From our first step out of bed in the morning to turning out the lights at night, we are taking risks. The Cambridge English Dictionary defines the word ‘risk’ as ‘the possibility of something bad happening’. We take risks because we hope (or expect) that something good will happen rather than something bad.
When we think about our financial planning we tend only to think about risk in terms of investments. That is the risk that an investment might underperform expectations, lose money, or even become worthless. By taking care with our investment research we are able to reduce these risks and, we hope, make you money. However, we can’t remove the risk – or more importantly the consequence of the risk – entirely.
It’s this same idea of the consequence of risk that has resulted in the insurance industry. We insure our homes against the financial (and physical) consequences of damage (for example due to fire). We insure our cars against the financial consequence of having an accident – having to pay for repairs. These are high impact, low occurrence events.
Planning for the unexpected
When we plan for the future we make assumptions that things will go well. For example that we will continue to work and that our family will remain in good health. But what would happen if this wasn’t the case? What would be the consequences for your financial plan?
Thankfully these are relatively rare things to happen, but the impact could be catastrophic. In the UK we do have a State benefit system which provides an element of safety net. However, the amounts of money involved are relatively small compared to the amount of money you may have been earning. Indeed your family might find that there are additional costs that arise such as more childcare. These events could potentially result in being forced to move home if your mortgage/rent became unaffordable.
This is before you consider the long term impact on your objectives such as educational expenditure or your lifestyle in retirement. Just dealing with the here and now could be a huge challenge.
Building a financial safety net
So what can you do? Just like our car and home insurance we can take out financial protection products for our health and life. These can provide either income or capital in the event of a claim. In return, you pay a regular premium which, just like your car insurance, takes into account how likely you are to make a claim. There are a few different types of product, but we’ve tried to keep it simple here.
This pays out a lump sum if you die during a particular period of time. You agree up front how much cover you require and for how long. The insurer underwrites the cover and sets the monthly premium based on the information you share with them (and sometimes a medical).
For example, you might have a £100,000 interest only mortgage due to be repaid over a set period of time. You could set up cover to pay this off if you died during this time.
There are further options on this basic formula. You could have a reducing level of cover to match a reducing mortgage liability (this would result in a lower premium). Instead of having a large lump sum you could have a series of smaller payments, this is called Family Income Benefit (FIB).
You can also choose to add Critical Illness cover. In addition to death, this would pay out in the event that you were diagnosed with a condition specified in the policy document. The cost is higher because you are more likely to suffer one of these than die during a particular period.
Many employers provide sick pay for a period of time. Statutory Sick Pay (SSP) is available to all employees for up to 28 weeks but is only £89.35 a week. If you are self-employed you will not receive this.
It is possible that after this period you could be eligible for State Benefits such as Employment and Support Allowance (ESA). However, payment isn’t automatic and the amount you receive depends on many factors. It is a complicated process and difficult to work out how much you will receive. At most, if you are severely disabled you might receive up to c£188 a week, but you might receive less than £73.10!
These amounts may be substantially less than you earn. Whilst some of your costs might have reduced there may be new costs that you need to cover.
Income Protection provides a replacement stream of income if you are unable to work due to prolonged ill health or disability. It carries on until you are able to return to work, you die, or you reach the pre-agreed retirement age. Most providers will work with you to get the help you need to return to work.
Many businesses (especially small businesses and start-ups) are reliant on the expertise of one or two individuals. If they could no longer work, the consequence could range from the inconvenience of having to replace them to the business being unable to continue.
The same types of cover are available. The business can set up cover to provide itself with a lump sum or replacement income stream. It is possible to provide these types of cover to employees as well as a Death-In-Service benefit and Income Protection.
Most types of cover are designed to last for a specific period of time. If is, however, possible to take out life cover that is not restricted to a particular period. Instead of paying out if you die during a period of time, it pays out when you die. Although this does mean that the cost is higher.
You might use this if you know that a liability (such as Inheritance Tax) will arise when you die. Given enough time you might be able to make provisions yourself. Having this cover would protect against the risk of not having enough time to do this.
Peace of mind
Once you have a safety net in place, you can sleep easier knowing that this can help keep you protected through even the most difficult situations.
Written by Dan Atkinson, Head of Technical EQ Investors, a boutique wealth manager, based in London