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Today’s post features an important question from a reader: who needs life insurance, and what sort of product makes the most sense?
[Lightly edited for clarity]
First of all, thank you for this blog as it provides a lot of valuable insight on personal finance topics.
Secondly, I was just curious to hear your thoughts on life insurance in general. I hear a lot about different types of insurance and it seems to me that many insurance sales people are taking advantage of customers who have no idea when or why one should purchase this product. Recently I have heard a lot of promotion around index life insurance which seems almost like structured products whose value is based on some underlying index. I’ve been trying to read up on them to share my understanding with family members considering a purchase before they sign any docs. So I would love to hear your thoughts.
I’m not an expert on life insurance, but I can certainly share my personal experience evaluating different policy options. My general position on life insurance is that it’s mostly appropriate or necessary for families for whom the death of a spouse/parent would be catastrophic in consequence.
Examples of this would include a household with children and a stay-at-home mother or father, with only one spouse bringing home income. Even then it comes down to numbers; you want only the amount of coverage necessary. All insurance is generally made for the the average person to lose out in value and the insurance company to capture the gain for themselves. This is not necessarily bad – what you are getting is piece of mind, because you are smoothing out the risk of an individual coin flip in your specific case and sharing the cost across a pool of individuals who are likewise afraid of being the one coin flip that ends in disaster. The insurance company uses mortality tables and statistics across a pool to determine the expected outcome of payouts, and then it sets prices on individual policies that will pay for this in the aggregrate on average for the group, plus some reserve and plus some profit for themselves.
That’s why I think it only makes sense to purchase when you cannot afford the risk that you’re the poor coin flip.
As you delve into specific types of policies, you can figure out what is appropriate if you are concerned about a catastrophic scenario. The option I think would best suit most folks who are considering life insurance is term life insurance. Most dependents’ needs are temporary in nature rather than a need for life. Say you and your spouse have two kids in elementary school and your spouse stays at home to raise the kids. Your obvious concern is if you pass away and leave your spouse with two children to provide for. Term life insurance during the period of child-rearing years would make a lot of sense. It would give your spouse financial breathing room to re-tool for the workplace and ramp his/her own independent income-generating capabilities while money comes from the policy.
Whole Life Insurance
I looked briefly into whole life insurance. I have less to say about that. If you are happy with the fixed level of payments offered in a policy, it may be worth evaluating. These levels are always set to underperform a basket of assets invested directly in the market yourself. What you are buying by taking this lower than expected rate vs the market is peace of mind. There’s no shame in that, but I see very few circumstances in which it makes sense. Perhaps if you were worried your spouse could never re-tool for a job that would sustain them in the event of your passing, or if you have an adult child with a disability who will always require financial support. Again, I find the cases for which permanent financial support is necessary to be the minority.
The products you talk about whose payouts are tied to underlying performance of some sort of bond or equity index sound like the worst of all worlds, whether they are term or whole life insurance policies. When you buy insurance, you are buying peace of mind. You are buying a policy that provides the minimum amount of cash you think your loved ones will need. An indexed payout throws volatility back into the equation, and it does so in a fashion engineered to stick you with more volatility relative to actual performance under the policy than you could get if you go out on your own and made your own investments (this is the profit the insurance companies make).
Again, I add the caveat that I’m not an expert on life insurance. Given we have accumulated a significant basket of assets which would sustain any dependents and given that I no longer generate income through a job, I have no immediate plans to take out a policy, nor does my husband. I hope that gives you a place to start.
What have been your experiences with life insurance? Are you pro life insurance, and in what specific circumstances?