Chapter 8: Insurance and a Will
An unavoidable fact of life is that things happen unexpectedly. Occasionally, these unexpected events may result in damage to you or your belongings. Falling from a tree in the school yard and breaking an arm or forgetting a phone at a concert stadium are a few examples. While inconvenient, these events are typically only temporary setbacks on an otherwise enjoyable path through life. The need for insurance occurs when the potential damage from unexpected events goes from unpleasant to unmanageable. This typically happens at two major times: when you make larger purchases and as you develop dependents. You should consider insurance if damage or loss to a recently purchased asset would leave you financially unstable. In addition, if you have dependents—someone that relies on you for support—insurance is important to protect you from potentially losing your ability to provide for them.
Buying insurance presents a valuable tool to protect yourself from the unknown. Through relying on averages, insurance companies can take on risks that you can’t handle on your own. A house burning down, a car crash or, in the worst-case scenario, death would likely leave you or your family facing financial hardship if it weren’t for insurance.
Insurance companies group your situation, which presents unpredictable risks, with others in a similar situation. This forms a collection of people with a much more foreseeable and consistent level of risk. For example, while it’s quite difficult to predict when any one person will pass away, the average life expectancy across a whole country is more predictable. Insurance companies don’t know where or when tragedy will occur, but they can estimate what will happen on average over time. Through this process, insurance companies can take unmanageable risk off your hands for a fee.
Insurance Premiums
Insurance companies work by collecting fees, called premiums, from many customers and pooling the money together. As disaster strikes individual customers, the insurance company makes payments as outlined in the customer’s insurance coverage. The premium you pay depends on the riskiness of what you’re covered for. This risk depends on several factors including:
how frequently the event happens to people in similar circumstances
the cost if the event happens
whether you have a deductible that you’re required to pay toward the cost
whether there’s a limit to the insurance company’s coverage
The following provides a common example of an insurance company collecting premiums for car insurance. A twenty-three-year-old named Jason approaches an insurance company for a quote to insure his car against the risk of a crash. The insurance company determines that the chance of a crash occurring in a month is 0.1%. They also determine the cost of the average crash to be $50,000. By multiplying the two together, the company expects its cost to insure Jason’s car to be $50 a month. The insurance company may quote a $75 premium that Jason needs to pay monthly. This covers the $50 risk, operating expenses, commission for the insurance agent and the company earning a profit. The $75 is collected from numerous people all with similar risk levels. It’s then set aside for the future.
After a month of collecting $75 from 1,000 customers, the insurance company has $75,000. The expected number of crashes across the 1,000 customers is one, since there was a 0.1% chance of an accident. The resulting damage of $50,000 from the crash is covered by the $75,000, and the cycle continues for each future month.
Exhibit 22 – Monthly premiums are collected and pooled together by the insurance company. When a car accident occurs, the insurance company pays the policy holder, and the remainder covers expenses and profit.
Coverage for Major Purchases
Whether you need insurance and the amount of coverage required varies from case to case. The goal is to eliminate unmanageable risk if it exists. In the case of insuring an asset such as a home or car, you’d likely want insurance to cover any expense that would leave you financially distressed. Most insurance policies have something called a deductible, which is the portion of any damage or loss that you must pay. This deductible helps minimize frivolous claims and lessens the cost to the insurance company when a payout is required. The higher your deductible, the less expensive the premium since the cost to the insurance company decreases. It’s important that the deductible is an amount you can afford.
Once you’ve determined a reasonable deductible, you’ll want to decide how much coverage you need. It’s common to insure an asset for the amount it would cost to replace it with an equivalent. By insuring your assets for the cost of replacement, the only expense you’ll have if something goes wrong is the deductible. If you’d like to lower your premium, you could insure the asset for less than it would cost to replace. This option is only reasonable if you’re willing to take on some of the risk yourself through adjusting your lifestyle if required.
