The fine art of choosing an amount of life insurance: Case Study #4

Johann S. Bach once said, “All one has to do is to hit the right keys at the right time and the instrument plays itself.” It’s mechanical, right? I had a CPA friend make the same observation when I first told him about my idea of a life insurance planning service: just devise a computer program to do it. Many insurance companies have done just that… and the recommendations they spit out compared to mine are as different as night and day. Why?

While there is an underlying element of mathematically measurable data, we are also dealing with people with a variety of human emotions and experience, all of which color their thinking. Blending these two components together is done better with experienced judgment, just as the piano is best played by the experienced.

Yesterday I finished a case with a South Carolina engineer. It started like this:

My present plan is to get a term policy that will bridge the gap until Beth would qualify for Medicare and Social Security. My thoughts are that I would get a 15 year fixed rate term policy for $500,000. I would like to get assistance in evaluating if this is the right type of coverage to get and if this is adequate in duration and amount and where is the best place to purchase it.

It ended like this:

I looked over the Life Insurance Needs assessment you prepared and I have a real peace about buying the $250k life insurance. For me, the $5800/month [income goal] looks good. This gives Beth about 15% more than I had calculated her needs would be.

What he initially wanted costs $1500 per year; what he ended up with costs $700 per year. What transpired in between? It was a combination of financial analysis (clarifying survivorship benefits from his pension, and the way assets were growing and liabilities were being quickly discharged, and the low probability of death within the next 15 years) along with addressing what was emotionally driving him.

Let me make a couple of observations:

  • He would not get this advice from an agent. They promote more, not less.
  • The consequence of this upfront decision has 10 times the effect of getting a good rate.

On the other hand I got a recent inquiry from another person wanting a quote on term insurance. Apparently he misunderstood the service I provide and when I ask him to complete the questionnaire for the needs assessment, he balked; he “just wanted a quote”. The presumption is he knew how much and what type he needed, so could not benefit from my input in this respect. This is getting the cart before the horse and overlooking the greatest opportunity for price savings, not over-buying to begin with.

Shopping rates is important, but it’s not the starting point. If that’s where this engineer had started he might have felt shrewd while straining at gnats, but would have been unwittingly swallowing a camel. Instead he started with experienced counsel, as Proverbs 20:18 commends. While the second guy saved a consultant fee, the engineer most likely came out way ahead.

Notice that I don’t tell people what to buy. Rather he said, “I have a real peace about buying the $250k life insurance.” I just raise their awareness of facts and considerations that are overlooked in most insurance sales settings. I try to calm their fears, as per Luke 10:41 and 12:25, so they aren’t emotionally off balance as they decide. Then they make their decision. It’s a combination of financial analysis and emotional counseling- it’s an art.

Debt-free is stronger than well-insured: Case Study #2

Clients typically have two or three primary objectives, each of which is in tension with the others: they may want to get out of debt and save for retirement, or they may want to be sure their insurance is adequate and build up their emergency fund.

The nature of economics is the distribution of limited resources, and every dollar spent on insurance means one less dollar available for debt repayment. Each of these goals may strengthen you financially and both can be done simultaneously, but the resources that go to one cannot go to the other. The real question is often which should be emphasized and which should be deemphasized. It is from this tension that we get the title of this blog.

Being well-insured has a possible advantage:

  • if the precise event insured against occurs, an amount of money will be paid.

Being well-insured has risks:

  • the insured event frequently never happens and much premium is wasted.
  • This means that every $1 spent on insurance tends to yield less than $1 return (for term life insurance, it’s $.05)

Being debt-free has a guaranteed advantage:

  • saving interest.
  • If you die, are disabled, or have a salary reduction, it helps to have no payments.

Being debt-free does not have the risks cited above:

  • you always save money, regardless of what contingencies materialize in the future.
  • every dollar spent on debt tends to save a $1.20, after accounting for interest saved.

Many people have liberally bought insurance and then lost their jobs, to discover their insurance didn’t help at all. (Can you spell “Maginot”?) On the other hand many who were debt free have been able to weather a variety of financial storms: disability, death, a layoff, or shrinking real estate values.

How does this translate into the real world? I’m working with a California couple both about 50 years old with two independent children. Husband and wife each earn about $70,000 and their chief concern is a $200,000 mortgage.

Currently they each have a $250K variable life policy. Additionally, they each have 10 year term policies: $200K on him and $150K on her, for a total of $450K on him and $400K on her. Their goals are to pay off debt, save for retirement, and optimize their insurance.

How much should they carry? What about $250K each, just enough to pay off the mortgage and bolster the emergency fund? The survivor is debt-free, gets a $50,000 emergency fund, and has a reasonable ongoing salary. The wife (typically more security-oriented) may want $350K on her husband. We can always justify more, but that translates into less for debt repayment, and I’m keenly aware that 95%+ of term policies end up in the trash can.

This is the emphasis you don’t typically get from a sales agent and this couple’s decision will largely hinge on their emotional comfort with an amount reduction. Many don’t want to reduce coverage (see Sharon Baergen on our Testimonials page) and that’s fine too. However at least they get the nudge toward what’s likely to strengthen them most, since being debt-free is some of the best insurance one can have.

The Paradox of Insurance

We buy insurance to help our families. Can this effort hurt them? Most people pay more into insurance than they receive out of it.

Wouldn’t it be nice if we could trust our instincts to do the right thing? Frequently, however, our natural inclinations lead us astray. “There is a way that seems right to a man, but its end is the way of death.” Pr. 28:26

We see it personally: greed leads to want. “There is one who scatters, and yet increases all the more, and there is one who withholds what is justly due, and yet it results only in want.” Pr. 11:24.

We see it in government: raising tax rates decreases tax revenue; sponsoring welfare kills personal initiative and fosters generational poverty; lowering lending standards to encourage home ownership creates a housing crisis.

The same is true in insurance. Recently a wife called about buying a $1 million, 20 year level premium term life policy costing $5000/year on her 57 year old husband. It will probably make her a poorer widow. The actuarial tables say the chance (after screening with an exam and blood work and for driving and smoking habits) he will die within 20 years is highly unlikely. After all how many $1,000,000 claims can they pay collecting $100,000 (20yrs x $5k)? After 20 years, the premiums explode as he approaches normal life expectancy, forcing most policyholders to discontinue.

However she just had a close family member die accidently. With this fresh in her mind, her most easily recallable fear lured her to a plan unlikely to deliver. Yes, statistically she is likely to be a widow, but her husband’s life expectancy is closer to age 82, comfortably beyond reach of the 20 years. Dollar cost averaging those premiums at 7% would accumulate to over $200,000. So there’s over a 90% probability this policy will “cost” her this much for the widowhood most wives face.

Might a $500K 10 or 15 year term policy meet the need for much less cost?

Proverbs 19:2 says, “It is not good to have zeal without knowledge, nor to be hasty and miss the way” (impulsively responding to fear). What kind of knowledge should one have when buying life insurance?

  • Know what normal life expectancy is, in light of your health, etc.
  • Know what future premiums are after the level period.
  • Know the opportunity cost. Figure what premiums would accrue to if invested for the same duration. Consider a Roth IRA using Sector Fund Rotation strategy.

Fear is an enslaving human emotion that not only undermines sound investing, but it also causes Americans to waste billions of dollars each year in unnecessary insurance premiums. This is a paradox: the insurance that claims to save us costs us in the end.