Sunday, November 21, 2010

Life Insurance - Do You Need It?

I have had a couple of people ask me about life insurance lately.  One thing that new attorneys sometimes don't realize is that once your bio and contact number go up on the firm website, you become target #1 for salespeople - after all, they "know you make a lot of money because you are a lawyer," right?  One of the areas that seems to be aggressively sold to lawyers is life insurance.  Lately, insurance salespersons are also approaching young lawyers under somewhat false pretenses by emphasizing their "certification" as a financial planner or something similar.  They say that they want to give the young lawyer a "free financial planning checkup" or something similar.  The attorney goes to a meeting with the insurance salesperson and "lo and behold!" it turns out that what the young attorney needs more than anything else (in the eyes of the salesperson) is insurance - typically life insurance.  The fat commission to the salesperson is not mentioned.

On the other hand, life insurance is not all bad - and can be something that you should have in some cases.  However, there are a whole host of confusing questions to consider.  I'll provide some answers below.



In the beginning there was Term Life Insurance.  Term life insurance pays a benefit to the beneficiary if the insured dies during the term.  The term can vary - 10 year and 20 year policies are typical, but there can be other terms.  Often the yearly charge (called a premium) is level - that is, the yearly charge is the same each year of the policy.  Once the term is over, you no longer pay premiums and there is no payout if you die.

Term life insurance is conceptually simple.  For example, a 35-year-old man makes a deal with an insurance company in which for the next 10 years the man pays $600/year to the insurance company and if the man dies the insurance company will pay $1M to the man's spouse.  These are generally representative numbers for the cost for a healthy 35 year old.  The cost is determined based on the statistical probability that he will die during the term period PLUS a commission for the agent selling you the policy PLUS some profit to the insurance company.  It's kind of ironic, but for the 35 year old, the very fact that life insurance is so cheap emphasizes the low probability that he will die during the term.  Conversely, for a 50-year-old buying 10-year term, the cost may be several thousand/year because the odds of death are much higher.

I believe that we have an obligation to our families in the event of our deaths to be sure that they are provided for.  If you don't believe that, then there is no need for you to procure life insurance.  Conversely, if you feel you must provide for your family, the next question is how much must you provide?  People can answer this question in different ways, but I feel that it should be enough to preserve a reasonable lifestyle for your family indefinitely.  In this regard, I note that $1M can generally provide $50K/year in income indefinitely and $2M can generally provide $100K/year in income.  Consequently, just take the amount of money your family's lifestyle costs - if it's under $50K, then get $1M - if it's under $100K, get $2M.

However, when determining the amount it may be important to also consider your other assets.  For example, if your wife has $500K in educational loans, maybe up the amount.  Conversely, if you have $500K in educational loans, it doesn't matter because they are discharged at death.  Additionally, if you have been working for several years and have accumulated $1M in savings, and your family's lifestyle is $80K/year, you would generally need $2M to produce the $100K/year needed for your lifestyle - but you already have $1M - so you probably only need $1M in life insurance.

Some people may mention that 3% yearly CPI inflation may reduce the effective amount.  That's certainly true.  However, I would counter that the numbers above do not take into account the survivor's benefit that is payable under Social Security and is indexed for inflation.  The benefit is going to be something for the survivors, but is going to vary widely based on the work history of the deceased.  Also, we are not taking into account any work performed by the spouse - which may certainly be a possibility, especially once the kids are in school or are out of the house.  As a quick-and-dirty estimate, I think that the above works pretty well.  If you want to fine-tune it by considering other factors, then go right ahead.

When do you not need life insurance? First, if you are a single person with no wife or child, then you don't need life insurance.  Period.  You don't have any responsibility that you need to pay for.  Insurance companies might try to get you to buy right away by saying "the price might go up if you wait!  Insurance is less expensive if you are young!"  Like most things insurance companies say, that statement is both true and very misleading.  The price for a 10-year policy will certainly go up for every year older the person is when they buy it - the odds of dying just get higher as you get older.  However, it's an apples-to-oranges comparison - a 10-year policy from ages 25-35 is not the same as a policy from 30-40 - the odds of dying are just different.  Also, note that the 25-35 policy does not cover you from 35-40 - you would have to buy an additional policy for that.  In general, don't buy insurance until you have a responsibility that makes the insurance necessary - like a wife or child - or you will just end up paying more over your lifetime.

