insights What is income replacement

Income Replacement is a concept which introduces a way for the policy holder’s beneficiaries to receive income through an alternate source, should an untimely death occur to the insured.

It is the essence of life insurance - should one no longer be around to provide financially for one’s loved ones and for them to have sufficient financial security to live comfortably, the insurance pay-out can fill that void. Though some in the industry may feel that a HNWI does not necessarily need to replace his or her income in the event of death, the potential loss of financial security for loved ones is a significant risk to the value of his/her estate.

One of the basic tenets of insurance, the principle of indemnity states that the insured or his/her beneficiaries should not profit from a loss or damage, but should be returned to similar financial position that existed before the occurrence of the loss or damage. In other words, the insured party is paid proportionately to the loss and there is no profit or damage upon receiving the insurance pay-out.

Although a life insurance policy is not a contract of indemnity, the insurance company is guided by the principle of indemnity when determining the appropriate amount of protection to write in a policy, as a check on the moral hazard.  

Insurance companies are required to determine the capacity for each individual they insure in the high net worth space. Not everyone can just go and get $50 million worth of Life Insurance. The insurable need has to be determined to avoid individuals being “worth more dead than alive”. A main form of supporting this need/ capacity is through Income Replacement - the primary and secondary income the individual would expect to gain, should he or she live to old age. Generally, the industry has adopted the following method of determining the Income Replacement capacity:

• Protects against loss of potential income up to the economic age of 75
• Formula: (75 – individual’s current age) x annual income

• Replaces loss of potential income from financial assets
  
• Formula: 30% x (net worth – cash)

Income Replacement is the main form of determining capacity, however other forms may further increase the capacity on an ad hoc basis (e.g. cover for future inheritance tax obligation).

Age: 50 year old Male

Family: Wife and two sons

Occupation: Business Partner

Net worth: $50M categorised as follows:

• $20M in business
• $20M in real estate
• $5M each in bonds and cash/ cash equivalents

Yearly Business Income: $1M

Capacity for this Profile:

1. Primary Income: (75 – 50 years of age) x $1M = $25 Million
2. Secondary Income: 30% x ($50M – $5M cash) = $13.5 Million

Total Income Replacement Capacity = $38.5 Million

Without Income Replacement Insurance:

An untimely event occurs at 60 years of age and the Client had no life insurance.

• Although his total assets had increased by a further $10M to $60M, the assets were mostly tied up in the business. He had a number of financial obligations including inheritance tax on half of his property portfolio (with an IHT obligation now of $5M), $6M left on mortgages on three properties, and a personal loan to the business of $1M.
• With most of the assets tied up in the business a forced sale to his business partners was made at a substantial discount. The family paid off the obligations but the estate reduced substantially in value and embittered family members, who clashed over the remaining assets and how they should be distributed.

With Income Replacement Insurance:

• The Client decided to purchase $30M of Sum Assured, which required a premium of $9M.
• He used the cash surrender value of the Policy to finance 72% of the premium value and other AUM to finance the remaining $2.5M, meaning all he needed to contribute was the yearly interest payment.
• At 3.25% interest on loan, he was left paying $292.5k pa ($2,925,000 over the 10 years) for a net cover of $21M ($30M SA – $9M loan).
• With his liquidity objective covered both on occurrence of event, and should he wish to surrender the policy he further optimises his portfolio. He reduces his cash position by $4M and bond position by $2M. This $6M he invests in equity and property, generating an average return of 6% (= $360k pa) and thereby covering the loan obligation.
• When the untimely event occurred, his family would receive $21M and can pay off the $12M in debts and obligations. The family could as well keep their family’s share in the business; have full ownership of the properties; and an additional $9M in cash. The family’s wealth and standing is thereby protected.

• Allows your estate to increase in value, providing more wealth and income for your family.
• Possibility of covering all financial obligations and giving insured peace of mind.
• Diversification of assets.
• Provides a significant death benefit should an untimely death occur.
• Optimises estate and current portfolio due to the positive carry on the loan.
• Since liquidity concerns are covered remaining assets can be further optimised.