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How to Use Life Insurance

How to Use Life InsuranceLife insurance can be confusing. Especially since so many people want it to be. But it doesn’t need to be. Life insurance is one of the simplest financial tools out there – as long as you use it correctly.

There are two basic components to your wealth:

  • Your Financial Capital – All the stuff you generally think about as your assets: your investment portfolio, your home, your cars, etc.
  • Your Human Capital – The value of what you will earn in the future.

When you’re young, human capital is typically a bigger part of your total wealth than financial capital. As you get older, your financial capital (hopefully) outgrows your human capital through savings.

The Purpose of Life Insurance

All insurance exists to replace a loss of some sort. Life insurance is specifically built to replace lost human capital. If you pass away earlier than expected, your family loses out on a lot of unearned capital.

It’s not a tool to get rich, it’s a tool to prevent your family from being poor. It’s there to replace that lost future income and immediately turn (some portion of) your human capital into financial capital that your family will be able to live off.

Life Insurance Companies are Not Your Friend – But They Are Useful

The expected value of the premium payments you make to a life insurance company will outweigh the expected value of the payout your family will get if you die. It makes sense. Just like any other business, life insurance companies want to make money.

This is okay, though. You’re paying them to take on a large part of the financial risk of your early demise.

But just like anything, there’s decreasing marginal utility here. (The first cookie tastes good. The tenth one, not so much.) As you reduce the amount of risk to your family, you’re not willing to pay as much to get rid of that next unit of risk.

When you buy life insurance, you want your policy to be as simple as possible. Insurance companies want to sell you all sorts of “extras.” These are usually really good deals – for the insurance company.

Generally, you’ll want the boring, plain vanilla, term life policy. There are always exceptions, such as if you’re using your life insurance policy for estate planning, but term life does the job in most cases.

So How Much Life Insurance Do You Need?

Just like any other financial planning question, the answer to this is always a big, fat “it depends.” Every situation is unique. An insurance salesperson will usually say you need roughly seven to ten times your annual income.

For most folks, especially people in their mid 30s or 40s, this is at least in the right ball park. It won’t be exactly right for you, but it’s probably close enough.

But life insurance isn’t something you can set up and forget about. Remember the two components of wealth we discussed earlier?

As your total wealth shifts more to financial capital, you won’t need to protect as much of your human capital. As a result, as you get older, you generally don’t need as much life insurance. You only need enough to replace the value of the earnings you won’t be bringing in, which is a much smaller number at age sixty than it was when you were thirty.

The real answer to how much life insurance you need relies on understanding your holistic financial situation. You need to review where you are, and where you want to go to be able to understand just how to protect yourself.

To learn more about insurance (life and otherwise), and all sorts of other issues you should be thinking about in planning for retirement, check out our ebook I Want to Retire Soon

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