Life Insurance and Portfolio Growth Are Different Objectives
While we may think at first glance that life insurance and portfolio management are closely related, given that their purposes are aligned, to provide for our long-term financial welfare, the way they seek to achieve this objective is very different.
In a real sense, these two goals are competing and therefore opposed to one another, at least as far as the actual life insurance component of a policy is concerned. The savings part, with a whole life policy, is perfectly aligned with the goal of growing our wealth, because this is exactly what this component does, just like any investment.
Life insurance premiums deplete our savings, due to the fact that if we’re planning on spending this money on our portfolio our contributions to it will be reduced by the cost of the premium. In spite of this often being a wise move, we still need to account for the opportunity cost here, which is having less money if we end up not needing the policy, and this is true of any funds devoted to insurance.
We could even say that paying insurance premiums dilute rather than add to our wealth, our portfolios, and while doing so may be a sound decision overall as far as our financial management is concerned, we need to make sure that the benefits of the insurance protection outweigh the costs of diluting our savings and wealth.
There may be instances where we may need the protection yet it may be unwise to seek it, at least full protection anyway, because we need to look at outcomes not just in light of what might happen if we die and don’t have enough financial security in place, but what the benefits of committing more of our funds to investments would be.
Comparative Value of Life Insurance
If we just looked at probabilities, expected value in other words, insurance would never be a good idea, because the odds are against us here, by design. The odds are of course in favor of the insurance companies, because that’s how they make their money, and if this were not the case no one would offer life insurance or any other type of insurance to us.
Insurance companies do not do so just to benefit mankind, they are like any other business, and are out to earn profits over time. If this were not the case, they would simply go out of business, and be replaced by profit-oriented insurance companies.
People willingly engage in arrangements with these negative expected value outcomes though, due to wanting to purchase more financial security. They know that if certain events happen such as their house being lost by fire, their car being written off, and their loved ones being left without sufficient financial security should they die prior to establishing enough of this security to them, insurance can serve to protect them against such grim outcomes.
Any time we enter into such an arrangement though, we are in essence putting ourselves in a worse position should the event not happen, in order to be in a better one should the event that is insured against occur.
The principal of diminishing marginal utility also applies here, and is actually what ends up making sense out of the coverage. The smaller the amount of money we have, the more important it is to our well-being.
If we just have enough money to survive, this amount will be the most important, and even within this meager amount, lesser portions are going to be more important, for instance enough money to be able to eat enough food to stay alive, versus minimal shelter costs which will be less important provided that we can live without shelter and survive, depending on the climate.
The first dollar is understood under this principle as having the most value, with each subsequent dollar having a little less, which is why it is called diminishing marginal utility.
Whenever we compare money that is spent on insurance versus just saving the money, as long as the insurance makes sense, it will have a greater utility dollar for dollar, because this is what is needed to meet our minimal financial needs.
On the other hand, if the coverage goes beyond these basic needs or whatever minimal level of financial welfare that we consider to be acceptable, we may not have enough utility to make that much of a difference. We are therefore paying the price of the inferior expected value that all insurance has without getting enough benefit out of the greater utility of having more important needs taken care of and therefore may not be getting enough value out of our money versus just saving more of it.
Life Insurance and Probabilities
If we’re going to be calculating the comparative value of insurance versus investment, we are going to need to have some idea of the probabilities involved in our needing the insurance. While it is typical for these probabilities of needing the insurance to be quite low with life insurance policies generally, depending on the situation we may be in, even low probabilities of needing the policy can still be quite significant and worthy of attention.
We might buy a policy where the chances of our needing it may be 1 in 1000 for instance, but depending on what the consequences of this may be, we still might want to protect against it. If our family ends up living on the street or our kids become wards of the state, this may be something that we never want to see happen, regardless of how unlikely it may be that this may happen over a given time period.
There are two elements under consideration here though, the probability of the event and the extent of the hardship. People do worry about 1 in 1000 type events though, and they do insure against it, but we do want to make sure that there is enough that is at risk for us to become concerned with such low probability events.
There are always risks in life and some of them are worthy of more concern than others, and this is why a life insurance assessment always needs to start by looking at the consequences of our premature death and allow that to guide how concerned we need to be about this.
If there is a 1 in 1000 chance that our family would be left destitute, and a 1 in 100 chance that they might need to cut back a little on luxuries, eating out less often for instance, the more serious outcome is going to be worthier of concern and protection even though it is considerably less likely to happen.
Probabilities do matter therefore but we need not do all that much calculation to gain a good idea of what sort of likelihood that we are seeking to protect against, but it still may be a good idea to become at least a bit familiar with overall risks during a given period in our life in addition to what the consequences of not having enough coverage may be in order to at least have a good sense of what we’re deciding on.
Life Insurance and Portfolio Growth
Whatever we contribute to life insurance is going to reduce our future wealth, not just by the nominal amounts that we spend, but by compounded ones. The better investors we are, the more we stand to gain by investing a given amount, and therefore the higher the real cost of the insurance is.
Provided that we have a positive expectation with our portfolio, that it will tend to grow over time at a certain positive rate of return, we can at least gain a sense of where we may be over time, and we may expect to be better and better off as our portfolio grows over the years and we continue to invest.
We never really know how these things are going to go, and perhaps we might see a very long bear market over the time that we’re looking at, and may endure financial losses, but we have to use the information we have and based upon the past it is not unreasonable to project long term average returns for our portfolios.
While the great majority of investors just look to track the market, if one is truly skilled at investing, and this provides a superior expectation of return, this will skew the calculation more toward investing and away from life insurance, meaning that we may need less coverage or even none at all in some circumstances.
How much we have already will also factor into things, and we may already be in a position where we don’t have to worry about passing away and not providing for our dependents enough because we already may have enough.
Calculations of life insurance needs always are dynamic, meaning that they change over time and the expectation is that they will lessen each year provided that we are growing our portfolio. As we accumulate more and more wealth, there will be less and less reliance on contingency payments, the insurance in other words, because they will be needed less and less.
Life insurance can indeed provide more financial security if the consequences of not having it outweigh the real cost, but this real cost does not just involve the dollar amounts that we spend on it, it also involves the opportunity cost of the loss of both the principal and the returns if we were to invest part or all of these funds instead.
In order to best prepare ourselves here, we need to consider both approaches to financial security, with the ultimate goal of becoming more and more self-sufficient as time passes.
This is not the way we normally think of life insurance, at least fundamentally, and even though we may be thinking that it would be good to lessen our reliance on life insurance, it is for the most part well-grounded in people’s financial strategies such that the importance of this becomes less transparent.
The way to do this is not just to accept that there will always be a need for life insurance, but instead to seek to both address present needs and also look to reduce and preferably eliminate them through wealth building and growing our investment portfolios sufficiently.
This approach also allows us to seek out whatever the right balance may be at any given point in time between buying life insurance coverage and protecting ourselves against these events from our own resources.
Life insurance and portfolio management are opposing goals, which both seek to improve our future financial security, and the secret to managing both is to seek the right balance between them and also understand that this needs to be an ongoing event as the need for one or the other does change quite a bit over time.
Ultimately, provided we have a somewhat normal life expectancy, we are going to reach a point where we are either going to be unable to purchase life insurance or it will be way too expensive to make sense of, and the better we prepare for this by making sure we focus on our own means to provide the financial security that life insurance addresses, the better off we will be.
This does not begin at the point where we’re too old for insurance, it needs to be considered throughout the journey there.