Is it Life or Death Insurance?
by Richard P. Halverson
How to figure your optimum coverage.
A few weeks ago I attended the funeral of a colleague who quite unexpectedly dropped dead on a treadmill. He was way too young. His wife and four pre-teen children were bricks during the ordeal. The problem is now. He didn’t leave a penny of life insurance. Professionally, he invested money for other people, and he had done a little for himself. Unfortunately, he was not old enough to have accumulated much. The family’s situation is going to be very difficult.
I have another friend whose funeral I have not attended. He is in his late 60’s. He is suffering from arthritis and some other annoying ailments. He is retired from his first job due to age, but he is still working. He doesn’t want to work, but he can’t afford to quit. The organization he was employed by for many years had an unusual benefit program. He could use his benefit dollars to buy life insurance and/or investments. He always chose 100% life insurance. If he had died five years ago his wife would be a multi-millionaire today. Unfortunately, when he reached mandatory retirement, his job and his life insurance ended. They have very little savings. It looks like a social security type retirement for them.
Life is full of financial trade-offs. Here the extremes were no life insurance or all life insurance. Neither extreme seems very wise.
Actually, life insurance is not life insurance at all, it is death insurance. It pays off to your loved ones in the event you die. It might be more proper to refer to your investments as life insurance. Investments pay off to you and your loved ones in the event you live. In fact, if you have handled your investments well they will keep paying off to your loved ones even after you die. However, there is a risk you will die unexpectedly, creating a financial loss for your loved ones. You may need to insure against that risk. Of course, there is probably an even greater risk you will live. There are financial obligations associated with living as well. You also need to insure (or invest) against that.
I have a purpose in stressing the fact that life insurance is really death insurance and investing is really life insurance. I hope it will become clear as you read on. But, I am not going to try to change the commonly accepted names of these financial products in these few paragraphs. There is already enough bafflegab in this business without trying to change the names of products everyone thought they understood. So I will plow ahead using conventional terminology.
Life insurance is like all other types of insurance in that it exchanges an uncertain loss you can not risk experiencing for a certain loss called a premium. Unlike most risks you insure against, your death is a certainty. Damage to your car is not a certainty (unless you have a lot of teenage drivers in the house.) It is the timing of your death that is uncertain. And timing is everything. The financial loss to a young family associated with losing a breadwinner is very different than a 95-year-old great grandparent. This means you must refigure the amount of life insurance you will need at many different points in your life. In this regard it is like writing your will. It is no fun to do, the questions all have very uncertain answers, it doesn’t seem terribly urgent, and it is easy to postpone. Since you know you shouldn’t postpone it, I won’t preach to you.
I will say this. Buying the right amount of life insurance is important. If you are under insured you risk creating a financial hardship for your family you would never wish upon anyone. Over insure and you have less money to invest. Less investment means less insurance against the more likely scenario that you keep living. Then you run the risk of creating a financial hardship later in life for you and your family that you would never wish upon anyone. It is not easy.
The first step in determining how much insurance you need is to determine the amount of uncertain loss you (your family) can not afford to take. This is a function of a number of things. It depends on who is dependent upon you financially and how long they will be dependent on you financially. It depends on what other assets you have. You may have sufficient investments to handle all your obligations. It depends on the life style of your family. Life style is a tricky question. Feelings range all the way from providing enough life insurance to actually improve the life style and security of the family to providing just enough to avoid living in a homeless shelter. One approach makes you worth more dead than alive. The other makes your family wish they could kill you all over again. The responses can make quite a difference. Remember every dollar you pay in insurance premium is a known loss. It is a dollar that can not be invested to provide living and retirement insurance. I will attempt to illustrate how much difference that can make.
The following example is hypothetical. It represents a family with four children ranging in ages from 16 to 8. The thirty-five year old husband and father is the principal breadwinner. The wife and mother is a stay-at-home mom. Here we assume they have no other investments except a nice home. In this example we are looking for life insurance for the man. But women need life insurance too, even if she is a stay-at-home mom. The analysis is the same. Figure out what the financial loss to the family is associated with her death and determine what portion of that loss the family can not risk taking.
