How much insurance is enough?
Determining the right amount of cover can be a highly complex and personal process or follow a few simple rules. Working out how much you need is an imperfect science as the exact amount won’t be known until AFTER you have died, become disabled or seriously ill.
The purpose of this guide is to work out an amount that is “better than nothing”, and while it doesn’t replace personal advice, it should allow you to work out an amount that suits people like you. The guide is not an exhaustive list; we have attempted to condense our most common approaches into a concise document to assist most people. You can always speak to one of our advisers to ask more general questions or engage us for personal advice.
The most important thing to remember is that you are dealing with disaster – you or a person very close to you has died, become so seriously ill that they can NEVER work again or been diagnosed with something terrible. It’s effortless to be glib about these things and assumes that you would “get by” or “she would marry someone else”,, etc. etc.. trust us, we have heard them all. We have also listened to the total misery, blame and anger that comes when people suffer these events and don’t have cover.
Think hard about what would happen, how you would cope and what this money would be used for when working out the levels of cover. You can seek personal advice to get this right at any time – often, the value of a financial adviser in this situation is their personal experience having helped clients before. You will only die once; our team have to deal with it more often than we would like to, but our expertise can help guide your choices.
THE SHORT VERSION
LIFE INSURANCE
Salary divided by 5% + current debt = Life insurance cover
or
salary x years it is required for + current debt = Life insurance cover
TOTAL AND PERMANENT DISABILITY COVER
If you have income protection: salary x 2 + $200,000 + current debt
If you don’t have income protection: salary divided by 5% + $200,000 + current debt
TRAUMA COVER
If you have income protection: Current debt + $100,000
If you don’t have income protection: Current debt + $100,000 + 2 years salary
INCOME PROTECTION
Total annual salary (including bonuses, car allowances and super) times 75% divided by 12
Waiting period – as short as you can afford – typically 30 days
Benefit period – as long as you can get – typically to age 65
BUSINESS EXPENSES (FOR SELF EMPLOYED PEOPLE)
Look at an insurance PDS under “allowable business expenses” and mark these off on your profit and loss. Add these expenses up, divide the number by 12 and select the lowest waiting period you can afford
THE LONGER VERSION
LIFE INSURANCE
We want to replace the person who has died with a pile of money that can go some way to returning their financial contribution to the family. Typically, this means clearing the debt and replacing the wage a person earns.
You can replace a person’s income with a simple calculation: annual salary divided by 5%. This will create a number that will pay a payment for eternity if the amount earns 5% interest.
As an example: $50,000 divided by 5% = $1,000,000. $1million invested in an account earning 5% would pay $50,000 per year forever.
But a person doesn’t work forever, so why do we present this as a basic calculation?
Interest rates are not currently 5%, so we would need to take investment risk to achieve that return, and that income won’t be indexed with inflation. These two factors mean that it is highly likely that the amount won’t last forever, but it does provide us with a meaningful way to determine a reasonable amount of coverage that would suit most people.
So why pay out debt when we have an income stream for life? Most debt is tied to the person, and the bank will eventually call in a loan when the person who has borrowed the money passes away. In most circumstances, it’s better to ensure there is money to pay out the loans straight away AND provide that income stream. This method works best for young people with young families but can result in too much insurance if you have significant assets or are older and closer to retirement.
Another method is to multiply your salary by the years that it would be needed. For example, a family where the youngest child is ten might expect to need both wages for another ten years. In this case, multiply the salary by 10. This amount won’t account for inflation, but considering we have also cleared all debt, the amount should put you in a suitable position.
What about non-working spouses?
In this case, you might multiply the working spouse’s salary to provide enough time for them to take time off work to look after the kids or reduce working hours.
TOTAL AND PERMANENT DISABILITY
Total and permanent disability means that you or your partner is so injured or ill that two doctors agree that they are not likely or unable to work again.
This can sometimes be a fate worse than death – none of the financial contribution, all of the costs. Income protection can make a big difference here, and if that cover is part of your plan, the amount of disability cover reduces significantly.
