I mentioned at the end of my last post that life insurance is a completely different product, with a different set of rules. Here’s why:
We previously came to the conclusion that the question of whether to purchase insurance or not should be based around the risk of exposure to the accident/calamity, rather than the statistics, or expected value of when the accident actually occurs. You must ask yourself – can I afford the situation where the accident occurs? Well, here’s the first problem with life insurance: Can we afford the situation where we would be dead? (I don’t mean to sound morbid or insensitive)- If we are dead, we can’t benefit from the insurance payout anyways, so why purchase insurance? Technically, one cannot afford losing his/her life, but what point is there in insuring against that situation, if it won’t matter anyways?
Another problem arises with the valuation of the insurance. I am really milking the previously-mentioned TV example, so we’ll use it again. I know exactly how much the TV is worth – let’s say, $500. I can also calculate how much my house is worth, in order to insure it against fire/theft (in fact, the insurance company does this for you; so you don’t actually need to figure this amount out). But how much is my life worth? That is a very difficult question to answer. In fact, insurance companies don’t answer this question at all – they ask you to value your own life! There is no set life insurance amount – when choosing a policy, you, the policy buyer, must decide on the size of the payout if G-d forbid you were to pass away. You can buy a $500,000 policy, or a $1,000,000 policy, or any other amount – it’s up to you.
These are two of the main conceptual problems with life insurance. How should we view life insurance then? Let’s look at the first problem. Why would anyone purchase life insurance if they will never be able to enjoy its benefits? Well, because it’s not you, the insured individual, who is buying the product; it’s the benefactor of the policy. Every life insurance policy needs a stated benefactor, most commonly your spouse or children, and they are the ones who get paid out if the insured individual were to pass away. This may seem obvious to you – but let’s think about the implications. The person who should be asking the question “Can I afford the situation of situation XX happening?” is actually the benefactor, not the insured individual. If he/she can afford that situation, it may be that life insurance is pointless (I’m saying maybe – life insurance can be used for other purposes, rather than just strictly protection against death). If a person were to own a $500 million estate, it’s rather pointless to buy a life insurance policy – the benefactors actually can afford (monetarily) the proposed situation of death. Again, I don’t wish to sound morbid or insensitive – but these concepts are crucial to understand. Think about Bill Gates again. Before you read this blog, you may have thought that Bill Gates has like a $1 billion life insurance policy against himself. However, I doubt he has any life insurance policy. What would be the point? It’s a losing investment.
What’s very interesting about this idea is that it dispels a common misnomer about life insurance. Many people think that life insurance is only for rich people who can afford to buy it. Quite the contrary – the richer you are, the less of a life insurance policy you would need, because the more the benefactors can afford the bad situation. If you have less money you have in your estate then perhaps it is more crucial to purchase life insurance, because the benefactors cannot afford the situation where you can’t provide for them anymore. Even if one can only afford a $100,000 policy – if he/she has children who absolutely cannot afford their parents’ death, I would practically always suggest buying that policy. Those children absolutely need that life insurance protection, even if the chances of their parents’ passing away are very small.
There is an old saying regarding insurance: “It’s a great hedge, but a lousy investment”. Why is it a lousy investment? Well, as previously explained, insurance companies will always price their premiums higher than the average expected payout. Think of it in a different way: Let’s say an insurance company approached you and offered you a life insurance product against a random person that you never knew before. Would you buy it? Of course not – on average, that life insurance product will produce negative returns. You’d much rather put the money in the bank, or even under your mattress. It’s a terrible investment. You may get lucky one year, but on average, you will lose out. Insurance should only be used for protection against your own loss.
There is another old adage stating that you can never buy enough life insurance. I believe this is really bad advice. Why? Supposing that you actually can put a price on a person – let’s say Person X was worth $1 million dollars. If that person purchased a $1 million policy, he is purchasing a hedge (which means ‘protection’ or insurance). But if he purchases a $5 million policy, he is in essence purchasing an investment. Think about why that is – he isn’t just protecting against his own value of $1 million, but he’s adding a type of investment or gamble with the extra $4 million of policy. He’s going beyond protecting himself (or his own value), he is really making a bet that he will die, and will get paid out for it! But as we said before, insurance products are terrible investments. That’s why it’s not a good idea to overbuy insurance. (If you have trouble understanding this idea, think back to the TV example – if the TV was worth $500, should I buy a warranty that pays out $1000 if the TV were to break? That’s more of an investment or gamble, not an insurance product, and we can be sure that Future Shop is pricing that $1000 warranty to exceed the average payout of the TV breaking!)
