How to think about life insurance

Life insurance is an incredibly valuable and powerful tool. But it’s also wildly controversial. I find that properly thinking about the role life insurance plays in your life can greatly simplify the decision of how much and what kind of life insurance to buy.

First, let’s start with what life insurance exists to do: replace the income that you will not earn if you die. That’s very important because it sets the ceiling for how much life insurance you can even purchase in the first place.

This ceiling is called your “Economic Life Value” (ELV), which basically means how much money you are expected to earn over the course of your life. It’s not an exact number, but it is roughly equal to:

Your current income x remaining number of working years

For example, if you’re 30 years old, make $100,000 per year, and are expected to work another 35 years, your ELV is $3.5M. This is roughly the maximum amount of life insurance you could purchase. 

While that’s the maximum, how much do you actually need? Let’s go back to the reason life insurance exists: to replace the income you won’t earn if you die. So to determine how much life insurance you need, ask yourself these three questions:

1. Who is relying on your income today? 

2. What position will they be in if you die and your income disappears?

3. How much do you want to change that position?

It’s a deeply personal decision. If you have four young kids and a spouse who stays at home, your answer may be very different than a 55-year-old with an empty nest.

Now, where the controversy really heats up is around what kind of life insurance you should buy. There are two main categories of life insurance:

1. Temporary - policies that last for a set number of years (e.g., “term” insurance)

2. Permanent - policies that last for your whole life (e.g., “whole life” insurance)

The price of any insurance—how much your premiums are—is based on the following formula:

Probability of claim x size of claim

And since the probability that you will die is 100%, permanent life insurance is far more expensive (at least has a higher premium) than temporary policies.

For most people, a term policy makes the most sense as it allows them to cheaply solve the problem people relying on their income will face if they die, and allows them to go save for other important financial goals. That being said, there are plenty of valid reasons for having a permanent death benefit and thus paying the higher premiums. Unfortunately, the invalid reasons for obtaining permanent life insurance are what get the most attention and generate most of the controversy.

Permanent policies typically come with other features that can seem quite impressive. The most popular feature is the ability to build a cash value that may grow and that you can access (usually tax-free) while you’re alive. But this cash value builds as a result of having paid far more in premiums, so when you compare buying a term policy and investing the difference in premiums (temporary v. permanent), the analysis is usually a much closer comparison (subject to a litany of sensitive assumptions).

In a later post, I’ll do a deeper dive into the pros and cons of permanent life insurance. Spoiler: it’s a tool. It does what it does. The problem or controversy doesn’t stem from how these policies are designed, it stems from how they are “described” (ahem, sold).

But for now, ask yourself those three questions:

1. Who is relying on your income today? 

2. What position will they be in if you die and your income disappears?

3. How much do you want to change that position?

If you want to change that position, there are several ways you can do so. You can:

1. Purchase insurance directly through websites like lemonade.com, ethos.com, or ladderlife.com (typically only term policies)

2. Work with an insurance agent who is paid a commission to sell it to you.* 

3. Work with fee-only advisors (yes, like Ataroke) that don’t sell insurance but can advise you and help you place it. 

If you know what you want and need and know how to evaluate a good or bad deal, then you can likely do it yourself. If you have an insurance agent you trust, then going through them is probably best (assuming they are independent and can offer more than one company's products). If you don’t have an insurance agent you can trust and really don’t know how much you need or how to evaluate a good deal, then it’s probably worth paying a flat or hourly fee to a fee-only advisor to help you objectively make that decision.

*Commissions aren’t necessarily bad. Interestingly, the premiums on policies that pay commissions and don’t pay commissions are the same (counterintuitive, I know). The problem with commissions is what that pay structure incentivizes. Typically, commissions are based on the amount of premiums, so the incentive is to sell “more” insurance. Sometimes that’s in your best interest, sometimes it’s not.