Life insurance is a very important part of good financial planning. As I have mentioned several times before in personal finance, protection is the outmost important aspect of personal finance. When it comes to personal finance many forget about insurance, I believe the Financial Pyramid illustrates the importance of insurance in financial planning.
Why is Insurance Important in financial planning?
To illustrate the importance of insurance in financial planning, imagine the following scenario:
You are in your early 30’s and married for 5 years, your spouse is also in her early 30’s. You have a son 5 years old. You both are doing very well household income of $200,000 house worth $600K and mortgage of $450K. You have a car financed with $25,000 in loans. You both have RRSP’s each worth $200K and RESP now worth $15,000. Your plan is to have at least $1.5Million each in your RRSP and fully pay for your sons education and give him some money after graduation you estimated about $85,000 will do. You have great investments and a top investment advisor, you save aggressively on monthly bases and can reach your goal in about 20years you have the “perfect” financial plan. Now, You find out that you have some type of cancer and can not work for at least 18months, if you get the treatment right away. The only way you can get the treatment quickly is if you go to the west coast to a private clinic.
I will not go much further with the illustration, but what are some costs associated with this illness now?
Loss of income
Withdrawal from RRSP (you pay tax and loss on earnings)
Travel and accommodation costs
These are just a few costs that come to mind. This will throw your “perfect” financial plan out of the window, all the great hopes you have are diminished and may not be possible anymore. The point here is that one unexpected event can cause the best financial plan, without insurance, to be worthless. If you had Critical Illness Insurance you would not feel the major financial impact, as you would have received tax-free lump sum.
What types of Insurance do I need?
There are many types of insurance, some important others not so important. Most of us are well aware of Auto Insurance and Home Insurance. A lot of us have Health Insurance in our benefits package at work. Other types of insurance are: life insurance, disability insurance, and critical insurance. I have discussed Critical Illness insurance before, here is a quick overview of Life and Disability insurance.
Provides tax free lump sum to the beneficiary, the amount is predetermined. The purpose is to help loved ones in case of your death. If I die I want to make sure my spouse is taken care of well, which means the bills are paid and she has enough income to support her life style. Now in our earlier example imagine something happened to you what would your spouse do? She would have the mortgage and car payments as well as everyday expenses. If you had enough protection she would not have to worry about those issues. [A more detailed post about life insurance is coming.]
One of the most important and most complicated types of insurance policies is Disability Insurance. The purpose is to replace your income when you are disabled and unable to work. Disability insurance is much more complicated than Life or Critical Illness, so I recommend reading through your contract very carefully. I will discuss Disability insurance in more detail in another post.
Do I need to have all of them?
The simple answer is YES YOU DO. Each insurance product serves a different purpose and you need to protect all of them to have a proper financial plan.
This will cost too much?
Not always true! Many over estimate how much insurance would cost them, I recommend speaking to a knowledgeable insurance agent and looking at different options. Some of this is available through your employer group plans, mainly Health and Disability. You might have to pay for the Disability Insurance, but the cost is a lot lower than and individual Disability plan.
How much Insurance do I need?
This is the most common question in financial planning when it comes to purchasing insurance. There will be a full post on this, but here is a short version of it.
Life Insurance: Add all your debt+ funeral costs (about $20K) + 6 months of your after tax income, this will give you the total amount you would need. Now subtract from this number any savings you may have specifically for this purpose. DO NOT count RRSP savings or RESP savings. This will give you the amount you would need. I suggest get TERM Insurance and the length of the term should be at least the length of your longest debt.
Critical Illness Insurance: This is somewhat different and more expensive, I suggest checking a few different types of products to find a good one. There really isn’t a formula for this, some suggest 2X salary others suggest 6 months Salary plus 1 year mortgage payments. The reason for this is that the amount you will need will differ for each illness, if you have a heart attack a lower amount will be enough than if you have cancer. I suggest get an amount you would be comfortable with in the worst case scenario.
I hope you see the importance of insurance and start thinking about it, if you haven’t already.
Tips for insurance:
Buy simple plans, no bells and whistles
Buy from reputable company
Buy Term with Renewable and Convertible options
Do your research and shop around
Review annually and modify as needed
Insurance is a PROTECTION tool, NOT a wealth creation tool