Insurance - Life Insurance
Happy Sunday!
Insurance - Life Insurance
There’s something special about building LEGOs with your kids.
I grew up playing with them, so seeing my girls build their own creations is a blast. Last week, while my wife was stuck in an absurdly long Costco line, she grabbed a LEGO set for us, and unknowingly picked one of the best F1 cars ever, the McLaren MP4/4.
I got into F1 a few years ago, and my daughters will snuggle up on the couch to watch races with me. One loves the crashes. The other loves the driver with the rainbow helmet because… rainbows.
Needless to say, this was a nice break from the mermaid and princess sets I’m used to.
But down to business….. This week’s topic is one of my favorites when it comes to chumming the water on LinkedIn. Just mention the potential downsides, conflicts of interest, or alternatives to permanent life insurance, and the horde of salesmen comes flooding in.
Before we dive into this week’s topic, here are some things I read this week that I thought you’d like
Kitces – Why Health Savings Accounts Aren’t Always Worth the ‘Triple Tax Savings’ Advantage
Last week we briefly discussed HSAs. This article is the opposite of a brief discussion on HSAs. You want information? You got it.
REI Hub – About
If you’re in need of standalone accounting software for your rental properties, this is a great option. In addition to their super easy user interface, their pricing hasn’t caught up to the value they deliver, so that’s a huge win. When it comes to rental property accounting, it blows QuickBooks away.
Friendly Forces – Friendly Employers
This one is for my Reservist readers and their friends who don’t want to work for a company that tries to screw employees whenever they go on orders. Yes, it happens more than you think, and Eric has built a great database for screening employers.
Let’s dive in!
This month’s topic is INSURANCE. If I had to pick someone to learn about insurance from, it would be someone who does financial planning and doesn’t sell insurance. Sound familiar? Here’s what we’re covering:
Health insurance
Life insurance
Disability & long-term care insurance
Life insurance is an important consideration of any financial plan I build, and you should know its place in your family’s financial plan.
Fundamentals.
First off, life insurance is an insurance product, not an investment.
Insurance of any kind is there to protect you against financial loss. That’s the primary purpose.
Say that with me again… life insurance is an insurance product and not an investment.
As soon as you forget that, you’re going to be vulnerable to a well-rehearsed sales pitch. At that point, emotional vulnerabilities surrounding death can cause your quantitative skills to dry up.
So why buy life insurance?
To cover financial needs that would go unmet if you weren’t around.
If you die with a life insurance policy in force, the death benefit pays out tax-free to your beneficiaries. That’s the fundamental purpose of life insurance.
Life insurance can be split into two main categories: permanent life insurance and term life insurance.
Permanent life insurance.
Permanent life is the most profitable type of life insurance for the companies that sell it.
As such, there are a ton of permutations designed to segment out the customer base (you) and capture as much revenue as possible (from you).
A permanent life policy remains in force as long as the premiums are paid and include not only a death benefit but also a savings component, often referred to as “cash value,” that can grow tax-free over time.
Here are a few broad categories of permanent life insurance:
Whole Life
Universal Life
Indexed Universal Life
Variable Life
Variable Universal Life
Whole Life is the least complicated of the group.
Some of these policies may sound compelling with features like: “guaranteed minimum return,” “flexible premium payment,” “adjustable death benefit,” and my favorite combination of phrases “higher growth potential with increased downside protection.”
The unicorns my 4-year-old believes in are more real than that last phrase.
Think about it. You cannot simultaneously have downside protection and upside potential unless both are limited.
In this case, the upside potential is generally limited by a “participation rate” and a “cap.” For example, if the index being tracked went up 13% and you owned a product with a 70% participation rate with a 10% cap, your return would be 9.1%. If the tracked index in this example went up 20% your return would be 10%.
Insurance companies do not exist to lose money.
Lastly, let’s discuss the incentives behind selling life insurance. Salespeople are paid on commission and receive a portion of the premiums for the policies they sell. The more profitable a product is for the company selling it, the higher the commission paid to the salesperson.
Do you think this incentivizes salespeople to recommend what’s best for you, or what’s best for them?
Permanent life policies are generally more suitable for older buyers who have not saved up enough yet want to pass on some assets to family, but generally not ideal for younger buyers with high earning potential. Do not rely on salespeople to do your research for you.
You do your own research and tell the salesperson what you want. Shop around collecting a few quotes, then make an informed decision.
Is permanent life insurance BS?
Now, you might get the impression that I dislike permanent life insurance and think it’s a scam.
