Personal insurance is becoming more difficult to obtain and increasingly costly to maintain. This blog outlines the approach we take when formulating how much insurance our clients need and strategies to manage its cost.
What is personal insurance?
This blog refers to personal insurance only. That typically includes up to four products:
- Income protection insurance – which pays a monthly benefit if you are unable to work due to illness or injury;
- Life – pays a lump sum benefit if you die;
- TPD – stands for Total and Permanent Disability which pays a lump sum benefit if you are unable to ever return to work in the future, due to illness or injury; and
- Trauma – pays a lump sum benefit if you are diagnosed with a ‘specified condition’ which, statistically, includes cancer and cardiovascular events. Even if your ability to be able to work is not impaired, you can still claim a benefit. Benefits are paid according to diagnoses, not symptoms.
Other common insurance products such as health, house and contents and car insurances are defined as ‘general insurance’ products. These are the domain of general insurance brokers, not financial advisors.
What determines how much insurance you need?
In most situations, the two key factors which dictate how much insurance you need are:
- Financial commitments and obligations including mortgages, living expenses, children’s education, dependents and so on. The higher the levels of commitments, the more insurance cover you need. I view the cost of insurance as a necessary consequence of borrowing money. That is, if you aren’t prepared to obtain insurance to reduce your risk, then perhaps you should reconsider borrowing.
- Your financial strength or net worth. The stronger your asset base is, the less insurance you need, as you have sufficient financial resources to maintain living expenses and meet goals for the rest of your life in the event you cannot work. Of course, if you do not have sufficient assets, you need some level of insurance cover.
Your requirements often depend on your stage of life
In the below video I walk you through the four common life cycle phases and how they relate to your insurance requirements.
Whilst young adults typically have very small asset bases, they also tend to have very few (or no) financial commitments or dependants. As such, they tend to need very small levels of insurance cover, or possibly none.
When you buy a home and start a family, your insurance requirements are probably at their lifetime peak. That’s because your financial obligations tend to be most significant (e.g. large mortgage, cost of raising children for the next 18+ years, etc.) at the same time as your asset base being relatively low. It is convenient that insurance is relatively cost-effective in your 30’s, so having an adequate level protection is often affordable.
As your kids get older and your asset base grows, arguably you can begin to reduce your level of cover, particularly as it becomes more costly.
As your children approach financial independence and you have concentrated on repaying your home loan, it may be appropriate to begin reducing your insurance cover, particularly as it becomes a lot more costly in your 50’s.
Income protection becomes less valuable the older you are because it usually only pays a benefit until you are age 65. If you are 30 years of age, you are essentially insuring the next 35 years’ worth of income, which is a very valuable asset. However, if you are 58, you are only insuring 7 years of income, which is far less valuable, especially since it is so costly in your late 50’s.
Assuming you have sufficient assets, it is safe and appropriate to cancel all insurance cover when you are 2-3 years away from retirement.
How much do you need?
You need sufficient cover so that you will still be able to achieve your goals even if you are unable to work. That can include covering things such as:
- Replacement of living expenses. If a surviving spouse will continue to earn an income, you may only need to replace a portion of living expenses;
- Repayment of debt. This would typically include the full repayment of any home loan and partial or full repayment of investment debt (at least to the extent that investments become neutrally geared);
- Compensate for investment asset deficiency i.e. if the client is not expected to have sufficient assets by retirement age; and/or
- Funding of specific goals such as children’s education.
The tension between insurance premiums and building wealth
Reducing the cost of insurance frees up more cash flow to invest. The more you invest, the more wealth you will accumulate, and the less insurance you need. It is a “chicken or the egg” type situation.
It is my view that you must find an acceptable balance by being willing to accept some risk, but not an unacceptable amount of risk. Optimising your insurance cover involves obtaining the appropriate levels of cover, with the highest quality policies (i.e. terms of cover) at the lowest cost. To use a common vernacular, you must get the best bang for your buck.
But if I can’t work, I can sell investments
Sometimes people think selling assets is an adequate response if they are unable to work. This may help you repay/reduce debt, but it creates another problem. That’s because the role of investments was to help you fund retirement. Therefore, selling assets tends to be a short-term solution that creates a long-term problem.
Important warning about new income protection insurance products
If you have an existing income protection insurance policy with a retail insurer, you should think carefully about cancelling or reducing your cover. That’s because new insurance products provide substantially less cover, particularly if you are incapacitated for the long term.
Insurance providers have not yet released all information and pricing, but we are aware of some big changes including reducing the contract term to 5 years (used to be non-cancellable), reducing benefits for claims that last longer than 2 years, relaxed disability definitions (i.e. less comprehensive cover) and so on. I’ll write a detailed blog about this when all details become available.
Your investment strategy must inform your insurance needs
Constructing a well-thought-out long-term financial plan makes it a lot easier to develop an insurance strategy because these two matters are closely interrelated. If you have a low asset base, then it’s likely you need more insurance. At the same time, you need to develop a plan to help you improve your financial position, which will eventually allow you to reduce your insurance cover. A holistic approach to insurance advice yields the best outcomes.