Insurance Should Be Third Tier

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I just finished a case that showcased how smart people are tricked by the insurance industry. As I reflected on it I thought of a simple exercise that can keep others from falling into the same trap. I’d like to share the story and solution with you.

This client is a surgeon– a pretty smart guy. Yet he did something so inappropriate I could cry. He bought a cash value policy from Northwestern costing $3000/year. What’s wrong with that?

Sometimes (rarely) cash value life insurance is OK, so don’t automatically cash in your old policies. It depends. But this client had much debt and was eligible for a Roth he couldn’t afford to fund each year. These are two key points. They shout of the inappropriateness of cash value insurance, and the simple paradigm I’m about to share puts it in clear focus.

Here’s the paradigm. Most financial planning decisions fall in one of three broad categories: repaying debt, saving/investing, or insuring. Yet financial planning decisions being made every day are more detailed: buy this stock or that mutual fund, accelerate the mortgage or fund a 529 plan, a Roth or more in the 401k, etc. It’s easy to lose sight of the forest for the trees.

So here’s the plan. It’s worth its weight in gold. Clip it and save it and use it for the rest of your life. It will help you avoid many costly mistakes.

When confronted with a decision of where to send your precious few discretionary financial planning dollars, first step back and view the decision from a higher altitude. First put the decision at hand in one of these three broad categories:
1. Repay debt
2. Save/Invest
3. Insure

Initially don’t sweat the small stuff, don’t swallow the camel while straining at the gnats, and don’t be pound foolish while trying to be penny wise. The abundance of similar maxims testifies of this strong human tendency that trips people up. For now, simply put the decision in its general category; one of three; simple.

The agent directed his focus to preparing for death with a $75,000 whole life policy. Knock out that issue with a policy that pays after your term ends. Sound good? But it’s out of context. For this client, buying the policy is obviously insurance, category 3. He could quickly realize that’s the lowest priority and until the top two are satisfied, he shouldn’t spend extra insuring. He still had unpaid consumer debt (1) and an unfunded Roth (2), so expensive cash-value insurance should’ve stayed relegated to the back seat until 1 and 2 were satisfied.

Why are these ranked in that order? It’s as simple as asking which advances your net worth in the most surefooted manner:
1) By saving interest, debt-repayment dollars are guaranteed to increase your net worth, from day one; 1) investment dollars may do the same, depending on transaction costs and how invested (it could go down);
2) insurance dollars (for most people), decrease your net worth because transactions costs are the highest of the three and for most the insured peril does not occur.

For this client, these dynamics were extreme. His most expensive debt was at 11% interest and the cash value policy he bought, after three years’ premiums totaling almost $10k, had a surrender value of only $2000. In defense of the insurance sale, the doctor did not have this high interest debt when he bought the policy. Incriminating the sale however is that the company sells other policies building cash values much quicker. This was clearly commission driven.

No sense in cursing the darkness (caveat emptor), so how could this client have avoided this mistake? By stopping to put the decision at hand in its broad category. Insurance should be third tier in the scheme of financial priorities.

An agent will try to make it first tier… so expect it. Your emotions will also lure you to give it a higher priority than appropriate. Seldom do emotions lead well in finances.

If you relegate insurance to the back seat, you’ll make better decisions. There will be some exceptions, and that they are …exceptions, not the rule. Postpone them or deal with them a cheaper way (term insurance), but hold fast that pecking order.

What might that look like? Higher deductibles, not insuring old cars for collision, skipping dental insurance for most people, term life insurance often at smaller amounts, tinier long-term care policies or none at all, recognizing that self-insurance is the cheapest form of insurance and not insuring that which you can pay for yourself.

It’s not just that insurance is so bad, but that other options are so priority. You can’t do it all. Tenaciously keep right priorities: honor God with the tithe, be at least somewhat generous to others as you’d want done to you, avoid debt like the plague (and aggressively work to get out of it), keep a reasonable emergency fund, fund your matched 401k and maybe a Roth.  This will likely moderate your use of insurance and help you come out ahead.