So we need to find a way to value the person being insured, in order to avoid turning our life insurance policy into a big gamble or investment. But how can we value a person – how can we determine the size of the policy that should be bought? Well, I believe there are 2 ways. You can try to find the total amount of wages or income lost, if the policy purchaser were to die. There is a formula that can be used for this calculation – it basically adds up all your expected future wages, and discounts that amount to today’s prices. If one will earn $100,000/year for 30 years until he/she plans to retire, then the policy should be 30 times 100,000 = $3,000,000, and then that amount should be discounted to today’s present value (you can ask me for the exact formula and how to discount/why we need to discount). This is a bit of an over-simplification of the formula, but I hope the concept makes sense.
The second way to finding an insurance amount is more relative. You can decide the amount of money that the benefactors would need to survive until they are self-reliant, in case they lose your income. There are many ways to estimate this amount, but the concept is there. However, this amount shouldn’t be much higher than the amount calculated by the first method (present value of all future wages). Why? Because, again, if it is, you are really investing in your death rather than insuring against it. That is true because had you been alive, the benefactors wouldn’t have had that much money to begin with. If this concept is hard to understand, please feel free to comment.
These are the main concepts behind life insurance. However, let me warn you, life insurance is a lot more complicated in practicality. There are numerous different types of policies, including term vs whole life, withdrawal options, etc. As well, life insurance can be used for other purposes besides strictly protection against death. Life insurance payouts are taxed differently than other vehicles. An application of this could be if someone wanted to leave a large legacy/inheritance for his/her children. Insurance policies may actually be a better investment than other investments, because the tax advantages outweigh the negative returns on an insurance policy.
Therefore, it is crucial to speak to a good insurance broker to guide you through this process. A good insurance broker can combine policies with different types of investments and tax saving vehicles which are ultimately beneficial to the policy holder. However, beware - insurance brokers are usually paid commissions relative to the size of the policy that they sell, so they may not have your best interests in mind. Make sure you speak to a trustworthy individual.
I know that I didn’t really delve into the actual application of life insurance. Life insurance is a very complex topic that should be left to the experts/brokers, who know of all the different types of policy vehicles and how that can help any particular family situation. However, I hope that you now have a better sense of when a life insurance policy needs to be considered, and the conceptual ideas of how big that policy needs to be.
Stay tuned... Due to popular request, the next topic that I’ll be covering is income taxes!
Wednesday, February 24, 2010
Thursday, February 18, 2010
Insurance: Do I really have to buy it?
Insurance is the type of subject that should be dealt with solely on logic, and yet people make snap decisions on whether to buy it, or how much of it to buy. In reality, what most young couples do when faced with any insurance products (not only health or life insurance, but also product warranties, house/fire, etc.), is weigh the chances of it happening against the potential loss if the ‘bad thing’ were to actually occur. In other words, they do an expected value calculation.
For example, if you were at Future Shop, and you just bought a brand new 52” plasma TV for $1000, (with HD technology and a March Madness channel pack) and then the store offered you an extended 3 year warranty for an extra $200 – would you purchase the extended warranty? Well, if you’re like most people, you’d try to guess the chances of the TV breaking down – maybe you’d ask the store clerk about it. Let’s say, you estimated that a quarter of TV’s (1/4) break down within three years. You would then apply the formula: (1/4) times $1000, which equals $250. Aha! – that’s more than the $200 price of the warranty, which means I should definitely purchase the extended warranty. Correct?
You’d apply this concept to most scenarios, even if you aren’t so mathematical. Should I buy house insurance against theft/fire? Well, you might reason, I live in a safe neighbourhood, therefore the chances of my house being robbed or burnt is very low, so I don’t think I need to buy the house insurance, especially since it costs over $500/year. In plainer terms, you’re looking at the price of the insurance, and then comparing it to the potential loss and probability of the accident occurring.
What’s wrong with this type of thinking? Seems logical, eh?
To understand why it’s wrong, think of it from the Insurer’s perspective. How does an insurance company make money? Well, they calculate the average amount of money they’d have to pay out, and then charge slightly higher to make their profits. For example, if a particular college student crashes his car on average X times a year which costs on average $5000/year in total, the company would charge maybe $6000/year in insurance. The insurance company would NEVER charge less (or even equal to) the amount they’re expecting to pay out for accidents. In the aforementioned TV example, there is no way the company would offer a warranty for the price of $200, if they expected to payout $250 on average. In fact, most insurance companies charge WAY more than the expected payout, as much as 200% of the expected payout! That means, if the warranty costs $200, the company is only expecting to pay $100, meaning that only 1 out of 10 TV’s break down within the first 3 years (not 1/4 as you predicted). Ouch! Maybe you shouldn’t have bought that warranty...
