Insurance and The Principals of Risk Management

 

The term risk has several definitions as it relates to personal financial management.

 

The definition of risk that is explored in this Client Information Summary is exposure to the chance of loss. More specifically, we will identify those risks that can be insured, thus protecting ourselves from financial loss.

 

Chance of Loss

Let’s start out by identifying the areas in which you may be exposed to the chance of loss. Perhaps the most obvious is loss of property. Property would include your house, cottage, car, or your personal belongings. Thus, one example of loss of property would be having your house burn down.

 

Another type of loss, one which we hear more and more about today, is the loss of money or future earnings resulting from your personal liability for; personal injury you caused to someone else (someone slipped on your front steps); destruction of another person’s property (little Bobby smashed your neighbour’s bay window); or an error in the discharge of professional responsibilities (as an accountant you made a mistake in working on an audit which resulted in a $500,000 lawsuit!) 

 

Another possible exposure is for medical expenses outside Canada (you are hospitalized in Florida for two weeks as a result of a car accident and get a bill for $40,000). Each of these examples illustrates losses of money or future earnings. Fortunately, most of these “chances of loss” are insurable risks.

 

As catastrophic as some of these losses may seem, many people face the risk of a much greater loss each day, without blinking an eye. It’s the potential loss of income caused by sickness or injury resulting in pro-longed disability or pre-mature death. Consider for a moment what your ability to earn income might be worth.

 

 

What Your Ability to Earn Income Might be Worth

While we don’t always associate pre-mature death with loss of income, if the deceased was gainfully employed, the loss is very real. Aside from the emotional trauma, thankfully, loss of income as a result of loss of life is an insurable risk, with some exceptions and limitations. The magnitude of the financial loss can be very dramatic as the following chart illustrates.

 

 Assumes 4% inflationary increases each year.                  

No doubt the value of your home pales in comparison to the potential loss of your future ability to earn income.

 

The Chances of Becoming Disabled

What are your chances of actually suffering a loss of income as a result of a disability during your working career?

 

                                                                                                      

 

Thus, with an understanding of our exposure to the chance of loss, we recommend strict adherence to the following:

 

 

Principles of Risk Management

 

1—Insure Your Income

If your earned income is necessary to attain financial independence, then transfer the risk of loss of income resulting from long-term disability to an insurance company (if possible).

 

If you are a professional or business owner and have expenses which would continue even if no income was coming in, then consideration should be given to transferring this responsibility to an insurance company by acquiring an office overhead/business overhead expense policy.

 

2—Insure Your Life

If loss of income through pre-mature death would pose a threat to your family’s financial security, transfer the risk to an insurance company, by buying life insurance (if possible).

 

Consideration should also be given to the loss associated with the death of a spouse who doesn’t work outside of the home. There may be large financial consequences in terms of loss of services that have to be replaced such as childcare. Also there could be loss of future pension benefits or even the loss of an inheritance that was being counted on as part of an overall financial independence strategy.

 

Insurance coverage on children should only rarely be considered. One of the few times it may have merit is when the parents have concerns for a child’s future insurability. In this situation, securing coverage while it is still available may be a prudent step. The premise being that the child would assume the burden of the annual premium as they become able to do so.

  

 

3—Insure Your Property

Insure against the possibility of major loss of property, such as, your home, cottage, cars and other prized personal possessions. Minor losses that can be reasonably self-insured should be. In particular, liability insurance is absolutely critical.

 

4—Insure Against Contingent Liabilities

It makes sense to eliminate catastrophic chances of loss that would impair your ability to attain or retain your financial independence. This can be accomplished through a combination of homeowner insurance, auto insurance, professional liability insurance (if applicable) and in some cases, excess liability insurance.

 

5—Insure Against Major Medical Expenses

As Canadians, one area of concern is when we are traveling outside of the Country. Private health insurance is available to provide this protection.

 

By adhering to these principals, you’ll protect yourself and your family from the hardship that can result from all of these contingencies.

 

 

Types of Life Insurance and Their Proper Use

 

One of the principals for creating and preserving wealth is to manage the risk of loss of income. Thus, until an individual has created sufficient wealth to provide adequate income for their family in the event of death, it is vital to manage the risk. In most situations it is possible to transfer the risk to an insurance company.

 

Once you have identified the appropriate amount of insurance you require today, and the amount you will need beyond retirement, making the decision as to which type of life insurance best meets your specific requirements is the next task.

 

Term Insurance (1, 5, 10, 20 Year and to Age 65)

Term insurance is life insurance that is purchased at a specific cost for a specific period (1 year, 5 years, 10 years, to Age 65, etc.). It is insurance in its purest form, with no "savings component", thus there is normally no cash surrender value if the policy is cancelled.

