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The Money Management Newsletter: Insurance Products
Term coverage and the myth of self insurance

The subject of life insurance can be a confusing place to tread at the best of times but recently, the popularity of yet another method of coverage, called "self insurance", has been on the rise.

In simple terms, self insurance consists of the theory that once an individual or family has accumulated a large asset base, they can drop their life insurance coverage and use their savings as a cushion in case of financial disaster. It makes sense, doesn't it? Unfortunately, there really is no such thing as self insurance.

Insurance and risk

A good way of understanding insurance is to think of it as a way to deal with risk. This risk can take on many forms but there are four basic ways to handle it including risk avoidance, risk reduction, risk retention and risk financing. When someone purchases insurance coverage, they are employing a risk financing strategy and in effect, transferring the risk to the hands of an insurer in exchange for a fee or premium.

When the same risk is present but the individual chooses to accept it themselves, this is referred to as risk retention. They are not insuring themselves against risk as they might think, but instead they are expressing a willingness to give up a portion of their accumulated assets as a way to finance the risk.

The idea of self insurance is often applied in the case of the "buy Term and invest the difference" theory of purchasing life insurance. The theory is structured around the belief that term coverage should be used to insure a family during the dependency period. The difference in the premiums between Term and Permanent insurance should then be used to invest in securities. When the asset base becomes large enough, the family is then able to cover any risk that may develop with their own money.

Unfortunately, this theory is dependent on several factors working cohesively. First of all, the individual or family must possess an absolute certainty that there will be no need for life insurance after the dependency period. Secondly, the difference between the premiums of the Term and Permanent coverage must be saved, not spent. Third, the returns on the invested money must be positive.

Protect yourself

In spite of all of this, there are some that may argue that risk retention is still their preference. If this is so, it may be beneficial to consider the following example. Let's say that a person not only had their home mortgage paid off, but they also had enough money saved to purchase three more houses identical to their original home. In this situation, would it be prudent for them to cancel their fire insurance? After all, they have enough money to buy another house if their existing one burnt down. In most cases, most people would opt to protect themselves by purchasing the fire insurance.

It follows then that the question of whether to purchase life insurance should not be a difficult one to answer. It has been said that the chance of someone on your street dying is much greater than that of a house on the same street burning down. Life insurance is there to protect and provide for your family when you are no longer able to.

In Canada, more and more people are becoming aware of the government's place as a beneficiary of your estate. For this reason, one of the most popular strategies used to handle the taxes due at death is by using life insurance. This strategy involves paying the taxes with the funds obtained from the insurance policy instead of having to delve into the accumulated assets of the deceased. Now, many of the people who thought that their need for coverage was temporary are finding out that there was indeed a permanent need after all.

Term and Permanent Insurance

So, what is the difference between the insurance types? Simply, Term insurance has been designed to cover temporary needs while Permanent insurance (such as Universal Life) is for permanent needs. Term insurance is available in many different forms including a 10 year and 20 year term. It starts out at a lower rate but the cost of insurance rises each time the policy is renewed.

Permanent insurance has a higher premium in the early years of the policy but the cost is level throughout the life of the insured. Due to the rising premium costs, the price for a Term policy generally overtakes the premium for a Permanent place after year 20. If the insured is looking for temporary coverage, a term policy may be the best bet. Permanent insurance is usually a better value if the insured person wishes to keep the coverage for more than 25 years.

 

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