Topic 8: Insurance and Annuities Flashcards
Insurance:
- Types
- Contract
- Risk
Types
- Death insurance (AKA life)
- TPD
- Salary continuance (AKA income insurance)
- Trauma (specified list of ailments)
Contract
In all cases, the terms are key, as simply a contract
Risk
Credit risk against the insurer (e.g. HIH) plus “decency”risk (e.g. flood insurers)
Life Insurance
Life insurance
–Term insurance (once set up, insurer cannot cancel if pay premiums)
–Pre-existing conditions & medicals, once sick too late: (Current and past health issues / Smokers / Health of immediate relatives / Why automatic coverage within super funds can be attractive
–Duty of disclosure
TPD Insurance
- Total and permanent disability
- Can be worse than death for the family
- Own occupation vs. any occupation
- Might be happy with any occupation as not want indemnity but just loss mitigation
- Often bundled with death insurance, same medical issues
Salary Continuance Insurance
- Regular income if unable to work
- Weird people don’t insure their biggest asset
- Usually max 75% or 85% of income
- Choices:
- Waiting period (90 days, 3 months etc.)
- Benefit period (2 years, 5 years, to 65 (after which get pension))
- Agreed value vs. indemnity (latter cheaper as need prove income at time of claim and may have dropped)
Trauma Insurance
- Listed ailments, read terms
- If get illness but wont die and cannot claim on TPD
- May have to give up work, yet waiting period on salary continuance wont pass
- May be large medicals or physio that Medicare and health insurance not cover
- Relatively expensive
What / How Much Insurance?
- Depends on risk aversion and financial situation
- If bad things happen can also adjust life, only get enough insurance so tolerable?
- Costs money so overinsuring over the long term hurts clients
- Aim is to replace what lost, reduce risk to an acceptable level
Longevity Risk Drivers
- Gender
- Socio-economic status (i.e. dollar weighted life expectancy is greater)
- Health status
- Thus even a greater issue for relatively healthy, well-off people
GFC impacts
- Besides loading up on growth assets not really helping, post GFC many “growth shy”
- During GFC fixed income would have protected nicely
- Invest in Vanguard Wholesale Australian Share Fund start of January 2008 until 31 December 2008…a loss of 42%
- Similar results for other equity like asset classes
- Invest in Vanguard Wholesale Australian Fixed Income Fund start of January 2008 until 31 December 2008….a gain of 10.8%
Include fixed income into portfolios:
- Dampen volatility
- Provide income
- Only true diversifier of the major asset classes
Fixed Income may not be the answer
- Hybrids are not fixed income, which is listed variety of FY most popular with retail
- Inflation hedging really not available
- Even if retail bond offerings become easier and cheaper following ASIC discussion paper, director liabilities for retail may limit use
- More importantly:
–Large fixed income allocations may limit portfolios ability to grow in real terms, especially after tax in accumulation phase, and fees; and
–Thus the risk of outliving one’s money (i.e. the great fear) remains
Annuities
- Define
- Varieties
Define Annuity
- Contract whereby the payer agrees to pay a regular stream of income
Varieties
–Fixed term (i.e. FY) vs. life time (i.e. longevity hedge) –Immediate vs. deferred
–Nil RCV (i.e. capital returned over life) vs. 100% RCV
–Nominal vs. inflation protected
–Fixed income vs. participate in market upside (variable annuities, with or without guaranteed income or capital levels)
–Locked in vs. ability to commute –Guaranteed payment periods for heirs etc.
Move away from basic longevity hedge, costs in terms of lower payouts, costs and confusion
Superannuation Annuities
- different restrictions and tax implications if purchase using super funds
- Annuity payments tax free in drawdown phase
- If within a super vehicle can only be paid to superannuant, cannot be in joint names
- Need be minimum annual payments
Advantages / Disadvantages of Annuities
Advantages
–Hedge longevity risk
–Certainty of income
–Peace of mind
Disadvantages:
–Priced off fixed income curve so low if low interest rate environment
–Inflexible if want most pure and cheapest product
–Credit risk against issuer
•But of course disadvantages can be “removed”for a cost
Barriers to Competitive Annuities Market
- Adverse selection impacts “pricing”–some level of “compulsion or coercion” is required (Mercer, submission to Henry Review)
- Behavioural barriers –seen as a bet against dying early rather than hedge against longevity
- Tax and reg barriers to the pure longevity hedge
–Tax in accum phase on income not received
–Min drawdown req’ts in drawdown phase as value of annuity increases
–APRA min surrender value rules - Lack of financial literacy (investors and advisers)
- Priced off fixed income curve so low returns
- Lack of longevity risk instruments to hedge
- Lack of long-dated Govt paper, especially inflation protected, to match long term liabilities
How much of portfolio should be annuitized and when?
- Studies suggest large allocation:
- Yaari (1965): 100%, hence the “annuity puzzle”
- Scott (2008 & 2009): 100%, but even 10-15% allocation to deferred annuities ideal for all
- Davidoff, Brown & Diamond (2005): min 2/3
- Challenger: 30% compulsion
* It is a personal decision
* Suggest gradual but increasing annuitisation from about age 65 until early 80’s, effectively dollar cost averaging interest rate based pricing & all other risks
