DO YOU NEED LIFE INSURANCE?
THE INTELLIGENT USE OF LIFE INSURANCE
Draft
IS LIFE INSURANCE A MIRACLE PRODUCT?
It seems that some people promote life insurance as a great investment or as some noble thing to do, without looking and analyzing what is an appropriate use of it.
But the plain and simple function of insurance is to reduce catastrophic or "costly" risk - in other words to avoid a risk that could have a significant impact on you - probably one that would "hurt" alot.
And of course there is a cost for protecting against risk. [It ain't free!]
PRINCIPLE - MAXIMIZE THE DEDUCTIBLE AS MUCH AS IS REASONABLE
An example of a general insurance strategy that is commonly used employs this "it's not free" concept. In general liability insurance, some people carry insurance where they take more of the risk by having a larger deductible, so that the premium is reduced. This means they are, in a sense, making a "profit"' over time by cutting into what would ordinarily be profits to the insurance company.
But if one gets into an accident and must pay the first $1,000 (the deductible), then one would not make a profit from the high deductibility strategy. However, the cost, though unpleasant, was affordable and therefore the strategy was wise.
RISK OF LOSS OF INCOME
Obviously, a young widow or widower could be in big trouble if he or she was to lose the income of a spouse with major earnings. So an insurance amount would have to be calculated so that the lump sum provided for investments would be enough to cover whatever asset and income deficit there would be.
That's the obvious first need.
But be aware that once you accumulate assets (and there are fewer years of life left to cover expenses for) you have a smaller "deficit". Then it is appropriate to reduce the amount of insurance because you will no longer need as much in assets to replace what is missing (or in this case "no longer missing" as much, since you have more actual assets in hand).
So, your life insurance amount would be gradually reduced until it goes to zero at some point. In that case, if you are thinking ahead, you do not need "whole life insurance" and can save money by using term insurance. The term insurance should be guaranteed renewable, though the premiums would increase over time as the risk of passing away increase with age. The cost should be significantly less than whole life insurance.
RISK OF COSTS DUE TO ESTATE LIQUIDATION
If people have a large enough estate to incur estate inheritance taxes, their heirs will have to come up with cash to pay the taxes. If the estate has what are called "illiquid" assets, then there could be a problem of lack of liquidity, which essentially means they do not have enough cash or cannot get enough cash without a large cost.
A farm cannot be liquidated easily in most cases. Nor a business. The cost would be too great, so therefore the insurance cost could be justified. And that might apply also to real estate or other long term investments of an illiquid nature.
But if the estate had sufficient liquid assets, such as cash or stocks that were easily marketable or if there was sufficient borrowing power to provide enough cash without too much loan risk, there would be NO need for life insurance.
BUT I'VE PAID INTO IT AND WILL LOSE SOMETHING IF I CANCEL IT
Later on, although it can be difficult to understand and buy into the idea at first, when one no longer needs the life insurance, it is could reasonably be a good strategy to just cancel it, even if you have paid into it for years.
There is no insurance company stupid enough to not make a profit in the future on your future premiums - that means they will probably come out at the end getting more money over time than what they have to pay out. They win, you lose over time, from a strictly investment point of view. From the broader point of view, beyond investment return, you bought something of value if it actually protected you against a risk that could be costly. Again, it seems unwise to accept any claim that insurance is a good investment type product - run the numbers to see what the actual return on your money is, after adjusting for taxes.
When I taught "management accounting", the intermediate students would initially make the mistake of holding onto something due to the idea they would lose all of what they paid in the past. However, all that they have paid out has already been paid out, so it is no longer an option to not pay it out. It is what we call a "sunk cost", no longer redeemable or relevant, except emotionally. All that matters is what the owner can get out of it in the future minus the costs that will be incurred in the future. In other words, only those occurrences in the future matter.
Of course, psychologically one can "lose" in one's mind [as a figment of one's imagination] if one sees the situation without better knowledge. And we all do not want to look stupid for making the mistake of doing something that didn't turn out well in the past. That's why we hold on to our stocks that have gone down and sell our winners. We essentially become "irrational". A psychologist won the Noble Prize In Economics for proving how humans operate this way. (See the discussion about him in The Irrational Investor .)
NOT A PROFITABLE MIRACLE INVESTMENT
In all of this, we are assuming that there is no miracle provided where the insurance will provide you with a greater profit than what you could earn on your own. So, it would not be used as an investment.
BUT IT COULD BE "PROFITABLE"
The only time that life insurance premiums becomes a good investment in a sense is when the odds shift into your favor, so to speak. If your health or your spouse's has declined severely and the odds of dying much younger (than the insurance tables specify) increase substantially, then the premiums could be a good investment on its own.
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Most people should not read further, as this would not be applicable to anything other than charitable giving involving a low cost basis asset.
A UNIQUE USE OF INSURANCE
In one case, we used a "Wealth Replacement Trust" so that we could make a large charitable contribution where we were able to avoid huge capital gains but still provide some benefits to the donor. The problem was that the payoffs were over time, so if the donor passed away his estate would not have recovered enough benefits to offset what was given away. In that case, the life insurance premiums were fairly minimal, so the life insurance could be used to provide enough money back to the kids to replace the wealth that was given away after deducting for the tax effect. So it was "wealth replacement" insurance, so that the strategy we were using would never result in a loss to the estate.
However, once sufficient benefits were accumulated to where the assets going to the kids were greater than the initial amount, the "replacement" insurance was no longer needed. Then it would revert to the logic up above.
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A 2002 Nobel Prize winner in economic sciences, Dr. Kahneman has laid the foundation for a new field of research, called behavioral economics, by discovering how human judgment may take shortcuts that systematically depart from basic principles of probability. As mentioned, some discussion relevant to this is in The Irrational Investor .
This is all part of a special course I am developing (or may have finished developing by the time you've read this): The Course In Stupid Thinking 101, with a title meant to prod where it is actually a failure about learning how to do smart thinking.
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This is solely an opinion and "logic" piece, with some theory and principle included, for your consideration in thinking all of this out. It is not meant as a conclusion that is immutable, as circumstances and various factors may vary over time. Use it only for "understanding", but do a thorough analysis before making a decision, using a qualified objective expert.
