The Refreshments, Oasis, Jim Carroll, and insurance.
Insurance and the Insurance Companies We Love to Hate
Now that my rant is over, and knowing that this current kerfuffle is destined to end with something that funds the government for at least another year 45 days, I move on to talking about something useful: Insurance.
Insurance is something we hate to discuss. Insurance is emotionally triggering. By definition it addresses unpleasantries: death, disability, and disaster (the Three D’s). And no one wants to think about the Three D’s voluntarily. We often frame insurance companies as thieves, bloodsuckers, and bandits who take advantage of us. We want to control them with extensive regulation and price controls (how’s that working, Florida and California?).
Virtually everyone needs it in some form, whether it is personal or business. Your financial plan should include a review of potential risks, including:
Death;
Disability;
Being unable to care for yourself;
Personal liability:
Damage or loss to property;
Business liability;
Loss of business revenue;
Loss of business value.
If there is a cost and/or risk to you, and there is a chance that you would experience that cost, you ought to consider insuring that potential loss. This is most emphatically true when the likelihood that you could cover or recover from the cost is low. The point of insurance is to use the probabilities of loss to your favor and to the insurance company’s favor at the same time. How can this be? Let’s look at your house.
What’s the probability of your house being damaged in a fire?
In 2021, there were approximately 142,000,000 housing units in the United States. This means that about .2486% (25 one-hundredths of one percent, rounded) of these properties experienced a fire, and a smaller percentage experienced significant or total loss. The expected loss here, in a given year, for an $800,000 home would be $1,989. Well, heck, most of us can carry that risk! Here’s the behavioral issue with probabilities: we believe small probabilities will never happen and larger ones are certain. This one is pretty damn small. The interesting thing about homeowner’s insurance, which is in opposition to how we view probabilities, is that we have been socialized to insure our homes. Also of note, which is why HO insurance coverage has been socialized, is that a risk of this magnitude, regardless of the probability, is not something most of us can carry, and when a total loss happens, you hear about it. So most of us own it, if we own a home. Renter’s insurance is a completely different issue, however, since most renters are not responsible for property damage unless the renter caused it (at least, you would want this in your rental agreement!).
So why does everyone “know” that homeowner’s insurance is not optional? First of all, virtually every mortgage lender requires it. They understand loss and don’t want to take the risk. Second, it has been socialized in our society: You buy a house, you insure it. Renters insurance is less well socialized, however.
Life Insurance Without the Sales Process
The house discussion is pretty easy. Conceiving of losing your house is dispassionate and easy to grasp. Dying “too soon” is an entirely different concept and feeling. For most of us, it is a low probability, and we prefer to think it won’t happen. Often, we are not exposed to life insurance other than through an insurance salesperson. The insurance business tends to be a high-pressure sales environment, which makes us defensive. And everyone has a story about being a teenager, doing something stupid, and living to tell about it. When we are young, we think we are invincible.
So here is my simple view of things.
You earn, let’s say, $300,000 per year. You are 35 years old. You intend to work until age 60. That 25 years of your income is, disregarding taxation, equivalent to a lump sum of $6,012,000 if you assume 5% compounded returns and 3% inflation over this period (you can, of course, complicate this). If there is no one relying on this income, then you can fairly say no one is financially harmed by your early demise, other than funeral costs (which tend to be $10,000-$25,000 or so). Now, realistically, since life insurance, properly owned and paid for (that is, with after-tax dollars), is a tax-free benefit, what you might want to replace is the after-tax value of that $300,000.
If we assume a marginal tax rate of 25%, then the after-tax value of your compensation is $225,000. The lump sum replacement cost is then $4,509,000. What you can see is that it’s not really hard to have a need for a life insurance amount that feels like a ridiculously large number. But Mark, you say: “We don’t spend all of my salary”. OK, well let’s then say that your desired lifestyle costs $15,000 per month, your survivor is the same age, and you would like to be sure that your survivor does not have to return to work (this is the case with most young families, in my experience). You need that income, realistically, given where lifespans have been trending (I will discount these recent, COVID years where we’ve seen a US lifespan decline), until age 100, and certainly mid-90’s. That is 65 years (note that if you make it to 65 your expected lifespan then is about 20 years, and if you are married one of you has a 50% chance of living to 92).