 

§        Term insurance should be used when a specific amount of coverage is required for a specific period of time and when available cash flow relative to your personal financial strategy is limited.

§        Consideration must be given to choosing an insurance company that is financially secure, with "competitive rates" being a secondary consideration. For example, a company offering the best rates may be a company that is not regarded as being financially sound.

§        If future cash flow is anticipated to improve, term insurance could be acquired with an option to convert to permanent life insurance at a later date. If conversion is contemplated, additional care should be taken to choose a quality insurance company that offers quality products to which conversion may be available.

§        To determine which type of term insurance (1, 5, 10, 20 Year or to Age 65) would be the most cost effective for a specific situation, it's important to analyse the total cost of various plans over the course of the required time frame.

§        Features of the plan should include renewability, guaranteed renewal rates, and disability waiver of premium.

 

Optional Group and/or Term Life Insurance

Most companies and many professional associations as well as some trade organizations offer a form of optional group life insurance coverage to their employees and/or members. The coverage can normally be tailored to each individuals situation, similar to private term life insurance.

 

The premium for this type of coverage may be much less than that of personal life insurance. The reason for the reduced cost is partly because the benefits are sold on a "group discount" basis. Another contributing factor to the low cost is due to a degree of uncertainty relative to whether a member's family will actually collect benefits under the plan. This is because the group or association coverage can usually be cancelled at the discretion of the insuring company (if claims are excessive). Also, premiums are not guaranteed and thus can be increased at any time to offset any bad claim experience.

 

Association group coverage should be viewed as a method of merely "reducing risk", in comparison with private life insurance which "eliminates risk".

 

Term to 100

Term to 100 is the simplest form of permanent insurance  (meaning that it is available for the whole of life) and provides a specific amount of life insurance, with level premiums, to a specified point in time. In some cases, premiums may be payable for life while in others the payment period might be reduced to 20 years or to age 65.

 

§        Term to 100 should be acquired when there is a long-term need for a specific amount of insurance (need beyond retirement) and limited cash flow is available after implementing your personal financial strategy.

§        Choose an insurance company that is first, financially secure and second, offers competitive rates.

§        Features of the plan should include guaranteed rates and disability waiver of premium (where appropriate).

 

Universal Life

Universal Life is a type of permanent insurance that is flexible. It can be adjusted to change with ongoing changes in lifestyle and other personal needs or requirements. It provides an initial specified amount of coverage that can be adjusted as required subject to various contractual limitations, depending on the insurer. Premiums can also be adjusted with cash flow changes (minimums and maximums apply).

 

Deposits can normally be made in excess of the actual cost of the insurance. These excess deposits are invested within the policy, attracting no tax on growth while the funds remain in the policy. There are guidelines relative to the maximum tax-exempt value that can accrue in the policy.

 

Investment options for surplus cash invested within the policy will vary with each insurance company, but can include a variety of deposit terms. The short-term performance of a universal life policy may be more dependent on fluctuations in interest rates than other types of permanent insurance (i.e. Whole Life).

 

§        Universal Life should be considered when coverage is required or desired beyond retirement, and there is a cash flow surplus after implementing your personal financial strategy.

§        Features of the plan should include guaranteed rates, and disability waiver of premium.

§        Choose an insurance company that has good long-term financial stability, competitive rates, flexible contract provisions, and a variety of investment options.

§        Universal Life should be considered as an alternative to whole life when flexibility is important.

§        Universal Life is normally less cost effective than Whole Life for someone over age of 50. Thus, Whole Life may be considered as an alternative.

Important Note: Universal Insurance is very complex. As a result it is often used inappropriately and with less than optimum results. Care should be taken to examine all cost effective alternative strategies before turning to a product this convoluted. Combining investments and insurance into a single product sounds good in theory but the “devil” as they say is in the details.

 

Universal Life—Term to 100

Term to 100 is appropriate where there is the possibility of using the tax-sheltered savings aspect of the product and where cost is comparable to straight Term to 100.

 

Whole Life

 

Whole Life is also permanent insurance and can be less flexible than Universal Life. There are many variations of Whole Life, thus our comments will be confined to what is referred to as participating Whole Life, which means that the policy-holders participate in the upside of a company's ability to manage their reserves through the payment of dividends.

 

Premiums for this type of insurance are normally greater in the early years than the actual cost of the insurance. The degree to which the premium exceeds the actual cost of insurance will determine the long-term cash accumulation that takes place within the policy. Usually the higher the premium, the higher the cash value accumulation.

 

The actual long-term performance provided by this type of insurance is impacted by the actual results the insurance company achieves relative to their death claims and actual operating expenses.

