Life Insurance

Case study: Some Considerations before Committing on an Insurance Policy

Recently, I had a chat with a friend about an insurance policy that he was thinking of buying for his child. Everyone has a different risk tolerance and views value differently. However, after I pointed out some key issues about it, he agreed he now had a different perspective – let me tell you what I said in case it is useful to you if you are facing a similar decision.
Author Andy Yang
Date 2021-06-21
Updated on 2021-07-21
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What was the mentioned insurance policy?Take Inflation into Consideration The Larger the Sum Insured, the better?The policy can be surrendered, hence protection ends You may earn more by investment rather than savings in insuranceHow to get the best coverage & benefit for yourselves or beloved ones?

What was the mentioned insurance policy?

Without mentioning specific names and numbers, the policy would protect the child against critical illnesses (such as heart attacks, cancer, etc). Premiums would be paid by the parent for 10 years unless the parent passed away. If something were to happen to the child, the policy would pay a guaranteed fixed sum insured as well as a non-guaranteed sum insured that would grow significantly over time. Similarly, the surrender value for the policy was partly guaranteed and partly non-guaranteed.  

My friend remarked that he mostly focused on the guaranteed amount as these were certain. He found that his insurance agent focused on the total amount (including both the guaranteed and non-guaranteed amounts), which was obviously much larger.  The amounts grow with compound interest particularly after a long period of time because you earn interest on the original investment and earn interest on the interest already earned.

Take Inflation into Consideration

One factor to consider is the impact of inflation.  The numbers in the projection obviously look large after many years, but medical costs tend to rise faster than common inflation.   Let us assume that my friend’s child is 10 years old.  Critical illnesses tend to crop up around middle age – so let us assume that age 40 is when ill fortune can strike.  A sum insured of (say) HK$800,000 after 30 years (age 40 minus age 10) might look like a good outcome.  

However, most central banks in the world before the pandemic were looking at keeping inflation at around 2% p.a.  In today’s dollars, this lowers the sum insured to HK$800,000/ (1+2%)30 = HK$441,656 which is slightly over half the original sum insured.

Medical inflation is commonly higher than overall inflation due to improved medications and techniques which can be expensive.  An internet search shows that it was 6.2% p.a.in 2020. Let us see what happens to the sum insured if we assume 6% p.a. over the long term. In today’s dollars, HK$800,000/ (1+6%)30 = HK$139,288 which is less than a fifth of the original sum insured.

The non-guaranteed part of the policy rises over time and will counteract the impact of inflation, but if you only relied on the guaranteed part of the policy, the sum insured may buy you much less medical care than you were expecting. I would counsel you to make sure you have the right level of cover when you need it and to seek professional advice regularly to update your cover.

The Larger the Sum Insured, the better?

A relatively large sum insured looks impressive in the early years, but I would note that a 10-year-old child is unlikely to get heart disease and cancer.  

Having said that, bad things, unfortunately, do happen (hence my earlier comment that everyone sees value in these products differently) – I did have friends at university who passed away in their early twenties – one from nose cancer and one from multiple sclerosis.  

Amounts for the Sum Insured really depends on your own assessment of your risk due to genetics, lifestyle, and external factors.

The policy can be surrendered, hence protection ends

My friend wanted to protect his child for the rest of his/her life. In the conversation, there was a realization that at age 18, the policy would belong to the child, and he/she could (if they wanted to) surrender the policy and take the money out.  

Obviously, this was not the original intent of the policy so there is a risk, from the parents’ viewpoint. It is important that children be taught about responsible attitudes to money, so they do not fritter it away on what they see as important in the short term.

You may earn more by investment rather than savings in insurance

My friend is a good investor and has a long-term track record of achieving excellent returns in the double digits per annum each year (I wish I could do as well).  I suggested that he use a relatively conservative 8% p.a. return (in a mix of equity and fixed income) and see what would happen to the premium if he simply invested it by himself.  

The calculation showed the invested amount was higher than the projected numbers from the insurance company.  A benefit of investing yourself is that you have full freedom of what you do with the money – you could liquidate it if needed for example.

On the downside – there is no guaranteed sum insured if an unfortunate incident did happen.  Also, not everyone is able to or has the time to achieve a high stable return over the long term.

The point is – if one sees the risk as low in the early years, you may be better off investing the money yourself.

How to get the best coverage & benefit for yourselves or beloved ones?

Well, even after getting a different perspective, my friend is thinking about the policy and is likely to go ahead as he can see the value in it. But I hope I have given him (and you) some additional perspectives to consider before committing yourself to a long-term policy.  

You may seek professional advice for your own circumstances and make sure you have adequate cover for what you see to be your risks.

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