The ‘What If…?’ Question

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Figuring out how much life insurance you need can be daunting. To the average person, life insurance seems complicated and expensive, and finding someone to ask about it who does not earn a commission from products sales is not easy. When times get tough, it is all too tempting to cut insurance premiums out of the budget in order to get by. For people nearing the end of their working life, the question is, do you still need life insurance and if so, how much?

Before considering how much insurance you need it is important to understand what insurance really is. Put simply, when you buy insurance, you are entering into a contract to transfer financial risk from yourself to another party. Insurance premiums are the price you pay for the benefit of transferring risk. Once you understand that concept, it becomes a lot easier to work out how much insurance you need. There is a three step process to follow:

  1. Determine what financial risks you face
  2. Quantify the risks in dollar terms
  3. Decide how much risk you can afford to accept yourself and how much you can afford to pass on to another party.

Those who don’t follow this process can find themselves overinsured, in which case they are paying too much in premiums, or underinsured, in which case they are taking on too much risk. In an ideal world it would be possible to transfer all financial risk to someone else, however the cost of doing this would be prohibitive. Determining the optimal amount of insurance cover is a delicate balancing act between deciding how much risk you are comfortable accepting and how affordable it is to pass risk on to someone else.

The easiest way to identify and quantify your financial risks is to ask the question, ‘What if….?” followed by a range of different adverse events. These could include:

  • I die
  • I am too sick to work for an extended period
  • I am permanently disabled and unable to earn as much as I currently earn
  • I require medical treatment which is not publicly funded or for which there is a long hospital waiting list

Consider the financial impact of each of these events on yourself and on those who are financially dependent on you, including your family and your business partners. The answers may surprise you. For example, if you are single with no children or with financially independent children, your family would no doubt be very upset if you died, but would probably suffer no adverse financial impact other than having to pay for your funeral. In fact, if you have assets, your family are likely to be financially better off if you die and it is unlikely you need death cover. However, if you are too sick to work for an extended period, you could suffer considerable financial loss, especially if you don’t have a partner to help take care of you. Protecting your income may be of more benefit than insuring your life.

Having said that, the issue for young people is insurability. As you get older you are more likely to develop health issues that could result in exclusions or high premiums, so arranging at least some basic cover when you have no health problems is a good idea.

The financial impact of adverse events can include loss of income and increased costs of living (for example having to pay for care for yourself or your children). Loss of income may in turn lead to difficulty with debt repayment and with saving for retirement. Calculations are necessary to quantify how much you would need either as a lump sum or as regular income to maintain your standard of living for you and those who are dependent on you at an acceptable level. As you near the end of your working life, the risks around loss of income become significantly less.

Buying insurance is not like buying lottery tickets. The aim of insurance is not to allow you to potentially benefit from a financial windfall that will increase your standard of living. In fact, if an insurance claim would result in your standard of living rising, it probably means you are over-insured.

Over your lifetime, your insurance needs will change as your income, your wealth, and your family circumstances change. It is vital to review your cover on a regular basis, preferably annually As a general rule, your insurance cover should reduce over time, especially once you have no debt and no dependents and you are not relying on income from employment. A good insurance broker will help you quantify your financial risks, recommend an affordable solution and review your insurance needs over time.

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