Life Insurance – Choose the Right Policy and Cover
Financial planning is not just about managing your money, but also about protecting your financial future. All carefully laid plans will be fruitless should you be affected by a financially devastating event such as death of total permanent disability. For a portion of the potential costs, you can transfer the risks to another party such as an Insurance company.
Why Do You Need Life Insurance?
Life insurance is the most basic form of risk management to protect your family needs through adequate insurance coverage against major illnesses, disability and death. This is also to ensure that all financial goals and objectives will still be met should any of the unforeseen adverse events take place.
The basic idea behind life insurance is to provide for loss of your active income. Currently, your family would be living on active income from your work or business, so if that source of income is lost due to disability or death, then your family would have a hard time surviving. If you are the sole breadwinner, insurance is even more critical as there is little backup, i.e. your spouse is unlikely to generate the same level of income even if he/she is to re-enter the work force.
How Much Should I Be Protected For?
While there are some rule of thumb calculations using a multiple of salary as a guide, the best method is to go through a Needs Analysis. Needs Analysis is a framework used by financial planners to determine the amount of money which is required for your family in the event they lose your income. It generally covers the amount of money required for the living expenses of your family, the children’s higher education, amount of loans outstanding, estate which you would like to leave behind for them and any other needs.
Needs Analysis will include projections like inflation and investment returns, so make sure you understand the assumptions used by your financial advisor in determining your insurance needs. A stress test on the assumptions is recommended to see how different rates can affect the total amount required.
Understanding the Insurance Quotation
One of the most misunderstood aspects of insurance quotation is the guaranteed benefits and non-guaranteed benefits in whole life policies. Insurance agents usually like to focus on the total payout which consists of the guaranteed portion and non-guaranteed portion. It is advisable to focus mainly on the guaranteed portion as this is the amount you will get regardless of how the company performs. The non-guaranteed portion may look very attractive early on, but many insurance companies were unable to declare the projected bonuses later due to losses from investments.
Types of Life Insurance Policies
There are 4 mains types of life insurance policies. They are Term Insurance, Endowment Insurance, Whole Life Insurance and Investment Linked Insurance.
1. Term Insurance
Term Insurance is generally the cheapest form of insurance as they provide the highest coverage with lowest premium. Term insurance is recommended for individuals who require high levels of protection but cannot afford to pay too much for it. It can also be used as a supplementary insurance to raise the protection temporarily until it is no longer required.
However, the term insurance does not have cash value in the policy upon expiry. Term policies are usually renewable up to an age limit at which they are no longer available, around 60-70 years old. Term policies may also come with a convertible option to convert it into a whole life policy.
While premiums are low initially, the premiums do go up as the policyholder ages. One of the alternatives is to get a level term insurance policy. Many people do not know that this product exists as insurance agents do not promote it generally. A level term insurance policy locks in the premium until a certain age. Level term insurance is highly recommended if you want a long term protection up to the age of 60+.
2. Whole Life Insurance
Whole life insurance policy is a lot more expensive than term insurance, but provides coverage for the policyholder’s whole life as compared to term insurance which has an age limit. The premiums are constant throughout the policy, so it is easy to budget for the insurance premium.
Whole life insurance accrues cash value over term, which consists of a guaranteed portion and non-guaranteed portion as discussed earlier. It is more important to focus on the guaranteed portion as the company may not declare the bonuses as projected.
3. Investment Linked Insurance
Investment linked insurance is generally a whole life policy which has benefits linked to investments. While investment linked insurance has the potential for higher returns as compared to normal whole life insurance, it also has potential downside risks like any investments. The investment portion is invested in unit trust like instruments, so the cash value is based on the price of the invested funds. However, the sum assured is generally much lower as compared to term and whole life.
4. Endowment Insurance
Endowment Insurance is a combination of insurance and savings instrument which provides a lump sum of money at maturity. It is commonly used as to save for purposes such as children’s education or retirement. So the endowment policy should expire just before the funds for the intended purpose are required. However, the sum assured is generally much lower as compared to term and whole life.
Total and Permanent Disability and Critical Illness
Total and Permanent Disability (TPD) is generally provided together with the life insurance, hence the benefits will be payable upon death or TPD. TPD generally refers to a permanent loss of income caused by either 1. Loss of sight of both eyes or 2. Loss of use of both limbs or 3. Loss of sight of one eye and one limb.
Critical Illness (CI) coverage on the other hand, is generally not included, but can be added through the use of a rider. The difference between TPD and CI is that the qualifying terms for TPD involves disability while CI covers various major illnesses such as a heart attack or stroke. One of the main criticisms of a CI rider is that it can accelerate benefit payments out of the insurance policy, leaving less death benefit when the policyholder dies eventually.
Choosing an Insurance Policy
There are many schools of thoughts when it comes to insurance. There is one which suggests “buy term insurance and invest the rest”. The idea behind this is that the guaranteed benefits of whole life insurance provides for a low rate of return which can be easily beaten if the policyholder invests in other instruments. Some suggest only whole life policy as there is cash value while others suggest a combination of both. When it comes to choosing the insurance policy, it is more important to focus on the amount of sum insured required first; the type of insurance comes second. The choice of term or whole life generally comes down to affordability of premiums.
Even for those who can afford the premiums, it may not make sense to take up a huge whole life policy amounting to millions. The premiums will be simply too high. A better option would be to use a combination of whole life and term.
While term policy ends at age 60+, one would generally not require life insurance by that point of time as the children would have mostly grown up and most of the household debts would have been cleared by then.
Investment linked insurance is generally not recommended as the sum assured is very low compared to the premiums. That is because the insurance charges are very high for investment linked insurance, even when compared to whole life insurance. It is better to split up insurance and investments instead of lumping them into one.
Getting Independent Financial Advice
It is recommended to get an independent financial adviser or consultant who can provide risk management planning as part of a comprehensive financial plan. An independent adviser can give more objective advice and provide a wide range of insurance products from the different insurance companies as opposed to an insurance agent who is tied to a particular company. Make sure that the adviser performs a thorough Needs Based Analysis before making recommendations.