What are the odds?
Monday, 16 November 2009
Insurance is a basic component of everybody’s financial planning - even those who don’t think they are planning. But why? What’s the point?
Insurance in any form is about 'risk transference'. When you consider risks, what happens is you form an opinion about the personal impact of losing your assets (the risk), and then decide whether you can assume the entire cost yourself or whether you wish to pay a relatively small price (a known loss) instead, and transfer that risk to somebody else.
But usually we don’t really know the odds. What are the chances of the things we dread actually happening? We make subjective assessments - not objective ones. Apparently the chance of these things happening in your working life are:
- Your house being totally destroyed by fire is 5%
- Dying before you turn 60 is 13%
- Writing off your car in an accident is 20%
- Suffering a 6 month disability is 33%
The last one leaps out as being a really statistically “significant” risk doesn’t it? According to research conducted in NZ in the mid 1980’s, more than 5 out of every 6 “disabilities” were caused by illness, and not covered by ACC then. Some 275,000 Kiwi’s were temporarily disabled per year - two thirds of them being out of action for a month or longer.
It’s probably still about the same. So being selfish (which is always a good attitude to take in assessing personal risk), what’s the potential loss if it happened to you?
If you’re a 25 year old earning $30,000 p.a. on average through to age 65 - well there’s over $1,000,000 at stake in personal earnings. A 40 year old averaging $45,000 p.a. through to age 65 has at risk $1,125,000 in future earnings. Pretty impressive sums. Pretty impressive losses in a worst case scenario too. Luckily these risks are transferable or insurable most of the time.
A friend of scottish descent (who openly admits to closely watching his wallet) once described it to me as follows:
“If my employer paid me $40,000 per year, with 5 days guaranteed sick leave and 3 weeks guaranteed annual leave, it is good. If my employer instead offered me a salary of $39,000 per year, with the same leave provisions, and with a further guarantee that I’d receive 75% of my income through until age 65 in the event of a major disability - I’d take the lower wage. That is excellent value. Certainty comes at a price - but this one is reasonable.”
A further thought - those with the most risk are those who live up to every cent of their current income. If you cannot survive on less income than you have now, you really should consider tightening the household budget and taking a known loss. Because the odds are reasonable that at some stage in your working life a calamity will hit your earning ability - and your financial survival may already be fragile so it might be a good idea to create as much certainty as you can.
It’s all about weighing the odds, and putting the “loss” into perspective. Calculate what is at risk, find out what the known cost is, and then make an objective decision.
This information is general in nature and should not be used as a substitute for financial advice. Always consult your financial adviser before making any financial decisions.