feet up and “doing nothing.”
- bank interest, money received from a bank or financial institution for keeping your funds in their accounts;
- dividends received, your share of company earnings based on your shareholding;
- rental income, money received from a tenant in exchange for allowing them to reside at your premises;
- other examples include inheritances / lottery winnings etc.
Each of the examples above highlight the fact that the income received is relatively independent of any personal exertion by an individual. This type of income is generally not taken into consideration by life insurers.
How do we find out how much income has been earned by a life insured either at policy inception (underwriting stage) or at claims stage?
Unfortunately determing how much income a claimant has earned is not as simple as looking at a “total income” figure in one’s individual tax return.
There are an array of complex accounting structures out there with the sole purpose of minimising an individual’s tax payable to the ATO at the end of the financial year. It is important to note that tax minimisation is completely legal yet tax avoidance is illegal – this is something that you should discuss with a qualified accountant. Some examples of these structures include:
- Trusts: G. Distributing profits to spouse & kids;
- Partnerships: G. Distributing profits to spouse & kids;
- Companies: G. Taking advantage of prior year losses to cancel out current year’s profits as well as access to a potentially smaller rate of tax
What is unique about these structures is that they allow for the transfer of income to various parties in a tax effective manner.
It is up to us as the insurer to filter through these structures to determine how much personal exertion income was derived by a life insured for a relevant period.
A common requirement for an underwriter or a claim assessor is to request a life insured financials. This includes their individual tax return as well as the tax returns and financial statements for ALL associated entities the life insured may have.
We request these financials as part of the underwriting & claims process to gain a better understanding of the potential financial loss that could occur should a life insured be unable to work due to illness or sickness. To this end, we need to look at a life insured’s income position holistically, rather than focus on what is merely on their individual income tax return.
When dealing with a life insured and their associated group of business entities, we need to determine 2 things:
- Is income derived through personal exertion or via passive income? (explained above);
- If there is personal exertion income, what percentage of income is attributable to the life insured directly?
Mr Jason is a young builder married to Mrs Jason. His business operates through a trust where profits in the trust are distributed 50% each to Mr & Mrs Jason. Mrs Jason is not a builder, she’s a part time model, and the purpose of Mr Jason distributing this income is under the guidance of a qualified accountant who has put into place a legitimate tax minimisation strategy.
For underwriting & claims purposes, we would review his application which would state that Mr Jason derives 100% of the income for his business through his time, skills & personal effort. This is different from the Australian Tax Office’s (ATO) view of Mr Jason’s income.
To illustrate this example, we will use some actual figures:
|ATO’s View||Insurance View|
|Net Profit of The Jason Trust||$ 50,000.00||$ 50,000.00|
|Mr Jason||$ 25,000.00||$ 50,000.00|
|Mrs Jason||$ 25,000.00||$ 0|
|Total Income for Mr Jason||$ 25,000.00||$ 50,000.00|
Income protection insurance, at its core, is the promise of financial support at a time of disablement for a life insured. To determine the appropriate levels of cover or potential benefit payable, our clients really need to have a good understanding of what income they have, how it is derived and whether a period of disablement would reduce or remove the ongoing element of that income.
We exist to support claimants when they’re unable to exert themselves to be rewarded for their time, skills and efforts. Knowing how much financial support is required is imperative to make sure that a life insured lifestyle can be maintained should they be unable to work.
- Calculations based on data from the institute of Actuaries of Australia 2000. Interim report of the Disability Committee IA Aust: Sydney)
Ryan Katzen is a degree qualified accountant who started his professional career working in public practice accounting for over five years before moving into the field of life insurance. Starting at AIA as the team’s financial specialist, Ryan has gained exposure to all facets of claims management and assessment over the last few years and was promoted to be a Team Leader 4 years ago and appointed to the role of AIA’s National Retail Claims Manager in January 2017. With a strong technical background, passion, enthusiasm and willingness to initiate change, Ryan is always open to feedback and suggestions on how we can make a difference.
Ph: (03) 9009 4545 / Email: email@example.com
Jason Noyahr is a degree qualified, chartered accountant with over 6 years’ experience. He started his career in a public sector accounting firm, moving on from his role of 5 years as a Senior Taxation Accountant, into the Life Insurance industry with AIA. Since commencing with AIA in March 2017, Jason has been working as the Financial Specialist within the Retail Claims team, assisting the Claims department and other departments within AIA with the analysis & interpretation of financials, while also being involved in the assessment of claims.
Ph: (03) 9009 4592 – Email: firstname.lastname@example.org
Siobhan Nelson has over 10 years’ experience in the Superannuation, Insurance and Complaints industry having worked a Regulator, Fund and Insurer. Currently a Retail Claims Team Leader at AIA, Siobhan thrives on leading, inspiring and motivating a team of Claim Assessors to deliver the best insurance outcomes to our clients and advisors and to make a difference in their lives during a time of need. Siobhan specialises in people management, end to end claims management and assessment, complaints management and the strategic development of both our people and our processes.