Life Insurance : How Much?

How much life insurance should one buy?

First of all, one should assess how much are the needs of his or her dependants.

Say one wishes to provide for his child in case daddy is not around to pay the bills, one has to figure out how the kid needs. If the kid needs about $1000 per month for the next 20 years before she become independent, that will come to $240,000.

Enter inflation and that figure changes. The $1000 per month that the child needs will become $1030 per month next year if the inflation is 3% per annum. Project that for 20 years, that coverage needed for the child becomes $322,445.

However, there is another school of thought. Say the unfortunate happened and the dependent receives a lump sum payout. It would not be wise to simply put the money in a POSB savings account for the 0.25% interest and spend it over a period of 20 years. The advisable course of action would be to put it in a safe investment like government bonds and drawdown on it over 20 years. If the investment can keep up exactly with inflation, the coverage needed is reduced to the original $240,000.

But still the coverage needed will not stay constant for 20 years. And the good news is, the coverage needed will actually decrease over the years. Why? This is because as every year passes, the child will be 1 year closer to achieve independence. The same principle applies for dependants like parents and spouse; for every year that passes, they are 1 year closer to their life expectancies.

Therefore, while a child in our example needs an initial coverage of $240,000, that figure becomes $234,840 ($1030 x 12 months x 19 years remaining) in the second year. In the third year, it becomes $229,154 ($1061 x 12 months x 18 years remaining). Note that the monthly expenses still increases due to inflation. While we did not include inflation after the hypothetical payout occurs, we still have to include it before the hypothetical payout happens.

If we plot the needs of 1) aging parent needing $750/mth for 30 years, 2) spouse needing $1000/mth for 40 years and 3) child needing $1000/mth for 20 years, we have a chart the looks like the following:


Add all the needs up, and we will get a Total Dependants Needs curve that looks like the following:


From the curve, it seems that person in our example needs about $1 million of insurance. However, we need to take into consideration, how much net assets the person currently owns. If he currently has more than $1 million worth of assets, he does not need insurance; his assets are enough to cover the needs of his dependant should anything happens to him.

Say this person has $100,000, invests them for a return of 3%, saves $500/mth (adjusted for inflation) and draws on his savings $1500/mth after retirement, his Total Assets over the years should look somewhat like this:


In this case, the Protection Required would be Total Protection Needs minus Total Assets:


This example is typical of many Singaporeans in their 30s when they have a few dependants and little assets to their name. This is the time where they need more insurance. As time goes by, their assets grew and their need for insurance diminishes.

On a practical note, I have not seen a term insurance that has a coverage that decreases over the years with the exception of mortgage insurances. So if one does not qualify of a mortgage insurance but still wish to have a term insurance policy that tracks the diminishing insurance needs, one can take up multiple term insurance of different terms.

For example, one can buy a $200,000 5-years insurance, a $100,000 10-years insurance and a $50,000 15-years insurance to achieve a coverage of $350,000 for the first 5 years, $150,000 for the next 5 years and $50,000 for the last 5 years.

To recap, the process of determining one’s life insurance needs, one has to:
1) Assess dependants’ needs and project them into the future
2) Assess current assets owned and future assets growth
3) Estimate how much of dependants’ needs are not cover by the assets
4) Periodically assess the needs and assets as they changes from time to time and seldom pans out as planned

P.S. There are other insurance needs that are not covered here. One important need is health insurance. But that should be relatively simple if one can take away the principles of life insurance needs.

Life Insurance: What Type?

Recently I had lunch with a friend who is about to get married. Over the meal, the issue of financial planning was brought up. Being a responsible husband-to-be, he thought about taking up an insurance policy to protect his wife-to-be in case he is not around to provide for her. But what kind of insurance is adequate? And how much to buy? I shall first give my opinion to the first question.

There are basically 2 types of life insurance available: whole life policies and term life policies. Whole life policies provide protection for the whole life of the insured. There is cash value in the policy such that at any point of time the insured wishes to stop the policy, he or she may cash in the cash value.

Term life policies protect the insured for a limited period of time. One can, for example, take up a 10-year term insurance for protection over a 10 year period. There is no cash value in the policy, so if the insured decides to stop the policy, he or she cannot get any refund from the premium paid.

Most Singaporeans are sold the whole life policies because insurance agents in Singapore pushing these products in preference over term policies. The reason is simple: they earn more commission selling whole life policies over term life policies.

While insurance agents earn about 5% of the premium paid for term insurance, they pocket about 50% of the premium paid in the first year for whole life policies. Add to that the fact that premium for whole life policies are about ten times that of 20-year term life policies, you don’t need a PhD to figure which products are more popular among insurance salespeople.

Insurance agents will often point to the cash value of the whole life policy to illustrate the advantage of whole policies over term life policies. But one has to remember that the premium for a whole life policy is about ten times that of a 20-year term life policy. It is this extra premium that is creating the cash value.

When you pay the premium for a whole life policy, a small part of it (after paying for expenses of the insurance company like commissions etc.) is used to purchase term insurance for your protection. Whatever is left is being invested to give you the cash value of the policy. If the expenses that the insurance company charged are high, you get a bad deal.

