How much insurance do you need?

BY BRUCE SHEPPARD

OPINION: If you’ve been following this blog’s lessons on financial independence, you have now learned the lesson of earning a dollar and spending less.

You have begun to work out how to earn more money, you have observed and understand compounding, you have worked out how to manage your banking, and most importantly you have sorted out your needs from your wants and how to resist temptation. You are now ‘level one’ street smart when it comes to money.

Once you have accumulated a bit of capital, prepare for the salesmen who want to take it off you. Some will sell you the story about how bad life in retirement will be. You’re probably in your 20s and they are selling you how horrid it is going to be when you are seventy – hell you might die before then.

They will try to sell you savings plans – KiwiSaver and all sorts of organised things to deprive you of the pleasure of you controlling the growth of your wealth yourself. In short they want to drive you back into dependency because when you are truly independent you start thinking.

They will tell you how bad it will be if you get sick, or have an accident or even die, and that you need to worry about these things too. Come on if you die who cares. Tell all these sods to get lost but one, the guy who wants to sell you medical insurance, and/or income continuance insurance.

Now there is plenty of choice in this market and the products are all different. The guy talking to you will pretend that he is an insurance consultant, or maybe he will tell you he is a broker. He will dress nicely and speak with absolute authority, but he is likely to be nothing more than a door-to-door salesman.

Insurance selling techniques are way more sophisticated than the sales techniques for selling a car. They try to get to you by all sorts of means. They will try to get access to you via your employer, which means validating their credentials on the back of other relationships you respect. They will network with accountants and financial planners (sometimes financial planners become insurance salesmen too). Through these respected relationships they open the door to you. Don’t be fooled.

The process is simple, they share the commissions with the people who recommend them. You still have to understand that they are nothing more than door-to-door salesmen, paid on commission and sharing it with others for lead generation.

If you choose to avoid all insurance it doesn’t alter the fact that some of these risks are real and do threaten your medium or long term security. So if you do not insure some of these risks it means you need to have more money in the bank for a rainy day than would otherwise be the case.

So how much do you need in the bank to cover these risks to your independence?

The first risk that is uninsurable is joblessness. If you are still dependent on a job to pay the bills hold at least six months of the cash you need to pay the bills in the bank on short term deposit. For most people that will be around $25k. Until you have this much in cash you should not even think about housing or investing.

The next risk is sickness or accident that deprives you of your ability to work either for a long time or permanently. If you choose to self insure the sum you need to cover this to age sixty five is enormous, so you will never be investing, but at least the amount gets less as you get older.

The final risk is death. Under no circumstances should you be sold life assurance while you are single or even if you are in a relationship without children and debt.

If you do get sick or have an accident the number one priority is to get back to work as soon as possible, thus medical insurance is essential as waiting on a list in the public health system burns up your time and your future.

Medical Insurance.

There are many options to consider.

Firstly you should buy this insurance when you are young as when you get older insurance excludes pre-existing conditions, and the older you get the more of these you will have.

Never lie on an insurance application, if you take drugs or smoke dope tell them, if you get sick and they find out, and they will, they won’t pay out.

Don’t buy policies that dollar churn. You can get policies that pay 100 per cent of everything. These are expensive and if you are healthy you will not get value from these policies. Only buy cover for the really big things - heart, cancer, orthopaedics and other electives. If you buy the dollar churn policies the small print will drive you crazy and you will forever be filling in forms while your insurer builds up an enormous health database.

Medical insurance is something you will need for your entire life, but sadly not one single insurance company offers a whole-of-life policy in this space. The reasons for this are we are living longer, we expect to have our plumbing working well for longer, and medical science is advancing quickly and costing more. There are so many variables it is almost impossible to cost.

Most of these policies have caps on cover and also give the insurance company the power to direct when and where you will be treated. As you get older and wealthier you will work out that these restrictions and caps are such that you may choose to self-insure. You can’t do this when you are young as your future income is your greatest asset and anything that stops you earning that income must be covered.

There is not much point reading the policy documents for these policies as they all have a clause giving them the power to extend or contract the cover on notice  to you, but read it anyway. Southern Crosses policy document is long and arduous, but at least in plain English.

Income Continuance Insurance

Theses polices are usually offered by life offices, although banks have now got into it as well. The polices must all be carefully read.

Remember the purpose of the policy and you will buy the right cover. The purpose is to cover your income that you would lose if you can no longer work due to illness or accident.

In NZ we have ACC, so the policy will only top you up after ACC has paid you. ACC pays 80 per cent of income with a cap, and for most people the capped amount is enough to pay the bills. If however you are spending more than $70k pa it will not be enough. When you are young most income stopping events involve accidents. As you get older it will be sickness, but again pre-existing conditions are always excluded so it is better to buy this cover when you are young.

Make sure that the policy is automatically renewable at your option to age 65. Some are not.

Make sure any cover is adjusted for CPI.

Make sure that you have an agreed value policy, not one that requires you to prove your pre-disability income. These policies are a pain when you are completely incapacitated, who is going to do this for you?

Choose to cover yourself for your expenditure plus a bit, not your income. This is the real risk, your lost income above expenditure is the savings you would have produced if you had had a normal life. If you go on claim for a long time, you will not have a normal life. Accept this, but cover the cash you need to pay your bills. Do not over-insure.

Elect the longest stand-down period you can, but get them to price the variables. Sometimes the stand-own period doesn’t save you as much as you think. If you have put aside six months cash in the bank for joblessness, then you can self-insure the first six months of sickness too.

Over time your cash needs may well increase, so also check to see if they will allow you to increase your cover by more than CPI. Often you will have a right each year to increase your cover by 5 per cent without fresh medicals etc. You should elect to do this each year, if you become over-insured you can always decrease the cover later.

Critical Illness and Trauma cover

This is the newest Life assurance sell. The pitch is, if you get sick it would be nice to have some of your life cover paid out while you are alive so you can make the most of whatever time you have left. For some illnesses you will still have a bit of good time left, but mostly when you are sick you just want to get better. This cover is expensive, if you have medical insurance and loss of income insurance don’t buy this cover as you will be  doubling up cover on the same risk.

Permanent Disability

If you are permanently disabled and can no longer work, this pays out the life assured sum in total. This is a useful extension but only if you need life assurance for other reasons.

Life assurance

Never buy a whole of life policy. You will not need life assurance for your entire life, and it is a bundled product of risk cover, and investment without transparency of cost or efficiency on either.

You will only need to consider life assurance in the context of your responsibility to others you care about. The amount you need is the amount that will ensure their quality of life will be persevered if you are taken out.

You should have enough insurance to pay off all debt and leave an investment fund that will produce sufficient cash with the capital being drawn down to get your kids to adulthood and educated, and your wife or husband to age 65 or beyond without having to change their own work habits. The good news is that for young people this cover is as cheap as chips.

The salesmen

Not all of these guys are bad, some do understand that these risks will be with your for your whole life and therefore they want to build a relationship with you that will be long term. The right broker will become part of your financial team over your life. It is these guys who will be around to help you if you go on claim. So while you must understand how they get paid, just because the insurance company is paying them doesn’t mean that they will work exclusively in the interests of the insurance company.

The good ones will not over-sell to you, they will help you understand what you actually need to be secure and simply sell you what you need.

Once you have dealt with the risks to your income and life you are then ready to go to the next step on the path to independence.