Question: I have just been offered life insurance. Frankly, I don’t see the need for it because the benefits will be received way into the future. Andy Rooney, an American author and news commentator, once said that “death is a distant rumor to the young.” The money I will use to pay the premiums can be used more productively elsewhere. I could just invest the money and build a fund equal to the amount of insurance coverage. And that would be my insurance.—Budding entrepreneur
Answer: Since we are talking about life insurance, let’s try to define life first. The scientific definition of life according to TheFreeDictionary by Farlex is: “The property or quality that distinguishes living organisms from dead organisms and inanimate matter, manifested in functions such as metabolism, growth, reproduction and response to stimuli or adaptation to the environment originating from within the organism.”
A more simplistic definition is that life is a state of being, which can be happy or sad, vibrant or spiritless, exciting or dull. But right smack in the middle of (the word) life is a big what “if.”
What if I don’t get a good job? What if I get fired? What if I incur a huge loss in my business? What if I develop a life-threatening illness? All of these “what if” questions lead us to focus on the risks in life. As human beings, we have learned that the best way to manage risks is to buy protection.
Investment accounts
Believe it or not, we buy protection every single day. In food and nutrition, homemakers will make sure their household will not grow tired of the food served to their members. To insure this, homemakers will buy protection by offering a wider variety of viands and perhaps serving an occasional dessert. The homemaker will also insure better health by buying vitamin and mineral food supplements.
In transportation, a person driving a motorcycle will buy a helmet to protect himself against nasty spills. Another who is buying a car will surely not want to buy one without seatbelts and a spare tire, even if the car was priced at a discount. That person will be willing to pay more for such protection.
To avoid having to scrounge around for money in cases of emergencies, people who are wise with their finances will set up emergency funds in short-term savings and investment accounts. Such accounts bear the opportunity cost of potentially higher returns from longer-term instruments.
Heuristics
Even in investing we buy protection. Rather than just invest in one instrument that may result in wild fluctuations in value, the smart investor will create a portfolio of instruments that have the potential of canceling out each other’s wild fluctuations. The cost of protection is the time and effort spent on analyzing and monitoring more than one investment instrument.
As just shown, we are willing to pay the cost of protection every day. Despite this, many people still don’t see the need to buy life insurance. Isn’t it that in Maslow’s hierarchy of needs, the security need is next only to the most basic need, physiological? This is where we turn to behavioral finance, or the study of why people sometimes behave irrationally with their money.
In web-based research, I’ve come across studies that say we humans make over 200 food decisions per day, around 125 decisions per hour of driving and a total of around 35,000 decisions every day. Most of them are not that important. But due to the sheer number of decisions that have to be made, we humans rely on heuristics, which are rules of thumb, educated guesses, intuitive judgments, and plain and simple common sense. It is the over-reliance on these that can sometimes cause trouble.
Overconfidence is one of the heuristics. With overconfidence, a person overestimates his ability to perform a certain action. For example, he believes that he can easily earn the amount of coverage that insurance policies offer by simply investing his money. Anyway, he claims that he has all the time in the world to do so and that there is a low probability that he will be hit by calamities, accidents or diseases that may lead to death.
Bad news! The probability of dying is 100 percent. We just don’t know the time or place. So rather than pretending to be James Bond who can weather a dangerous life, set your feet back on the ground and protect your downside.
Prospect theory
The prospect theory, as advanced by Drs. Kahneman and Tversky, is another one of the heuristics. The theory says that the average person tends to feel more pain in incurring a loss compared with the amount of joy experienced from earning an equal amount of gain. Put simply, the average person would choose a situation where he gains, say P5,000, over a situation where he initially earns P10,000 then loses Php5,000, even though he ends up with the same P5,000 in both situations.
And to the average person, a premium is an expense and a loss (especially since there is no perceived immediate gain).
Ask any accountant and he will tell you that premium payments, while cash outflows, are not immediately treated as expenses but rather as assets in the form of pre-paid expenses. They are only expensed out when the benefit, which is either the period of protection against loss or the maximum possible claim, is used up. But with life insurance, the protection can be up to point of death. Only by that time will the insurance asset be fully expensed, but not without a corresponding gain in the form of the benefit claim.
Benefits
One last argument remains. The insured doesn’t get to enjoy the benefits of the insurance. Well, of course he doesn’t because life insurance is there primarily to financially protect your loved ones when you meet an untimely demise. So don’t think of insurance as continuously paying premiums without any benefit in sight.
Remember that the benefit will be paid only when you die. And you certainly do not pay premiums to die. Instead, think of your premiums as installments on the gift of financial protection for your loved ones. Live by what one of the greatest minds in human history says. “Only a life lived for others is a life worthwhile.”—Albert Einstein
If you want to learn more about life insurance, as well as effective cash, debt and wealth management, attend the EnRich training scheduled on February 16. Wealth management includes investing in financial securities as well as investing in your own business. Visit www.personalfinance.ph, e-mail info@personalfinance.ph or call (632) 2161541 for more details.
Stay safe. Be insured.
(Efren Ll. Cruz is a registered financial planner of RFP Philippines, personal finance coach, investment adviser and bestselling author. Questions about the article may be sent by SMS to 0917-5050709 or e-mailed to efren@personalfinance.ph. To learn more about the RFP program, visit www.rfp.ph or e-mail info@rfp.ph.)