What about life insurance?

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!