I don’t think it’s a scam.
I do think it shares many similarities with a certain class of Navy ships, especially if you’re a high-earning young MBA.
Here’s the beautiful ship in question:
Oh, and for the Army and Air Force folks wondering what the similarities are, replace the “Littoral Combat Ship” with “Whole Life Insurance” in this response from ChatGPT.
It’s uncanny how true those statements still are.
So what’s the alternative?
Term life insurance.
This one’s simple.
You buy a policy that lasts a defined number of years, known as the term.
If you die while the policy is in force, it pays out a tax-free death benefit to your beneficiaries.
That’s it.
There are a few variations of Term Life that are more expensive, including “Renewable,” “Convertible,” and “Return of Premium.”
Then there is the tried and true “Level Term.”
This is a straightforward insurance product. You pay a fixed price for coverage, and if you need to make a claim it pays out.
If you don’t make a claim during the term, both you and the insurance provider go your own way.
You might also consider “Decreasing Term” policies for reasons we will discuss later. These policies have a coverage amount that decreases over the term of the policy.
Let’s go back to “this is an insurance product, not an investment.” You get insurance for a specific reason. It is there to insure you against a specific loss.
Before you purchase life insurance, you need to identify that gap you are trying to fill.
You’re good at math, so let’s talk it through.
Deciding on an amount.
Time to dust off those math skills.
You are buying an insurance product to fill an unmet need. Money is not going to replace the gaping hole in your family’s heart if you die early.
What it can fill in for is the loss of your future earnings and savings.
When you are younger, you have more years of earnings ahead of you and generally have less saved up. You will probably have some unmet obligations, or at least feel as if you do.
These may include a large mortgage you would leave your spouse with, unfunded college savings plans for your children, unmet retirement contributions that your spouse is relying on you to make over your lifespan, the portion of your family’s living expenses covered by your salary, and anything else weighing on your mind.
These are all things you can put a dollar value on, or at least a decent estimate.
Relying on rules of thumb is all well and good if you’re a thumb, but you’re not a thumb.
Use the Present Value of an Annuity formula to get a rough estimate of the financial gap you are trying to fill.
You might use a rate of return around 7%, 3% inflation for most things, and 6% inflation for tuition. These rates are assumptions and you should do your own research.
Let’s run through a rough example.
Example: You have a $800k mortgage. Your unmet need would be $800k. You want your newborn to be able to afford a Harvard undergrad degree, it costs about $56k per year today, you inflate this cost by 6% (or whatever you want) for 18, 19, 20, and 21 years then discount each back by 7% (or whatever your expected rate of return is) for a present value of about $186k. Your hypothetical total unmet need is now $986k. Now you’d have to do a lot of guesswork to back into a present value of your retirement savings, but let’s call it another $1mm to keep it simple. So, your unmet need is up to $1.9mm. You would keep going until you’ve added up all your unmet needs.
When it comes to calculating unmet needs, rounding up doesn’t hurt as much as being low. Here you might round up to $2mm of coverage or maybe you’d go for $3mm.
But what would that unmet need be in 30 years? Well, your home would likely be paid off unless you refinanced or bought a new one, your kids would have graduated and moved out, and you hopefully saved diligently and didn’t fall into any one of the behavioral finance mistakes that plague investors.
So your unmet need would be…….zero?
If so, a 30-year term life policy might do the trick. If you wanted to get a bit more sophisticated you could look at decreasing term policies that may better align coverage with the downward trajectory of your unmet needs.
Back to permanent life policies: if you were still paying for a permanent life policy, would you keep paying premiums even if you didn’t have an unmet need?
Life insurance salesmen proliferate the saying, “with term insurance you’re renting and with a permanent policy you own something that can grow with you.”
That statement attempts to frame renting as a bad thing, with nothing left over after the term ends and all those premiums paid for nothing.
But who gives a shit?
Why “own” an expensive policy you don’t actually need?
When I go on vacation I don’t buy a car. I rent one, use it for what I need, and return it when the trip is over. Then I fly home.
Bringing it back.
Finally, if you’re submitting a VA disability claim and planning on getting life insurance, you may want to secure life insurance first.
Do not lie or omit information on your insurance applications!
When it comes to life insurance, it’s smart to question the incentives of the person recommending the policy. Are they recommending what’s best for you, or what’s best for their own wallet?
Simplicity and flexibility are the foundations of financial plans I build. Maybe one day I’ll encounter a scenario where a permanent life policy makes sense for a client, but it hasn’t happened yet.
Hope you have a great week.
-Henry