The risks of using a traditional FNA for Iife cover

FMI Life
The risks
of using a
traditional
FNA for
Iife cover
Introduction
Using a FNA to determine Life cover?
The Financial Needs Analysis (FNA) is an entrenched part
of the financial planning process when advising clients on
appropriate levels of disability and Life cover. This is so
much so that the requirement to perform a documented
FNA is entrenched in FAIS legislation.
It is doubtful that most clients understand the critical
assumptions that underpin FNA calculations. And this
leaves them open to a number of serious risks:
For risk insurance, FNA tools calculate the present value of
all the assets and liabilities that will arise following a risk
event like the death or disability of the main breadwinner
i.e. the amount required if the Life Insured dies.
Assets would include investments and savings, the value of
realisable assets such as property, and Life cover benefits.
Liabilities would include a mixture of once-off and recurring
expenses, such as debt obligations, estate duty, death
expenses, and financial provision for dependants after
death.
In simple terms, if the present value of liabilities exceeds
the present value of assets, the FNA calculation will
recommend that Life and/or disability cover be put in
place to cover the shortfall – financial advisers use these
recommendations to determine appropriate levels of cover
for their clients.
FNAs work with present value (PV) calculations
FNAs use a PV calculation method that converts all future
assets and liabilities into a lump sum. The PV calculation
assumes that death occurs on the date of calculation so,
for Life cover, the calculation would be today’s liabilities
minus today’s (realisable) assets.
The implicit assumption is that the risk event, say death,
will occur on the day that the FNA calculation is performed.
Theoretically, the calculation should include allowance for
the probability of the risk event occurring at each future
point in time and a basis for projecting the difference
between liabilities and assets (the Life cover need) at that
same point in time. In reality, the date of death is unknown
on the date of calculation, as is the relationship between
assets and liabilities at that point in time. This inevitably
results in over- or under-insurance at all points in time
except the date on which the calculation is performed.
FMI Life
The risks of using a traditional FNA for Iife cover.
FNAs are based on assumptions about the future
Similarly, the present value of an annuity stream depends
critically on assumptions made about inflation, interest and
annuity rates, and (probably) beneficiary life expectancy.
There is also no guarantee that the lump sum amount paid
to a beneficiary can be re-invested on the assumed terms
at some unknown future point in time.
How does a traditional FNA calculate what lump sum is
required to produce an income of R25 000 per month for
the rest of a beneficiary’s life?
It calculates the lump sum amount required using today’s
Life annuity rates. These rates are a function of today’s
interest rates, inflation rates, mortality assumptions, and
future investment returns and inflation.
Consider this:
• In 1994, inflation rates were sitting at 9.5%, interest
rates at 15%, and investment returns were expected
at 15 – 20%.
• In 2014 (just 20 years later), inflation rates are sitting
at 6.5%, interest rates at 8.5%, and investment
returns are expected at 10%.
What does this mean? A FNA calculation in 1994 would
yield a lump sum recommendation that was exactly half
the recommendation that same calculation would have
yielded in 2014.
What will happen in 2024? Or 2034?
It can be argued that these problems can be managed
through regular reviews of the client’s cover. This is not an
ideal solution as it is administratively intensive and also
introduces future insurability risks as the Life Insured’s
health may deteriorate over time. The point remains that
the recommendation the FNA calculator produces today will
almost certainly not be the correct amount at the unknown
date of death.
The risks for beneficiaries
The risk continues even after the Life cover amount has
been paid out. Because traditional FNAs ‘promote’ the
conversion of income based liabilities into a lump sum
cover amount, beneficiaries are left with a lump sum
amount that they will need to re-invest in order to provide
a future income stream matched to their needs. The truth
is that beneficiaries receiving seemingly large amounts
(such as in the form of a lump sum pay-out) often lack the
discipline or knowledge needed to make sure that they use
their pay-out as intended.
Did you know? The risks of using a lump sum investment
to produce an income stream are so extreme that research
shows any insurer using a balanced fund investment to
match an income based liability would be required by
financial regulations to hold between 32% - 41% additional
capital to mitigate the risks.
Essentially, the use of lump sum benefit to match recurring
liabilities transfers risk from the insurer’s balance sheet
to the client’s. Even if the beneficiary is wise enough to
re-invest the lump sum amount, on what terms will they be
able to do so? And how will these terms be different from
the assumptions made when calculating the lump sum
amount required?