This concept should be pretty obvious to you. Yet, you still try to use expected value calculation to figure out whether to buy that insurance product, or how much to buy. We clearly need a new method here!
The method that most experts suggest is that you should really only focus on the size of the potential loss, and whether you can afford to take on the risk of the loss occurring. What I mean by that is, you should have a floor value of what type of loss you can take. For example, let's say that in your financial situation, you cannot afford losses greater than $1,500. If your house were to burn down, you'd be in big trouble. If your car were to crash, there’s no way you could afford to replace the car, or pay huge health bills associated with the crash. Conversely, while it would be really annoying if your $500 TV broke down tomorrow, it wouldn’t be the biggest deal. You could live with the $500 loss. What I’m saying here is, you shouldn’t insure ANYTHING that is worth less than $1,500, which is the floor used in our example. However, you can’t take chances on bigger things. Even if the chances of your house burning down are really, really small, what happens if it does? You cannot afford that situation. The RISKS involved are too great.
Case in Point: If I told you not to insure the next printer you buy, and then it actually did break down and you lost your money, you’d be a bit upset with me. However, you would probably still continue to read this blog. But if I told you not to get car insurance, and then your Porsche was stolen, you’d probably hunt me down. Why? Because, that's a loss you cannot live with. There is actually a mathematical formula that represents this concept –it’s called negative logarithmic utility. Ask me to explain it if you like..it’s pretty simple.
So, my advice is to never buy insurance/warranties on small potential losses. For me, computer purchases are at the tipping point – sometimes I buy the extra insurance, and sometimes not. But if you’re a millionaire, you probably shouldnt buy extra computer warranties – you’re guaranteed to lose value on your money, and you’re better off putting that extra money in the bank, and I guarantee you that you will, on average, end up with more money than before, at the end of the warranty term. How can I guarantee that? Simple – I’m 100% sure that Apple Computers is ripping you off with their insurance product – that the price of their warranty is higher than what they expect to pay you out. And believe me, Apple knows best when it comes to how many of its computer break down and are needing of warranty repairs.
Finally, to even further illustrate this point, I can pretty much guarantee you that Bill Gates does not purchase warranties or insurance on anything (regarding his household life; I’m not talking about his company/overall net worth). Think about it.
How can we apply this concept to car or health insurance? Well, what many experts advise is that you should look into buying an insurance product with a high deductible. This means that the insurance company only pays you out when the insurance claim is higher than the deductible amount. For example, I can buy car insurance that has an $800 deductible, which means that any damage worth less than $800, I have to pay for. Only if the damage tops $800, will the insurance company chip in. Insurance companies will almost always give you cheaper premiums as your deductible increases, since their expected payout is less. Why should you do something so crazy as too get high deductibles on your insurance? Well, for the same reason mentioned above – the losses worth less than $800 are losses that you can live with, so there’s no point in paying insurance premiums that, are on average, going to be higher than the expected pay out. Only the losses that you cannot afford to take a chance on, should you be insuring against.
So in conclusion – when deciding about whether to buy insurance/warranties, focus on the risks of that accident happening. Can you afford to risk not buying insurance against the relevant loss? What happens if the accident occurs – can you live with that situation? This method should give you an approximation of your floor insurance price. For some people, its $500. For others, it could be $500,000. Either way, it’s important to keep this in mind when faced with any insurance product.
Note: Life insurance is slightly more complicated and involves a different set of rules – ask me about it if you’re unsure and I’ll tell you what the consensus opinions are on that.
For example, if you were at Future Shop, and you just bought a brand new 52” plasma TV for $1000, (with HD technology and a March Madness channel pack) and then the store offered you an extended 3 year warranty for an extra $200 – would you purchase the extended warranty? Well, if you’re like most people, you’d try to guess the chances of the TV breaking down – maybe you’d ask the store clerk about it. Let’s say, you estimated that a quarter of TV’s (1/4) break down within three years. You would then apply the formula: (1/4) times $1000, which equals $250. Aha! – that’s more than the $200 price of the warranty, which means I should definitely purchase the extended warranty. Correct?