I hid a few rows so that you can see the total math here - the need is now $6,743,000. Once again, you can see how we can arrive at a large number. I have intentionally kept this simple, as there might be college or other costs you want to cover, for example. What matters is, with no sales pressure and no emotion, the math supports a significant amount of life insurance if there is a $15,000 monthly need.
And whether we like it or not, things happen, and to young people, too.
Perm or Term?
Now comes the question of what product to buy. The insurance folks will tell you that you really ought to buy permanent insurance. They will intimate that it is an investment as well as insurance (Editor: It’s not an investment. To get your money out, you either borrow it or withdraw it. Withdrawals reduce the death benefit of the policy. So do loans). You could argue , once all costs are recovered by the insurance company, that the permanent policy has the opportunity to become an asset. You will also see that, in general, permanent insurance is, most of the time, at least ten times the annual cost of a term insurance product. Permanent insurance is just that, assuming you pay the premiums to schedule and the life insurance company’s investment earnings and mortality and operating expenses are as forecast (this is incredibly unlikely) - it is permanent and there until you withdraw the cash value (which causes the policy to lapse if you withdraw, generally, more than about 80% of the cash value, and also may result in substantial, taxable income) or you die without having withdrawn cash, whereby your beneficiary receives the death benefit. There are a lot of variables and much complexity here. Then there are the uncertainties of your ability to pay the premium over many years and your tolerance for limited or no cash value for, most likely, at least 8-10 years and, even more likely, a 10-20 year period when your contributions are greater than the cash value of the policy. It’s a complex product that many people cancel before they receive the forecasted benefits. You also have to select the right product and the right company. It takes much discipline and a quite long time horizon, in my experience, for permanent insurance to make sense as an asset.
Term insurance is exactly what it sounds like. It is in force for a term, generally of 10 to 30 years. It is easy to understand. You pay an annual premium and the death benefit is in force for the term so long as you pay the premium. Now, at the end of the term, because you remain alive, the entire amount of premiums paid could be considered a poor use of your money. What you did was mitigate a low probability but hugely impactful (if it had occurred) risk. And while we know the probability of death at any given age, we cannot predict that you will be one of the actual deaths. I wish we could, because we would wait and buy the insurance the year before you died - the rate of return on that premium would be monstrous. So the risk here is you flush your premium dollars. Another risk is that you may still have a need at the end of the term period, and if you want to buy another term of coverage, it is likely to be much more expensive (you are older and perhaps not as healthy) and it is possible that you become completely uninsurable. The bet you are making is that you save enough during the term period to make the insurance need either zero or immaterial.
Everyone’s situation is different. Should some people purchase permanent insurance? Yes. Does it make sense for most people to buy term insurance? In my experience, yes. We have both products in place for some clients, only one of them for others, and most of our clients have saved enough by age 55-60 to have no insurance need at that point. Are there other reasons to own life insurance once your own independence is established? There may be for you. You may want to use life insurance to pay expected estate taxes, for example. Some of the outcomes of a continuous and repeated planning process are ongoing assessments of your financial independence, forecasts of the value of your estate, and estimates of your estate tax position. Part of this process is identifying risks and costs as your life changes and then determining what you wish to insure.
One other option is to purchase term insurance that is convertible to permanent insurance. There is usually an additional cost (it tends to be fairly small) for this feature. It does mitigate the risk of needing insurance beyond the initial term period and becoming uninsurable during that term period. You do have to be careful, though, as the conversion period is often not the entire term period.
There are many variations here, with combination products and a number of different and generally more and more complex, permanent products. This is where having a financial advisor, knowledgeable in insurance planning and modeling, paid by fee and not commission (life insurance products almost always pay a commission to the selling agent, although there are fee-based insurance products) can provide a great service. They can tell you what you need based on your feelings, desires, facts, and circumstances. They will not be swayed by the size of the commission they might earn, so they are most likely to provide true advice without the influence of their own compensation.
Now What?
Think about what you want to have happen should you die too soon. Model the financial implications and probabilities. Decide whether you want to carry the risk or insure it. Then look at your particular financial situation, including free cashflow after paying your “keep the lights on expenses”, and determine what product is the best fit.
There is no right or wrong here. There is only what is right for you and those you care about.
Sundry:
Here’s the most moving song I heard today:
I added two books to my reading list: Your Future Self and Same As Ever (next up is Clear Thinking)
My pure fun reading at the moment is the Ann Cleeves’ Mathew Venn/Two Rivers series.