THE Babylonian king Hammurabi who ruled in 18th century BC was famous for devising a comprehensive legal code that included a system of justice of “an eye for an eye, a tooth for a tooth”.
The code also included one of the earliest recorded ways to manage risks in a contract-like manner. Law 48, for example, states that if you owed a debt and your field’s harvest was destroyed by a flood or a drought, you do not need to repay grain to your creditor that year.
Later in history, societies and organisations managed risks by pooling money from their members. The money would be used to reimburse them or their families for chance events in life like shipment losses, funeral expenses, fire, robbery or theft.
Today, the modern insurance company helps individuals and corporations take on various risks. You pay the insurance company a regular payment called the premium. In return, you receive a payout to compensate you for losses should the event you are worried about occurs.
Contracts to protect against risks, known as insurance policies, can be for all sorts of things. There are broadly three kinds of insurance products: life insurance, health insurance and general insurance.
Life insurance protects a breadwinner from worries that he or she will die or become disabled, such that family members like aged parents or young children will not have enough to get by on.
Health insurance protects individuals from worries that they will rack up hefty medical or hospitalisation bills for major illnesses or accidents. They can also provide a small income while one is hospitalised.
General insurance protects one’s belongings from worries that they will be damaged by natural disasters or crime. One can protect one’s house, car, luggage or even pets.
While you can be protected for all kinds of risks, not all that protection is necessary. The costs of insurance products can escalate quickly beyond what is affordable for the individual.
Some people sign up for insurance products but have no idea how much they are paying in premiums, how long they need to pay for, what protection they are entitled to, or how much money they would get back at the end of the insurance policy.
Knowing what you need and making a suitable purchase decision is critical for financial planning. If done right, you will be protected against the unexpected in life while not stretching your finances too thin.
This article focuses on life insurance. This addresses worries that tend to be uppermost on the minds of young adults beginning their working lives and starting their own families.
Figure out how much you need
When starting out your career or planning to start a family, you might get worried about not being around to take care of loved ones should anything untoward happen, especially if you are the breadwinner.
Life insurance policies can help ease that fear. They pay out an agreed-upon sum if events like death and permanent disability occur. A typical sum paid out can be $100,000, $200,000, $500,000, or even $1 million or more.
When considering life insurance, you should first calculate how much you need, as the cost of the insurance will vary depending on the coverage required.
Those with aged parents will need to estimate how much is needed to support them every year after taking life expectancies, assets and potential healthcare costs into account.
Expenses can include health insurance premiums, medicine for chronic ailments and the cost of caregivers and part-time housekeepers. In 2011, the life expectancy at age 65 for residents in Singapore is 18.3 years for males and 21.8 years for females, according to the Department of Statistics.
In the “2012 Protection Gap Study – Singapore”, the Life Insurance Association (LIA) here assumed the average cost per year of a dependant elderly parent to be comparable to their annual income, which ranged from $8,640 to $16,380.
Meanwhile, those with young children will need to factor in how much their education and living expenses are every year, until they enter the workforce.
The LIA study used figures from a 2006 study, inflated to 2011 dollar values. The estimated cost per child per year ranges from $4,321 at the pre-school stage to $16,489 for a child attending university. These estimates are for necessary expenses and do not take into account expensive private pre-schools, overseas education, or private enrichment lessons.
You also need to consider your own debts and assets when figuring out how much life insurance coverage is needed.
The Central Provident Fund (CPF) website has an online estimator to help: https:// www.cpf.gov.sg/cpf_trans/ssl/financial_model/insurance_estimator/ie1.asp
The LIA’s website gives a benchmark figure: A 2007 study by the Nanyang Technological University puts the life insurance coverage needs of an average working adult in an average household at $490,000.
Once you know how much coverage you need, you are ready to shop. There are two basic types of life insurance products: term insurance and whole life insurance. The younger you are when you buy, the cheaper it is. Costs will be lower for non-smokers and those in good health.
Term insurance offers straight-out protection with no investment element. There are no annual dividends or cash bonuses, and the policyholder usually gets nothing back.
