All insurance protects against financial loss from some peril or other, for instance the loss or damage of one’s home or car, loss of income resulting from loss of employment, protection against credit default, coverage of expenses related to illnesses, and so on.
The peril in the case of life insurance that is being covered is of course the death of the insured, where those named as beneficiaries are provided compensation for the financial losses involved due to the death.
While we call all insurance payouts benefits, we should never think of this as a benefit, as this is another way of looking to use more pleasant words to describe what really happens with insurance, and insurance payouts are not really designed to be benefits per se, net benefits at least.
In all cases, insurance is designed to cover losses, these perils that are being covered by insurance policies. Insurance companies require that beneficiaries, those who become compensated in the event of the peril, are subject to financial loss, or at least are potentially subject to it.
You can’t take out an insurance policy on someone who you have no financial interest in, and people will naturally only take out insurance to benefit those who do have a financial interest in them, which means their family, or a business may buy a policy for one of its partners or employees to insure their financial interest and potential business losses that may result from their death.
The policy is therefore not designed to benefit people financially by your dying, it instead looks to make up for contributions that you are making, will be making, or at least could be making to their financial welfare.
All Insurance is Designed to Protect Against Financial Losses
Since it is those insured by life insurance, those that will see benefits paid to their beneficiaries upon their death, that purchases the policy, it is natural that the amount of insurance they purchase will be tempered by the needs of their beneficiaries. While we may set up insurance policies that are large enough to actually improve the financial welfare of beneficiaries, this should not really be the goal as it is not an efficient way to use life insurance.
Any time we purchase insurance, it involves a negative financial expectation overall, meaning that this is not a good investment straight up and is instead designed to pay a premium over its fair value in order to cover contingencies that you would not otherwise be able to manage.
An example of this would be with car insurance. We pay a certain amount per month for this and when we look to calculate the value we get for this we will see that we pay more for it than we may expect to get back on average.
The reason why we’re willing to pay more than the expected value that we get back is that if our car becomes lost due to various things like accidents and theft, or if we injure someone or cause other damage, these events can be anywhere from very expensive to extremely expensive in the case of liability lawsuits, and this subjects us to the risk of not being able to manage the costs involved comfortably, or perhaps not at all.
If your house burns down, and you are not covered, you lose its entire value, and if you have a mortgage as most people do, you still owe that but now have to buy another home. It’s unlikely you will be able to do that and therefore this is not a situation that is acceptable and we’re willing to pay more than we expect to get back on the balance of probabilities to be protected against this.
We don’t always think of life insurance as operating this way but it clearly does, and when we see this as purely a means to cover against financial losses to our beneficiaries due to our death, and nothing more, we put ourselves in a better position to understand the proper function of life insurance and be more prepared to make decisions concerning it.
If we seek to cover these actual losses that may occur, this will both help us from buying too much or too little life insurance coverage. We don’t just want to shoot for a certain amount of money paid out and not think enough about the utility of this amount of money, which is often considerably too little in fact, or the benefit might not be all that important at all in some cases and we aren’t justified in paying a premium to obtain these benefits because it isn’t justified by enough need.
Life Insurance Should Cover Needs, Not Necessarily Income
The key to assessing how appropriate an insurance coverage is, and whether or not we are receiving enough value to justify our paying more than its expected value, is to asses it based upon needs, and in particular, confining it to needs that cannot be taken care of otherwise or at least would be sufficiently uncomfortable to bear to make it worth paying extra money to protect against.
If someone is wealthy enough that their dependents aren’t going to be affected by a life insurance policy too much one way or the other, it really doesn’t make sense to buy one, as the money spent on it could be better allocated elsewhere, particularly by investing it yourself where you would be seeking a positive expectation from the money.
Life insurance, at least the life portion of it, once again involves a negative expectation, and without the benefit of covering needs that cannot be sufficiently addressed otherwise, we are not obtaining any true benefit from the insurance compared to other means of allocating our funds.
Given that so many people do have these needs though, and don’t address them enough, the concern is more toward not insuring these needs enough. Someone might for instance have a $100,000 life insurance policy and consider that this is a better situation than if they had no insurance or had less but this amount may not come close to taking care of the needs of their loved ones should they die.
We therefore have to approach this not from a purely monetary perspective but from a needs based one. We normally view life insurance as a form of income replacement, compensating for the lost income that results from one’s death, but how much of this income needs to be replaced if any is what we instead need to be looking at here.
We need to look at how much money it will take to allow for our dependents or those who we are looking to protect to be able to live with at least a minimum level of comfort, and the way to properly decide this is to avoid situations which would deteriorate beyond the level that we deem to be acceptable.
This is not a purely objective calculation as what one person considers to be minimally acceptable will differ from another. For example, one person may decide that their family could stand to see their lifestyle diminish to a certain degree and still be within what is acceptable, while others may be put off too much by seeing this to any degree and may instead strive to keep things as close to where they are when they are alive as possible, even if that means maintaining what others may view as extravagance.
Very often we will not be able to afford to fully protect these needs though, and we may be forced to relent and seek lower levels of needs protection, but the first step is to realize what we’re looking to do here and that will involve a needs calculation of some sort.
Seeking the Right Way to Protect Needs After Our Death
From there, we need to seek out the proper balance between providing for the needs of oneself and one’s family now and insuring that these needs get addressed if we die during the life of the policy.
We also want to be open to other ways to provide for these needs besides using life insurance. For example, by accumulating savings or investing in something like an annuity, we can look to provide for these needs out of our own pocket, and life insurance is more designed for those who do not have the means to do so and their risk of death is low enough that they can insure against this event at a reasonable cost and obtain a reasonable amount of protection.
What’s important here is addressing these needs, not necessarily the financial product or means in which we will seek to do so. Life insurance certainly has its place, but is not the only way to address these needs due to the shortfalls in income upon our death and we often will be best served to take advantage of a combination of means to seek this protection, which may include life insurance.
In the earlier stages of our life, our wealth tends to be very modest and we may actually have a negative net worth, from spending beyond our means, and our risk of death is on the lower side as well. We are also often in the earlier stages of raising our families with dependent children and this increases our needs if we die, and life insurance may not only be the best good option here, it often is the only good option.
Later in life, as these needs diminish, and the cost of life insurance goes up as our risk of death increases with age, life insurance will tend to become less valuable to us, especially if we manage to build our wealth over time and be able to rely more and more on our own resources to provide for our loved ones when we go.
By focusing on what really matters financially upon our death, which is seeking to provide for the financial needs of our loved ones, we will be putting ourselves in a good position to decide how we are going to provide for this and the best ways to do so, including but not being limited to holding life insurance policies.