The first column in our analysis represents some questions a financial planner might ask. (Most financial planners get paid on commission. The more he/she sells the better for them. Thus the bias you will see in the questions.) The second column is the “Let’s Make Them Happy I’m Gone” response. The third column is the “Hey, Everybody has to Sacrifice a Little” response. These responses do not imply as much bias on my part as my flippant headings imply. There are no right or wrong answers. Responses are a very individual thing. And because there are no right or wrong answers, it can make agreeing on the answers hard for the family. There will be legitimate differences of opinion. Despite the differences of opinion it needs to be a family, at least a husband and wife, decision. After all, it is the survivors who must live with the consequences of the decision.
MAKE THEM HAPPY I’M GONE!
Annual Need
Annual Need
Yes. Annual cost for staying in current home including mortgage, taxes, insurance, maintenance, utilities, etc.
-$24,000
Not necessarily. The family could live with dignity in a much smaller home.
-$18,000
Annual earnings from net equity in existing home.
+$5,000
Yes. Annual savings needed to pay for college for four.
-$25,000
No. Shauna and I worked while we were in college. Our kids can work too. We aren‘t putting away that much now.
-$2,000
Further, the kids will be driving soon, they will need a car.
Yes. She should get a better car. Payments, gas, maintenance, etc.
-$10,000
Yes. The kids will need to get around.
-$3,000
Reliable yes, luxury no. Her current car isn‘t fancy but it runs well.
-$7,000
No, we are not going to provide life insurance to buy cars for the kids.
$0
Yes.
-$22,000
No. Many of these will need to be provided for but we take some expensive trips that aren‘t absolutely necessary. There are other savings as well.
-$18,000
No. She needs to be available to the kids.
+$0
She could work part time.
+$15,000
Yes.
+$12,000
Yes.
+$12,000
Yes. If the payment gets spent there will be nothing for future living expenses.
At this age yes. If Shauna were much older it might be OK to spend a little of the insurance payment every year with the idea that it will finally be all gone when Shauna dies.
_ Assumed earnings 9.00%
_ Taxes on earnings 20.00%
_ Inflation Adjustment 3.50%
Net divisor 3.70%
Divide the total annual living amount needed from above by this divisor.
Total annual living $72,000
Divisor 3.70%
Needed Benefit $1,945,946
Total annual living $13,000
Divisor 3.70%
Needed Benefit $310,000
You will need to add something for one time expenses related to your death.
Yes.
-$25,000
Yes, but buy me the cheapest casket available. I‘m willing to sacrifice too.
-$24,000
Total insurance needed (rounded)
$2,000,000
$350,000
The math here at the end is important. Most life insurance will pay out as a lump sum. You may provide some insurance to cover the one time death related costs like funeral, casket and possible legal needs. Most of the money, however, is intended to meet ongoing living expenses, expenses you would have provided for if you had lived. You do not want the family to have to spend this money to live on. That would be like eating the seed corn. When it is gone there is nothing left to live on. Instead, you want the family to be able to invest the money and live off the earnings. The divisor is a factor that takes into account the estimated investment earnings, less taxes on the earnings. Additionally, it makes an adjustment for inflation. The cost of living keeps rising every year. The divisor is important, but it does create more uncertainty in arriving at the correct amount of insurance. Estimating future investment returns, taxes and inflation rates are all uncertain. The amount of insurance you estimate you need will vary substantially based on those assumptions.
In our hypothetical example above we can see that the amount of insurance needed can vary from $2,000,000 to $350,000. Naturally, the premium to buy the insurance also varies widely.
MAKE THEM HAPPY I’M GONE!
Annual Cost
Annual Cost
$2,000,000
$350,000
$1,775
$355
Annual investment $0
Annual investment $1,420
Accumulated Investment in 30 years. $0
Accumulated Investment in 30 years. $149,071
The figures here make the point about insurance against the risk of you dying and insurance against the risk of you living. When the gentleman in our example retires at age 65 his insurance will lapse with no value at all to him. His investments will be worth $149,071.
In my next article I will provide a worksheet readers can use to help calculate the amount of insurance they need.
I am anxious to make clear my example here is not intended to encourage you to lower the amount of insurance you buy. I am encouraging you to make a thoughtful analysis of your needs. What risk of loss associated with your death should you transfer to the insurance company? There are tradeoffs. Don’t just pick a number out of the air like $1,000,000 because it sounds good. It may be too high or too low. If you work with a financial planner, make sure the answers you provide represent your opinions and not the salesperson’s. And perhaps most important, don’t put off doing something just because the answers are hard to figure out. That is one risk your family really can’t afford to take.
2001 Meridian Magazine. All Rights Reserved.