Coverage for Loss of Income
With assets now taken care of, it’s time to review insurance that covers the loss of income due to disability or death. Families function through the combined efforts of every member. If the contribution from one or more member is lost, the ability for that family to function begins to falter. Once you have dependents who rely on you for their livelihood, you’ll want to protect against any unmanageable risk. Disability insurance and life insurance help guarantee that your dependents are looked after financially in the event of an injury, an illness or death.
Disability Insurance
Your need for disability insurance depends on several important factors, including:
how an injury or illness would impact the work you do
how dependent you are on your income
any existing coverage you have through your employer or government programs
Disability insurance can be purchased to cover you for a short-term period of three to six months or on a longer-term basis. The goal is to ensure that between all your coverage, you’re able to meet your expenses while you figure out a long-term plan. If you’re not sure about your needs, you can shop around between disability insurance providers to get opinions and pricing.
Life Insurance
Life insurance is a crucial step in almost all financial plans. While budgeting, saving and investing are all important, their benefits are of little help if an income provider passes away. To address this, there are two main types of life insurance available:
Whole life insurance, which typically provides a payout when the insured party passes away or at a predefined maturity age
Term life insurance, which provides a payout only if the insured party passes away during a defined period, usually ranging from ten to thirty years
Whole Life Insurance
With whole life insurance, premiums are more expensive because it’s a combination of pure insurance coverage and a savings product. Over time, the policy builds cash value because the amount you’re paying in premiums is partially going toward investments. While this may sound attractive, the fees charged on the investments are often higher than you can find elsewhere.
Term Life Insurance
With term life insurance, you purchase insurance coverage only, and as a result, it’s less expensive. A common approach is to select term life insurance and to put the savings from the lower premium into investments yourself. This way you have life insurance and maintain control over how your savings are invested. A second benefit to term life insurance is that as your coverage needs change, which is common as your savings grow and dependents shift, you can adjust the amount of insurance you’re purchasing.
Term life insurance works similarly to the previously discussed car insurance example. Based on your age, gender, health conditions and other factors, the insurance company determines the cost to provide coverage. This includes the likelihood that you could pass away over the length of the ten to thirty-year term. Combining this likelihood and the coverage of your insurance, which is the amount the company pays if you should pass away, provides the expected cost to the insurance provider. Adding the expected cost to the expenses we outlined previously determines the premiums required to take on the risk.
Premiums are then charged over the period of the term at a constant rate. If a payment is required due to your passing, it’s provided to the beneficiary named in the insurance plan. If you survive through the term of the insurance coverage—as is often expected to be the case—then no money is paid by the insurance company. While the company may not pay out in most cases, they’ve done their job of removing an unmanageable risk off your hands.
Calculating the Coverage Needed
The most important number to consider when purchasing life insurance is the amount of coverage you need. This number determines how much you’ll pay in premiums and is how much your family will receive in the event of your passing. It’s important that you take the time to calculate what you need. Too much coverage leads to unnecessarily high premiums, and too little coverage could lower your family’s standard of living. To demonstrate how to calculate the amount of insurance coverage needed and to show how this coverage may change overtime, we’ll consider an example involving a family of four.
Life Insurance for a Family of Four
Today the family in question lives comfortably on a combined income of $80,000 after tax. They’re setting aside savings, making payments toward their mortgage and have two cars in the driveway that are nearly paid off. If either parent was to pass without life insurance in place, the damage to the remaining family’s well-being would be substantial.
There are two common ways the family can determine how much coverage they need. We’ll refer to these options as the income formula and the expense formula.
Option One: Income Formula
The first option is to calculate how much income the family needs going forward if either parent was to pass away. To do this, the following steps are required:
Determine what portion of expenses today will no longer be required if a parent passed. For example, retirement savings or transportation costs for that parent would no longer be required. In our case, we’ll assume this is $15,000.
