This is a continuation of our article series that began with How to Manage Personal Financial Risks, where we explored the various financial risks individuals are exposed to, and the approaches you could use to manage those risks. In the previous article Using Insurance to Reduce Personal Financial Risks – Part 1 and this Part 2, we are focusing on the role of insurance in managing and ultimately reducing our various risks.
For clarity, it is not our objective to recommend which insurance product is right for you, nor do we intend to provide a complete explanation of insurance terms and conditions. Both of these matters would need guidance from an insurance company and its authorized representatives.
In the previous article, we noted that insurance is commonly categorized into life and general. Let’s consider each in more detail.
In a broad sense, life insurance is designed to protect against loss of income, which could arise in various ways:
- Premature death
- Ill health
- Ageing – we’ll specifically cover this in a separate article series
The risk of income loss is particularly significant when you have dependents, but it is also important even if you are without dependents because you still need to provide for yourself.
Let’s examine the options for each risk.
Risk of premature death
Premature death could affect those you leave behind in several ways. It results in an immediate loss of income, which could lead to a reduced standard of living for those who relied on you. It can expose those you leave behind to fulfil your obligations, as well as prevent you from building an estate to leave for your dependents. There are various forms of life insurance to protect against premature death.
Note you may sometimes hear the description “life assurance” versus “life insurance”. While there is a subtle difference between the two, the distinction has become less relevant over time, and for our purposes, they could be considered interchangeable.
Term life insurance pays the face value of the policy if the insured dies during a specified period of time, for example 10 or 20 years. The coverage ends when the term expires.
All premiums paid are used to cover the cost of protection, and as such, term life insurance is pure insurance protection. It is referred to as “pure” because there is no savings component/cash value build up. Generally it is the least expensive form of life insurance to purchase.
Term insurance works well when you only need insurance cover for a specific period of time e.g. while you have a loan outstanding, or until your children complete tertiary education, or you currently have a low level of savings and family members who rely on your income – term insurance can protect you while you build your level of savings.
Whole life insurance
Whole life is permanent life insurance i.e. once you pay premiums according to the policy, you are protected for your “whole life”. This is in contrast to term insurance, which is in place for a specified length of time.
Whole life policies could be viewed as insurance with a guaranteed savings component built in. Over time, this savings component allows a cash value to be built up, which provides the policy owner with certain options (e.g. taking a loan secured against the cash value or cancelling the policy in the future and withdrawing the accumulated cash value). All investing decisions regarding the savings component are made by the company and you have virtually no say.
Whole life premiums are more expensive than term life premiums because you are also paying for the savings element. In addition, once the premiums are set, they are fixed for the lifetime of the policy.
You’ll sometimes hear term and whole life policies referred to as “Traditional” life insurance products. This is because they are characterized by fixed or level premiums and predetermined cash values.
Universal life insurance
Whole life insurance, with its consistent premiums and guaranteed cash values, is sometimes regarded as “old fashioned”. During the 1980s, a variation on whole life insurance called universal life became popular.
Universal life essentially unbundled (i.e. separated) the insurance and investment components, which provided policyowners the flexibility to change premium payments, adjust death benefits, allocate amounts separately to the insurance and investment components, as well as choose where funds could be invested (within certain parameters). Another major difference compared to whole life is greater transparency with fees/costs incurred.
It must be recognized that with this level of flexibility comes added complexity, more than some individuals will be able to manage comfortably.
Endowment insurance is probably best viewed as a term policy with a savings component, but when the policy matures (at a date you choose), or if you die during the life of the policy, you receive a guaranteed payout, called an endowment.
So, it is similar to term insurance, except with term insurance, you do not receive a payment if you are alive at the policy expiry. It is also similar to whole life as it includes a savings component, but whole life policies are in force until you die.
Because there is a guaranteed payout over a fixed term, monthly premiums are relatively high.
Most insurance policy documents are fairly standard, apart from policyowners being able to choose coverage levels or similar options. You can achieve a more tailored policy (one that is more appropriate to your needs) through policy riders.
A policy rider is a change to the basic policy to include additional coverage e.g. an accidental death benefit rider (provides an additional death benefit in the event of death due to accident). There are usually several possible add-ons at an additional cost.
Risk of Ill health
Protection from the impact of sickness is provided by various forms of medical/health insurance. It is usually a supplement to public health care or in addition to that provided by employers.
Medical issues range from simple conditions that require basic physician services (including dental and vision) to other cases that require surgery or hospitalization. Depending on the severity, it may not necessarily result in a loss of income, but it could result in unplanned expensive treatment. On the other hand, more serious situations could lead to long convalescence (i.e. recovery) periods with no income.
Most insurance companies offer a range of plans to provide individual and family medical coverage.
In addition, there is evidence that more persons are contracting and surviving the more significant medical problems, namely cancer, stroke, heart attacks (“Dread diseases” ). These conditions are protected by critical illness coverage.
Risk of disability
Disability is a situation where you are unable to pursue your regular, or any work, due to injury or illness. For most persons, being able to work is a necessity to earn income in order to provide for themselves and dependents. Being unable to work could therefore lead to major financial hardship.
In broad terms, disability insurance pays you a portion of your previous income – the amount and length of time you are paid varies by policy.
All types of life and protection insurance can be provided either individually (i.e. a policy is issued in your name) or as part of a group plan (a master policy in place). Group plans are most commonly arranged by employers, with the employer paying a portion of the premium.
The two main points to note with group insurance is that they are generally cheaper than obtaining individual coverage, and if you leave the plan, your coverage terminates.
Broadly, general insurance (also called property and casualty insurance) protects against personal losses, for example:
- Losses related to personal property due to fire, theft, floods, etc. and
- Losses due to personal liability
Personal property generally encompasses automobiles and real estate.
Automobile insurance provides various levels of coverage to protect from losses involving an automobile. By law, the minimum insurance you can obtain is third-party coverage, which ensures that others are protected in the event you cause an accident, but you will bear the cost of your vehicle’s repairs and any other liability. On the other hand, with comprehensive coverage, your vehicle’s cost of repairs would be covered if you are at fault, and other types of perils (e.g. floods) could also be included.
Homeowners insurance protects your home and contents, which for many persons constitutes their largest investment. You can obtain protection against various perils (e.g. hurricanes, floods, fire) and various components can be covered (e.g contents, valuables, the home itself).
This is an exposure to risk of loss from action taken by a third party for injury or damage. Numerous of these circumstances exist: a simple example could be pets – you should have insurance if you have pets that could harm visitors. Another example could be professional indemnity (e.g. a lawyer breaching professional duty of care).
As you can see, insurance plays a major role in providing financial peace of mind, and in many respects is the cornerstone of a good financial plan. In future articles we’ll look at different aspects of insurance in more detail.
We hope you enjoyed reading, and we’d love to hear from you in the comments below if you have questions or experiences to share!