Insurance is a way to deal with a real cost but for some it seems like a useless expenditure. Give up money that I might have preferred to use for something else and get back nothing of current value. People are time and probabilistically incompetent.
We all think in the present. Our financial life is a series of assets and commitments spread over time. Some of the commitments come from the past, (mortgage, or student loan) and some of the assets (salary or inheritance) will appear in the future. We try to balance the assets and the commitments so that today works.
There is another aspect of the future that matters. Some of the things that can happen are not certain, merely a probability. I might win a lottery. Low probability. I might die too soon. Low probability. I might be injured or develop a serious disease. Bigger, but still not high.
The question of what to do becomes easier if you look at expected value. (EV) If the odds of winning $50,000,000 in a lottery are one in 20 million, then the EV of every ticket is $2.50. The fact that they charge $5.00 shows how they make money.
It is similar but a little arithmetically more difficult to determine the expected value, in this case expected cost, of dying before 45.
The process is similar. How much salary would I expect to earn from age 45 to retirement? What would be the value of that at 45, assuming some interest rate, inflation rate and tax rate? For someone earning $100,000, with interest at 2.5%, inflation at 2%, taxes average at 22% the loss for 20 years income is about $1.5 million. For retirement at 60, just $1,100,000.
To that, add any commitments that have not been satisfied. Educating children and paying of debt are the common ones. From the total subtract any spontaneous income that results. Pension plans or government programs. Call the net $1 million for convenience.
Now for the probability. Suppose the person is a 25 year old male non-smoker. The probability of dying by age 45 is around 1 in 50, so the expected value of the $1,000,000 cost is at least $20,000.
How much to insure those 20 years for the million dollar loss? $750 per year for 20-year term. With after-tax interest of 2.7% accumulating on the premiums you could have $20,000 in 20 years.
It’s is an arithmetically neutral deal for the insurer and I suppose for the insured too. The problem is arithmetically neutral does not apply to individuals. By age 45 you will be either alive or dead. You cannot be 98% alive.
You will have suffered a loss if you die at 45. $1,000,000. You will have suffered a loss if you insure the million and fail to die. $20,000. The difference is that you can afford the $750 per year and you cannot afford the $1 million.
Insurance is not a real cost, it is just a way to pay for a real but potential loss. If you look at the premium by itself, you will be confused. Pick one or the other. $750 or $1,000,000. Same deal for every other kind of insurance.
In homage to Harvey MacKay’s Lesson 62, The million dollars is a problem and you can make it go away by writing a check. If you do that, it is no longer a problem.
Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.