Great Financial Plans Do Not Require Life Insurance
How to know when you need it
Agents and some financial advisors will say, “Life insurance is a topic most don’t like to discuss; it deals with death, after all. The product isn’t purchased. It is sold.” Unfortunately, that trivializes actual consumer behavior as if potential life insurance consumers are not mindful of how to value such a purchase. Health insurance is in high demand, particularly among those who are middle age and older. Indeed, many other personal insurance coverages are in high demand. Homeowner’s insurance is purchased to protect lenders and the household balance sheet from wildfire, tornadoes, and hail. Auto insurance helps when an insured runs a red light, hits a pedestrian, or is caught in a riot and has their car overturned. Like death, the prospect of these perils isn’t particularly attractive. But many people do not regularly jump on life insurance policies because conceptual motivation is uncomfortable? Hogwash. The demand for life insurance is well understood, and economic principles answer the question, “How much life insurance do I need.”
Liebenberg, Carson, and Dumm (2012) surveyed 1,479 households and found that life events such as getting married, becoming parents, or starting a new job are statistically related to a life insurance purchase. Moreover, end-of-life events such as the death of a spouse, divorce, and retirement are related to lower life insurance demand.1 It reads like rational behavior to me.
To be fair to agents who feel they have to push-sell life insurance, few is the count of circumstances where third parties juice life insurance demand. Auto and homeowner’s insurance are the prime examples. Compliance requirements of state automobile financial responsibility laws and mortgage lenders that require homeowner’s insurance help the demand for insurance in these markets. However, the risk tolerance of individuals, their levels of wealth, and their actual needs will dictate whether the benefits justify life insurance costs. Life insurance is never an investment, regardless of the lipstick on some product offerings. It is always a non-discretionary expense.
In no market is the purchase of insurance a preferred household expenditure. It just isn’t a warm and fuzzy. In fact, hard to think of any type of insurance purchase that is fun.
Those flying out-the-window insurance dollars fall short of entertainment. Life insurance premiums are not discretionary expenses akin to a beach vacation in Seaside, Florida, or a weekend in Vegas. Still, life insurance should be taken seriously and continuously during one’s life. It deserves discussion, and the underlying economic principles should come into play. That is the focus herein. How does one determine how much life insurance to own? It is easy to be sophisticated in answering the question. Economics-based financial planning has the solution.
The Recipe
Today’s newsletter comes to the point quickly. Here it goes.
The obvious zero life insurance need case.
If you are single without kiddos and no other person who is financially dependent on your income production, a description that matches most of my SMU students, you do not need life insurance. This holds true for the single 35-year-old and the widow who is 65.
If you are married or coupled, economic principles resolve whether a need does exist. At its foundation, multiple-member households are individuals brought together under the same roof, with shared living expenses that make each individual’s living standard a little higher because of the benefits of shared expenses. Ride-sharing groups who stuff themselves into an Uber and apartment roommates know the costs of life are lower when expenses are shared. The “economics of shared living” concept is fairly intuitive. The implications for life insurance needs follow.
For a two-member, dual-income household, the lower-income member has the additional living standard benefit of participating in the higher-income lifestyle of the higher-income member. Kurt, who earns $45,000 per year, benefits from living with his long-time wife, Katy, who earns $450,000 per year. The expectation that Kurt’s standard of living is better because of Katy’s high income is fairly intuitive as well. How does Kurt’s living standard change if Katy dies tomorrow? It will suffer.
A closer pair of household incomes is more nuanced. Shannon, who earns $85,000, benefits from a higher living standard, partly because her husband, Liam, earns $110,000. The income difference will reveal amounts of life insurance higher for Liam than Shannon, but not too much more, depending on the other financial characteristics of the household.
How do children fit into the question of whether there is any life insurance need at all? That may be clearest. Economically dependent on food, shelter, and clothing, a child’s living standard is determined by their parents or guardians. And the “child as a consumer” lowers the adult’s living standard. Ever heard the phrase from a new empty-nester, “I feel like I just got a raise.” But, while children are still dependent, if an adult dies prematurely, a new asset needs to be created to replace the lost income until the child reaches adulthood.
The Quantity of Life Insurance
How does one make the calculation? Take the perspective of Kurt, who wants to know how much life insurance should be placed on Katy’s life. Total household income is $495,000. If Katy dies, household income will become $45,000, and Kurt may have assets available as well. But Katy isn’t around to consume. Moreover, at this moment, while Katy is still alive, Kurt and Katy need to discuss how many years they would like Kurt to maintain his existing living standard. Presumably, one to which he has grown accustomed. Today’s living standard and all those future years of a higher living standard are weighed against Kurt’s ability to produce his income plus any existing real and financial assets available to Kurt after Katy dies.
If you are into formulas, then here is a representation of the words,
where life insurance needs are dependent on the three terms in the brackets to the right of the equal sign. Moving from left to the right, the first term is today’s value of Kurt’s living standard while Katy is still alive under the normal conditions that both Kurt and Katy are kicking with Katy’s complement of her high income, taxes, expected retirement contribution, social security benefits, etc. This is the living standard per adult that exists today for Kurt and Katy under their structured economics-based financial plan.
The middle term is distinctly related to Kurt’s current value of human capital. This value is Kurt’s $45,000 present-day income plus all projected income amounts for as long as Kurt intends to keep working.
The last term captures assets available to Kurt today if Katy dies prematurely. Bank and brokerage accounts owned as joint tenants with rights of survivorship (JTWROS) are typical examples. Taken together, the life insurance needed on Katy’s life to maintain Kurt’s current living standard fills the gap in Kurt’s present living standard not met by his human capital and available assets.
What about Katy? Does she need life insurance on Kurt’s life? It is unlikely because of the middle term within the brackets. Katy’s human capital is very large and more than offsets the living standard she needs. Plus, and this is a spoiler. Economically, Katy will benefit from Kurt no longer being a live consumer, and her “after-Kurt” financial life may be better after Kurt’s death. One less person consuming will leave more discretionary funds for Katy that did not exist to her when Kurt was alive and consuming.
What Should I Do Now?
You can accomplish great financial planning and never buy a cent of life insurance if you don’t need it. But what if you fall into the recipe at the stage of who may need life insurance? Start by reading the Madigan’s story. They are a two-income couple, and then Frito comes along. If you or a member of your household has an economic dependent, then life insurance needs to be assessed. If you want to determine your needs independently, I suggest MaxiFi Basic. It will calculate the life insurance need automatically with the added benefit of finding your optimal spending pathway and living standard.
You may have zero life insurance needs but have life insurance policies. Now, you can redirect your cash outflow toward a feel-good purchase or an investment. If you think you have a life insurance need, then now is the good time to get on it. If you would like some guidance, make a general comment below. No details are needed to get you headed in the right direction. I will respond. That is why we are both here.
Liebenberg, Andre P., James M. Carson, and Randy E. Dumm. "A dynamic analysis of the demand for life insurance." Journal of Risk and Insurance 79.3 (2012): 619-644.
Thanks for sharing this analysis! While I understand the formulaic representation of no *need* for life insurance on Kurt, I’m curious what your thoughts are on a small term policy in order to cover medical costs should Kurt be diagnosed with a cancer or other diagnosis that requires steep healthcare costs prior to an untimely death? Also if Kurt & Kathy divorce, Kurt may be unable to qualify down the road should he end up needing life insurance. The low cost of a basic term policy seems to make sense here.