Note that you can achieve the same results by buying a term life policy, save the difference in premiums and invest it yourself. You will still incur expenses when you invest your savings, but you will be in control of it and you can minimize it by investing n low-cost funds (more of that another day). More importantly, your insurance is not tied to you savings and investments so that you may cash in on your investments or withdraw your savings without terminating your insurance and deprive yourself of the protection.

This strategy is known in the industry as “buy term and invest the rest”. Advocates of this strategy include former CEO of NTUC income, Mr. Tan Kin Lian, and New Paper columnist, Larry Haverkamp.

Singapore Economy Contracting

At first glance, a 6.6% contraction seems quite bad, but please bear in mind that the 6.6% is a comparison made with reference to the high base in Q1 which saw a 15.6% rise when compared to Q4 2007. Things are not as gloomy as they looks. But will it get worse?

If Q2 figures are low (since it contracts by 6.6%), there is a good chance that Q3 figures may come in higher than Q2, making it possible for Singapore to avoid a technical recession (defined as two consecutive quarters of negative economic growth as measured by a country's gross domestic product), right? Not quite so, actually.

Bearing in mind that Q1 saw a strong growth of 15.6%, the contraction of 6.6% in Q2 only gave up a portion of that growth. So it is still possible for Q3 to surrender more of that growth even if the economy is still doing well.

That brings us to the more important point. If Q3 figures show that Singapore slips into a technical recession, it may well be due to the lower figures of Q2 and Q3 when compared to Q1, not necessary because the economy is not doing well.

Likewise, if Singapore experience a big contraction in a quarter followed by a slight recovery in the subsequent quarter, it does not mean that the economy is fine although we escaped a technical recession.

So what does the technical recession tells us. Nothing much actually, unless we take a closer look at the figures and their comparisons.

CPF Life and Inflation

Details of CPF Life were announced a few weeks ago.

The scheme is basically an annuity that aims to provide Singaporeans a monthly income for life. The objective is good, but can it deliver?

A calculator on CPF website estimates that a female retiree with $40,000 minimum sum can expect a lifelong monthly income between $342 and $372 depending on the plan she chooses.

Assuming the paltry sum of $300 is enough for her monthly expenses, CPF Life will be able to meet the objective.

Enter Inflation. What seems to be enough will be insufficient in a matter of time due to inflation.

Say $300 is needed for daily expenses now. With an annual inflation rate of 2%, $359 will be needed for daily expenses in 10 years time. In 20 years time, that figure is $437.

So while the monthly income stays stagnant, cost of living increases exponentially. If you think that is bad, it gets worse.

The CPF website states, “…for the entire duration of the policy, payout amounts can change, depending on the actual CPF interest rates and underlying mortality experience. For instance, a 0.5 percentage point difference in interest rate assumption will lead to a change in payouts by about 10%.”

If the CPF interest rate rises with inflation, that is a relief. But the CPF interest rate for the Retirement Account is pegged to the yield of the 10-year Singapore Government Bond plus 1%, and the trend of the 10-year bond yield vs the trend of inflation is not encouraging.

While central banks in most other countries fight inflation by raising the interest rate, the policy of MAS is to allow the appreciation of the Sing Dollar. This has an effect on pushing the interest rate lower.For the 10-year period from 1998 to 2007, the 10-year bond yield fell from 4.48% to 2.68% while changes in CPI implies that inflation rose from –0.3% to 2.1%. See figure.

So while the motivation behind the CPF Life scheme is good, it does not address the problem of inflation.

Good Bye 2007, Hello Inflation

The financial highlight for 2007 is definitely the sub-prime crisis in the US. But in Singapore, there are other attention-grabbing headlines like the surging property prices and rising inflation. The CPI for Nov 2007 rose 4.2% when compared to a year ago.

Going forward, the bad news of inflation is getting worse. UOB has increased its inflation forecast for 2008 to between 4.5% and 5%. This comes after a taxi fare hike, which UOB said was more than what it had expected.

Things are not as bad as it seems if wages has kept up with the inflation. But has wages rose in tandem with the inflation? Except for the 21% pay hike that the ministers are getting, the rest of the Singaporeans are set to see tougher times ahead. No wonder Mah Bow Tan said that there is no property bubble in Singapore. His annual pay of almost $2 million is more than enough for a penthouse.

The MAS announced that it will allow a greater rate of appreciation of the Singapore dollar to combat inflation. While this is a move in the right direction, there is a limitation to what that policy can do. For one, it cannot control the interest rates to cool domestic demands.

Since MAS allowed a greater rate of appreciation of the Singapore dollar in the second half of 2007, the 3-month SIBOR has dropped from 5.63% in August to 4.73% in December. Baring a recession, there will be enough liquidity to sustain high asset prices.

On the global front, China is struggling to contain inflation. For the past decade, China has been the low-cost factory for the world, it's entry into the world market has produced an era of high growth with low inflation. As inflation continues to take its toll on China, it is a matter of time that the cheap made-in-China T-shirt becomes not so cheap after all.

In the US, the Fed signalled that it is ready to act aggressively (read rate cate) to prevent the US economy from falling into a recession. If that fails to re-ignite the US economy, stagflation, period of low growth and high inflation, will soon follow.

So what can you do in Singapore to overcome inflation? Enter politics. If you can make it as a minister, you don't have to worry about inflation, ever.