In our last piece, we defined what insurance is and whether or not you might need an actual policy. Now we’re going to discuss why second-guessing an insurance policy would require knowing the future and why it’s important to review your policy on a regular basis.
As we said in the previous blog, it happens often enough that folks don’t approach the evaluation of an insurance policy from a position need, and instead, broach the subject based on want. Need, in the context of a financial plan, is revealed through analysis showing that there is an identifiable scenario under which financial consequences would be realized that would threaten the chances for success of the plan. If we are talking about the evaluation of a life insurance policy, this means that the chances of failure are too great without a certain amount of coverage.
If the consequences are not known or are ignored, then there is no basis to determine whether the amount of insurance at hand is too little or too much, and by extension, whether the premium can be justified. If it were to be discovered that the coverage was too little, that means there’s a need, which means there is justification. Specifically, it is when coverage turns out to be excessive that the issue of want is revealed as a problem, because it essentially turns a life insurance policy into an investment, as opposed to a tool to manage risk.
Life Insurance as an Investment
The are essentially two ways to evaluate a life insurance policy as an investment, and each presents their own problem(s).
- Evaluating a policy on the basis of wealth accumulation within the policy: it should be understood that a life insurance policy is going have additional internal costs that are not present in other investments--i.e., life insurance is more costly, which automatically means is less efficient. Further, there are also restrictions and consequences that are associated with accessing the cash value that are not present with other investments. For these reasons, it is rare that a life insurance policy proves to be the best investment, purely for accumulation.
- Evaluating a policy on the basis of the death benefit: the problem here stems from needing to know when the insured is going to pass away—a morbid joke within the industry is, “tell me when you’re going to die, and I’ll tell you what the best decision is.”
The reason why it would need to be known when someone was going to pass away has everything to do with the total amount of premium that could potentially be paid toward the policy. A person living another year, as compared to living another 30 years, would potentially make a substantial difference in the amount of funds that would need to be committed to the policy. The greater the amount of funds committed to the policy, the lower the return would be on that investment. Obviously, if you don’t know when someone is going to pass away, then there is no way to evaluate the total premium commitment, and the return on investment, with a reasonable degree of confidence.
The way this issue of evaluating an insurance policy as an investment often comes up is with folks saying that they will just start saving premium payments in a bank account and surrender a policy, having rationalized that he/she would be better off accumulating funds in the bank. Alternatively, it’s often said that saving money in the bank from the start would have been a better decision.
Both of those scenarios essentially require the ability to tell the future, with the second scenario being tantamount to claiming that it was always known what the future was going to be—otherwise, why purchase the policy? The fact is, though, that these are emotional statements, and the uncertainty of the future is the very reason the concept of insurance exists.
Experience has revealed that a key factor that dictates the evaluation process being defined by want and emotion is that requests for help frequently come when a policy is in danger of lapsing. The reason I consider this to be a key factor is because this seems to create a sense of urgency. If the situation weren’t of such a seemingly urgent nature, then there might be a better chance of the approach to the evaluation being a little more objective.
Some irony, though, is that I can’t recall a single time that I have ever received a request to evaluate an insurance policy without someone having first received some sort of notification indicating a problem. That is most certainly not the only circumstance under which a policy can, or should, be reviewed, and if more policies were reviewed as part a best practice for maintenance purposes, then fewer policies might be at risk of terminating, with a corresponding loss of coverage.
I wouldn’t necessarily blame policyholders for this phenomenon, though. I can recall my dad, who also made his career in financial services, sharing with me how messaging from the life insurance industry used to include telling folks to never change their life insurance policy. While I can understand some folks being in a position of health that would eliminate the option of purchasing a new policy, it would seem that this advice assumes some things that stand a good chance of not being true.
The first assumption is that an individual’s need for insurance doesn’t change.
Well, how is the need defined? Income replacement has already been mentioned as a factor, but there’s also debt repayment, protecting against falling short from an accumulation goal (e.g., saving for a child’s college education), protecting a dependent with special needs, etc. Based on that, is it not possible for income, and/or living expenses, to change over time? What about debt? Can someone not establish new goals, or change old ones? Are the circumstances that define special needs only present when life begins, or can they arise at any point?
Another assumption is that insurance products don’t improve over time.
If that were true, it would seem to make insurance products pretty unique. Are there any other products that we would say don’t improve over time? The fact is that life insurance products have improved over time, and this can be illustrated through the example of mortality-related expenses.
The reason health information and records are sought as part of the insurance application process is to evaluate someone’s health to essentially develop, and evaluate an individual’s life expectancy. Part of what dictates life expectancy are general factors, like medical services that provide new cures or improve the quantity and/or quality of life. As threats to life are mitigated, this is reflected in mortality tables, which are used in determining life insurance pricing.
What this means is that if the same individual were able to simultaneously apply for a new policy and one that is, say, 20 years old, the mortality differences would ultimately be reflected in the amount of premium that would need to be paid toward each, with the newer policy having lower mortality-related costs represented in the premium required. This factor, alone, could potentially explain why it might be beneficial for someone to evaluate coverage they’ve had for some time and compare it to what is available today.
The picture that has hopefully become clear is that it is really an understanding of the need for insurance and the best way to meet that need, policy or not, that must be maintained. If the need for a life insurance policy is proven, then by extension, the policy should be maintained. This is not automatically accomplished by simply holding on to whatever policy one might have in perpetuity. Rather, this is done through the same diligence that any owner of anything of value should exemplify.