Debt-free Is Stronger than Well-Insured Case Study #2

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Clients typically have two or three primary goals, each of which is in tension with the others: they may want to be debt-free and save for retirement, or they may want to have adequate insurance while investing adequately too.

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 many 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.  From this tension, we get the title of this blog.

Being well-insured has a possible advantage:

  • if the precise event insured occurs, proceeds will be paid.

However, being well-insured also has risks:

  • most term policies expire before the insured does, so much premium is wasted.
  • This means that every $1 spent on insurance tends to yield less than $1. Most people pay more into insurance than they get out of it.

Being debt-free has a guaranteed advantage:

  • saving interest.
  • Regardless of which contingency arises (death, disability, or losing a job), it helps to not have debt payments.

Being debt-free does not have the risks of carrying insurance 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.

For example, many people buy insurance and then lose their jobs… to discover insurance doesn’t help at all.  Insurance is often like France’s Maginot Line, not only ineffective but also so expensive to maintain that it results in underfunding other priorities.  On the other hand, those who are debt free can better weather a variety of financial storms: disability, death, layoff, shrinking real estate values, etc.

How does this translate in the real world?  I’m working with a 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 have term life insurance of $450K on him and $400K on her.  Their goals are to pay off debt, save for retirement, and optimize their insurance.

How much LI 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 (often more security conscious) may want $350K on her husband.  We can always justify more, but that means less for debt repayment.  A major tape running in the back on my mind is that 95%+ of term policies end up in the trash can anyway.

You don’t get this emphasis from a sales agent and this couple’s decision will largely hinge on their emotional comfort with an amount reduction.  Some don’t feel comfortable reducing coverage and I respect that.  However at least they get the nudge toward what’s likely provide the best long-term return.  Being debt-free is some of the best insurance you can have.

 

America, the Colossal Example

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We’ve talked about how we are creatures of fear, how fear can move us to idols, and how idols levy a heavy toll. Insurance can become an idol. Because this is rooted in the human heart, you see it played out at different levels. Let’s look at a macro and micro-level example.

You hear a lot about the debt, but one of America’s greatest economic challenges is insurance: Social Security, Medicare, and now national health care. Each has enormous overhead. Consider our move to national health care. Already private health insurance has been the greatest facilitator of inflated health care costs, encouraging provider greed and consumer abuse. Now we want to take it to a new level, with incomprehensible overhead to boot. (Can you define “insanity”?)

What would address the real problem at its roots is moving oppositely: rather than bolstering insurance, unraveling insurance.

Simultaneous with this harmful expansion, we are borrowing trillions we cannot repay. So we have two mega forces working against us. Massive insurance plans whittling down every dollar that goes through them by the overhead inherent in any type of insurance; along with interest that makes every dollar cost two.

Now consider the same dynamic on a micro level. For about ten years I worked with a school system on its group benefits. Frequently I would see teachers paying $30-40/month for Short Term Disability insurance, with another significant amount going to credit card interest. This was two slow bleeds each month: premiums and interest.

Because they spent on premiums money that should go to emergency fund, when an unexpected event occurred (new tires or washing machine) it had to go on the card (meaning even more interest). Then because they had this credit payment they were afraid to drop the insurance. (Fearing if sick they couldn’t make payments). One fueled the other.

Why this dual damaging dynamic? Many bought the insurance because of how it was promoted: “What would you do without a paycheck?” However once reminded of Sick Days, the ability to borrow from a retirement account, and the likely poor return on the insurance, they had a different attitude. Many dropped the insurance and redirected premiums to credit cards. Carefully thinking about how they were insured already allowed them to jettison extraneous insurance, pay down debts, and build emergency funds, which allowed them to stay debt free.

Uncle Sam should do the same.

There is a corollary lesson here. The source of advice on how to best use insurance made a big difference for these teachers. The purpose of Impartial Insurance Advisor is to offer an alternative source of high quality, experienced advice from someone not under the influence (of commissions).