If actual investment returns or annuity rates on the
reinvestment date are lower or higher than those assumed
when performing the FNA calculation, then the lump sum
recommended will similarly be either too low or too high.
This brings us back to the initial problem – the implicit
assumption that the risk event will occur on the date
that the calculation is performed. In reality, the risk event
will occur at some point in the future, at which point the
level of annuity rates, achievable investment returns, and
even the beneficiary’s life expectancy may have changed
substantially.
In summary, using a lump sum to match an income liability
introduces a number of uncontrollable risks that many
clients may not have considered, including timing risks,
investment return and rate risks, and longevity risk (the
beneficiary may live longer than expected and the money
might run out before they die). Additionally, whole-oflife lump sum benefits limit the client’s ability to specify
different cover terms for different needs – for example, why
would you want whole-of-life cover when your intention is to
secure a debt with a 10 year repayment term?
FMI Life
The risks of using a traditional FNA for Iife cover.
Consider this:
Peter is 40 years old. He has no debt and is not liable
for estate duty. When he dies, he wants his wife, who
is 40, to receive an income of R25 000 per month,
increasing annually at inflation, until she dies.
Using an FNA tool, Peter’s adviser determines that he
needs a Life lump sum cover amount of R9 610 248
in order to provide the above income to his spouse for
the rest of her life. The assumptions behind this number
include:
• The investment return generated by the lump
sum will be 8.5% pa, net of taxes, expenses, and
commission
• The inﬂation rate will be 6.5% throughout the
payment of benefits to the spouse
• Peter’s spouse will live to age 90
These are the best possible assumptions we can
make today. Let’s consider how the answer changes
if we change the investment return and inflation
assumptions:
Inflation
Investment Return
9.5%
8.5%
7.5%
6.5%
5.5%
R 6,699,413
R 7,952,781
R 9,615,192
R 11,857,089
6.5%
R 7,959,404
R 9,610,248
R 11,830,965
R 14,867,141
7.5%
R 9,605,152
R 11,805,022
R 14,804,368
R 18,958,352
8.5%
R 11,779,258
R 14,742,543
R 18,834,234
R 24,569,493
9.5%
R 14,681,642
R 18,712,627
R 24,344,577
R 32,326,519
The original answer is the orange cell. Compare this
with the impact of simply increasing the inflation
assumption by 1%, and decreasing the investment
return assumption by 1% (as seen in the red cell).
The amount of lump sum cover required to match the
income stream is now more than 50% higher.
The two assumptions that have been changed have not
moved very far, yet the answer the FNA provides has
changed drastically. This illustrates just how sensitive
the results of an FNA tool are and how exposed
beneficiaries are to the risk that reality differs from
assumptions.
In addition to the above, the FNA also assumes that
the spouse lives to age 90. Even with this prudent
assumption, the risk is that the spouse lives beyond
age 90 and thus outlives her pay-out. With constantly
improving life expectancy, this is increasingly becoming
a possibility.
Conclusion
Current FNA methods convert all expected future cash
flows to a present value. This works pretty well for once-off
expenses (such as estate duty and debt settlement), for
which a lump sum benefit is the perfect match, but is far
less reliable when dealing with recurring expenses. This is
because the method relies on assumptions about the future
but those assumptions are based on today’s reality. This
approach implicitly encourages over- or under-insurance.
This means regular review of a client’s cover is essential.
Despite these concerns, lump sum benefits dominate the
Life cover market and are inadvertently promoted by current
FNA methodologies. We believe this encourages consumers
to purchase sub-optimal risk cover solutions. A far more
effective long-term solution to this problem would be to
purchase an insurance product that exactly matches the
future recurring liability.
FMI’s Life benefit is one such solution – with a
combination of income replacement benefits (Life Income)
and a lump sum amount (Life Lump Sum), it ensures
that risk is retained on the Life balance sheet, rather
than transferred to clients and intermediaries. The same
cannot be said of Life benefits that are determined solely
by an FNA tool.
At FMI our philosophy is simple. We pay claims.
For more information please contact our FMI Financial Advisers Distribution Team
on 0860 10 52 08, [email protected] or www.fmi.co.za
Insured by Guardrisk Life Ltd FSP 76. FMI is an authorised Financial Services Provider FSP 2717.

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