May 7, 2007

The Four Financial Risks

And the knowledge that they fear is a weapon to be used against them.
-- Rush, The Weapon (Part II of Fear)
Actuaries measure and manage risk (the probability of harm). I focus on financial risks. Here are the four main ones
  • longevity: outliving your savings
  • mortality: dying too soon
  • morbidity: getting sick
  • disability: getting disabled
Longevity Risk: Outliving Our Savings
Who would think that living a long life would cause financial risks? As we live longer, we need more money. If we're healthy, we may have expensive hobbies such as travel or cottages. If we're ill, we may face additional medical expenses.

We no longer believe that the government will be able to take care of us. Or rely on a company pension plan. We must save for ourselves. The sooner the better. There's plenty of (conflicting) advice on investing elsewhere. So I'll defer to those experts.

You can get guaranteed income as long as you live with a life annuity, which enjoys preferred tax treatment: each payment is a blend of interest (taxable) and return of capital (tax-free).

Mortality Risk: Dying Prematurely
If we have dependents, we need life insurance to cover the expenses of mortgages, education, etc. Inexpensive term insurance is available widely. The consumer site provides price quotes. Term 10 is the most popular choice.
Tip: for Health Risk, select "Regular". If you're healthier, you'll get lower rates. very few qualify for "Super Preferred".
As we age, term insurance becomes increasingly expensive. When we reach the ages where death is more certain, the term coverage unavailable. Why would you need life insurance when you're 70 or older? For estate planning --- for example, to offset the taxes on the capital gains from your cottage, investment real estate or shares.

Morbidity Risk: Losing Health
As we age, we realize how feeble our bodies can be. Even people who take excellent care of their health can be stricken with cancer, heart attack, stroke or require heart bypass surgery. Critical illness insurance can help by paying a lump sum in these situations. Some plans refund your premium if you make no claims. So you get another source of retirement income to tackle your longevity risk.

Disability Risk: Losing Income
If we become disabled, does our income go up? Expenses may rise, but income usually drops. The disability could last for years. Who has that much in savings? Or friends and relatives who are that generous? That's where disability income replacement insurance can be helpful. Maybe your employer provides this for you.

The Costs
How can we afford to insure against every risk? We can't (see Stagnant Family Incomes). We wouldn't even if we had the money. Everyone's situation is different. You'll need to see which risks are more likely and more financially devastating.

This is the point where you're tensing up because you're expecting me to tell you that I can solve all your problems ... for a price. Relax. I'm simply here to provide education and insights. A different perspective. Why? I've been helped by so many people. This is my way of giving back. With interest :)

Feel free to leave comments on topics you'd like to see addressed.

Canadian Tour of Personal Finance Blogs
Visit A Canadian and Her Money for links to the other participants.


Anonymous said...

Very well organized, Promod.

Longevity – I have my own custom-made annuity: a diversified basket of dividend paying stocks.

Mortality – Term insurance rocks. Regarding estate planning, my opinion is that we should only buy insurance to protect against catastrophes, not to maximize profits. I can see insurance premiums being higher than the tax-saving by the time you hit 70.

Disability – Very well written. I’m terrified of becoming disabled. Disability insurance is arguably more important than life.

dj said...

Where do you recommend getting more info on critical illness insurance? (before speaking to my salesperson)

Promod said...

Thanks for the comments,

I'm glad you're preparing for longevity.
1. With the dividend paying stocks, are you going to live off the dividends? That'll give you less income than selling some stocks periodically.
2. If you're going to sell stocks, your portfolio is subject to market fluctuations. Selling in a down market makes it harder to recover the losses when markets recover.

Term insurance is best for temporary needs because it's gone by the ages people normally die. If you want to maximize your financial legacy (e.g., for family or a charity), you'll want to consider the effect of taxes upon your death. If you have stocks, for example, your estate is taxed as if you sold them just before death. So there's tax on the capital gains. Permanent life insurance is often used as a cheaper way to pay those taxes, leaving a larger estate after tax.

Disability is much more likely than death during the working years. As is getting a critical illness. Naturally, we think that we'll be spared and don't want to "waste" money on insurance.

Promod said...

dj, you can learn more about critical illness insurance here. Your timing is good. This week, I spent several hours getting updates from experts. So I've got fresh insights to share.

I'll post an article within a few days.

The product is simple enough: you get a lump sum a month after something dreadful happens to you (as defined in the contract).

I'll skip the usual fear mongering statistics and give you tips on what you can ask your advisor.

Promod said...

dj, the post about critical illness is here. I hope it helps.