What is financial insurance and what are life’s worst outcomes? Financial insurance is insurance that protects us on our wealth building journey in the event of injury, ill-health, or death during our working life. Income protection, serious illness cover, mortgage protection and term insurance are some of these financial insurances. They are tools to insure people and debt. These events are largely outside our control and can pose a significant risk to our financial well-being. In Nassim Nicholas Taleb’s book The Black Swan: The impact of the highly improbable, the author discusses the impact of rare unpredictable events and our blindness with respect to randomness. This books message has many parallels to the unlikely but very possible occurrence of negative life changing events and the devastating financial repercussions it can have on families. Degenerative disease, heart disease, heart attack, cancer and stroke can be improbable and random but upon diagnosis are life changing. We can control this financial risk by having the right insurances in place. Have we asked ourselves what would happen to our family financially if we were to become injured, ill, disabled or die?
Insurance is the pooling of risk. Actuaries use statistical modelling to make calculated assumptions on the likelihood of paying out future claims given the associated risks. They seek to estimate the number of claims that will be made in a given year. They also calculate what premium needs to be charged to ensure that all potential valid claims, insurance company operation costs and profits are covered. An insurance premium is the monthly payment required for cover. For example, across a sample set of 300,000 people with home insurance, only a small portion of the 300,000 will make a claim and therefore the insurance companies’ potential liability is relatively low while making the cost of insurance cover somewhat affordable. Those who don’t make a claim pay for those that do and then some. Insurance premiums will rise and fall based on the number of claims in a given year. Car insurance is a legal requirement to protect other road users if we cause an accident. Financial insurance is not a legal requirement although it could be argued it ought to be. This is largely because we are protecting ourselves from ourselves and not protecting others from ourselves, like we do for car insurance. Let’s be honest, insurance is a pain in the face at the best of times. It is a payment to protect us against a bad outcome, so we have an inherit dislike of repeatedly paying for something we hope never happens and, in many instances, never does happen. It is however on those occasions when something bad does happen and we are covered, it provides great relief and peace of mind. When renewing my car insurance each year I always flirt with the idea of third-party fire and theft because it is about €100 to €150 cheaper. This is because I’ve been fortunate enough to never have an accident. In the end I always choose comprehensive insurance because I know I’ll be cursing myself if I’m ever in an accident. The risk is just not worth the saving. Insurance is a lot like an umbrella, useless most of the time except for when it rains, and we are glad we have it when it does. If we don’t have an umbrella when it rains, we wish we did and are kicking ourselves in retrospect. We need to have our financial umbrella ready, ahead of time, in case it starts to rain.
I can’t talk about financial insurance without talking about human capital. Human capital in a financial planning context is our ability to earn an income into the future during our working life. Take Peter for example. Peter is married to Sophie and they have one child and another on the way. Peter is a thirty-five-year-old graphic designer earning €80,000 per year. Sophie is taking a career break, working in the home until the two children are old enough to attend primary school. Peter and Sophie plan on being financial independent by age sixty-five. Ignoring, salary increases, decreases, career breaks and so on we can multiply Peter’s €80,000 per year salary by the thirty years to financial independence at age 65 which equals €2,400,000. This is a simple estimate of what Peter expects to earn throughout his career over the next 30 years on a straight-line basis. Peter’s human capital is valued at €2,400,000. When we compare Peter’s expected future earnings to other assets and things, we insure such as our home, car, phone, pet, travel and health insurance we might be left wondering why we haven’t insured our livelihood. We insure assets and things that are funded by our income but not the very income on which they depend. We protect the golden eggs without protecting the golden goose that lays the golden eggs. Our human capital is certainly one of our biggest assets, if not the biggest. If Peter were to be injured in an accident, become unwell or pass away between now age 65 it would have a significant financial impact on Peter and his family. Money will never replace the pain of rehabilitation, the emotional and physical toil of medical treatment or the anguish and suffering of losing a loved one. A financial cushion can mean there is one less thing to stress or worry about. We can take the time to heal or grieve without the pressure of putting food on the table, clothes on our backs and a roof over our heads.
