Why do people think life insurance is a good idea?
Most people with any kind of disposable income at all eventually decide to get life insurance. For one thing, people don’t want their survivors to have to pay for their funeral expenses. For another, people want to leave their survivors with a replacement for their income.
These considerations change according to your circumstances. If you have no children and no spouse, life insurance needs change. Also, if you’re married, does your spouse make plenty of money? Did they already pay off the mortgage? They might not need to replace your income.
The purpose of this post is to list all the reasons why people think life insurance is a good idea. I’m also trying to delve into specifics related to various circumstances.
Term life insurance is the cheapest kind you can buy. Since it doesn’t cost as much as whole life insurance, you can take the difference in price and invest it in something else that pays a higher return. If you’re young, you can eventually build up enough savings to be “self-insured”.
Term life insurance is called “term” because it expires when its term has elapsed. In other words, it’s not permanent.
Need help defining terms? See our article: Life Insurance Jargon: 20 Terms Defined
Term life insurance is a good idea for some people, but you need to understand a few things about it:
At first glance, it might make sense to buy term and invest the difference. After all, the cash value of a permanent life insurance policy grows slowly.
But the buy term and invest the difference crowd ignore some of the disadvantages of this approach. For one thing, the savings in a life insurance policy are tax-deferred, which makes a big difference over the course of 2 or 3 decades.
For another, since a term life insurance policy has no cash value, you can’t borrow against it. (There’s nothing to borrow against).
Also, most term life insurance policies expire and are no longer renewable once you reach the age of 65 or 70. Most permanent life insurance policies pay benefits if you don’t live over 100.
On the other hand, the investment in term life insurance is small and results in a big payoff if you collect. Proponents of buying term and investing the difference consider this a good investment. (But it’s not a good investment if you never collect, which is the case for most people.)
Another argument in favor of buying a permanent life insurance policy is the guaranteed rate of return. Sure, you might be able to see an 8% return in the stock market over the next 20 years.
But that’s not guaranteed.
Past performance is not a predictor of future results in every case.
Whether you should buy term and invest the difference is a personal decision. My goal is to present the advantages and disadvantages of that approach for you to consider.
There’s a lot more to life insurance considerations than just its use as an investment vehicle. It’s also a way to provide yourself with peace of mind.
Here are some examples of worries that having a life insurance policy can eliminate:
Big expenses – The investment potential of a life insurance policy can be borrowed against once you’ve paid on the policy long enough. You can use this money to launch a small business or buy a house. You could even use some of this money to pay for major life expenses like a college education for your son or a wedding for your daughter.
Burial costs – Funeral arrangements are expensive. At one time, you could have a funeral for $3000, but those days are gone. A traditional funeral in the United States averages between $7000 and $10,000. You don’t necessarily need a large life insurance policy to cover that. But most people don’t have close to ten grand sitting around for just such a purpose, either.
Debts – Most people, no matter how lackadaisical they might be in their approach to money, don’t want to leave their survivors with a pile of debt to handle. The money from a life insurance policy can be used to wipe out debt you don’t want your survivors to deal with.
Peace of mind – What kind of price can you attach to peace of mind? I think it’s priceless. Having life insurance doesn’t help you avoid tragedy. But it does help you ameliorate the results of those tragedies, especially your family. I know some people don’t worry about what’s going to happen to their relatives after they die. But most people worry, especially when they start getting older, their health starts failing, and they realize that the inevitable for everyone else is also inevitable for them.
Retirement – I discussed this to an extent in the previous section, but it bears repeating: permanent life insurance plans can be a prudent investment. Yes, you might see a higher rate of return from a disciplined plan of investing in stocks and bonds. At the same time, few investments are as safe and secure as a life insurance plan. Also, you’ll be paying for life insurance anyway (probably, anyway). Why not make it serve 2 purposes? The new life settlement markets also enable you to get even more money from your life insurance policy as you age.
Riders – Most life insurance policies offer additional riders you can buy to serve multiple purposes. One of the most common riders is a clause that allows you to claim a certain amount of money in the event of a life-threatening illness or an injury which interferes with your ability to make a living. Riders cost extra money, but they also provide additional safety and security for you and your family.
