Insuring against loss of income

For young people in particular, their biggest asset is their income-earning ability 

Not all people have enough income protection insurance.

It's amazing that so many financial planners don't talk about it. 

About 35 per cent of people insure themselves for income protection - and the vast majority of those people are self-employed. 

Many people in full-time employment rely on an income protection through superannuation that they may not actually have. 

A lot of people think they have protection through super when they don't. 

Also, people don't understand the difference between total and permanent disability benefits and temporary disability benefits. 

Take a moment to check your policy: the answer may surprise you.

Attitudes to income protection can be baffling. 

If you don't have an income, then there are all the other things that are dependent on that - you can't pay the mortgage, you can't feed the family. 

A lot of people could only go a month or two without income.

Ask the population if they have home and contents insurance and 90 per cent would say yes.
But they don't think they have to insure themselves, and they're the ones generating the money to pay for all this.

Then there's redundancy. 

Many mortgage providers offer - and sometimes insist on  mortgage insurance.

It's estimated that ten per cent of people have taken income protection with their mortgages over the long term. 

But that's more historical than current; it used to be more like twenty per cent and now it's more like five. 

People feel a lot more confident.

This sort of insurance means that if you lose your job, or your ability to earn income for another reason, the policy will continue to pay your mortgage. 

Periods vary with policies but can be one to two years.

Some institutions require people to get mortgage insurance, particularly if they are gearing heavily in their mortgage. 

If the loan to value ratio is above 80 per cent, for example, many lenders will require mortgage insurance ... with good reason for doing so: at the 80 per cent level, about 1 per cent of mortgages default. At the 90 per cent level the default figure climbs to 2.5 per cent.

Then there's the loss of income from an untenanted rental property. 

Landlord insurance can cost as little as a couple of hundred dollars and covers, for example, defects in the building or damage caused by a tenant. 

But if you can't rent it just because it's unpopular, you can't protect against that - it's a case of looking closely at the quality of the product in the first place.

Life Insurance: How much is enough?

The Two Approaches to Setting Life Insurance Policy Amounts 
You can use one of two approaches to estimate how much life insurance you should buy: the needs approach or the replacement-income approach.

Using the needs approach, you calculate the amount of life insurance necessary to cover your family’s financial needs if you die.

Using the replacement-income approach, you calculate the amount of life insurance you need to equal the income your family will lose. Let’s look briefly at each approach.

You need how much? 

Using the needs approach, you add up the amounts that represent all the needs your family will have after your death, including funeral and burial costs, uninsured medical expenses, and estate taxes.

However, your family depends on you to pay for other needs, such as your child’s college tuition, business or personal debts, and food and housing expenses over time.

The needs approach is somewhat limiting.

The task of identifying and tallying family needs is difficult, and separating the true needs of your family from what you want for them is often impossible.

Replacing Income 

Using the replacement-income approach for estimating life insurance requirements, you calculate the life insurance proceeds that would replace your earnings over a specified number of years after your death.

Life insurance companies sometimes approximate your replacement income at four or five times your annual income.

A more precise estimation considers the actual amount your family members need annually, the number of years for which they will need this amount, and the interest rate your family will earn on the life insurance proceeds, as well as inflation over the years during which your family draws on the life insurance proceeds.

Note: Do remember as you quantify the income you want to replace that Social Security provides generous survivors benefits if you’ve qualified.

Calculating Replacement-Income Amounts with Excel

If you’ve got access to a computer running Microsoft Excel, the popular spreadsheet program, you can use your computer to calculate the amount of insurance you need to replace a specified number of years of income.

Suppose, for example, that you want to buy enough life insurance to replace the income from a $50,000-a-year job for 15 years.

If you figure your family will earn 5% on the life insurance proceeds should the worst case scenario occur, you enter the following formula into a cell in an Excel workbook to calculate the replacement income life insurance amount:

=-PV(5%,15,50000)

Excel returns the formula result 518,982.90 indicating that you would need roughly $520,000 of life insurance, invested at 5%, to payout $50,000 a year for 15 years.

Two Calculation Tips 

If you want to factor in inflation because you’re trying to replace income over a long period of time, you should use a real rate of return rather a regular, or nominal, rate of return.

To calculate a real rate of return, subtract the inflation rate from the interest rate in the formula.

For example, if you expect 2% inflation, you could replace the formula shown earlier with this formula:

=-PV(5%-2%,15,50000)

Here’s a final calculation tip:

You probably want to round up your number. For example, if the formula provided earlier returns the value 518982.90, you might want to round up this value to $600,000. Or $750,000.

Editor's Note: Financial Services Online provides a free online calculator that uses a combination of replacing income and needs approach in helping to determine the amount of life insurance cover you may need.