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Time to Address the Myth in Disability Cover, FA News, June 2013

Myth: Should a client be permanently disabled, he/she will receive a large pay-out from a capital disability policy and the client will be adequately covered — for life.
Brad Toerien, CEO at FMI

Think again! Financial advisers need to take another look at the real disability risks their clients face and how these risks are addressed by their current policies.

Attractive immediate benefits

Take Roy's case. He's a 35-year-old self-employed electrician, supporting his wife and two small children. As a self-employed contractor, his work is his only source of income. He takes out a capital disability policy which will pay out a lump sum amount should he become permanently disabled. This sum is calculated by the adviser as enough to meet his current income needs until retirement. For Roy, this multi-million rand amount seems seductively huge.

Future and unpredictable factors not taken into account

However, the payment of such a huge sum represents a high-stakes gamble as there are too many unpredictable factors involved in the calculation of this sum: the date of Roy's disability in relation to his expected date of retirement; the risks associated with managing a large lump sum; and both investment and inflation uncertainties. In truth, Roy has a high chance of being critically short of money by retirement age because capital disability policies are not designed to protect future income.The strength of a lump sum pay-out lies in providing for the immediate demands of a permanent disability: home conversion; big medical bills; staff pay-outs; and settling outstanding debts. Future needs, such as a steady income, should be covered by monthly income replacement benefits that will ensure the policyholder's current income is matched, in line with inflation, right through to retirement. And, while the lump sum pay-out is tax free, premiums are not tax deductible.

Loss of income during time of injury

Should Roy be seriously injured, it could take months to establish whether he will recover from the injury or be permanently disabled, during which time a capital disability policy will not pay out. It would also not pay out in the case of a temporary disability. Roy will probably have no income from the time he is disabled unless or until permanence is established.

Selecting all disability options to ensure full cover

Due to the different risks involved, it is recommended that a combination of lump sum and income replacement benefits be selected.

To ensure that Roy is properly covered for temporary and permanent disability, he should consider

  1. Temporary income protection with a short waiting period to meet immediate cash flow needs during a temporary disability;
  2. Inflation-adjusted monthly income replacement benefits, which guarantee insured income until retirement age in the case of a permanent disability or during a long temporary disability; and
  3. Permanent disability cover in the form of a properly weighted lump sum payment for large once-off expenditures with some left over for a long-term investment strategy.

Income protection gap creates financial burden

Relying entirely on a capital disability policy can result in an income protection gap and too often means that the future investment burden is shifted from the insurer to the client who is, in most cases, poorly equipped to carry it.

A recent report (March 2013 / from True South Actuaries indicates that when it comes to permanent disability, sales are skewed in favour of lump sum benefits, with income replacement benefits making up less than 5% of total insurance cover sold in 2011 (or 17% of permanent disability cover).

Time to address the myth

It is evident that the myth still deceives policyholders into believing one amount covers all, that it is adequate to provide for their current and future financial needs. It is crucial for financial advisers to address this myth by being fully informed of the risks policyholders face and to educate their clients to make informed decisions. Don't dispel the myth — address it!