Deciding How Much to Spend on Life Insurance

Life Insurance is All About Deferring Benefits

Whenever we set aside money for anything, we are setting aside what we could do with the money now by spending it versus saving it to spend later or to bequeath to our loved ones after we pass.

How much we can afford to defer, to save, to set aside for some future use, will depend a lot on what we are deferring in the present. We always have to do this calculation, or rather, have a sense of what this involves, when we are considering setting aside money.

Deciding How Much to Spend on Life InsuranceWe usually only have a vague sense of the relative value involved in this and often this is enough, but it does pay to think about such things a little anyway. Western culture for instance is driven toward spending and often times this spending is overdone from not properly considering the comparative value between spending it and saving it for something else.

We can also go too far the other way and deprive ourselves by being too miserly, and the right approach is somewhere in between spending too much and not spending enough, although the right balance for any given person is going to depend, thus the need to have a good sense of what this balance may be.

This need not be done with any sort of real precision, and the mistakes we make tend to be rather large ones, blowing all the money we make on things that we may enjoy but involve paying too big of a cost if we’re borrowing to buy them, as we often do, or not providing well enough for our future as is the case with those who don’t plan well or at all for things like retirement or unexpected events like job loss.

There are other cases such as those whose income is so low that all they can do is provide for necessities, or those in debt to the extent that there isn’t much or any left over after their bills are paid. These decisions about saving will be easy as there is nothing to decide really, you just can’t, but we still plan for the future by seeking to improve our financial situation going forward.

Our Life Insurance Needs Are Only Part of the Equation

Therefore, the discussion about how much we should spend on life insurance needs to start by looking at how much we can comfortably afford. What we spend on the insurance will in all cases involve giving up something, either now or later, and this needs to be accounted for and compared.

Those who sell life insurance will focus on what our life insurance needs may be, and this is natural for anyone looking to sell insurance, because that’s what their task is, to sell as much as they can of it. It’s not hard to find people with life insurance needs, but what they should spend on it or even if they can afford to spend anything on it may be another matter.

Those whose income is very low shouldn’t be worrying too much about life insurance because they really aren’t going to have the capacity to spend on it. While this may put them at risk of placing their loved ones in a bad financial situation, they shouldn’t be looking to do that with the cost of the policy either. If they have to take food off of the table to pay for insurance, this is replacing a peril which is unlikely to happen with one that is certain, even though it may be of a lesser degree.

With insurance generally, we can say that if one is not able to afford the insurance for something then one should not be purchasing it in the first place, for instance with a house or a car. What we would do in this case is buy a cheaper house or car to allow us to insure it properly or if we cannot afford anything we just don’t buy it.

One’s life is different of course since we don’t acquire it, we just have it, and we do need to be open to the idea that there will be some people who just won’t be able to afford it, even though the cost of the life insurance policy may be rather modest.

This is a good example of how we need to look into the true costs of the policy, what we’d have to cut out to be able to afford it, and in our case choosing to go hungry or other manners of discomfort may not be appropriate. There is generally always something we can cut out but whether we should or not should be a matter of reflection.

Policies differ in cost, and this depends fundamentally upon the risk factors of the insured. The more likely we will be to need it, the more it will cost generally. The more coverage we are looking to purchase, the more the coverage will cost as well, and the amounts that we seek to be covered for will depend not only on our projected future needs if we die but also on what we can afford to spend on this.

This is where the two come together, or needs and our capacity, and there will generally be a tradeoff between the two. This is the main reason why most people are said to be underinsured with life insurance, not so much because they don’t care, but because they may not be able to afford the optimal amount of coverage or simply may be unwilling to spend that much on it.

Seeking the Right Balance Between Capacity and Need

It’s not a bad idea to explore what one’s optimal level of coverage may be, as a reference point at least, which would serve as the maximum amount of protection we require. From there, we can look at what we would have to give up to be able to spend the money that this optimal amount of coverage will cost, and should we be unable to comfortably do that, this is where the balancing act takes place.

This is not just about being able to spend the money that is required for a given policy, it’s really about what else we could do with the money, which can include anything from basic necessities to having a good-sized contingency fund to fall back upon if required, to saving enough money to retire comfortably on.

Most people’s financial resources are limited and there always must be decisions made about what to do with it, where one decision may be better than other. The very poor and the very rich don’t have that much to think about here, as the very poor don’t really have the extra money to decide, and the very rich have enough where these decisions won’t matter very much.

Most of us fall in between though and how we allocate our discretionary funds is going to matter a great deal generally, and this includes how much we spend on life insurance. This discretion usually involves trade-offs between competing choices, like how much of this extra income we may want to enjoy now versus later, as well as how to proportion money which we do wish to set aside.

We want to first decide how much money we can set aside for the future, and from this total, we can then decide how much of this we want to spend on life insurance coverage.

Our life insurance needs certainly need to guide these decisions, which include both the tangible benefits involved if the policy gets paid out as well as any psychological benefits of having the coverage in place in case this happens.

Using a psychological calculation actually is a good way to measure whether we’ve achieved a proper balance or not, where we feel better about spending a certain amount of money on life insurance versus doing something else with it, but this can only be done properly after examining what our needs really are and the financial consequences of dialing it down by a certain degree.

If we’re leaving our loved ones with a pittance which will only delay their hardship for instance, then we’re probably not going to feel very good about that, and we may want to look to how this discomfort compares to the psychological discomfort of allocating more money away from other purposes and toward the insurance.

Beyond necessities, we tend to spend a fair bit of our money on comfort, often physical comforts but also some pretty psychological ones as well, and using degrees of comfort and discomfort overall is actually a pretty good way of deciding such things, especially since a lot of this is actually subjective.

This is the case for sure with discretionary spending, although discretionary saving does tend to be more objective. We still can get a good subjective sense of this though, how we feel about a certain allocation after we have examined the more objective numbers involved such as what we may expect in retirement or how we feel about having a certain amount of savings to fall back on.

There are therefore three main components of a life insurance evaluation, the evaluation of our future needs, what we will need to give up to have these needs fully or partially met, and how we feel about the decision.

There are certainly some numbers involved here although this need only be accurate enough to give us a good sense of things, and from this sense, we can arrive at a decision that we feel best about, whatever amount that comes to.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

Contact Ken: [email protected]

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