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SA's No 1 Insurance Blog

So in my previous article, I wrote about having a long-term perspective when buying life insurance.
I think I might have lost a lot of readers when I started talking about the increases in cost every year. That’s because I mentioned:

  • The annual increase in the premium even if the cover itself does not increase,
  • that an amount is charged for the increase in cover when you select that option, and lastly
  • that the amount charged for this increase in cover is in itself, also subject to an annual increase

Even I find that a tad confusing.

So let me explain by way of example.

What I’ve done is make some projections using an Excel spreadsheet which you can download here. You’ll need this in order to follow what I’m about to say.

Basically, it’s about a 47-year-old guy (let’s call him Ernie) who is willing to spend R1,000 a month on life insurance.
Over the past five years, his annual salary has increased by about 5% every year. He expects that this will pretty much continue the same way until he retires.

If you look at column C you’ll notice how Ernie has budgeted for this expense (If you’re unfamiliar with Excel you’ll notice at the top of the sheet that each column has an alphabetical character. Look at column C). You’ll see that he is willing to spend R1,000 a month in year one. In year two this jumps to R1,050 per month and so it goes on. Still with me? Good!

So let’s look at what happens with a 5% compulsory annual increase in the cost:

Ernie has two options when choosing this type of financing option.
He can choose to keep the life insurance exactly the same every year but with a 5% increase in his cost every year.
Why would he do this?
Well by selecting a 5% increase in the cost, he starts off with a substantially lower premium than if he had selected a fixed monthly cost.

His second option is to select an increase in the actual cover amount along with this 5% increase in the cost every year.

  • The first scenario on our spreadsheet is option one where he takes up R3 million (Column E) in life insurance (as a fixed amount of cover), but with a monthly cost increasing by 5% each year (column F).
  • You can see that the monthly cost for this insurance stays in line with his monthly budget (column C).
  • In the second scenario is option two where he takes up R3 million in life insurance but with a 5% increase in the insured amount every year (column I). He also accepted a financing option which includes an increase in the cost of 5% each year (column J).

Did you notice that his budget is blown to smithereens in the second scenario? By year seven he had budgeted R1,340 per month for his life insurance. In the second scenario, his life insurance is costing R500 a month more than he has budgeted for. At that point, he starts shopping around for cheaper insurance but can you see how much he’s already spent on this life insurance? The R114,910 he spent could have bought a decent second-hand car (column K).

What would Ernie have done if the 5% increase in the cover was non-negotiable? Believe me when I say there are life insurance products out there with compulsory increases built in.
If Ernie cancelled his life insurance he would lose R114,910 in favour of his insurance company.

Now let’s take a look at the most popular life insurance option sold nowadays – age rated.

Ernie is very excited about age rated increases.
Remember he had budgeted around R1, 000 a month on life insurance. A 5% increase would pretty much have used up his entire budget. An age-related increase for the same amount of cover would leave him with R190 still in his pocket (Since age rated kicks off at R810 per month for Ernie).

  • In the first scenario he takes up R3 million in life insurance as a fixed amount but with an age-related increase in cost every year.
  • For the first eight years, it fits in with his monthly budget (column F).
  • The second scenario is one in which he takes up R3 million in life insurance but with a 5% increase in the insured amount (column I).

It doesn’t take a rocket scientist to see that from year nine in the first scenario, and year four in the second scenario that Ernie is blowing his budget.
If he cancels his life insurance in year five he has effectively thrown away 60 grand.

Here are the two questions I would ask myself if I was shopping for life insurance…

  1. What is this choice going to cost me 5 years from now?
  2. Will it still fit in with my long term plans for this life insurance? In other words, it doesn’t help having premiums which increase by 5% every year once you’re retired and stuck on a fixed income, does it?

Life insurance falls under the long term insurance act, so remember to always think long-term when buying life insurance.

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