Subtract this amount from the total income earned today to determine what you would need going forward. In this case, they’d need $80,000 minus $15,000 for a total of $65,000.
Subtract the income of the surviving spouse to determine what needs to be provided by insurance. Here, we’ll assume each parent earns $40,000, so the amount needed from insurance is $25,000.
Assume that the income is needed until the parent would otherwise have retired. We’ll assume this is a period of twenty-five years.
Multiply the income required by the number of years to determine the total coverage. In this case, the $25,000 is multiplied by twenty-five years for a total of $625,000.
With $625,000 in coverage, the family would have access to $25,000 a year for the next twenty-five years. There may be minor adjustments to this amount for inflation or the growth rate that could be earned on the money, but it provides a good approximation.
Option Two: Expense Formula
The second option is to account for major future expenses. To do this, the following steps are required:
Identify a list of future expenses that need to be paid for from the insurance coverage. In the case of the family of four, this may include:
Post-secondary school for both children
The remainder of the mortgage
Funeral and burial
Retirement savings for the surviving spouse
Determine the cost of each item on the list. For our purposes, we’ll make the following assumptions:
Education - $80,000
Mortgage - $225,000
Funeral - $10,000
Retirement - $250,000
Add up the list to find the total coverage required. With the expense base approach, the family would require $565,000.
With an initial payment of $565,000 to take care of major expenses, the parents may decide they could each manage with their current income of $40,000.
Coverage Needs Over Time
The family may find that the amount of coverage they calculate will be suitable up until the parents are forty-five. At that point, they could reassess their financial situation to determine the amount required for the next insurance term. In this instance, it’s clear to see why it’s attractive to break your insurance policies into multiple periods. As the years go by with both parents contributing to savings, the amount of insurance coverage required shrinks. Once the children are all finished with university, for instance, that’s coverage that is no longer required. By re-evaluating your financial needs regularly and purchasing the right coverage to protect against the worst-case scenario, you can live with peace of mind.
Life Insurance Policy Structures
One important thing to remember when purchasing life insurance is the way it’s structured. For instance, if the father in our case needed extra income to support the family going forward, then the insurance policy would be taken out by the mother. The father would be named as the beneficiary, which is the person that receives the money. That way, in the event of the mother’s passing, the required amount of insurance would be provided to the father. Another instance that’s important to consider is the event both parents pass away together. You’ll want to ensure that your policies are set up so there’s no risk that any surviving party will go without the required financial support.
Creating a Will
In addition to getting insurance, it’s often wise to create a will as your net worth increases, you marry or have dependents. If you pass away without a will in Canada, the laws of your province or territory will determine how your estate is handled. To have more control over your estate, including how your money is divided, you can set up a will. Nowadays, this can be done online or in person with assistance from a professional. Over time, it’s important to revisit your will to keep it up to date with your situation and intentions.
Final Thoughts
Protecting yourself against unmanageable risk is crucial to a successful financial plan. This can be done by setting up a will and purchasing the right insurance. You can determine what’s suitable for your needs by speaking with several insurance providers. With so many risks to consider—death, injury, illness, theft and damages—you’ll want to know what’s needed and what’s optional. Shopping around for insurance is beneficial since different companies place emphasis on different factors. This often results in different pricing for the same coverage. If you’re sure the coverage is equal in both cases, selecting the lower premium will help save money.
Some insurance providers offer additional services, like double coverage in the event of an accidental death, at little additional cost. Remember that the point of insurance is to cover your damages or loss of income—no more, no less. By purchasing the required coverage at the best possible rate, you’ll be prepared for the unknown while paying the lowest price possible.
Key Takeaways
Insurance and a will are crucial to your financial plan to protect against unmanageable risks.
Disability insurance and life insurance are important if you have dependents.
Shop around for the best rate and avoid add-ons that you don’t need.
This blog is a duplicate of the recently self-published book The Snowman’s Guide to Personal Finance available for purchase here.