Insurance companies have also coupled term life insurance with an investment product.  These hybrid agreements go by many names - "whole life", "universal life", permanent insurance", etc.  When you pay a premium, typically some amount goes toward a term life product and the remainder goes in an "investment account".  These were interesting products when you could have your company pay the "insurance premium" and then "take a loan" from the investment account and thus have a company give you tax-free income.  That loophole is now pretty much closed.  Usually what you are left with is a term life product coupled with an expensive and relatively under-performing investment product - however, the investment product comes with a guarantee which is attractive to some people.

Here's a question - would you invest in a mutual fund that took a 2-3% yearly management fee, but promised you at least a 4% rate of return (typically no more than 6% over time) - oh, and you couldn't touch your money for up to 10 years without incurring a hefty fee (called a "surrender charge")?  That's pretty much what you are signing up for with these products.  The insurance company typically just takes the premiums and invests them in the market - which averages 10% in the long run.  From an insurance company point of view, you have people lining up to loan you money at 4% that you can invest for 10% - it's a great deal.  For regular people, I have yet to see any insurance contract that could not be replicated more cheaply.  However, for some people there is the security of one-stop shopping and some people just have faith in the insurance company.  However, I am not sure why people believe insurance companies when they guarantee to pay 4%  - insurance companies can go bankrupt, too - just look at AIG.

One note in favor of these arrangements - if you just completely lack knowledge with regard to investing and would otherwise just waste the money, then investing in these products will at least produce some investment return for you. It's not great, but at least it's something.  If you figure inflation is 3%, then your 4% is 1% over inflation - which means the real value of your money doubles in about 72 years.  Yay.  However, at least you are preserving something rather than just spending it.  It is also better than hiding it in a mattress or letting it sit in a checking account, savings account, or money market.

It also sets up a consistent payment plan that might force you to save if you are having problems saving.  That's pretty much like what many families do with regard to their home.  The monthly mortgage just forces them to save, but they find a way to spend just about everything else.  If the mortgage were $500/month cheaper, they wouldn't save it - they would just buy more stuff.  In this regard, buying this type of insurance contract could help force you to save.

However, if you are reasonably knowledgeable and diligent, you can typically do considerably better on your own than with one of these insurance contracts.

In summary, term life insurance can make sense - if you need it.  However, any other type of insurance contract typically does not, unless you are willing to sacrifice a significant amount of gains - with the caveat that if you lack knowledge or have a problem saving, then such an insurance contract may help fix that.

6 comments:

  1. Few people need cash value life insurance because there are other kinds of accounts to save for the big savings needs of life, such as retirement and higher education. There are exceptions, such as people ineligible for IRA's and whose employers do not offer 401k's, but they are few. Most people are better off with term if they need life insurance at all. If that's you, then be sure to get term with the "conversion privilege." That allows you to convert a term policy to a permanent policy without having to show proof of insurability. Some kinds of insurance are always bad deals, such as accidental death and mortgage cancellation insurance.

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  2. MP,

    Great blog, thanks for your efforts. I'm curious if you think there is a diversification value in whole life insurance. That is, are there circumstances under which one is better off putting $500 per month into an S&P index and $500 per month towards a whole life policy as opposed to putting $1k into the S&P?

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  3. 8:12 - Agreed, many types of insurace are pretty bad deals for the customer. The "conversion privilege" is interesting, but I wouldn't buy it if it cost much. My experience is that insurance companies are willing to toss on all kinds of bells and whistles, but the more bells and whistles you get, the higher their margin and the worse a deal it is for you.

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  4. 12:11 - Good question. The answer is pretty long, though - so I will do a follow-up post on it.

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  5. Like any product, so it it with insurance - we need to do our research and find out what's best for us. Unfortunately many insurance companies' policies are quite complicated. It's always important to make sure you understand all the little details and compare companies.

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