Tax benefits – It’s hard to understate the importance of the tax benefits related to life insurance policies. Like a retirement fund, a life insurance policy allows you to defer taxes until you use the money. This means that the money you would have paid in taxes earns interest, too. Even though life insurance policies pay lower interest than many other investments, the extra principal and tax benefits help make up for that.
In the traditional American family unit, the husband and father is the breadwinner—the main earner for the family. If he dies without life insurance coverage, the entire family is put in a precarious situation. The biggest concern for many younger widows is how they’re going to afford their mortgage payment.
For this reason, most financial planners suggest that the breadwinner of the family should carry at least enough life insurance to pay off the mortgage on the house. This won’t replace that income, but it will eliminate the largest monthly expense the family has.
There is no cookie-cutter answer to the question of how much life insurance is the right amount. But paying off the mortgage is as good a starting point as any. If you have children, you might also think about having enough insurance to cover the cost of their college education.
Of course, in some families, the wife and the mom is the breadwinner. This doesn’t change the amount of life insurance needed. It just changes who needs it. Everyone’s circumstances differ, but it’s more important for the primary earner for the family to think about life insurance than anyone else.
You should obviously have life insurance for your spouse, even if he or she doesn’t work. You should have life insurance on your children, too. In neither case do you need to replace an income. But you do need to be able to afford a burial. In the case of a stay-at-home mom, you might need additional income to pay someone to cover those responsibilities—cleaning, cooking, shopping, and caring for young children.
Ask some people if life insurance is a good idea, and they’ll tell you they have better things to do with their money than bet on their untimely death. In a sense, that is what life insurance is—a wager with an insurance company that you’ll die and claim your benefits sooner rather than later.
Here’s how that line of thought goes:
You buy a life insurance policy for $100,000, and you pay $1200 a year for the policy. If you die 5 years after taking out the policy, you’ve only paid $6000 in premiums. But your family collects $100,000, which is a tremendous return on your investment.
There are 2 problems, though:
I’ve written on other pages about how actuaries are experts at analyzing the odds of you dying at a certain age and comparing them with the rates you’re paying versus the benefit your beneficiaries get when you die.
If you think of the insurance business as being like a casino, you’ll begin to see how they guarantee themselves profits. Yes, they’ll sometimes lose bets. People die young all the time. But when enough people live as long as they’re expected to, the insurance company has enough of a cushion to cover them and still make a healthy profit.
That’s the insurance company’s “house edge”, which is what we call the built-in advantage that the casino has over the player in a casino game. Gamblers sometimes go home winners, but the casino sets up the math to guarantee the casino a profit.
People with such an attitude might have other strange attitudes, too. Worrying about how the insurance company profits in this situation would seem petty to most people. After all, they’re in business to make money, too. No one should fault them for having a healthy profit margin—especially when it’s a product your family needs to take care of them should anything happen to you.
On a side note, one of the ways an insurance company makes money is from something called “the float”. When you and the insurance companies’ other customers pay your premiums, the insurance company has that capital to invest. Some of it pays for benefits, but the company invests the rest so it earns interest.
So the insurance company makes money 2 ways:
The first is by setting their premiums based on how long you’re likely to live. (That’s why it might cost a little more to get insured if you have high blood pressure or if you have a history of drug use.)
The second is by investing their extra cash and earning interest on those investments.
Not everyone thinks life insurance is a good idea.
In fact, life insurance isn’t a good idea for people who don’t need it.
Who’s an example of someone who doesn’t need life insurance?
Let’s take Warren Buffett as an example. His net worth is estimated at $80.5 billion.
Even with the most conservative return on that kind of money, his heirs will never lack for anything. A 1% annual return on $80.5 billion is $805 million a year. Even if he had 800 children, they’d be getting $1 million a year to live on.
Not only could no life insurance company replace his income, no life insurance company would ever need to.
Your goal in life might not be to make enough money to not need life insurance. But at some point, you do become rich enough that life insurance is no longer an issue.
(On a side note, a lot of Buffett’s money is invested in the insurance industry.)
Why do people think life insurance is a good idea?
The answer is simple enough:
For most people, life insurances IS a good idea—for a variety of reasons. It might not be the perfect investment vehicle for some people. And life insurance might be ludicrous if you’re absurdly wealthy.