Insurance Thought Experiment Day 1: Why Do People Buy Life Insurance?

Let’s say Alice is the bread winner of the family and her husband, Bill, stays at home to watch over their child Charlie. If Alice were to die Bill and Charlie would greatly miss Alice. If they weren’t able to save a real lot of money, prior to Alice’s death, Bill and Charlie would have to find a way to support themselves. Maybe Bill would need to get retrained in a skill to reenter the work force, if his former skills aren’t as marketable/lucrative. And maybe reentering the workforce incurs additional child care expenses, that before Alice’s death Bill was taking care of. That’s where life insurance could help.

Why do people buy insurance? Insurance lessens the blow of an adverse event. Why is life insurance purchased, and what is it protecting? Life insurance is protecting against the loss of someone’s LIFE, just like how you might buy computer insurance to protect against your computer dying. This particular life may have dependents that solely or partially rely on that person for money and/or support. If this person were to pass away it would be an emotionally adverse event and probably financially straining. Life insurance’s aim is to soften this financial blow, and give peace of mind along the way.

You may have heard the terms WHOLE LIFE INSURANCE and TERM LIFE INSURANCE thrown around. While these are not the only two types of life insurance let’s learn about these two to start. Whole life insures a person’s life for their WHOLE life. A person would typically pay premiums each year (there are policies however where one may only pay, for example, ten years of premiums but would be covered for their entire life) and when they inevitably die, or reach the maturity age, their death benefit would be paid out to their beneficiaries. In addition whole life policies also have a minimum nonforfeiture amount associated with them, or cash value, that one would be able to borrow against(overfunded whole life policy aka “infinite banking” policy examples to be in later post). This adds a savings component to a whole life policy.

A variation on that is TERM life which only insures a life for a specified period of time, for example five, ten, or fifteen years. In this case someone is paying premiums for a fixed period of time and IF their death occurs in that TERM window then the death benefit would be paid to the beneficiaries. What happens if that person doesn’t die in that TERM? The person stops making premiums and is no longer covered. If you’re one saying, “So you’re telling me I just paid premiums for ten years and now that I’m out of that window I get nothing back?”

Well, you’re still alive so maybe you want to look at that. And remember the goal of life insurance is to lessen the blow of a negative event. If you can avoid that negative event all together all the better. And if you’re still upset about not seeing any of your premium back you can get what is called a return of premium (ROP) rider, but it’ll cost you… Nothing is for free.

In the next insurance discussion we’ll look at the mechanics of term and whole life insurance and think through why, for a given death benefit, is whole life more expensive than term insurance.

Leave a Reply