Financial insurance can provide an income when out of work injured or unwell, a lump sum to help with living expenses & medical bills when seriously sick or mean that the family’s financial future is secure in the event of death. Our own health and mortality are a financial risk. Financial insurance is about controlling this risk. Our ability to pay for our lifestyle’s going forward is dependent on earning our income into the future. It is prudent to protect it. We are legally forced to pay car insurance to protect other road users but when it comes to protecting ourselves there is often a blind spot. None of us know what the future holds but we can hope for the best and plan for the worst. We hope it’s the best waste of money we ever spend but know that if the worst does happen, we are covered. If we choose not to have insurance, it may jeopardize much of our wealth building efforts as we will have to use all accessible financial resources available should we be unable to earn an income going forward. Protecting our human capital also assists us in the preservation of the wealth we are building or have already built. It affords us options rather than spending down our existing wealth. Offense wins games, defense wins championships. Financial insurance can provide funds to enjoy quality time together before saying goodbye if terminally ill and to replace the loss of future earnings. These events are unpleasant to think about and most of us believe that it will never happen to us. This is only natural but unfortunately it does happen and to more people than you might think. You can count yourself incredibly lucky if you don’t know a family member, friend or colleague that has not suffered, injury from an accident, a period of ill-health, or the death of a loved one during their working lives. In my line of work, we hear of bad news from time to time and it is heartbreaking. Lives are changed irreparably, and families have to cope as best they can.
Knowing the potential risks we now outline how we can manage these risks starting with:
Spending less than we earn and therefore create a savings rate;
Avoid further debt with a €1,000 starter emergency fund;
Eliminate all non-mortgage debt;
Build 3-6 months of expenses in an emergency fund;
It is after these steps we really start to focus our financial resources on building wealth. This is also a good time to review our financial insurance. Start with what cover we may already have by checking what we are entitled to under our PRSI class for State benefits and any protection benefits we have with our employer. Public & Private sector employers may provide protection benefits as part of our employment. Depending on these existing levels of cover and our own circumstances we may need to seek supplementary or full cover privately.
It’s important to remember financial insurance is about protecting ourselves against financial disaster. Having good health insurance, an enduring power of attorney and an up to date valid will are also particularly important. I will now briefly provide an overview of some of the personal protection products available to us.
Income protection. Income protection does exactly that, it protects our income. Income protection covers us if we are unable to attend work due to injury, illness or disability. This type of cover has the broadest scope. We can receive up to 75% of our salary less the State Illness benefit until we either return to work, retire or the policy term ends. I have seen employer group schemes offer 100% of salary but this is rare. The reason it is up to 75% of salary is to incentivize us to return to work. The percentage of income protection we choose should be linked to our lifestyle spending. If we spend less than 75% of our salary, we can choose a lower percentage. The state illness benefit is currently €10,556 and only available to those who pay class A, E, H or P PRSI. Each income protection policy has a deferred period. A deferred period is the number of weeks before the policy will start payment. This can be 4, 8, 13, 26 & 52 weeks. The deferred period should fit hand in glove with our emergency fund. For example, if Peter had income protection with a deferred period of 26 weeks, he would start to receive €4,120 per month before tax after 6 months. 75% of €80,000 less €10,556 state illness benefit, divided by twelve. Income protection policy premiums paid attract income tax relief at our marginal rate, that is 20% or 40%. For example, if the monthly premium for cover is €75, it will cost us €60 or €45 depending on our marginal rate of income tax. If the policy comes into payment the income received is taxed. A general rule of thumb is that if there’s tax relief on the way in, it will be taxed on the way out and if there’s no tax relief on the way in, it won’t be taxed on the way out. Income protection tax relief is not shared with pension tax relief, it is a separate tax relief.
The only downside to income protection is that not all occupations are equal when it comes to underwriting. Underwriting is the team within an insurance company tasked with evaluating an applicant’s details and determining what additional risks there may be. A loading may be applied. This is an additional charge that increases our monthly premium. Occupations are split into 5 classes. These classes are used to bucket occupations based on perceived risk associated with that particular job. These classes are 1, 2, 3, 4 and D for declined. Examples of these are: Class 1 Architect, Medical Doctor, Solicitor and Accountant. Class 2, Dentist, Beautician, Chef, Dietician. Class 3, Van Driver, Nurse or Midwife and Distiller. Class 4, Mechanic, Plumber, Builder and Painter. Class D for declined, Pilot, Taxi Driver, Soldier, Musician and Jockey. Occupations are often more nuanced than the broad professions highlighted above so it’s important to explore income protection as an option until we know the cost. If income protection is not a runner there are other options available. One of these is serious illness cover.
Serious Illness cover also known as critical or specified illness pays us a tax-free lump sum if we are diagnosed with an illness listed on our policy. It is less comprehensive than income protection. The list of illnesses vary from policy to policy, but all include the top 3 illnesses which are cancer, heart attack and stroke. These three illnesses account for over 75% of claims. Serious Illness policies are very prescriptive on the criteria required for a claim to be paid. There are strict medical definitions within the policy that need to be reconciled with medical records, otherwise the claim won’t be paid. These policies can be expensive and therefore are typically used to cover living expenses and medical bills for a couple of years. The monthly premium paid for cover does not attract tax relief and so the lump sum is paid tax free. One major risk to be aware of with serious illness cover is that we must survive more than 14 days in order to have a valid claim. If we are diagnosed and die within that 14-day window the policy does not pay out. For example, if Peter had €100,000 of serious illness cover, was diagnosed with cancer and met the policies medical definitions for payment he would receive €100,000 tax free lump sum so long as he survived more than 14 days.