But most financial advisers would say that term life offers the most effective form of protection. The reason is low costs.
One can buy term insurance for periods like 10 years, 20 years or 30 years.
Singaporean men who have served National Service will be familiar with Aviva’s SAF Group Term Life Policy. One can get covered for death and disability till age 65. Coverage of $100,000 can be obtained for $12.80 a month. Women can also get on their husband’s plan.
CPF members are covered under the Dependants’ Protection Scheme, a term insurance policy that covers members for $46,000 up to age 60 and pays the sum out in the event of death or permanent incapacitation.
One must choose the right period of time to be protected for. If one is worried about not being able to provide for dependants, one would typically want to be covered through one’s 40s and 50s at least, for one’s children to finish their education.
By contrast, whole life insurance provides protection for as long as one lives, as the words “whole life” imply.
They tend to be many times more costly than term plans for the same amount of coverage. For example, premiums for a 20-something can be around $100 to $200 a month for $100,000 of whole life coverage, compared to $10 to $20 for the same amount of term life coverage.
The higher cost is due to other features.
What tends to attract attention is how the policy accumulates “cash value” over time. This refers to the money that is paid out should the policy be terminated half-way. This “surrender value” is often significantly lower than the premiums you paid, not accounting for the interest you could have earned. You can also borrow money from the insurer based on the policy’s cash value.
You will be shown two tables of how cash values increase over time. This usually assumes a 5.25 per cent investment rate of return set by the LIA and a lower rate that is at least 1.5 percentage points lower, which is usually 3.75 per cent. Keep in mind that the actual return – and the cash values accumulated – will likely be different.
The plan can be “flexible”, meaning one can pay premiums for a fixed period of time, like 10 or 20 years, after which no more premiums need to be paid.
The death benefit paid out can increase over time. “Riders” can be added to the policy. This refers to additional coverage should critical illnesses strike, or should one meet with an accident. This additional coverage costs more to get.
Policyholders can also “participate” in a company’s life insurance fund in “participative policies”. The fund is invested in a mix of equities, bonds, properties and other assets.
A large proportion will be in safer bonds that do not return as much as stocks. “Dividends” and “bonuses” can be paid out regularly, more in a good year.
Endowments, annuities and investment-linked policies
There are also three other types of life insurance products that get bundled with life insurance policies.
Endowment policies are pitched as a way to help you meet your financial goals, such as saving for your children’s education or for retirement.
Annuities give you a fixed monthly payout for as long as you live. But because the payouts are fixed, there is also the worry that they will not be enough if inflation continues to be high.
Annuities usually require a single large premium of $100,000 and more. An example of a government-run annuity scheme is CPF Life. At age 55, one sets aside the Minimum Sum – currently $139,000. From age 65, one will start receiving payouts – about $1,000 to $1,100 a month with the full minimum sum placed, depending on whether you are female or male.
Investment-linked insurance policies, known as ILPs, bundle life insurance and investment. Part of what you pay monthly go towards protection purposes, and another part goes towards a fund of your choice. Policyholders bear the risks of the investments and they usually do not have guaranteed cash values. But one can switch funds, top up, or withdraw money from the policy.
Protection versus investment
Whole-life policies that bundle savings, investments, annuities and endowment elements usually come under criticism because of their relatively low investment returns.
This is due to marketing costs, sales commissions, and investment fees eating into the returns one otherwise would have. By confusing protection with investment, people pay more than they should as they forget the purpose of buying insurance in the first place.
Hence the phrase “buy term and invest the rest” is advocated as a strategy to go about buying insurance.
If you are a self-directed investor, personally picking funds or stocks to invest in will be cheaper than letting an insurance company do it for you. A low-cost term insurance policy can be sufficient to protect you from life’s risks.
But insurers say that bundled whole-life policies serve a market that prefers not to take as much risk, and thus is willing to settle for lower returns.
With all things, one must be careful before signing on the dotted line. Know what you need, to avoid paying an arm and a leg – or an eye and a tooth – for your insurance.