In the last few weeks I have received a few emails from investment advisors who avoid selling income protection to their clients. They argue that their client is better off using the premium they would pay for insurance as an additional investment contribution. If they are disabled and thus unable to work, they would cash out some of their investment portfolio to meet their loss of income.
What these advisors are prescribing is that their client self-insure their risk of being temporarily disabled. This means that they choose not to buy income protection to cover the risk that they are temporarily disabled. The theory is that if you have sufficient savings in your investment portfolio, you can choose not to transfer this risk to the insurer. Since the premium you pay to an insurer contains loadings for the insurer’s expenses and profits, as well as their margins for risk, you expect to make a saving by not purchasing insurance.
While the advisors are arguing against purchasing income protection, you can extend that same argument around self insurance to not purchase car insurance, household contents insurance, or even medical aid.
However, you should be aware that choosing to self-insure introduces some serious risks.
The main risks of following this approach are as follows:
The accumulated value of your investments are insufficient to meet your loss if the risk event occurs
This is the main risk of being self-insured. Consider if you chose not to purchase income protection. There is the very real risk that if you are disabled and unable to work within an early period of your investment, your accumulated savings are not sufficient to equal the payout you would have received had you purchased an income protection policy.
For the most part, temporary income protection policies have a 24 month benefit term (the policy will pay for periods where you are unable to work for up to 24 months). So you are at risk while the accumulated value of your investment is less than the income you would earn over two years.
Consider a 30 year old individual who earns R50000 a month. An income protection policy that pays for temporary disabilities for periods of up to 24 months will cost him approximately R550 per month. The maximum amount this policy could pay out is R50000 x 24 = R1.2 million. If the client decided instead to not purchase income protection, but instead decided to invest the R550 per month in a unit trust that earned 9% pa, it would reach R1.2 million when the client reached age 62. So until the client reached 62, his savings would not equal the amount that would be paid on an income protection policy for a two year claim for the first 32 years of investing.
The investment return I have assumed is on the low side, however:
- I have not assumed any salary inflation at all (very unrealistic)
- I have not factored in that income protection premiums are tax deductible
- You should assume a prudent investment return, because this investment risk remains with the client
So, the first risk identified remains for anyone who chooses not to purchase temporary income protection if they do not have an investment portfolio equal to two years’ worth of earnings. While the accumulated value of their investment portfolio is less than two year’s worth of salary, they are at risk of having insufficient savings to meet the cost of having a two year claim.
The example above is specifically for temporary income protection, but you can picture this risk for other types of policies as follows:
- If you choose not to purchase car insurance, this risk remains for as long as the accumulated value of your investments is less than what you would be paid out on a car insurance policy if your car is stolen or written off
- If you choose not to purchase medical aid, this risk remains for as long as the accumulated value of your investments is less than the maximum payout for any medical condition, which is potentially millions of rand
Even if you do have savings greater than the cost of the risk event, self-insurance still puts your retirement planning at risk.
Again, let’s look at an example in the income protection space. Assume that a 40 year old now has an investment portfolio equal to exactly two years of earnings. So the above risk is no longer present. If they were to be unable to work for two years, they can use their savings to meet their expenses for two years.
However, they have extinguished all their hard earned retirement savings. They have been disciplined enough to save a huge amount for retirement which is now reset to zero. At age 40, this represents a massive setback to their retirement planning and they will need to make tough life changes in order to rectify the situation.
Investing is not a realistic alternative to purchasing income protection, car insurance, medical aid or any other type of insurance. The way I see it, an insurance policy actually works hand in hand with good investment planning to protect your retirement savings. The impact of an event covered by an insurance policy might not impact on you today, but it will have big impact on your retirement planning in the future. Not purchasing insurance only defers your problems to a later date.
The practical problems with self-insurance
Even if you are comfortable with the above two risks, there are considerable practical problems with self-insuring. These are:
- Money in a retirement annuity cannot be touched until you retire
- Money in a pension / provident fund cannot be touched unless you leave your job
- There are costs associated with realising unit trusts
- If your investment is in illiquid instruments (think property or private equity), it is incredibly difficult to realise these investments at short notice, and there is a strong likelihood you will need to sell them at considerable discount in order get any cash for them.
Beyond that, we need to remember that investments are volatile. Consider if you need to realise part of your investment when the markets are down. You will be forced to realise your investments when their value is reduced. This risk is commonly forgotten, but it is a bigger problem than most people perceive. When you need cash on short notice, you lose your ability to time the market and are forced to realise your investments at whatever their value is at that stage.
Consistency of approach across your risk portfolio
This is less of a risk but more a philosophical issue. If an advisor advises that their client should follow this approach and not purchase one type of insurance policy, they should also advise them to not purchase most other forms of insurance. If the client’s savings are going to insulate them from one particular risk, then it should also be there to meet costs associated with other risk events. I have my doubts that this is what actually happens in reality, and advisors are thus in danger of giving advice that is inconsistent across all the major risks that an individual has.
You should think long and hard before deciding to self-insure, because you are choosing to retain some quite serious risks