How I Think About Risk: Insurance

I recently decided to purchase more life insurance. We are a single-income household, and while my wife could go back to work in the event of something horrific happening to me, I wanted to make sure that she and our daughter would have ample time to grieve and decide what made sense for them.

I knew that I wanted a term life policy. Largely this is based on a bias against blending functionalities (see “The best money I never spent“), and a preference towards having visibility into my insurance and savings separately, but also because even in the context of life insurance, I am a career optimist, and hope/believe that our financial position will be stronger in the distant future than it is now (though how much so is prohibitively hard to predict) opening up a different set of scenarios. My purpose in getting this insurance was to ensure that my family’s lifestyle could continue in more or less its present form until my daughter is a (more or less) fully functioning adult. With that in mind, I knew that I wanted a 20-year policy. I spoke with a very nice man at an insurance agency, but the “survivor needs analysis” for both myself and my wife was… not how I would have done it. Here are a few different possible projections I considered, and what I landed on.

Option 1: Replace all earned income. I could take my present salary (let’s call it $100,000 to make the math easy), multiply it by 20 to say “that’s what I’d earn” and have a $2 Million target. Subtract existing coverage from employer to determine need.
Pros: Simple, effectively maintains lifestyle.
Cons: Life insurance benefits aren’t taxed, so it overstates actual need on that dimension. Doesn’t factor in potential raises/increases in cost of living, so that might understate the need. Additionally, if something were to happen to me very soon, the money received now could be invested, used to pay off the mortgage, or otherwise reduce expenses. Overinsurance isn’t the worst thing in the world, but it decreases money presently available for expenses or savings, so it is a bit of an issue.

Option 2: Hybrid model. (This is approximately what the insurance company did) Take current income rate. Add inflation to it over the next 20 years to come up with a future value. Add the remaining debt on the mortgage and estimates of college expenses in the future (or “other savings goals”) to come up with a total need. Deduct current savings, investments, and insurance grown by an estimated growth rate on those, to identify the net new need. Set that as the target.
Pros: Captures all mathematically relevant factors.
Cons: I had several issues with this approach. First, it counts my retirement funds as an asset towards those needs. If we fully depleted those upon my death (especially if that winds up being 15 years from now), my wife would be in dismal shape for her own retirement. Secondly/alternatively, since we are insuring for the whole period, counting the present value of the mortgage as the need almost guarantees we will be overinsured on that front, since the outstanding debt there decreases every month. In my view, this model’s biggest drawback is the false sense of security lent by the complexity.

Option 3: Expense/objective-based approach. I decided that my objective was to cover my family’s basic expenses through to my daughter’s adulthood without my wife needing to return to the workforce. I didn’t want to tap the retirement funds, since my wife will likely need those for her own retirement. I assumed that for simplicity/security’s sake, my wife would pay off the mortgage out of the proceeds from the insurance, and then her cost of living would be dramatically reduced. Hypothetically, assume that our current mortgage payments (principal and interest) are $1200/month on a remaining $250,000 of debt at a 3% rate. I took the $250k as a lump-sum need, looked at our total annual expenses (not income, so tax rates don’t get involved) over the past year, reduced those expenses by ~$14k/year, and multiplied that by the number of years until our daughter’s adulthood. I deducted the coverage already provided through my employer and was left with a total need that was ~40% of the insurance company’s calculations.
Pros: Reflects ability of the family to make smart decisions in the face of changed circumstances. Not crazy-large need, or attempting to preserve hypothetical income growth that isn’t guaranteed.
Cons: Assumes no more input into retirement funds or my daughter’s college education fund. Ignores other things of value I provide to the house (lawnmowing, dogwalking, dishwashing services). Also overlooks my family’s cost savings from an end to my expenses (food, micro-roasted coffee beans, etc.). Doesn’t provide for my wife’s support after our daughter is an adult. I’m actually alright with all of those things. I know my family’s life will be worse if I’m dead than if I were alive; the purpose (in my mind) wasn’t to give them the exact same outcome regardless of whether or not I live- that’s impossible. It’s to make sure that they don’t wind up being forced to move (though they might choose to, to be closer to other family) and my wife doesn’t have to take a miserable job out of necessity while in the depths of grief. She’s phenomenally smart and capable, though, and I’m not worried about her ability to find employment that could cover her own expenses once our daughter’s out of the house. In fact, though I trust my wife enough to let her swing a sword at me on a regular basis, I’m also still glad that I’m not worth more dead than alive. And each month that goes by, as there is less debt on the mortgage and less time until my daughter’s adulthood, there’s additional (modest) surplus that could go towards inflationary costs, her education, or other life needs.

Insuring my wife required a different set of calculations; she’s currently a stay-at-home mom, so there’s no cash “income replacement” needed in the same way as there would be for me. At the same time, in the event of tragedy I would want to take some time away from work to be there 100% for our daughter, and child care is quite expensive for the scenario in which I do return to work. And her income potential is quite high, if she were fully employed in the right environment.

Option 1: Time off and path back to work. I assumed that I would take one year off from work to parent/grieve, so put that at our current expense rate. Since our daughter is not yet school-age, I took the cost of local pre-K options and multiplied that by the remaining years until she can enter public school. Lastly, since school hours aren’t a full workday, I took 50% of that childcare cost as the “ongoing need” to see her through to high school graduation.
Pros: Reflects a plausible scenario. Provides a manageable path back to work for me without yielding a massive insurance need.
Cons: Childcare costs have been increasing, and doesn’t factor in a growth rate. On the other hand, most of the need is front-loaded, so potentially overinsuring there.
Alternatives: I also considered assuming that I work part-time (rather than paying for childcare) once my daughter’s in school. Though there’s a part of me that would strongly prefer this as a lifestyle if I wound up a widower, since I don’t know precisely what level of part-time work might be feasible at what rate, I decided not to use it for a calculation of need.

I hope this proves insightful; as noted in my piece on lotteries, I don’t think there’s any “perfect” or “one right” way to think about uncertainty (though there are some definitively wrong ways). The critical element is to be aware of the elements that are over or understated in each context, and decide if they’re ones you’re comfortable accepting. For me, these levels allow me some comfort knowing that the basics would be covered, without feeling that I’m overburdening our current lifestyle. It also allowed me to discuss “the plan” with my wife and know that we were on the same page about what might happen if either of us were to pass, and know that we weren’t radically misaligned. I’m not sure how strongly I believe in the afterlife, but I hate the idea of leaving my wife feeling in a bind and like I hadn’t adequately thought about the family’s needs.

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