Insurance - why I prefer stepped premiums over level premiums

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Insurance is a great tool for managing risk. It's not for everyone, and it doesn't cover all risks. But it's a great tool for most people.

  • Life insurance can protect your loved ones from financial harm if you die suddenly and unexpectedly. 
  • Income protection insurance can help if you're unable to work for an extended period of time. 
  • Total and permanent disability insurance might help if you become... totally and permanently disabled. 
  • Trauma (critical illness) insurance can help you if you become diagnosed with certain types of illness.

(And yes, these insurances complement and provide additional cover to ACC.) 

    When you take out personal insurance, one of the common decisions you need to make is whether to take out "stepped" or "level" cover. 

    With stepped cover, your premiums will increase over time. You'll continue to be insured under the original terms of the policy, but the premiums will increase to reflect the increased likelihood that any of these things will happen to you. 

    After all, the number one risk factor for most illnesses is age.

    With level cover, however, you're effectively locking in your premiums. Your premiums won't increase nearly to the same extent.

    Which sounds great. Who doesn't want a bit of certainty?

    The question, however, is at what cost. 

    Stepped policies are much cheaper when you take out the policy, and increase substantially as you age. Level policies may not increase in cost, but are a lot more expensive to start with.

    If you plan on keeping your insurance in place throughout your working life, and not making any changes to your policies, I'd expect you to save money by choosing level policies. 

    But your insurance needs should reduce over time! 

    Your insurance needs should reduce as you get older. For example:

    • As your dependents grow older, and you build wealth, this mitigates the financial effect of your unexpected death, and the amount of life insurance you need.
    • As you accumulate wealth that you could use in the event of an emergency, you increase your capacity to self-insure in relation to being diagnosed with an illness, and can reduce or cancel your trauma/critical illness cover.
    • Even if you need to keep protecting your income throughout your working life, you might get into a position where you can increase your wait period. Changing the wait period from 4 weeks to 3 months can drastically reduce your premiums.

    If you choose a level policy, you can find yourself in some absurd situations.

    For example, I recently spoke with a couple who've had their life insurance in place for many years. They're financially independent, have no dependents, and don't need life insurance to manage financial risks.

    But when they signed up for their life insurance, they signed up for level premiums. And they don't want to get rid of it. They've paid so much in premiums now, they want to keep going with the insurance. 

    In their case, they aren't continuing with their life insurance to manage downside risk. They're effectively gambling for upside benefit. If one of them dies before the age of 65, the other will receive a significant windfall.

    They're paying close to $5,000 per year for the equivalent of a lotto ticket. The odds of winning are much better than Lotto. But the most likely scenario is that they're going to pay tens of thousands of dollars - if not hundreds of thousands of dollars, if you consider the opportunity costs of these premiums - and get nothing in return.

    I'll concede: there are times where level premiums are suitable. And sometimes it might be appropriate to consider combining some stepped cover with some level cover.

    But as a general rule, I say "no" to level premiums for personal insurance. 

    Related

    Also, check out my FREE online course: Insurance for Savvy Kiwis!

    Sonnie Bailey

    Sonnie is the founder and principal of Fairhaven Wealth.

    Before founding Fairhaven Wealth, Sonnie worked in the legal and financial services industries for over a decade.

    Sonnie first became involved with financial advice as a specialist financial services lawyer. For many years, he was an “adviser of advisers”, reviewing thousands of advice files prepared by hundreds of financial advisers, and providing feedback in relation to the quality and appropriateness of advice; industry best practice; risk management; and regulatory compliance. He has published work in industry publications and spoken at various financial advice conferences.

    Sonnie has also worked with banks, investment management firms, insurers, and derivatives providers.

    Sonnie has worked as a private client lawyer, focusing on succession, estate planning and trusts. He ran his own legal firm in Australia before relocating to New Zealand. He has also acted in independent trustee and company director positions.

    Sonnie is passionate about helping people achieve their goals and manage the risks to which they are exposed.

    He has written extensively on his blog, New Zealand Wealth and Risk, which can be found at www.wealthandrisk.nz.

    Sonnie is married to his wonderful wife Chrissy, and has two young children, Ben and Anna.