Why you (probably) don’t need life insurance: how to self-insure your family

I’m not categorically opposed to life (and most other kinds of) insurance, but if you follow good financial practices, you’re better off self-insuring.  Self-insurance is essentially the idea that you assume a risk instead of paying an insurance company for the service, either by not taking out the policy at all, or selecting a high-deductible. This requires financial discipline and planning to keep sufficient savings to pay for emergencies.

Here are my thoughts on why insurance doesn’t make sense in most cases. I’ll focus on life insurance, but it applies to many others.

When (term) life insurance makes sense:

I’ll begin with an example where life insurance makes the most sense:
The Smith family has a single income of $100K/year, two small children, and Mrs. Smith has limited means to replace the lost income if Mr. Smith dies. They have $5K in the bank. In this case, term life insurance is a very good idea, for reasons which I hope are obvious: if Mr. Smith dies, the quality of life for Mrs. Smith and kids will be significantly diminished.

Complicating factors:

If Mr. Smith has a well-paying job, it probably comes with some disability/death benefits. Mrs. Smith will also get his social security benefits. It will be a fraction of their former earnings, but a non-trivial portion of a typical families expenses are work-related. Mrs. Smith will also qualify for several government programs (WIC, school lunch, etc). Possibly they have relatives who might help. While life insurance payouts are not taxable, it may affect your ability to receive other benefits, so the calculation is not as simple as it may seem.

There are probably tens of millions of American families in this general situation. Yet only 44% of households have life insurance, and many don’t have enough. Why? Because if you only have $5K in the bank (most Americans have very little savings and millennials have a negative savings rate), you probably have bad financial habits, and limited means to have another monthly expense.

When (term) life insurance doesn’t make sense:

If you are single, there is no point in life insurance. Buying life insurance, in this case, is equivalent to your beneficiary (let’s say girlfriend or parents) playing the lottery on your life. While the odds are probably better than the government lottery (your chance of dying in the next year in your 20’s or 30’s are about 1/2000, whereas the chance of winning millions in a lottery are 1/185 million), it’s a lot less somber.

If you’re married and both spouses have similar earning capacity (even if both are not currently working), again, there is little point — your quality of life will not change dramatically if your partner dies.

If you are married with dependents, have very different earning capacity, but have sufficient savings to recover earning capacity, again life insurance is not needed. Unless you have six kids, you only need enough savings to rebuild your ability to support your family.

If you’re too poor to build sufficient savings to recover from the death of a spouse, you’re probably poor enough that a single income will not dramatically affect the quality of life, and can’t afford life insurance anyway.

If you have sufficient earnings to afford insurance but are too financially irresponsible to save for disaster, then you may need insurance, but you’re probably not reading this, and may not have the budget to pay for insurance.

Three bad assumptions financial advisors make

Financial advisors (especially non-fiduciary advisors trying to sell you something) will typically make three flawed assumptions:
1: a single, non-working parent should never need to work again
2: your quality of life after your partner dies should remain the same
3: your savings rate is fixed

Here is why these assumptions are wrong:
1 is flawed because most adults do have the ability to develop marketable skills.
2 is flawed because insurance is only intended to protect you against catastrophes, not pay for your boat and summer cottage. You only need enough cushion to recover from a budget crunch, not profit from your partner’s death
3 instead of trying to patch over bad money habits with insurance (and especially whole life insurance), advisors should help you save more and build additional income streams through your investments. Instead of overmedicating to cover up the symptoms of an unhealthy money habit, good financial advice should help you adopt good financial practices that would make the medicine with dangerous side effects (more on this below) unnecessary.

Self-Insure your Family Instead

Here is the financial strategy which I recommend (scenario based on demographic averages):

While you are single (age 16 to your mid 20’s):

Max out your savings rate at about 50%. This should give you a cushion of $100K going into your marriage — hopefully, both partners have something to contribute to your net worth.

Marriage – before kids:

In the first few years of marriage, you should maintain dual incomes and build your nest egg at least until you decide to have children. If you have kids around age 30, you should have a solid 8-10 years of savings — enough to build a portfolio of $300K.

Marriage – post-kids (when you need a backup plan):

Let’s say the mom decides to be a full-time parent. By your mid 30’s, if you have multiple kids, your savings rate will drop to 20-30%, but 20 years of savings and compound interest should give you a net worth of at least half a million. This, combined the social security and work benefits becomes your insurance policy. Buying additional life insurance is thus unnecessary because each spouse has enough cushion to preserve most of their quality of life and/or recover earning capacity.

Addendum: Whole life insurance (also applies to Infinite Banking)

Once upon a time, when a diversified, well-balanced, tax-smart, age-appropriate, and personalized investment portfolio was not available to most people, whole life insurance made a lot of sense. It still makes sense for people who
1: are compulsive spenders who can’t keep any savings or investments and
2: don’t have a tax-advantaged savings options available or
3: need to hide assets from someone

For everyone else, investing their money in the market makes a lot more sense. You can invest up to $55K per year in tax-advantaged or tax-deferred investments. A properly diversified portfolio will return about 12% (pre tax, pre-inflation).
Ask an insurance salesperson for the yield for whole life insurance. They’ve intentionally made the product so complicated (with lots of hidden fees) that they won’t be able to compare it to the yield of traditional investments.
What the insurance company is doing behind the scenes to make a profit on your money is locking it in various ultra-safe (aka low yield) bonds and giving you a fraction of the return. Those bonds return a maximum of about 5%, and you get a portion of that. You’d do much better separating your insurance and investment needs, especially since a young professional should have a high-risk stock-based portfolio.

If an advisor scares you with the uncertainty of stock markets,  remember that there is No Free Lunch.  Guaranteed returns mean low returns.  Less risk means less profits.  Take your risks while you are young and retire rich.  See my post for simple, low-cost investment options.