You’d apply this concept to most scenarios, even if you aren’t so mathematical. Should I buy house insurance against theft/fire? Well, you might reason, I live in a safe neighbourhood, therefore the chances of my house being robbed or burnt is very low, so I don’t think I need to buy the house insurance, especially since it costs over $500/year. In plainer terms, you’re looking at the price of the insurance, and then comparing it to the potential loss and probability of the accident occurring.
What’s wrong with this type of thinking? Seems logical, eh?
To understand why it’s wrong, think of it from the Insurer’s perspective. How does an insurance company make money? Well, they calculate the average amount of money they’d have to pay out, and then charge slightly higher to make their profits. For example, if a particular college student crashes his car on average X times a year which costs on average $5000/year in total, the company would charge maybe $6000/year in insurance. The insurance company would NEVER charge less (or even equal to) the amount they’re expecting to pay out for accidents. In the aforementioned TV example, there is no way the company would offer a warranty for the price of $200, if they expected to payout $250 on average. In fact, most insurance companies charge WAY more than the expected payout, as much as 200% of the expected payout! That means, if the warranty costs $200, the company is only expecting to pay $100, meaning that only 1 out of 10 TV’s break down within the first 3 years (not 1/4 as you predicted). Ouch! Maybe you shouldn’t have bought that warranty...
This concept should be pretty obvious to you. Yet, you still try to use expected value calculation to figure out whether to buy that insurance product, or how much to buy. We clearly need a new method here!
The method that most experts suggest is that you should really only focus on the size of the potential loss, and whether you can afford to take on the risk of the loss occurring. What I mean by that is, you should have a floor value of what type of loss you can take. For example, let's say that in your financial situation, you cannot afford losses greater than $1,500. If your house were to burn down, you'd be in big trouble. If your car were to crash, there’s no way you could afford to replace the car, or pay huge health bills associated with the crash. Conversely, while it would be really annoying if your $500 TV broke down tomorrow, it wouldn’t be the biggest deal. You could live with the $500 loss. What I’m saying here is, you shouldn’t insure ANYTHING that is worth less than $1,500, which is the floor used in our example. However, you can’t take chances on bigger things. Even if the chances of your house burning down are really, really small, what happens if it does? You cannot afford that situation. The RISKS involved are too great.
Case in Point: If I told you not to insure the next printer you buy, and then it actually did break down and you lost your money, you’d be a bit upset with me. However, you would probably still continue to read this blog. But if I told you not to get car insurance, and then your Porsche was stolen, you’d probably hunt me down. Why? Because, that's a loss you cannot live with. There is actually a mathematical formula that represents this concept –it’s called negative logarithmic utility. Ask me to explain it if you like..it’s pretty simple.
So, my advice is to never buy insurance/warranties on small potential losses. For me, computer purchases are at the tipping point – sometimes I buy the extra insurance, and sometimes not. But if you’re a millionaire, you probably shouldnt buy extra computer warranties – you’re guaranteed to lose value on your money, and you’re better off putting that extra money in the bank, and I guarantee you that you will, on average, end up with more money than before, at the end of the warranty term. How can I guarantee that? Simple – I’m 100% sure that Apple Computers is ripping you off with their insurance product – that the price of their warranty is higher than what they expect to pay you out. And believe me, Apple knows best when it comes to how many of its computer break down and are needing of warranty repairs.
Finally, to even further illustrate this point, I can pretty much guarantee you that Bill Gates does not purchase warranties or insurance on anything (regarding his household life; I’m not talking about his company/overall net worth). Think about it.
How can we apply this concept to car or health insurance? Well, what many experts advise is that you should look into buying an insurance product with a high deductible. This means that the insurance company only pays you out when the insurance claim is higher than the deductible amount. For example, I can buy car insurance that has an $800 deductible, which means that any damage worth less than $800, I have to pay for. Only if the damage tops $800, will the insurance company chip in. Insurance companies will almost always give you cheaper premiums as your deductible increases, since their expected payout is less. Why should you do something so crazy as too get high deductibles on your insurance? Well, for the same reason mentioned above – the losses worth less than $800 are losses that you can live with, so there’s no point in paying insurance premiums that, are on average, going to be higher than the expected pay out. Only the losses that you cannot afford to take a chance on, should you be insuring against.
So in conclusion – when deciding about whether to buy insurance/warranties, focus on the risks of that accident happening. Can you afford to risk not buying insurance against the relevant loss? What happens if the accident occurs – can you live with that situation? This method should give you an approximation of your floor insurance price. For some people, its $500. For others, it could be $500,000. Either way, it’s important to keep this in mind when faced with any insurance product.
