The purpose of insurance is to protect the risk against a loss. Like disability insurance, life insurance protects your human capital. Human capital is another way of saying the current lump sum value of your future income stream. If you were 30 years-old in Canada and earned the average income of $43,700, ignoring raises and inflation, your human capital would be $1.5 million. While that’s not normally included in your net worth statement, it’s still an asset, and a big one. Protecting that asset is important.
Now if you were a single hermit, would it really matter if your income stream stopped when you passed away? No. No one else is counting on any of that income, and you’d be dead so wouldn’t need it either. But most people aren’t hermits so there is potentially a need for life insurance. If you’re single, you might still need some insurance. Think about the various costs that might crop up if you were to pass away. Would your family have to pay for your funeral out of pocket? Perhaps your parents have co-signed a loan with you and if you passed away, they’d be on the hook for paying it back. If you don’t have enough assets to cover those potential expenses, life insurance is an option.
The easy scenario when life insurance is needed is if you have family depending on your income. Let’s say you have a mortgage, a spouse and 2 kids and bring home half of the family income. If you passed away without protecting any of your human capital (i.e. future income), things would probably be pretty tough for your spouse and kids. How would your family pay for the mortgage, food, daycare, education and/or retirement savings, let alone all the other expenses associated with life and raising a family. Unless you have lots of cash or other assets you could sell, you’ll need some life insurance to cover your family’s expenses when you’re gone. If you’re the sole breadwinner, life insurance is a must.
Those were some pretty easy examples to understand when life insurance is and isn’t needed. But let’s say you’re staying home with your 2 kids and your spouse brings home all the income. That doesn’t necessarily mean you don’t need any insurance. Raising children is a job, whether you’re getting paid or not. If you passed away, would your spouse have additional expenses associated with taking care of the family, like daycare, cleaning services, managing the household finances, etc.? Life insurance can provide funding to help with those costs so your family’s standard of living doesn’t decrease with your passing.
The key is to understand what happens financially if you or your spouse dies. What income would stop? What expenses might increase, and for how long? Understanding those numbers helps you get an understanding of how much life insurance is needed. It might be scary and uncomfortable to talk about death, but it’s absolutely necessary to ensure you understand what would happen to those you love and depend on you if you were to die. The goal is to have your loved ones be able to sustain their standard of living without having to make big sacrifices.
So how does life insurance work in practice? Once you determine how much life insurance you need (I’ll dive deeper into this in a future post), you will take out a life insurance policy for that amount of death benefit (in other words, the amount that will be paid to your beneficiaries if/when you do pass away). You pay a regular premium, monthly or yearly, for this coverage. Life insurance companies are able to pool risk. Not everyone who pays for life insurance coverage dies during the policy. Insurance companies can use mortality tables to estimate your risk of dying and price the premiums accordingly. Since young people have a lower chance of dying in any given year (i.e. a lower risk for the insurance company to have to pay the death benefit), their premiums are typically lower. The premiums paid are all pooled together and used to pay out the beneficiaries of those individuals that do die.
In summary, you pay a small monthly premium to an insurance company. In return, you receive the peace of mind that if you were to pass away your family will receive a lump sum benefit that can be used to cover their expenses and maintain their standard of living. Once you can cover those future expenses with financial assets you own, life insurance is no longer needed.
