I have a couple of insurance policies; these can roughly be grouped into 2 categories -- those that I didn't opt out and those that I voluntarily bought. Insurance policies that fall in the former group are CPF's Dependents' Protection Scheme and Home Protection Scheme (HPS) while insurance policies that fall in the latter group are the "as-charged" Medishield plan and disability income insurance. The key difference between the 2 groups is the former has lump-sum, one-time payouts while the latter have variable or regular payouts over a period of time. As shown in the title of this blog post, my preference is always for regular payouts over lump-sum payouts.
For insurance to be effective, the asset (from insurance payout) must match the liability. Not only must the value of the asset and liability match, the timing of these cashflows must match as well. An asset that is realised one year after the liability falls due is no help at all. The reverse is also true, as will be shown later, but it is always better to have the asset earlier than the liability. Thus, when buying insurance, one must estimate the nature of the liability and find the appropriate insurance to match both the value and timing of the liability.
When an unfortunate incident happens, it is likely to have 2 components, an initial period when there is high cash outlay such as due to surgery, and an recuperation period when the cash outlay is lower than that during the initial period but is regular, such as due to follow-up consultations, medication or loss of employment. Depending on the nature of the incident, the initial period will dominate for some incidents (e.g. accidents) while the recuperation period will dominate for other incidents (e.g. disability). Insurance with lump-sum, one-time payouts will be useful for the first type while insurance with regular payouts will be useful for the second type.
It is not wise to use a lump-sum insurance to cover a liability with regular expenses, as there is no certainty that the one-time payout is sufficient to cover the regular expenses even if the value of the payout and expenses roughly match. Take for example, a one-time $100K insurance payout and a liability that requires $3K in expenses a month over 3 years. The payout only needs to be invested at a rate of 3.1% to support the required cash outflow. It looks simple enough and does not require a bull market to achieve this rate of return. However, how can one be certain that there will not be a bear market that ruins the investment? Hence, there are challenges in trying to convert a lump-sum payout to a regular payout. Moreover, considering that the person is no longer as healthy as before, would he still be able to invest as well as he is when he is healthy? Thus, it is best to leave the risk of investing to the insurer and look for a regular-payout insurance to cover such a liability.
Notwithstanding the above, it may be possible to modify the cashflow of the original liability such that the asset and liability now match. For example, a loan obligation may require regular monthly repayments. It is possible to make a lump-sum repayment to either extinguish or reduce the amount of monthly repayment required in the future. A lump-sum insurance will work well in such cases. CPF's HPS plan falls into this category by extinguishing the loan when an unfortunate incident happens.
In conclusion, it is important to match the asset to the liability. Buying the right insurance matters.
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