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Insurance 101

Why You Should Never Overspend On Insurance

Think twice before you buy! Never overspend on insurance policies.

 

Whenever we read articles about how a person earning an average salary (think under $4,000 per month) is spending a few hundred dollars each month on insurance policies, we cringe.

Overspending on insurance policies is usually a tell tale sign of bad financial planning. There are of course, exceptions to this. But by and large, most people do not need to spend so much on insurance.

This can lead to a situation where people are overspending on insurance yet continue to remain underinsured. By spending a lot, we think we are being financially responsible (because we spend so much on insurance) but yet, many times, we will find that we are not.

Meet Andrew, Who Earns $4,000 A Month

Let’s take an example of Andrew, a make-believe but highly relevant 28-year old graduate drawing an impressive $4,000 a month. Andrew is already earning more than the median income in Singapore. He lives a reasonable lifestyle and believes planning for his future is important.

He currently stays with his parents, but has already bought a HDB BTO flat with his fiancée. They intend to move in once it is ready in 2 years time.

Here is a hypothetical example of how Andrew’s current monthly budget could look.

Item Monthly Percentage Of Salary
Gross Salary $4,000 100%
Less:

CPF Contribution

 

$800

 

20%

Giving To Parents

Basic Living Expenses (includes food, transport, telecommunication, shopping)

Entertainment and Hobbies

Holiday (based on spending $4,800 per year)

$400

$1,000

 

$200

$400

10%

25%

 

5%

10%

Total Expenses (excluding CPF) $2,000 50%
Total Expenses (with CPF) $2,800 70%
Free Cash Flow Per Month $1,200 30%

 

Andrew does spend a little money on holiday and has a budget for some entertainment. Even then, he only spends about 50% of his monthly salary, which he rationalises is probably not too bad.

After taking into account his CPF contributions, he still has about 30% of his salary as free cash flow each month.

Andrew Meets A Financial Advisor…

The advisor does a quick review of Andrew’s monthly expenses and quickly realizes that Andrew has a decent 30% free cash flow. The advisor shares about the importance of saving and investing for the future. Andrew knows this is important, and agrees.

Based on the financial advisor’s recommendations, Andrew decides to purchase a whole life insurance and an investment-linked policy. The premium adds up to $500 per month for a limited pay period of 25 years.

On first glance, this appears reasonable, since Andrew will only be spending slightly more than 10% of his income on these policies. Even then, he still has a free cashflow of about $700 per month, which he intends to save up for his upcoming wedding and home renovation.

The Flaw Of Financial Planning With This Logic

The flaw with this method of financial planning (which shockingly prevalent) is that it does not take into consideration the future needs of the individual.

Over the next 5 years (in some cases 2 years), Andrew gets married, has his own home and now has one child. His monthly budget has drastically changed. Taking into account he gets a comparable raise to inflation, his cash flow will now look like this:

Item Monthly Percentage Of Salary
Gross Salary $4,000 100%
Less:

CPF Contribution

 

$800

 

20%

Giving To Parents

Basic Living Expenses (includes food, transport, telecommunication, shopping)

Utility & conservancy charges

Child expenses (new)

Home mortgage (new)

Entertainment and Hobbies

Holiday

Insurance Expense (new)

$400

$1,000

 

$200

$500

$300

$200

$0

$500

10%

25%

 

5%

20%

7.5%

5%

0%

12.5%

Total Expenses (excluding CPF) $3,100 77.5%
Total Expenses (with CPF) $3,900 97.5%
Free Cash Flow Per Month $100 2.5%

Just like that, Andrew has hardly any free cash flow and is now living pay cheque-to-pay cheque. In fact, to make ends meet, he has already forgone the $400 per month that he used to cater for an annual holiday.

His added cost came in the form of child expenses ($500), home mortgage and utility expenses ($500), and insurance expenses ($500). The harsh reality is that he cannot drop his insurance policies without suffering a high surrender cost.

Insurance Is A FIXED Expense

Even though an insurance policy is meant for financial planning purposes, we must also recognize it as a FIXED expense, which you will incur as part of your monthly budget for many years to come.

When you buy an insurance policy (be it for health, saving or investment), it is permanently added to your monthly cost.

Though it appears similar, a person who has $700 free cashflow (like our example of Andrew above) and invests directly through a low cost Exchange Traded Funds (ETFs) or the Singapore Savings Bonds is making a very different decision from someone who decides to spend that $700 in an investment linked insurance policy.

If you invest directly, you are NOT adding any permanent fixed expenses to your monthly budget. You can stop your investment at any point in time without suffering any penalties. Whatever investments you have made prior to stopping will continue to grow. And you can resume investing whenever you want. Flexibility is entirely in your court.

The same logic does not hold true when you consider insurance policies. An investment-linked policy may need you to contribute about 10 years just to breakeven, assuming you keep up with the premiums.

What Andrew Could Have Done Instead

Rather than to prematurely commit to expensive form of investment and insurance plans, what Andrew could have done instead is to spend just a fraction of his income on term insurance, and to invest the remaining amount in a low-cost ETF. This way, he does not add fixed expenses to his budget and is able to get his money to work hard for him from day one (ie not paying hefty commissions to insurance agents).

Read Also: Why You Should Consider Buying Term And Investing The Rest

In the future, he can always adjust his monthly investments based on his future earnings and expenses, without having to commit a monthly sum to any insurance company that he may have difficulties meeting.

The bottomline is that insurance policies, while being a financial planning tool, must also be considered as a form of fixed expense which you commit to for many years. As such, don’t pick up a policy without considering your ability to pay for it over the long run.

Are you overspending on insurance? Or do you have an insurance question you wish to discuss on? You can consider joining this open Facebook Group which promotes open and transparent discussion on insurance related matters. 

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