Most people reading this article has life cover with one or the other life insurance company. My question today is, how did you determine how much this cover should be and do you understand the implication of your life insurance decisions on your long term planning?
It is important that your financial plan or provisions should be relevant, i.e. are you insured for the right amounts, are you saving enough for retirement etc. Where we see a lot of plans going astray, is with the long term sustainability of the plan itself. I suspect this is not entirely disconnected to the fact that the person selling the products, more often than not, does not have any inclination to be around by the time the plan becomes unsustainable.
One of these problem areas is life cover. This concept has been bugging me for a while now. I noticed over the years that very few 70-year olds have any life cover in place anymore. On the other hand, I know for a fact that all of them at some stage had life insurance with the intention of keeping it for whole of life. Most people today will also tell you that they plan on keeping their life cover intact for their children to benefit from it one day and will only cancel the cover if they can’t afford it anymore. Somewhere along the line, this outlook therefore had to change and as we know, deviating from a plan normally costs money. And when people change their minds and stop their life insurance, what happens to all the unclaimed premiums? Can it be that the insurance companies figured out that sustainability of life premiums after retirement would pose a big problem for most, and that at some point the liability would fall off the books, handing them very nice profits?
Let me start at the beginning and try to explain why I feel that most people might be incorrectly insured and why they may be misappropriating their hard-earned money and why this might be the case for you too?
When you sit down with your planner, talking about life insurance, the questions normally go something like this: “What are your assets and liabilities and how much, on a monthly basis, does the longest living spouse (and the rest of the family) need from an outside source if the insured life dies?” To determine the amount of liabilities that need to be paid off at death is easy, but determining the amount of money needed to supply the spouse with an appropriate escalating income for life is a whole different matter. When the spouse is not present at this conversation, the amount that is mentioned as sufficient is normally quite a bit less than what it is when she is at the meeting. First tip therefore is, ladies, be sure to be present when your husband sees your financial planner. The same goes for the husband of course where the household income roles are reversed.
After these figures have been punched into a computer program, which normally uses normal life expectancy tables where you only get to live to about 82, an amount of required cover is generated and a quote is given (normally at standard premium pattern) to satisfy this need. Now here lies the problem; Even if this number is correct, this calculation will only be correct for the period immediately following your meeting. This calculation has to be done every year and theoretically, your cover has to be adjusted every year or two (up or down). Do you re-calculate your required cover at least every 2 years? When is the last time that you have done this?
As I will indicate in my example, these numbers that we get to, can be far removed from the true requirement. If this is the case, the implications for your family could be severe.
Tim (fictitious character) is 34 years old. He and his wife, Jane, are both well qualified and earn good incomes. They have two little children. Tim’s gross salary, before any deductions, is in the region of R75 000 pm while Jane is earning in the region of R25 000 pm. They have a total of R800 000 in outstanding debt and roughly R800 000 in accumulated investments (Pension fund and unit trust investments). On the question of how much Jane and the kids would need in the case of Tim’s untimely death, the answer was R600 000 (R300 000 each) for the children’s education and R25 000 pm for the rest of her life. This amount has to escalate by inflation (6%) each year. Tim takes the financial protection of his family very seriously and has total insurance (pension fund + private insurance) of R6 281 980. See what his calculation of required life cover, if using the traditional method, amounts to:
According to the traditional calculation there is a SURPLUS of almost R400 000 and Tim can afford to reduce his life cover to R5.9 million. There are a number of obvious problems with this approach though:
The next problem with this way of planning is how the need for life insurance and provision diverge over time. If we assume that the amount of cover required is indeed equal to what his provision currently is, Tim would still have to start reducing his cover from about age 48 if he doesn’t want to misallocate premiums. This is because the profile of required cover increases slowly, levels out at about 10 years before the end of his life expectancy, and then reduces to zero towards the end of your life while the cover and premiums will just keep increasing.
When you are AT the “required” cover, even you can imagine that life cover of R20million for someone of 65 will cost a fortune. This is why we don’t see a lot of 65-year or 70-year olds with any life cover, what more to say R20million worth of.
I believe that a more sensible way of looking at life cover, is to look at the income generator as an asset and try to determine “its” value and insure that asset. When I look at the Wikipedia definition of insurance it correlates with this view.
“Insurance is the equitable transfer of the risk of a loss, from one entity to another in exchange for payment. It is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss.”
This “transfer of risk of loss” is the transfer via the life policy to the life insurer. The “uncertain loss” is the loss of Tim’s income, and by calculating a present value of his potential lost income, we can put a value on it. If we then take his gross pay of R75 000pm as our starting point, we adjust for things like tax of 40% and contributions to a pension fund that wouldn’t have to be paid anymore, we can come to some estimation of the net loss of income. See example below.
Contrary to the traditional calculation, Tim has a shortfall of R2.5million. This is a difference in outcome of almost R2.9million and will have a significant impact on the family’s quality of life after Tim’s untimely demise. If my logic about the real risk of loss is correct, then Tim is currently under insured by about 28% instead of being over insured.
Check the logic and make up your own mind though:
When we plot these two different approaches to calculating the life cover requirement on a graph, it makes for interesting reading. The blue line on the graph (next page) represents what I think Tim’s life cover provision over the next couple of years SHOULD look like, while the red line would be the answer we would get to if we used the traditional method.
What should be obvious from the above is that Tim will be under insured for the period until he is about 59 (with the first 15 years being the most crucial), while he would be significantly over insured after about the age of 59.
The problem with being under insured is that, if the undesired event of Tim’s untimely death DOES transpire, there is no way of correcting this mistake after the fact. The shortfall Jane is going to have will be a proverbial line in the sand that she will have to live with for the rest of her life.
My view of insurance is that its sole purpose is to insure against the loss of an asset (think insurance on your car). I cannot see why we should deviate from this definition the moment we talk about life insurance. If you feel the same, a couple of compelling arguments come to the fore.
In closure just the following final thoughts that you should consider when thinking about your own life insurance provisions.
Let me stop here. Even the most loyal reader of this newsletter will probably be asleep by now. It is strange how this topic will not interest anyone who hasn’t been affected by incorrect provisions and how most people, even after reading this, would still not go through the trouble of understanding their own position. When something bad happens, this subject gets right up in your face though. The sad thing is just that there is very little remedial action that I or any other financial planner can take at this point. Please do not make this mistake. Get to someone who can do the proper analysis for you, think rationally and make proper recommendations to you in this regard.
A good scare is worth more to a man than good advice. – Edgar Watson Howe –
Please contact the author (Andró Griessel) if you have any questions or comments on this month’s 2Cents.
Disclaimer: Although all possible care was taken in the drafting of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone planning on taking any financial action based on this document, is strongly advised to first consult with their personal financial advisor. ProVérte Wealth Management is an authorised financial service provider with FSP no. 5966.