Life Insurance And Inflation: Adjusting For Rising Costs

Life insurance is a financial safety net for your family after you pass away. But what happens when inflation devalues your policy's payout? Inflation protection is an additional feature that can be added to a life insurance policy to increase the benefit amount over time, relative to the inflation rate. This feature is designed to ensure that the benefit amount keeps up with the rising cost of living, so your family can still meet their financial needs.

Inflation riders

There are several types of inflation riders, including:

• Guaranteed purchase option (GPO): The option to increase coverage every two or three years without multiple approvals.
• Simple inflation protection: The death benefit increases automatically by a chosen percentage, usually 3-5%, annually.
• Compound inflation protection: The coverage amount increases by a percentage each year, with compound interest applied.

The cost of an inflation rider will vary based on the type chosen, the policy it is added to, and the amount of coverage increase. For example, compound inflation protection generally costs more than simple inflation protection.

Inflation protection

There are several ways to protect against inflation when it comes to life insurance. One option is to purchase an insurance inflation protection feature, which increases the value of benefits by a pre-defined percentage at specific time periods to keep up with inflation. This is an additional feature that will increase the premium payment, with lower inflation rate protection plans having lower premiums than higher inflation rate options.

Another option is to purchase a cost-of-living rider, which is an optional add-on that typically increases the death benefit in line with the consumer price index. This means your premiums will increase alongside any increases to the coverage amount. Not all companies offer inflation riders, and the cost may differ between insurers.

A third option is to link your premiums to figures that are intrinsically tied to inflation, such as the Retail Price Index and the Average Earnings Index. This is known as indexation and usually cannot be added to an existing policy, so it must be decided upon in advance.

Finally, if you already have a life insurance policy, you can add additional coverage to your existing policy to keep up with inflation. This is known as a periodic coverage boost and allows you to factor the inflation rate into your coverage based on your specific needs.

Calculating for inflation

The primary purpose of life insurance is to provide a safety net for anyone who relies on you financially. For example, if your salary covers the mortgage, utility bills, and school fees, a life insurance policy can cover those expenses if you die. Calculating how much life insurance you need may include multiplying your salary by a certain number of years, adding up your debts, and considering all the daily expenses you currently cover.

While these calculations are necessary, they don't account for inflation. When you buy coverage through a life insurance agent or broker, they may factor inflation in for you. But if you purchase coverage online, you may have to factor this in yourself.

A simple way to do this is to use historical averages. For example, the average annual inflation rate for the 20 years prior to the pandemic (2000 to 2019) was roughly 2%, according to data collected by the Federal Reserve Bank of Minneapolis.

However, inflation does not always climb at a steady rate. For instance, the consumer price index, which tracks the average cost of goods and services, rose by 8% in 2022 and a further 4% in 2023. So, if you factored in a rate of 2% when calculating your coverage, the current rates may seem alarming.

One way to address this is to use an inflation rate that is realistic for your needs. Your policy type, policy length, and financial obligations can help you build a custom plan. For example, planning for 8% annual inflation may not be realistic for a policy that you expect to last 30 years, but it may be practical for short-term coverage that could pay out in the next few years.

Think about the types of expenses you want the policy to cover. Some costs, like fixed mortgage payments, aren't as heavily affected by inflation, while others, like groceries and utilities, can change significantly over time. Speak with an agent or a fee-only life insurance advisor to find the right rate for your situation.

Also, consider whether your need for life insurance will change over time. You might need more coverage in the future if you plan to buy a home or have children. Over the years, as your mortgage is paid off and your children become financially independent, your need for life insurance may decline, making inflation less of a concern.

Cost-of-living riders

A cost-of-living rider, also known as an inflation rider, is an optional add-on to a life insurance policy that increases your coverage amount over time to keep pace with increases in cost of living. This type of rider can help offset the impact of inflation on the value of your policy.

When you add a cost-of-living rider to your life insurance policy, you are essentially indexing your policy's death benefit to an inflation measure, most commonly the Consumer Price Index (CPI). This ensures that the death benefit increases at the same rate as the cost of living, maintaining its value over time.

There are a few different ways that cost-of-living riders can work. Some riders are directly linked to the CPI, meaning that your coverage amount will increase based on the average price changes of consumer goods and services over time. Other riders may increase your coverage at a set percentage or amount at regular intervals, independent of the CPI.

It's important to note that adding a cost-of-living rider will typically result in higher premiums. However, the increase in coverage over time can provide valuable peace of mind, especially for long-term policies.

When considering a cost-of-living rider, it's essential to weigh the benefits against the additional costs. The specifics of these riders can vary depending on the insurance company and the terms and conditions of the policy. Be sure to carefully review the policy documents and consult with an insurance professional to fully understand the potential impact on your coverage and premiums.

Additionally, cost-of-living riders may not be suitable for everyone. For example, if you have a limited budget for premiums, the added cost of the rider may require you to start with a smaller death benefit. In this case, it might take several years for the increased coverage from the rider to surpass the initial death benefit you could have afforded without it.

In conclusion, a cost-of-living rider can be a valuable tool to protect your life insurance policy against the eroding effects of inflation. However, it's important to carefully consider your personal circumstances, financial goals, and the potential drawbacks before deciding whether to add this type of rider to your policy.

Indexation

Four times a year, the Australian Bureau of Statistics releases their Consumer Price Index (CPI), which is a group of statistics that looks at how much it costs every year to buy groceries, go to the cinema, put petrol in your car, and more. Having an indexed insurance policy means that the amount you're insured for changes with the CPI. That helps to future-proof your policy; each year as the cost of living changes, your cover amount increases by a similar percentage on the policy anniversary.

If you add indexation to your life insurance, the insurer will increase your cover and premium yearly. However, only one insurer, New Ireland, increases your cover and premium by the same rate. All the other insurers increase your premium more than your cover, so be careful.

Inflation protection is considered a desirable feature of a policy by policyholders, but it can cause headaches for insurance companies. This is because insurers can face limits to the changes in premiums they can charge individuals. To entice policyholders to accept a lower rate of insurance inflation protection, insurance companies may offer lower increases in premium costs.

Frequently asked questions