Insurance can be tapered over your lifetime, allowing premium savings

By Cassie Carstens

6/8/2022

This article is about life insurance…and no, I did not draw the shortest straw among my colleagues.

Maybe I am just tired of reading prophetic opinions about what is going to happen in the investment market. Plus, I was recently reminded of just how little clients understand about the math behind long-term insurance.

I was only 23 years old when I dealt with a shady insurance agent for the first time. I was single and only just started my career. The broker tried to sell a life policy of R40 million to me, his reasoning being that I will be successful one day, married with kids with a mortgage on a large property portfolio.

To date, he was right about the “married with kids” part. Fortunately, I did not take up that policy, or I would have been a lot further away from being successful.

According to the Association for Savings and Investment South Africa (ASISA), there were just over 14 million active individual life insurance policies by the end of 2021.

Life insurance (a collective name for death-, disability- and critical illness- cover) should not be intended to enrich anyone at claim stage, but rather to provide the present value needed to replace future cash flows (for example a salary) that will be lost due to a claim event.

If you are young, married with dependents with a long career ahead of you, you have a considerable amount of future expected cash flows which need to be replaced in the event of your death, whereas if there is only one year left until your retirement, you only need to replace one year’s pay cheques.

How does it work in practice?

Let’s look at a simplified case study to illustrate the considerable difference in outcome depending on how you plan to treat life insurance in your portfolio.

In this example, the husband and wife are both 42 years old, with two kids of 4 and 7 respectively.

Both spouses need to replace R40 000 per month in the event of disability or the other’s death. The monthly expenses per child are assumed to be R15 000 per month and an outstanding bond of R3 million (with a remaining term of 10 years) must be covered by the insurance in addition to the needs already mentioned.

We requested quotations from an insurer with a level premium pattern to illustrate this scenario.

Scenario 1: The most basic (and flawed) way to plan for these needs is to calculate the total need for the spouse and children of R70 000 pm as if it would continue till age 95, in addition to the mortgage that needs to be settled.

The present value amounts to approximately R21.8 million and the life cover premium works out to be about R9 005 pm.

Scenario 2: A more prudent approach would be to consider the respective terms or time periods associated with each expense and need. For example, the wife’s income needs end at age 65 and the expenses related to the children would stop at age 21.

Based on these assumptions, the present value of the needs/expenses required reduces to about R14.3 million and the premium decreases to about R5 936 with a fixed 5% annual increase in premium and cover.

The challenge with scenario 2 is that, while the assumptions and calculations may be correct on day one if this implementation is not reviewed every year, the sum assured and premiums will continue to increase every year, even though the underlying needs and expenses will decrease over time.

Scenario 3: The best way to calculate the insured amount is to find an insurer who takes into account that certain needs will end at a certain point in time, for example, the mortgage that has 10 years remaining, and adjust the premium accordingly. With the same set of assumptions and cover that gradually decreases or stops for every need, the premium is even less at R3 015 pm and premium increases look completely different.

It becomes clear that these three approaches render three completely different outcomes.

There are two components to our way of thinking about life insurance needs that need to change.

As a point of departure, the present value of the cashflows you are wanting to replace by means of life insurance should be reviewed every year with your financial advisor and your sum assured should be amended accordingly, if necessary. Ideally, the saving in premiums should be invested to aid your journey to financial freedom.

Secondly, consider using an insurance product that allows you to isolate individual needs so that it can be priced with the assumption that every need decreases and ends at varying points in time, for example, the expenses relating to your children end after 10 years once they have completed their studies.

In the graph below, we illustrate the premium difference between Scenario 2 (as if no revisions are done) and Scenario 3. If the difference in premium is invested in a typical balanced fund every month until age 65, you will have a nest egg of about R3.75m.

There are risks associated with reducing cover over one’s lifetime and they should be carefully considered before implementation.

Keep in mind that if you plan to keep life insurance until your death, at some point you will be worth more dead than alive. Keeping up with premium payments until death becomes a proverbial gun to your head.

You, therefore, need to wean your dependence on life insurance by the time you reach retirement.

Some of the pitfalls to avoid:

• The amounts paid out are based on calculated figures and nothing stops the surviving spouse from splurging R2.5 million on a luxury sports car.

If you have concerns about this, you should consider making a trust the beneficiary of your life policy. Keep in mind that there will be estate duty implications that need to be planned for.

• If you plan to utilise your investment portfolio from age 65, make sure that this is taken into account in your calculations. If the surviving spouse requires R40 000 pm for living expenses, but there are little to no existing investments, he or she will have to invest a portion of the R40 000 pm for retirement.
• If you are concerned that you might require additional insurance cover in the future, consider adding future cover (much cheaper) where you are underwritten now for convenience but only take it up at a later stage.

True value can be added if the conversations between advisor and client are centred around planning for different life stages and changing needs and less about comparisons between insurer X and insurer Y.

Cassie Carstens is a certified financial planner at Woodland Wealth (previously known as ProVérte Wealth & Risk Management). Contact him at info@woodlandwealth.co.za

Although all possible care was taken in the drafting of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone planning on taking any financial action based on this document, is strongly advised to first consult with their personal financial adviser. Woodland Wealth is an authorised financial service provider with FSP no. 5966.