Life assurance is of vital importance to proper financial planning. Life assurance products are designed in such a way as to provide benefits which do not normally accrue from other financial and investment products.
In order to be able to guarantee the payment of sums of money on the death of an individual, insurance companies resort to what is called pooling of risks.
A large number of individuals pay premiums to an insurance company and the insurance company knows, from statistics collected over past years, that a certain number of these individuals (or "lives assured") are going to die this year, next year and so on into the future.
The life company, of course, does not know who is going to die. But it knows the approximate number of deaths which are going to occur. The company is therefore able to plan things such that it pays a sum of money, the sum assured, to the heirs of these deceased.
The older an individual is, the greater the chance of death and, therefore, the higher the premiums which the person under consideration has to pay. Conversely, the better the health of the life assured, the lower will the premium payable be. However, once fixed, premiums usually do not change and remain level for as long as the life assurance policy is in force.
One should also note that the person who pays the premium (the "policyholder") may be different from the person whose life is assured. Usually, however, individuals take out their own life assurance policies.
Unless he has savings, it is impossible for an individual to ensure that his heirs will receive a sum of money on his death, whenever such death occurs, if he does not resort to life assurance. When a policy is taken out, and the first premium is paid, the life cover is immediate. This means that, even if a person were to die just one day after taking out a policy, the heirs will receive the sum assured, which may run into thousands of liri, even though the first premium paid is of a few liri.
It is sometimes stated that it is better to invest excess cash directly than to save, and protect one's family, by taking out a life assurance policy. If an individual is sure of living long enough to accumulate a substantial portfolio, this view can make sense. However, one should keep in mind that if one deposits Lm500 in a bank today and dies tomorrow his family will get Lm500, but if one saves Lm500 through the appropriate assurance policy, his family may get thousands of liri and not just Lm500.
Protection via life assurance is therefore immediate. The premiums paid under a life assurance policy very rarely, if ever, exceed the sum received on death or maturity of the policy. In addition to guaranteed sums, bonuses are paid by the insurance company from the income it receives by investing the funds at its disposal. Life assurance as a protection makes perfect sense and this explains its popularity.
Another wrongly-held belief is that a policyholder can only benefit from a life assurance policy if he or she dies. This view has probably gained ground because, for a long time, whole-of-life assurance policies were heavily promoted. Let us, therefore, take a look at the four main types of life assurance policies available.
The simplest type of policy is a term assurance policy. Term assurance is often used to provide banks with security on overdrafts and loan facilities. In return for an annual premium, the insurance company guarantees the payment of a sum of money should the person assured die within a fixed number of years.
For example, John pays Lm50 as premium each year for 20 years and, should he die during those 20 years, his heirs (or the bank) will get, say, Lm10,000. The uses of term assurance in financial planning are quite limited. If John does not die within the 20 year period and, at the end of the 20 years, he is 45 years old, he would have to take out another policy and, since he is now older, the policy would be more expensive.
Whole-of-life assurance covers an individual from the day he takes out the policy until death, whenever his death occurs. Premiums, however, are paid either during a certain period of time, referred to as short-term premium policies, or throughout the life of the assured. Whole-of-life policies, as their name implies, provide protection throughout life.
A third type of life assurance is an endowment policy. Here, a person pays premiums from the time he takes out a policy until he reaches a certain age. If he dies during this period, his family will get a guaranteed sum announced by the company. If he lives on until the policy matures, at the agreed age, he will receive a sum of money which may include bonuses declared by the company.
Many whole-of-life and endowment assurance policies include an element of investment. The amount of bonus declared depends on the investment performance of the insurance company. Usually, once a bonus is declared, it is not withdrawn.
A fourth type of policies are linked insurance policies, technically called linked long-term contracts of insurance. These are usually investments dressed up as insurance. Investment is made in an investment fund which is sold as part of an "insurance wrapper".
In substance, this would be an investment but legally it is often considered as an insurance. On death or maturity, the policyholder usually gets either what the investment is worth or just slightly more, say an additional one per cent. These linked insurance policies provide a variety of investment avenues. The popularity of this type of life insurance has increased.
Life assurance is especially attractive when death duties on estates have to be paid. The cash paid under the policy can be used to pay transfer ("stamp") duties or other death duties payable on the estate. Such duties are usually payable on immovable property and shareholdings in private companies which usually cannot easily, and quickly, be sold. Business firms can also make use of assurance policies to reduce certain expenses which would otherwise have to be incurred.
Life assurance policies, especially endowment policies, are meant for the long-term and should not be used to achieve short-term financial goals. It is very important that one should not bind oneself to save, under a life assurance policy, more than can be put aside comfortably.
I emphasise "comfortably" because if the premiums a person agrees to pay are high, when compared to income, the person may be forced, sooner or later, to terminate the policy and would be unable to get the full benefit due. If one terminates a policy, the so-called "surrender value" which one may get for certain policies (such as endowments) is usually at a substantial discount to the real embedded value of the policy, so much so that a market in "second-hand" policies has developed abroad. If a person has short-term financial goals other investment products should be used.
Certain life policies have the benefit that, once a policy has been in force for a number of years, the policyholder can borrow money against it. Furthermore, facilities usually exist to stop paying premiums if a person's income is terminated because of sickness.
The assurance policies described are just four of a wide selection of policies from which an individual can choose. Each company has its own products. Products differ but can be said to broadly fall into these four categories. Often individuals (and businesses) resort to a life assurance policy to provide a fund to meet future expenditure such as dowries, school fees, retirement income, investment funds and business start-up capital and not just to ensure that a sum is paid on their death.
The benefits discussed in this article make life assurance policies important building blocks in most financial plans.
Mr Azzopardi is managing director of Azzopardi Investment Management Limited (www.azzopardi.com) which is licensed by the MFSA to provide investment services, including stockbroking. He is also a director of Azzopardi Insurance Brokers Limited. This article is only meant to provide information, which the writer believes to be accurate at the time of writing, and is not intended to give investment advice and its contents should not be construed as such. The value of securities, and the currencies in which they are denominated, may go down as well as up. Readers are requested to seek professional financial advice tailored to their own personal circumstances.