 

However, the greatest factor governing performance of the policy are the investment returns on the surplus premiums collected that the company achieves. Any excess premiums collected by the insurance company are refunded to the policyholder in the form of a "dividend" which can be received in cash or reinvested to increase the death benefits and/or cash value of the policy.

 

The funds accumulating within the Whole Life policy are not subject to taxation provided the policy falls within prescribed limits categorizing the contract as an exempt policy.

 

§        Whole life should be utilized when there is a permanent, long-term need for coverage beyond retirement and when personal cash flow is sufficient to allow the maximum flexibility in the decision-making process.

§        May be acquired in concert with Universal Life or in place of Universal Life when flexibility to alter premium "deposits" and/or death benefits is not a major concern.

§        Financial stability of the company is a very important consideration, as well as the company's long-term dividend track record.

§        Features of the plan should generally include disability waiver of premium.

 

Hybrid Whole Life

Hybrid Whole Life is permanent insurance that is a combination of regular Whole Life and Term Insurance.

 

The actual design is typically for a base of Whole Life coverage to be put in place initially with dividends each year being used to buy term insurance for the balance of coverage needed. For example, there might be a $50,000 base whole life policy with term insurance of $150,000 for total coverage of $200,000.

 

The actual amount of Whole Life coverage will increase through the purchase of additional paid up insurance each year with the portion of the dividend not needed for the term insurance. This results in the need for the term insurance to diminish over time to the point when 100% of the total coverage will be converted to Whole Life with no further term coverage being necessary.

 

This hybrid version of Whole Life was developed by insurance companies in order to provide permanent coverage at a more affordable premium than regular straight-up Whole Life. It is often referred to as "Enhanced Protection" or "Econo Coverage".

 

§        Hybrid Whole life should be utilized when there is a permanent; long term need for coverage beyond retirement and personal cash flow is not sufficient to allow straight-up Whole Life to be used.

§        May be acquired in concert with universal life or in place of universal life when flexibility to alter premium "deposits" and/or death benefits is not a major concern.

§        Financial stability of the company is a very important consideration, as well as the company's long-term dividend track record.

§        Features of the plan should generally include disability waiver of premium.

 

Joint 1st or Joint 2nd To Die

While not technically a type of policy, coverage can be arranged on more than one life using a single insurance policy.  For example it would be possible to arrange a Joint 1st to Die Term to 100 policy that would pay the death benefit at time of death of the first person who was insured under the contract.

 

In some situations, it is more economical to purchase joint insurance on either a 1st to die or 2nd to die basis. Joint 1st to die is appropriate when capital is needed on the 1st death, such as a married couple, or perhaps two business partners in which the need would be eliminated after the 1st death.

 

Joint 2nd to die is appropriate when the need for coverage will only be applicable after both insured’s die. For example, capital gains tax on a family cottage won’t be triggered when the first spouse dies because of the spousal rollover provisions.  However, on second death, all capital gains taxes will be crystallized and might even force the surviving family members to sell the cottage to pay taxes due.

 

Because the insurance company is exposed to a reduced risk, the cost of a joint policy may be less than individual policies on multiple insured’s. This is particularly true in the case of Joint 2nd To Die situations. However, care should be exercised when this structure is used as flexibility is reduced with a joint policy in comparison with individual policies on each insured’s life.

 

All or Nothing

You may get the impression that the selection as to which type of policy is most suitable is an all or nothing decision for one type of policy or another. This is certainly not the case. Your advisor merely views these various types of insurance as “tools” to do a specific job—namely provide the amount of coverage that you require, for the period of time that you require, and for the lowest possible cost.

 

Consequently, our recommendations for the right type of insurance for a specific situation are always made on a strategic basis, and often will include a combination of various types of insurance.

 

In Summary

Choosing the right type of life insurance can be a complicated decision. However, the decision becomes easier when you know how much you need, for how long you need it, as well as the current and future cash flow you can allocate without having a detrimental effect on your personal financial strategy.

 

Once these issues are resolved we can then use the Insurance Selection Process that is diagrammed below to formulate our recommendations.

 

Insurance Selection Process Diagram

The flow chart on the following page provides a summary of the thought process one needs to go through in selecting the right type of insurance.

 

The Insurance Selection Process

 

 

	A.     Capital Needs on Death Analysis (Total)   B.     Capital Needs on Death Beyond Retirement
A minus B   Determine Amount of Insurance For Defined Time Period Need (Pre-retirement)			B   Insurance Needed For Undefined Time Period Need (Post-retirement)
Term   Interest Adjusted Cost Analysis   Compare Term 1, 5, 10, 20 Year, Term Plus, and Term to Age 65 to identify most cost-effective alternative			Low Surplus	High Surplus
			Permanent     Term 100	Permanent   Policy Comparison Analysis   Compare Term 100, Whole Life & Universal Life

 

 

 

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