Mark is a good friend of mine. Some years back he had the opportunity of his life time to build his dream house on a piece of land given to him by his grandfather and he had a budget of $1 million. After many months of construction and renovation, it was finally completed. When Mark invited us for his housewarming, we were all shock to see the house. Suffice it to say that it was badly done and aesthetically not pleasant. His wife and daughters were also unhappy with this new house and wished they hadn’t move at all. So, what actually happened?

You see, when Mark started the building project, everyone he spoke with had different ideas for Mark. Mark then met a friend who works for a fire safety company. He started sharing with Mark on the importance of fire safety and the various fire incidents that had happened over the course of his decade long experience in this industry. He shared horror stories on how fires have destroyed not just properties but also caused many lives to be lost as a result of poor fire safety planning. Mark then appointed his friend to come out with a fire safety plan for his new home. Very soon, Mark was presented with a comprehensive plan with recommendations to get all the expensive fire alarms & detection system, fire extinguishers, sprinklers & high-tech suppression systems. If Mark follows it to the tee, he will find sprinklers installed on the ceiling of every room and with different types of fire extinguishers hung on every single wall in the house. On top of that, Mark will have tens of spare fire extinguishers kept in his storeroom, just to cover all the possible risks. The only problem is this, it will cost up to 60% of the $1 million budget that Mark had for his house. If he spends lesser, it will not cover the risks fully. The advantage of this plan is that after 10 years, Mark can sell back the equipment back to his friend’s company for a reasonable sum. Mark’s friend convinced him that the best thing he could do for his family is to cover the fire risks fully. Mark trusted this friend, and executed the entire plan. As a result, Mark didn’t have enough budget to appoint an interior designer. He also opted for lower quality materials to build and furnish his house. Instead of concrete walls inside the house, he chose to use low cost MDF (Medium Density Fiberboard) that is combustible and susceptible to moisture and wood destroying fungi and termites.

So, Mark now has a house that covers all possible fire risk but ironically, lives in a house with materials that are low in fire resistance, unattractive to the eye and uncomfortable to stay in. Above all, his family is not happy staying there. But he argued that he will recoup some of the money back when he sells back the equipment in 10 years’ time.

I am sure many of you will find this story incredulous and cannot believe that Mark will make such an unwise decision. Yet, when it comes to building our own “financial house”, many of us use the same approach. Let me explain.

Our financial house are life goals that we want to achieve in our life time, like living a comfortable life now and also at retirement. The fire risk are life risks that we face that may destroy our goals, such as loss of income due to death, disability and a medical crisis, as well as huge medical expenses one may incur. The fire safety plan is the expensive whole life insurance plans which in many cases, are unnecessary.

When you are doing your insurance planning, you should start with asking yourself three questions:

  1. How long you need the insurance cover?
  2. How much insurance cover you need?
  3. What type of insurance to buy, after answering the first 2 questions

How long do you need insurance cover?

The most common risk that we face is the loss of income due to death, disability and a medical crisis. So, if we are buying insurance for this purpose, when we don’t have or no longer have dependants and when we are retired, there is no need for this coverage. Our need for this kind of insurance is therefore temporary and not permanent.

The next most common risk that we face is incurring huge medical expenses (whether it is for hospital expenses or for alternative treatment) in the event of a medical crisis. If you are buying insurance for this purpose, then you will need the insurance for as long as you live. Our need for this kind of insurance is therefore permanent and not temporary.

There are other needs when one buys insurance. The lack of space does not allow me to cover them all. But suffice it to say that for most of the higher priority needs, you will only need it for a period of time and not permanently.

How much insurance cover do you need?

Let’s use the case of Peter (table 1) who is aged 45 and has 2 children with the following needs:

Amount

Remarks

Monthly Income

$10,000

% of income needed to support dependants: 75% of monthly income

$7,500

No of years needed to support dependants upon demise

15

Amount needed to fund children’s education

$177,000

Peter wants to ensure 2 of his children can afford university fees, even upon his demise

Home Loans & Liabilities

$462,500

Peter wants to pay off these liabilities upon his demise

Total capital needed upon demise

$1,989,500

Peter has existing insurance coverage

$600,000

Current Assets

$400,000

Cash in bank, CPF and other investments

Shortfall in capital upon demise

$989,000

Peter needs to buy this amount of additional insurance cover

Table 1: Amount of insurance coverage needed

We can also assume that upon facing a medical crisis, such as being diagnosed with cancer, Peter wants to ensure he has an amount that is equivalent to 3 years of his income ($360,000) paid by insurance. This is so that if he can’t work, his family can live normally. As such, he will need to purchase critical illness plan with a sum assured of $360,000.

What type of plan to buy?

Based on Peter’s need, these are the types of plans available (table 2)

Needs

How long do you need

Amount needed

Premiums for Whole life plans

Premium for Term plans (coverage till age 70)

Income replacement upon death and disability

Temporary

$1 million

<$28,640 p.a.

$2,913 p.a.

Income replacement upon critical illness

Temporary

$360,000

$7,358 p.a. (pay for 15 years only)

$2,637 p.a.

Total

$35,998 p.a.

$5,550 p.a.

Table 2: Types of insurance plans

Due to the constraints of space, I have not work out the numbers for insurance needed to pay for medical expenses, such as alternative medicine. You can read a more comprehensive write-up at www.diyinsurance.com.sg. But already with the above, you will see how expensive it is if Peter uses whole life plans to cover the most basic need of replacing income loss due to death, disability and a medical crisis. I have not even considered buying insurance to pay for medical expenses, such as alternative treatments (which you will need whole life plans). And if Peter buy a smaller whole life plan to fit his budget, he will not be sufficiently covered. If he buys the full coverage, it takes up a large portion of his income that he does not leave enough to live a life now and also plan for his retirement. Yes, with whole life, he can get some money back later if he surrenders the policy in his later years. But what is the point of that when you cannot even achieve your goals now? Can you see Peter (and many of us) making the same mistake as Mark?

I have been advocating the use of term plans since 2003. Why do I continue to do so? It is not because there are no uses for whole life plans. It is just that for most of our insurance needs, it can be easily solved through term insurances. Whole life plans are expensive and unnecessary. But almost 15 years later, I still hear of many buying whole life plans for all the wrong reasons and risked building their financial house wrongly. Insurance is a contingency plan, not a goal. You really don’t want to use it. But if you spend a large proportion of your budget on it, the only way to achieve your goal is for the contingencies to happen. And as most of you will agree, that’s silly.

And by the way, if you suspect that the story of Mark is fictitious. You are right. It is a parable.

The writer, Christopher Tan, is chief executive officer of Providend, a fee-only financial advisory firm specialising in retirement planning.

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