Like life insurance, we typically want to remove the stress of debt and provide some income replacement. Separate from life insurance, though, we usually have ongoing medical and rehabilitation costs. As a general rule, we estimate that the price to restructure a person’s life after the permanent disability is $200,000. This amount was determined by calculating the cost of refurbishing a home with new kitchens and wider doors or moving to a new house. Furthermore, this lump sum allows the disabled to engage in personalized rehabilitation for 3-5 years, assuming a $20,000 annual cost and a $50,000 budget for equipment and a higher cost of living. Australia does have high quality and (comparatively) well-funded disability support programs. These estimates are designed to augment but not replace government services. If you do not have or cannot get income protection, then you should consider adding a multiple of salary calculation to the cover as well since that wage will be lost if you can’t work.
TRAUMA OR CRITICAL ILLNESS
Trauma cover is designed to provide you with choices. Typically claims for trauma include heart attack, cancer and stroke. These events account for 92% of all claims with some insurers.
In this case, you are neither dead, disabled or necessarily unable to work. Trauma has nothing to do with your ability to earn an income and everything to do with the specific illness you have been diagnosed with. You determine the amount paid, and it is delivered to you for anything you wish. You do not need to use it for your home loan or medical expenses.
This cover is difficult to understand and to calculate because everyone’s experience with trauma is unique. Cancer often feels like a battle to be fought and won, while a heart attack is more akin to having the rug pulled out from under you. Suddenly that lump of muscle in your chest that you never thought about becomes your single tenuous grasp on your connection to life. None of this is fun.
Determining the right amount of trauma cover is more about maximizing choice – you could go back to work after one of these conditions, or you could have enough cover to take two years off and refocus your life. You could keep paying the mortgage, or you could make it disappear forever. You MAY need to pay for medical costs, or you might be presented with treatment choices overseas that you can pay for. All of these things will cost money, and trauma allows for these choices.
Therefore, a typical “best outcome” would be 2x salary, the total amount of debt and $100,000 towards medical expenses. Why $100,000? Non-PBS medical treatments for cancer cost between $40,000 and up to $80,000 for a 12-month course, according to our investigations.
INCOME PROTECTION
Income protection is a fundamental cover – as you may have noticed from this guide, all calculations come back to multiples of income in some way, shape or form.
Income protection calculation is usually simple – 75% of your salary, including super and other payments paid for as long as possible, with the payment commencing after the shortest period possible.
The most common benefit period is until age 65; however, some occupations can pay until age 70. The most common waiting period is 30 days – you can make this shorter or longer, and the waiting period should be determined based on how long you can last before that income is required.
BUSINESS OVERHEADS
Business overheads insurance is designed for small business owners with ongoing costs if they could not work. An example would be an electrician with a car lease – if they stop work, the bank will still need that lease paid. The best way to determine the right amount of coverage is to refer to the product disclosure statement of an insurance policy and read the “allowable expenses” definition. It will tell you the items on your profit and loss that can be covered.
It’s important to note two things with respect to business expenses and income protection for self-employed persons:
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Determining the right amount of cover can be tricky (even financial advisers’ stuff this up)
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Business expenses insurance is designed for a business that would make a loss if the insured person becomes ill. It’s not intended for businesses with multiple staff contributing to the company profit.
MANAGING COSTS AND OPTIONS
Insurance costs money – often a lot of money. Buying personal life insurance is an important consideration, as is managing cost.
The cost of a policy is closely linked to its likelihood of a payout – you are far, far more likely to become seriously ill than you are to die. For that reason, trauma cover is significantly more expensive than death cover.
You can manage costs by removing options or reducing the amount of cover you hold. Typically, we suggest that you are better off having some of each type of cover rather than all of one and none of another. As an example – in an ideal world, you might need $2million of life insurance and $500,000 of trauma cover with income protection and a waiting period of 30 days. This might cost too much – in this case; it would be better to have $1mil of life insurance, $200,000 of trauma cover and a waiting period of 90 days rather than NO trauma cover or NO life insurance. Simply put, we don’t know what will happen, and some cover is better than none.
Remember - what we have covered here is the BASICS - there are many other considerations such as childhood trauma, policy structure, pricing options and more.