Choosing the appropriate level of insurance to cover the financial consequences of a loss of income from illness, injury and death can be tricky. In this post I’m going to provide you with a framework that you can use to help you decide what type of insurance you need and what level of cover you and your family need to get. The frame work is based on: understanding your household’s financial situation; identifying risks; determining the consequences of those risks; and selecting insurance to reduce the financial consequences of those risks occurring.
Before we proceed, this article is going to be based upon understanding risks in personal finance using the risk-matrix method to determine the necessity to identify and control risks. So, I’d suggest you have a quick read before diving in here in order to get a feel for the process.
Understanding your financial situation
To do this you will need to have a good grasp of the following pieces of information that make up your financial situation:
- Incoming cash flow – both active and passive
- Cost of living
- Size of emergency fund
- Size of investment portfolio
- Amount of debt
- Debt repayments
- Family situation such as dependents
- Financial goals
Identify risks
In terms of personal finance, risks are going to be any negative event that will affect your ability to achieve your financial goals or worsen your household’s situation. Remember that the purpose of insurance is to reduce the financial consequence of a particular risk; it can not reduce the likelihood of the risk occurring. As highlighted earlier the 3 risks we’re looking at in this post are the loss of household income due to:
- Illness
- Injury
- Death
These 3 risks are typically dealt with using the following types of insurance:
- Total and permanent disability (TPD)
- Life insurance (death cover)
- Income protection
- Trauma insurance
Understanding the financial consequences
In the event of a temporary or total loss of household income a household will need to consider numerous financial consequences. Some of these will include:
- An increase in living expenses – this could come from the requirement to pay for medical expenses; purchasing or installing new equipment to facilitate a disabled family member; or even increased child care costs if the primary care giver needs to return to work. This increase in living expenses could be temporary or permanent.
- At current expenditure levels, how long would your savings last?
- If you depleted your savings how long could you live off the cash from your liquidated investment portfolio? If you own a lot of illiquid assets you may need to give this extra consideration since you will need to allow more time before you can utilize these funds to cover your expenses.
- Do you have dependents? Having dependents means that reducing your expenses is going to be more difficult so you will need greater financial resources.
- What effect will liquidating your portfolio have on your financial goals such as financial independence? If you aren’t already financially independent you need to consider how willing you are to delay or re-evaluate certain financial goals. Granted, this is a higher order need than simply survival but it demands consideration.
Choose insurance type and level
Once you’ve gained an understanding of your financial situation, risks and consequences you can use the outcomes your household is willing to accept to determine what insurance you need and what level of cover you require.
Generally, the closer a household is to financial independence the less insurance they will require. The reason for this is that a financially independent household will generate enough passive income to cover living costs so a loss of income will have low risk rating due to a minor consequence. On the other hand, if a household is not able to ride through the consequences using passive income, investments or savings then more insurance coverage is required to bridge the gap. Insurances that will pay out quickly in order to reduce the need to draw down on savings and investments can also be considered.
Examples
Let’s apply this framework to a few imaginary examples, please note that any resemblance to an actual household is unintended.
Single income working family
Financial Situation
| Wife’s income | $80,000 post tax |
| Husband’s income | $0 |
| Debts | $300,000 mortgage |
| Dependents | 2 (ages 10 and 12) |
| Cost of living | $50,000 p.a. |
| Mortgage repayments^ | $1547*12 = $18,564 (Moneysmart 2020) |
| Savings | $50,000 |
| Investments | $100,000 |
How long will their capital last?
| Savings | $50,000/($50,000+$18,564)*12 = 8.75 months |
| Investments | $100,000/($50,000+$18,564)*12 = 17.5 months^^ |
This is an example of a household that needs to consider a high level of insurance cover. The main reasons for this are that they will likely have dependents for another 10+ years; they also have a significant sized mortgage compared with their income and size of their investment portfolio. Their sizable savings account gives the husband about 8 months before he must to return to work and capacity to ride through any large expenses that appear. Given that they are only able to save about $11,000 per year, liquidating their investment portfolio would materially lengthen the time it would take for them to reach financial independence as well as severely affect other large financial goals that they might have.
In this case, the consequences of any event that removes the main breadwinner’s income, temporary or permanent, needs to be insured for. Insuring the main income earner for a wide variety of scenarios with a high level of cover will reduce the likelihood that they will need to liquidate their portfolio. This will allow them to work towards strengthening their financial position. A combination of TPD, life, income protection and trauma insurance policies can be used reduce the risk in this situation.
Double income working family
Financial Situation
| Wife’s income | $40,000 post tax |
| Husband’s income | $90,000 post tax |
| Debts | $100,000 mortgage |
| Dependents | 3 (ages 15,18 and 20) |
| Cost of living | $60,000 p.a. |
| Mortgage repayments^ | $649*12 = $7,788 (Moneysmart 2020) |
| Savings | $30,000 |
| Investments | $200,000 |
How long will their capital last?
| Wife | Husband | Both | |
| Savings | n/a | 12.9 months | 5.3 months |
| Investments | n/a | 7 years 2 months^^ | 2 years 11 months^^ |
In this example, the household has a double income which helps to reduce the financial consequence of a loss of either one of the incomes. Even though their savings will only last about 5 months, for this to occur they would both need to suffer a total loss of income.
The main consequence of a permanent loss of the wife’s income would not be detrimental to the household’s ability to survive however it would reduce their savings rate which significantly decreases their capacity to reach their financial goals. If the husband were to permanently lose his income, they would have a shortfall of about $29,000 per year which should be covered through the use of TPD, death and/or income protection.
Because of the length of time that their savings will last in the situation where only one income is lost it’s likely that a payout received from something like Trauma insurance will not be needed.
For this household, insurance considerations will be more centered around reducing the risk of not being able to reach their financial goals in an appropriate time frame as opposed to surviving. This is especially true, in the temporary case. For this household a combination of TPD, death and/or income protection should be seriously considered for the husband with the same policies considered optional for the wife depending on how comfortable they are with risk.
Financially independent household
Financial Situation
| Wife’s income | $20,000 post tax |
| Husband’s income | $15,000 post tax |
| Passive income | $70,000 post tax |
| Debts | $50,000 mortgage |
| Dependents | 0 |
| Cost of living | $60,000 p.a. |
| Mortgage repayments^ | $425*12 = $5,100 (Moneysmart 2020) |
| Savings | $150,000 |
| Investments | $1,800,000 |
In this case the household has a large portfolio and passive income that can cover their living expenses without the need for either of them to earn an income. This means that there is a low/no financial risk if they lose their active income. As a result little or no insurance cover is required.
Key takeaways
The further from financial independence a household is the more insurance cover they require. This is because they are less able to tolerate the financial consequences of income loss due to illness, injury or death. Typically, income protection, TPD, life and trauma insurance policies are used to manage these risks.
There is no magic formula that can determine how much cover you require because everyone views risk in a different way. However, understanding your financial situation, identifying risks and understanding the consequences provides a good framework for deciding what cover you require.
Because insurance can only reduce the financial consequences of certain risks, you should always aim to use multiple methods of reducing the risk rating in conjunction with insurance. This means building a suitably sized emergency fund and working towards financial independence. It also means that you should look after your health, and reduce time spent in situations that could negatively affect your health.
Engineer your freedom
References
Moneysmart, 2020, Mortgage calculator, moneysmart.gov.au, viewed 28/6/2020, <https://moneysmart.gov.au/home-loans/mortgage-calculator>
^Based on 3.5% interest rate, 30-year term, monthly repayments, $200 p.a. fee
^^Based on the assumption that their investment porfolios are liquid and portfolio values will remain the same