Note: Life insurance is slightly more complicated and involves a different set of rules – ask me about it if you’re unsure and I’ll tell you what the consensus opinions are on that.
Wednesday, February 17, 2010
Welcome!
Today’s economic world is about as uncertain as it has ever been. Yet, from my personal experience, the average household, and specifically younger, starting couples, have very little knowledge regarding their personal financial situation. Simple questions involving investing, saving, mortgages, debts, insurance, RRSPs, and a host of other areas seem to stifle the average couple. It’s almost like your financial situation is a ship floating in the ocean with no sense of direction or purpose. You can continue to add gasoline to that motor, but without any steering, you will never get to the place you want to end up in (Does that parable make any sense? Something tells me I should just stick to personal finance).
What I intend to do here is give you ideas on how to manage your personal financial situation, so that you may achieve your long term monetary goals, whatever they may be. I will be posting weekly updates, focused on various aspects of personal finance, and also offer tips on how to improve your personal monetary situation. I also like to write in a more entertaining manner – not because I don’t want to bore you, but because I don’t want to bore myself. Some of these topics, like how to save money on your income taxes, could make you go to sleep faster than Valium. Believe me – I am an accounting student, and I don’t suffer from any type of insomnia, day or night.
Furthermore, I would like to encourage you to comment on my blogs and ask me any questions you might have regarding any of the discussed topics, and I will try to provide an educated answer or refer you to the right resources.
Should I get a variable or fixed interest rate on my mortgage?
Is now even a good time to buy a house, or should I continue renting?
Is life insurance worth it at my age? Is any insurance worth getting?
Is it normal for me, at my age, to not be saving any of my paycheque?
Why is the Toronto Raptors’ defence so bad?
Should I invest my savings in stocks, bonds, GIC’s, or my mother-in-law’s potato knishes?
What are all those things you mentioned in the previous question and how can I get them?
If these are the type of questions that currently keep you up at night, then this blog is for you. If they don’t – well, truth is, they should. Hopefully, I can help guide you to making the correct decisions for your financial situation.
Lastly, I want to state a disclaimer. I was considering putting this in size 2 font, but this isn’t a car commercial or late-night phone dating service. I am NOT a certified financial advisor. The words that emanate from my mouth are not the words of God, unless it’s about sports. A lot of the tips that I will be giving you are completely subjective. I do promise, however, to tell you when I am giving you subjective rather than objective information, and I am also happy to refer to you the right type of financial advisor to speak to if you need further, more specific information regarding the subject at hand. Please keep this in mind before you sell your house and move to Malaysia after I talk about real estate prices and interest rate movements.
What I intend to do here is give you ideas on how to manage your personal financial situation, so that you may achieve your long term monetary goals, whatever they may be. I will be posting weekly updates, focused on various aspects of personal finance, and also offer tips on how to improve your personal monetary situation. I also like to write in a more entertaining manner – not because I don’t want to bore you, but because I don’t want to bore myself. Some of these topics, like how to save money on your income taxes, could make you go to sleep faster than Valium. Believe me – I am an accounting student, and I don’t suffer from any type of insomnia, day or night.
Furthermore, I would like to encourage you to comment on my blogs and ask me any questions you might have regarding any of the discussed topics, and I will try to provide an educated answer or refer you to the right resources.
Should I get a variable or fixed interest rate on my mortgage?
Is now even a good time to buy a house, or should I continue renting?
Is life insurance worth it at my age? Is any insurance worth getting?
Is it normal for me, at my age, to not be saving any of my paycheque?
Why is the Toronto Raptors’ defence so bad?
Should I invest my savings in stocks, bonds, GIC’s, or my mother-in-law’s potato knishes?
What are all those things you mentioned in the previous question and how can I get them?
If these are the type of questions that currently keep you up at night, then this blog is for you. If they don’t – well, truth is, they should. Hopefully, I can help guide you to making the correct decisions for your financial situation.
Lastly, I want to state a disclaimer. I was considering putting this in size 2 font, but this isn’t a car commercial or late-night phone dating service. I am NOT a certified financial advisor. The words that emanate from my mouth are not the words of God, unless it’s about sports. A lot of the tips that I will be giving you are completely subjective. I do promise, however, to tell you when I am giving you subjective rather than objective information, and I am also happy to refer to you the right type of financial advisor to speak to if you need further, more specific information regarding the subject at hand. Please keep this in mind before you sell your house and move to Malaysia after I talk about real estate prices and interest rate movements.
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