There are a number of things to think about when comparing level and stepped premiums, says Richard Weatherhead.
More and more Australians are using superannuation as their preferred vehicle for life insurance. Risk insurance has grown significantly across all superannuation market segments. Personal superannuation in-force premiums, covering members of retail master trusts and self-managed superannuation funds (SMSFs), increased by 14.2 per cent between June 2008 and June 2009.
While superannuation is usually tax-effective for life insurance, it may be appropriate to place some cover outside the fund. Members should also consider whether to pay the traditional annual “stepped premiums” or take out a “level premium” contract. There is a wide range of options available through superannuation, although it is sometimes more restrictive than the equivalent non-superannuation products, due to:
- Limitations resulting from Superannuation Industry (Supervision) (SIS) rules. For example, trauma cover is not available in superannuation;
- Limitations resulting from tax law (benefits are not taxed on a concessional basis if not paid to dependants); and
- The lack of features and services available under some standard superannuation master trust products. For example, automated underwriting is often not available.
Income protection is not available under some master trust products, in part reflecting the fact that there is no tax advantage in writing this business within superannuation (and there may be a disincentive if the member is trying to maximise their concessional contributions). Nevertheless, many members do opt for income protection inside superannuation, due to the cashflow benefits of doing so – that is, premiums can be funded from Superannuation Guarantee (SG) contributions.
A number of insurers recognise that clients may want to change into or out of superannuation over time without affecting the overall liability. They offer superannuation and non-superannuation versions of their stand-alone risk insurance products, with the ability for any superannuation fund to hold the policy and pay the premiums. Clients sometimes switch cover into and out of superannuation as their circumstances change. A typical example is when they have adult children who cease to be financially dependant. Whilst a death benefit paid to a spouse would be tax-free, if it is paid to the children a tax liability will emerge, which can be avoided by moving the cover outside superannuation. Therefore, flexibility to change insurance arrangements as personal and family circumstances change is important. With the increasing use of risk insurance within retail and SMSF funds, the debate has intensified on the merits of level premium products, as opposed to stepped premium products, where premiums increase each year as the client’s age increases.
Stepped versus level premiums
Stepped and level premium policies provide the same benefits for any given sum insured, but the “premium profile” over the life of the policy differs. This means that the ultimate cost to the client will differ depending on their personal circumstances, how long they maintain their cover, and whether and when a claim event occurs. Under a stepped premium policy, premiums will be adjusted each year to reflect the insured person’s higher age. This generally results in an increased premium, reflecting the higher risk of a claim. Under a level premium policy, premiums generally do not change from year to year, provided the sum insured is unchanged, although in some cases the policy fee may be indexed for inflation.
As the premiums are averaged over the future expected term of the contract, clients pay more under level premium policies in the early years of the contract, but less in the later years. However, as with stepped premiums, level premium rates are not guaranteed and may change (either upwards or downwards) to reflect an overall re-rating by the insurer. So, there is a small risk that clients will pay more in the early years, but rates could still rise in later years should claims experience deteriorate. Level premium products generally revert to stepped premiums after the insured life reaches age 65, so the benefits of one strategy over the other emerge only up to that age.
Risk insurance in super
The merits or otherwise of setting up a client’s risk insurance within superannuation depend on their personal circumstances. Where it is established within superannuation, the impact of choosing level or stepped premiums on the ultimate retirement benefit available to the client can be determined. We can estimate this by assuming that the difference between the stepped and level premium is rolled up with interest each year. This is illustrated in Graph 1, using typical risk insurance premium rates. Impacts are shown assuming different levels of investment earnings (after tax) within the superannuation fund, from 0 per cent a year to 9 per cent a year.
Clearly, level premiums have a significant beneficial impact on the superannuation balance at age 65. However, if, for example, investment earnings within the superannuation fund are 5 per cent per annum after tax and cover is not in force for more than 22 years, then stepped premiums would have been a better choice. When considering the optimal strategy for any individual, the potential changes in insurance needs over the various stages of life need to be taken into account.
For example, a 35-year-old may have a definite need to provide for their spouse and children for the next 18 years but a less certain need to provide for their children after that. Even though the graphs above suggest that stepped premiums might be the optimal strategy to cover the definite need, on the balance of possibilities, there may be a high likelihood that the overall insurance need will be required up to, say, age 60, making level premiums a better strategy. Of course other strategies involving multiple covers, and timing a switch to level premiums, may also be appropriate in different circumstances.
Time horizons for different ages
Table 1 (male non-smokers) and Table 2 (female non-smokers) below show the period after which a level premium policy becomes cheaper than the equivalent stepped premium policy, measured in terms of premium, total premiums paid and total premiums paid accumulated with interest at 5 per cent per annum.
Other Considerations
Level premiums might increase for the following reasons:
- Indexation of the sum insured, as discussed earlier;
- Increases in cover due to greater insurance needs; for example, on key life events, where guaranteed future insurability or business insurance options are exercised;
- Indexation of the policy fee, although the impact of this is small;
- Changes in the underlying premium rates.
It is important to understand the insurer’s policy regarding product upgrades. Where additional benefits are included in the product at no additional cost, most insurers include those additional benefits for existing policies as well as new ones. However, in some cases, a “pre-existing conditions exclusion” applies in relation to the new benefits. When choosing between level and stepped premiums, a range of factors need to be considered, including:
- How long the client intends to hold their insurance;
- Their age; • Whether they require indexed cover;
- The rate of return that could be earned on the premiums “saved” in the early years of a stepped premium policy, compared with the equivalent level premium policy; and
- Potential changes in insurance needs over future life stages.
