The Business Times, Wednesday 19 January, 2005

MONEY MATTERS

To (cover) each according to his needs

By Stanley Sim

AS independent advisers, we often have to review clients' insurance policies and we notice that many are paying high premiums without getting adequate coverage. Why is this so? Is getting ourselves fully covered against all insurable risks really that expensive?

In life, there are some risks that can cause great personal financial hardship. These include hospitalisation due to illness and injury, critical illness (eg, cancer, kidney failure), total permanent disability (TPD), vocational disability and long-term care. Personal risk management begins with identifying the risks that an individual and his family face and quantifying the financial impact of these risks, which we term 'insurance needs'. (Chart 1).

An individual's insurance needs differ according to age, financial situation and lifestyle. A young working adult with a huge mortgage and car loan has very different insurance needs from a debt-free retiree whose children have already completed their tertiary education.

To manage the financial impact of these risks, we can either retain them or transfer them. A high net worth individual has the option to retain some of these risks. For example, in the event of a critical illness like kidney failure, a high net worth individual can use some of his liquid assets to settle the hefty hospitalisation bills and still afford to meet family expenses. This method is termed self-insurance.

A more common approach is to transfer the risks to a third party, ie, the insurance company, by paying a fee or premium. With insurance coverage, the policyholder can enjoy financial protection against various risks and have peace of mind that his financial objectives, like children's education and retirement plan, will not be derailed

After identifying and quantifying the different insurance needs, the final step is to choose the right insurance to address each type of risk efficiently.

Life insurance comes in two basic forms: cash value plans (ie, whole life, endowment, investment-linked policies) and term plans. For cash value plans, part of the premium paid goes towards protection and part of it to the savings component (which forms the cash value). For a term plan, the entire premium goes towards protection; there is no savings component.

As shown in Chart 2, for a male non-smoker aged 35, a whole life policy costs 4.6 times more than a level term policy and 12.6 times more than a decreasing term policy!

Term insurance

From the cost perspective, term insurance certainly looks more attractive for someone who wants pure protection. To see if it makes senses for us to include decreasing term insurance as part of our insurance portfolio, let's ask ourselves this question: do we need more life insurance coverage against death and disability when we are younger or when we are older? For the answer, look at Chart 3, which illustrates the growth of a typical working adult's net worth over time. Over time, our net worth will increase with regular disciplined savings and investments. The dotted line shows the amount of death and TPD insurance coverage that one requires.

Our insurance needs against death and disability decline along with the decline in our financial commitment, as we near retirement. At retirement, we would have already amassed a sizeable amount of retirement funds that we can use as 'self-insurance' against the risks of death and TPD. So the reality is that the need for life insurance coverage against death and disability actually declines as we grow older.

Today, most consumers own high premium whole life plans (that cover death and TPD) designed with increasing death coverage. That explains why so many are paying a lot in insurance premiums but are still under-insured against risks like hospitalisation, critical illness, vocational disability and long-term care.

Using a decreasing term insurance to cover the risks of death and total permanent disability can generate substantial savings in insurance premiums. Part of these savings can then be used to address other risks like health insurance (eg, hospitalisation, critical illness, vocational disability and long-term care insurance). The balance of the savings can be channelled into a diversified portfolio of global equities and fixed income which could generate higher returns than cash value policies over the long term.

This strategy, known as 'buy term and invest the difference', is popular in mature economies like the US, UK and Australia. In Singapore, one reason why this concept is still not widely known is probably due to the compensation structure of the insurance distribution channel, which is largely commission based.

Whole life policies

As the commission derived from selling a whole life policy is substantially higher than that of a term insurance with the same coverage, insurance advisers may tend to focus their marketing efforts on high premium whole life policies rather than low premium term plans.

Nevertheless, whole life policies (with critical illness coverage) are still useful and should be included in one's insurance portfolio, to provide lifetime protection against the risks of critical illness like cancer and stroke. However, to address the risks of premature death and disability, using term insurance as part of your personal risk management plan is recommended due to its cost effectiveness.

Last but not least, it is good practice to review your personal risk management plan as insurance needs change over time. If you feel that you are paying too much in insurance premiums, it may be time for you to consult an independent adviser to help you evaluate your current insurance needs and insurance portfolio. With a proper risk management plan and the right insurance portfolio, one can deploy the savings into investments with higher expected returns and possibly retire more comfortably.

Stanley Sim Chu Wei, CPA (Singapore), AFP, is a training manager and licensed Financial Adviser Representative with New Independent. He welcomes feedback at stanleysim@ni.com.sg