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Lately we had a number of queries about what Long Term insurance is and I thought it may ad some value to write something about the subject. Life insurance is not an investment but for our dependants it is the difference between keeping their standard of living or being destitute in time of need. Very often we get asked why do I need life insurance. Well if you do not have any dependants and no debt you probably don’t need any insurance and should rather focus on building up an investment portfolio.
If however you have dependants, life insurance becomes critical for the future financial wellbeing of your loved one’s. The purpose of life insurance is to replace the loss of income or major capital expenditure that needs to be paid in future if one were to die or become disabled.
There are so many different factors to consider and the best would be to get advice from the professionals since each persons needs are different. However the purpose of this editorial is to highlight some principles. I trust that these will help you to ask the right questions and to enable you to make informed decisions. Remember we cannot blame others because we are financially illiterate, each one of us should take the responsibility to ensure that in today’s world we understand the language of money.
Please understand that one cannot cover all the important aspects in an article like this and secondly each one’s circumstances differ and therefore the principles described is generic and may differ dependent on a clients specific needs – the purpose is to equip people with knowledge.
Lets first start by describing what we mean by long term insurance
It is believed that the first insurance started with the Roman soldiers going of to war. They would arrange for their monthly wages to be paid into a central fund and if they did not return from the battle fields these wages would be paid over to their spouses and children.
Not much has changed in the modern world. People would pay monthly payments called premiums into a central pool. In turn the insurance company undertakes to pay out a predetermined amount to whoever the insured nominated as the beneficiaries.
The term long term insurance includes a wide range of products ranging from whole life, term insurance, dreaded disease, trauma cover, business insurance, like key man and buy and sell agreements, and other types of products.
The premiums are calculated by actuaries who take age, state of health, life style, hereditary factors, occupation and other factors into consideration. It is logical that a person doing dangerous adventure sports or someone who smokes has a bigger risk of getting injured or sick than someone who leads a quiet life with healthy eating and exercising habits. The formers premiums will hence be more expensive than the latter all other factors being equal. Normally the older one gets the more expensive life insurance becomes and that may be one reason why you should not wait until you are to old before you take out life insurance.
Who needs life cover?
I suppose a young person with no dependants and no debt does not need life cover. Well what young people tend to forget is what happens if they become disabled? These young ones however may need disability or dreaded disease cover. As described above the purpose of long term insurance (a collective term for life, disability, trauma insurance etc.) is to replace an income stream in case of an adverse event that prevents the insured from being able to generate an income as in the case of death or some accident that leads to disability.
Imagine for instance someone earning R10 000 per month being paralised in an accident and cannot go on working. How will such a person survive financially? If such a person had a disability policy with a disability insurance of say R3m the cash amount would be paid out which can be invested and from this capital the individual could withdraw a monthly income which should be close to the R10 000 he or she earned.
People with dependants however need both types of insurance (life and disability) since in both cases the need to replace income is obvious.
Dependants may be anyone who is dependant on you financially. It includes spouses, children and extended family. The question is what happens financially to your dependants in case of your death or you becoming disabled.
Insurance is a way of managing risk that is all.
So how much life cover do I need?
Because insurance is not an investment, (it only pays if you die and hence you cannot get access to the money before such an adverse event takes place), one should be careful not to have too much life cover. Very often advisors tell you that 6 to 10 times your annual salary plus any debt should be enough. As an example say Mr Clark earns R10 000 per month or R120 000 per annum and has no debt, he should then, according to this formula, need between R720 000 and R1.2m in death cover. Cover of this nature could cost you anything from R100 to R300 per month dependant on many personal factors.
However, age should also be considered since inflation has an effect on the purchasing power of money and the younger the dependants the more inflation will have an effect on the purchasing power of the capital. This means today a R10 note may buy a bread and half a litre of milk, in 5 years time the price of bread and milk may have gone up to the point where R10 only buys half a bread. In the example above the R10 000 Mr Clark’s family needs today may have to increase to R15 000 in 5 years time. How will this be provided for? Well the money from the life policy will be invested and earn returns or interest which will offset the withdrawal. In Mr Clark’s case I would be more comfortable with cover of between R2 and R2.5m since this would be sufficient to compensate for inflation.
Remember to add any debt, home loans, outstanding vehicle finance etc, as well as provision for childrens education in your calculation.
This is enough for now. Next time I will elaborate on the types of insurance and specifically how insurance companies distinguish between types of disability.
Till next time!
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