Understanding Life Insurance
By Glenn Cooke
Life insurance is confusing to many consumers. What product is best? Should I get cash values? Is life insurance a good investment? It’s overwhelming and difficult to know even where to start.
In this e-book we’re going to clear up that confusion. We’re going to break the problem down into specific steps and educate on each step. For best results, you want to do these steps in order:
- How Much Life Insurance
- Best Type of Life Insurance
- Best Life Insurance Company
By focusing on those steps, in that order, you will end up with proper insurance coverage.
However before we get into details let’s look at a basic principle of life insurance that will underpin our decisions – catastrophic financial loss.
Catastrophic Financial Loss
Before we begin I want to introduce an underlying insurance concept that will help us evaluate if we’re making the right decision. We’re going to apply the term ‘catastrophic financial loss’ as a reasonability test for our insurance decisions. We want our choices to meet all three of the words in the term; if our decision fails any of these three tests then either we are making a poor decision or we’re using life insurance for something other than pure insurance needs (which is fine, as long as you’re aware of this).
- Catastrophic – if we are using insurance to cover a loss, the amount of the loss should be catastrophic; i.e. it should be a loss that we can’t easily recovered from. A counter example to this would be consumer warranties. e.g. If you break your $800 iphone that’s no fun, but it’s not life altering. This is why most consumer advocates advise not to purchase electronic warranties. Conversely if you total your $30,000 car that would be much more of a catastrophic loss and thus something you should insure.
- Financial – When determining our insurance needs, what we are seeking to cover should be financial. This is in contrast to insuring a need that is emotional. e.g. If you’re buying life insurance to gift your grandchildren some money on your passing, the amount isn’t financial – you’re making this decision based on emotions. In this case our insurance purchase would fail the financial test. Again, that’s fine as long as we’re aware and educated on what we’re doing.
- Loss – For insurance to make sense, we need to suffer a loss. If there’s no loss then we’re participating in a lottery. With both insurance and lotteries a bunch of people contribute ‘premiums’ into a pool; a random event happens that selects someone from the pool and that person receives the grouped proceeds from the pool (either you get lottery winnings, or an insurance payout). The difference is that with a lottery wealth is being created that wasn’t there before. With insurance we’re replacing lost wealth and returning us to the same position we were before. e.g. lets say you purchase mortgage life insurance to cover your mortgage. If you die, what happens to the mortgage? Nothing – there’s no loss. This tells us that we’re looking at the wrong thing – in this case we probably want to be looking at the income that’s being used to pay our mortgage. And your income is lost upon death.