Insuring for the right reasons

Ever felt baffled, bored or outright angry when confronted with insurance advice? You're not alone. According to a survey in Insurance Times, 45 percent of respondents who had ditched advisers thought their adviser didn't provide enough information or options, and 34 per cent thought the agent didn't have their best interest in mind.

While it's easy to point fingers, perhaps some of the dissatisfaction derives from a widespread blurring of the uses of insurance. When the marketing hype is stripped away, insurance is a very simple idea, and it should confuse nobody. Insurance is a way to transfer risk - not a panacea for financial well-being.

Arguably, Singaporeans continue to (mis-)use insurance for investment planning, to under-insure themselves, or to insure for the wrong period. Yet a golden rule sums up all you need to know: insure a lot for a little, for the right time. If you can remember that you shouldn't go too far wrong.

Insure…

You can avoid, reduce, retain or transfer risk. For example, you can avoid risk by not taking up parachuting as a hobby, reduce risk by not smoking, and retain risk by accepting you will cover the loss of a misplaced wedding ring. Transferring risk is what you do when you buy insurance (this is why insurance was invented!). You should do that if there is a possibility of an event happening, and the consequences of the event are very adverse to you or your family.

The classic example of risk transfer is life insurance on the sole family breadwinner. That idea is easy to grasp. Less obvious is insurance against the death of a mother who stays at home to look after children. Here, the risk of having no childcare is transferred away. Hence it's mistaken to consider life insurance as simply breadwinner's insurance - it's fundamentally about transferring risk.

A lot…

Under the rule, "a lot" means insuring for the maximum future cost of the unwelcome event. This means forecasting costs, rather than simply taking the current income of a person, or market value of a service. Determining future cost may be easy. For instance, insurance to cover a home loan would need to be equal to the outstanding amount at anytime.

In other situations the amount of coverage might take a bit of calculation and knowledge. For example, to cover college education (in the event of the death of parents) one should investigate current college costs, and then assume high inflations rates, as much as 10% per year.

Fortunately, costs of disasters can go down too, often in a predictable fashion. Money to provide for children works this way. The chart below shows how costs gradually decrease to zero as children grow up. Insurance can cover to the maximum at any point in time using a number of possible strategies, including a sequence of level term insurance, or a decreasing term. Either approach might provide "a lot" without over-insuring (which helps on reducing costs — "the little").

In the earlier example a mother's services are not billed at a dollar value. Yet the father needs to consider how much money would be required if his wife were not around. That could mean a maid to take care of the children, part-time tutors to help with homework, and taxi fares to ferry children around, to name but a few hidden costs.

Likewise, it would be a mistake to assume that an individual has no economic value after retirement. A grandparent could provide valuable, but free, assistance in many areas to working parents. The replacement cost of that help could be significant.

For the right time…

There are plenty of needs that last the whole of your life (see table). For example, estate duty and funeral expenses don't occur on a known date. Likewise, money in the event of grave illness is likely to be a lifetime need.

Then there are needs that have a predictable duration. For example, it's reasonable to provide for children until their 21st birthday, at which point no risk remains. Loans usually have a fixed tenure, so risk is only present for that duration. Insuring beyond that date is wasting money.

Insurance comes in two forms: for a fixed period of cover ("term"), or for the lifetime of the insured ("whole life"). The golden rule states that you should match permanent needs with permanent insurance, and match fixed period needs with term insurance.

For a little

How do you keep expenses low without compromising your financial well-being? The largest liabilities you will ever have are typically non-permanent, so can be dealt with at low cost using term insurance of a suitable matching period. It's sensible to have the bulk of your insurance in term policies.

If your need is investment it's probably better to seek pure investment products rather than insurance policies with cash values. As well as having modest rates of return, such policies have low or non-existent surrender values in their early years.

Does that mean you should always "Buy term, invest the rest" (meaning buy term insurance and invest the saving on premiums compared with those of a whole life product)? No. More logically you should "buy term for term" and "buy whole life for whole life". You could slip up if you bought "term for whole life" and "whole life for term", although there can be exceptions.

Here's an example which demonstrates that the most effective solution depends on the individual's need, identifying it properly, and not necessarily choosing what seems the lowest cost solution over the short-term. Indeed, it could be an expensive mistake to buy a term plan for a permanent need, and then trying to rectify it later in life when premiums have shot up.

By the same argument, it doesn't make sense to get life insurance for a child simply because the premiums are very low when they are young. Young children don't usually have dependants - generally, it's the parents that need more life insurance (a child needs medical and critical illness plans). When the child has reached his early 20s the premiums will still be low.

Building in flexibility can also lower your long-term costs. If you do decide to get term insurance, check that you can renew it regardless of your future health. You might want to extend coverage when it expires, perhaps saving you money later. Making insurance renewable might add only 10% to your premiums.

Be aware that small amounts of coverage could cost proportionately more (see chart), and a little extra insurance might take you into a cheaper band. A consequence of this is that two policies of $50,000 cover from two separate companies might cost a lot more than a single policy covering $100,000. On the other hand there is a good argument for diversifying your insurance providers - insurance companies can have accidents too!

Another sensible strategy is to anticipate the motivation and skills of your potential financial adviser. One who offers a range of pure investment products as well as insurance policies has less incentive to sell the wrong products (generous commission levels on whole life can be a temptation). Pick an adviser who is well-rounded enough to understand the distinction between risk transfer and investment, and who is able to calculate the most advantageous solution for your needs. Best of all, choose one who follows the golden rule - then you should never get insurance for the wrong reasons.