If we close our eyes for good the following insurances can help financially:
Mortgage protection also known as decreasing term insurance clears the outstanding mortgage debt with the bank, in the event we die during the mortgage term. The level of cover tracks the outstanding balance and reduces in line with our mortgage repayments. The bank will require this minimum level of cover before you can draw down mortgage funds. The bank are covering their risk of our death by ensuring we take out a policy that settles our mortgage debt with them if we die. The bank can only offer it’s own policies and therefore they are usually more expensive than the open market rate. They will also likely try to bundle in other insurances linked to the mortgage such as serious illness cover. This means that if we were diagnosed with a serious illness covered on our policy the bank will receive the lump sum payment. This is because the mortgage protection policy is in our name but is assigned to the bank and therefore, they are the beneficiary of any payments under the policy. In short, search the open market for the best mortgage protection quote and only provide the bank with the minimum level of cover to secure mortgage funds. Depending on our life cover at work, we can seek additional cover privately.
Term insurance is life cover that pays out a lump sum if you die within the term of the policy. For example, if Peter has life cover of €500,000 over 30 years and he dies during the term of the policy, Peter’s family will receive a payment of €500,000. It is also important to remember that Sophie while on a career break and working in the home is also at risk. Just because Sophie is not earning an income does not mean that if something were to happen to Sophie that there is no financial risk. If Sophie wasn’t insured too, Peter would have to continue working and would likely need help looking after the children.
Whole of life insurance pays out a lump sum when you die. So long as you maintain monthly premium payments it covers our entire life. We must keep paying into the policy until we die. I would strongly encourage you to stay away from whole of life insurance. It is typically three to four times more expensive, a poorly designed product and almost always wholly unsuitable compared to other alternatives. It was designed decades ago in a time of high inflation and interest rates and has only come back to haunt policy holders years later in the form of massive increases in monthly premiums when nearing or in retirement. If you have a whole of life policy, I strongly encourage you to seek good advice. Whole of life is and will continue to be an unmitigated disaster in my opinion. Insuring our own death at an unknown time in the future is a costly cross to bear. We would be better off obtaining more appropriate insurance and saving the difference. Financial insurance is about managing the financial risk of our working life, a stop gap from A to B while we build wealth and transition into financial independence. There should be no need to continue to protect our human capital in retirement because there is no human capital to protect. Instead, we shift our focus to estate planning.
In summary, financial insurance is a necessary evil we hope to never need to claim. Similar to budgeting, insurance is also an art and not an exact science given the variables involved. Protect what matters most to you by hoping for the best and planning for the worst. Control the risks we can control. We are dealing with products that last decades into the future, seek good advice. A good financial planner will have a protection process. If seeking cover privately look to be educated on the variety of options and permutations that are available. The best policy is not always the cheapest. We can also protect ourselves by building wealth through our pension. A pension can be accessed by retiring through ill health, being diagnosed with a terminal illness and upon death. Financial insurance is there to protect and preserve our wealth and afford us options on our wealth building journey.
This week’s book recommendations are The One Page Financial Plan: A simple Way to Be Smart About Your Money by Carl Richards. Carl has made it his mission to simplify the complex when it comes to financial planning and this book is no different. It is a great book from which to start your financial planning journey. Carl’s also does great financial sketches which can be found online at the behaviourgap.com. And The Simple Path to Wealth: Your Road Map To Financial Independence and a Rich, Free Life by J.L. Collins. It is a US centric book but delivers many universal money truths. This week’s movie recommendations are Watchmen, set during Cold War times, superheroes, governments and the public are descending into a state of anarchy. And No Country For Old Men, a welder stumble across a drug deal gone wrong, takes a sizeable sum of money and is pursued by sadistic hitman who is hired to retrieve the money. Javier Barden is brilliant, and the coin toss scene is something else.
Link to Spotify podcast episode: https://open.spotify.com/episode/5cvKJMFK4qmJnIFi5Xzwsm?si=c2bbad8b6e1447ff
Link to Apple podcast episode: https://podcasts.apple.com/ie/podcast/s1-e6-human-insurance/id1539630506?i=1000502424366
For personal financial planning advice email firstname.lastname@example.org or call (01) 539 2670.