Key considerations when you decide to buy an insurance policy
Cost of Premiums vs Cost of Risk
The price to pay for the insurance premiums must justify the risk that you are eliminating from your life. Such risks would include unforeseen medical bills. Medical bills are subjected to inflation and we have not possible way to foresee when we will fall ill or get into an accident.
The cost of a hospitalisation insurance is approximately $600 per year for someone aged 25 (Singapore integrated shield plan), and it would help to cover bills of up to $,000,000.
Calculating the cost of outsourcing this risk would suggest a proportionally small yearly cost of 0.06% ($600/ $1,000,000). Even a bill half the size, $500,000 would not move the needle much in terms of cost of premiums to cost of risk at 0.12% ($600/$500,000).
Also read: Best of Integrated Shield Plans in Singapore
This is also why we do feel strongly about insurance plans that cover particularly small risk, such as mobile screen insurance.
We buy insurance to cover ourselves from potentially large medical bills (We’ll get to that in a bit).
Opportunity Cost of the Money
Let’s assume you have $500,000 lying around and you would be able to pay for the medical bills with your liquid savings. There are 2 possible and undesirable scenarios that could occur.
- Since such medical emergencies are unforeseen and sudden, you would have wanted the money easily accessible. Hence foregoing the opportunity to invest in a longer term investment vehicle that could earn you higher returns and will have to keep it liquid in your bank account.
It would be unwise to keep such high liquidity in preparation for an event that is unforeseen bills and earn little to no interest. Savings account interest rates could be as low as 0.05%.
A better use for your money would be to have invested in a low risk investment vehicle that earns 3% per year, while you pay an insurance premium of $600 per year (0.12%), and have the money earn an additional 2.88% (3%-0.12%) interest.
- Invest the money assuming this unfortunate situation will not happen. And having to liquidate the investments at a loss during that emergency.
As much as we cannot control when a medical emergency would occur, the investments are largely subjected to market movements and we cannot guarantee that we would be able to cash out the money without losses.
Size of the Risk
You get to decide how small or big a risk is to you. If it is a risk that you can personally take on, perhaps you may not want to pay a premium to outsource that risk.
For instance, if you look at mobile phone insurance that pays out $1,000 for damages on your mobile phones (assuming your mobile phone is $1,000). A risk of $1000 may be small for many, and especially so for a phone that we tend to replace every 2 years or so.
This means that the benefit of the coverage is depleting as the phone is closer to its 2 years lifespan since you will be replacing it. For a premium of about $120, the cost is 12% and seems rather high in comparison to 0.12% for the health insurance.
Of course, it’s really dependent on how you view $1,000 as a risk you wish to take on or outsource. No judgement if you choose to have mobile phone insurance. It’s all about understanding how big a risk is to you and whether you are willing to pay to be covered for that risk.
Longevity Risk and Legacy Planning
While planning for our retirement, we may consider longevity risks and gifts that we wish to leave behind for our family or loved ones. We may plan for our retirement with certain assumptions in mind, such as our planned retirement age and expected longevity, but we cannot be sure that things will not change.
An annuity product provides us with an assurance that we have a lifelong stream of income. At the same time, if we do pass on earlier than expected, part of the unused funds can be gifted to our family. A legacy plan on the other hand could also help to provide a $1 to $5 leverage on your savings, creating an after-life asset that is multiplied by 5 times.
Considering these factors, the next question is probably, when is the best time to get life insurance?
The short and straightforward answer is – sooner, rather than later.
When you are young and healthy, the risk to the insurer is smaller, so you will be charged with a lower premium rate. These rates are usually fixed through the period of coverage from the day you start the policy. This could allow for an affordable life insurance premium and you would actually save your money over time.
This is true apart from medical insurance which is subjected to change due to medical inflation rates. Health is the other main factor, as insurance policies typically do not cover pre-existing conditions, it is always better to get insured early to prevent getting these terms imposed on your policy.
Insurance coverage helps you to create an asset that you otherwise would not have, and you pay a cost to acquire it. That in itself is the insurance premium. It allows us to have a source of funds available in case any medical situation arises.
Insurance coverage is part of holistic financial planning, and we should always consider the affordability of the premiums and the amount to insure, according to our incomes.
Definitely read: The three pillars of financial planning.