“I don’t understand insurance. I just need you to tell me what to do.”
While I appreciate the trust implied in these comments offered by an orphaned life insurance policyholder, they are not all that unfamiliar or surprising to me, because of how many times I have heard comments of this sort. The same sentiment is often expressed via this question: “If you were in my shoes, what would you do?”
Besides trust, there are at least two additional and fairly obvious implications to those kinds of statements and questions.
- The person making the statement is not familiar, or comfortable, enough with life insurance to arrive at a conclusion on his/her own—which is perfectly understandable.
- Life insurance, in particular, is something that folks often assume you should just have. In other words, the simple fact that we don’t live forever means that we should all have life insurance.
While I generally agree with that idea, whether I agree in any specific situation depends on how insurance is defined.
What is Insurance?
At the mere mention of the word insurance, I have no doubt that the vast majority of folks automatically think of a policy—i.e., a contract between a person who pays a premium and a company who offers a corresponding benefit for a specific risk. A more practical or functional understanding of insurance, however, is that it is simply a contingent, or emergency, supply of a resource to rely upon, should a conventional source prove unreliable due to some risk being realized.
For example, one of the reasons why someone might consider the purchase of life insurance is income replacement. Particularly if we are dealing with a single-income household, the loss of an income could mean that there are bills that won’t get paid. In such an instance, money is the resource, the conventional supply of money is the income in-question, the risk being realized is the loss of income due to death, and the contingent supply of money would be any available source.
The fact that any available source could be the contingent supply of money means that a policy is not the exclusive form, or definition, of insurance. In fact, one potential source that I have found is often overlooked is that of an individual’s own assets.
Can You Be “Self-Insured”?
Any individual who has managed to accumulate a sufficient amount of wealth that is easily liquidated, or converted to cash, and accessible in an emergency, could potentially be understood to be self-insured. Regardless of the exact nature of any emergency source, if someone is sufficiently insured, it simply means that available resources are equal to, or greater than, the need for the resource that is created upon a risk being realized.
The implication of that last line is that whether you have enough insurance, regardless of the form, is a function of comparing any available resources with the need, which obviously makes the need pretty important. Any individual’s need is an important concept for another reason, though: if someone asks for the help of an advisor, or anyone else, in evaluating an insurance policy, it must begin with that individual’s need for insurance.
The reason why evaluation must begin with an individual’s need is because that is an objective standard upon which to base the evaluation. The easiest way to explain what this means would be to give you the simple example of a wife who would be left with more financial liabilities than resources if her husband were to pass away, without a life insurance policy—i.e., for all intents and purposes, the wife would be broke. The fact that the wife only has sufficient resources if her husband has a life insurance policy means that the policy, itself, is a need.
Evaluating a policy based on need not only makes the process a simple one, but also objective: whatever needs to be done to maintain the coverage must be done, in the most efficient way possible. This includes paying whatever premium must be paid. That, or the financial liabilities that would be left for the wife need to be reduced as quickly as possible.
Now, experience tells me that some probably read that the “premium must be paid” and started rationalizing ways or reasons the premium would not need to be paid. So, allow me to cement what is meant by need: you need to eat to live—if you didn’t have food to eat, what would you be willing to do to get food?
Don’t get me wrong, though, I realize that sometimes things are simply unaffordable. In such a situation, though, we still need to be honest about what it means to not have enough insurance. Further, my guiding principle in these situations is that doing something is better than doing nothing—i.e., if you can’t afford to insure the whole need, insuring part of it is better than none of it.
The wife in our example above needs her husband’s life insurance coverage, if she stands a chance of achieving the life that she and her husband envision for her, if the husband were to pass away. Without it, a tremendous amount of uncertainty is introduced, including what life would be like for her. Uncertainty is not an all-or-nothing proposition, though, and if it can’t be eliminated, then looking at reducing it, through partial coverage, might be an acceptable solution.
It happens often enough, though, that folks don’t approach the evaluation of an insurance policy from a position of need, and instead, broach the subject based on want. By default, this means that the standard being used for evaluation is subjective. This makes it virtually impossible for anyone else, including an advisor, to assist in the evaluation process, because of the inability to justify the cost of the premium—justifying it as a want renders it a matter of opinion, and opinions are subjective. Having a need for coverage renders any cost to obtain, or maintain, the necessary coverage a necessity as well, and this is expressly because there is sufficient information available to understand the potential financial consequences—this is something that is lacking when only desire (want) for the coverage exists.
In our next blog we’re going to talk about why understanding financial consequences helps to determine the role that life insurance can play in your financial plan: is it used solely for insurance purposes or is it considered an investment?