Life insurance as a lottery ticket

Question

Suppose spouse1 and spouse2, aged 55, and children aged 17 and 19. Both spouses purchased 20-year term life insurance 19 years ago. The insurance is no longer needed to support either spouse or children in the event of a spouses's death.

The bill for the 20th year has arrived. The question is whether to pay it. This looks like a lottery ticket question: pay a small amount, usually win nothing, and very occasionally win big. In this particular case, the premium is $175 and the payout is $250,000. $175/$250,000 = 0.07%. So if a spouse's probability of dying in the next year is greater than 0.07% then it probably makes sense to pay the premium for that spouse. One can use data from the CDC to estimate the probability of death and thereby make some kind of reasoned choice about whether to pay the final year's premium.

It's usually the times when my logic feels airtight that I am mistaken. Is my analysis correct?

Answer 1

Term life insurance is something that you purchase when the financial loss that would be incurred by your loved ones if you died would be catastrophic. In your example, 20 years ago when you were expecting a baby, most people would be well-advised to purchase term life insurance.

Now that your kids are (nearly) adults, and the insurance money would not be needed, you wouldn't make that new purchase today. As Hart CO said in his answer, life insurance is structured to make a profit for the insurance company.

However, one thing to consider is that the term life insurance payments are structured so that the payments are uniform throughout the term, but the odds of your death go up as you get older. This means that, from an expected outcome perspective, you are overpaying for the life insurance in year one, and you are underpaying for the insurance in year 20. If being covered in the last year before your youngest turns 18 helps you sleep at night, rest assured that you are likely getting a bargain for your last term life insurance payment. If you were to renew your insurance for another term, the payment would be much higher.

Answer 2

The insurance is no longer needed to support either spouse or children in the event of a spouses's death.

Life insurance is pretty much only for people who aren't in your situation. You know that the insurance company is making money by using their actuaries to come up with very accurate payout probabilities for large cohorts of their customers. Since their math determines your premium and they make a profit, it's a losing proposition from your end unless you need the insurance to provide for those left behind.

You're right though, it can be viewed as a morbid lottery. If you had inside information that they were not privy to that significantly changed your odds then it could also be financially worthwhile. Though, depending on your policy not disclosing certain things could result in reduced benefit. The house always wins.

Answer 3

1. "no longer needed to support either spouse or children" -- needed != valuable. "Needed" is ill-defined anyway -- I doubt even when you thought it was needed that your family would have starved to death without it. Would a death now still impose a financial cost, even if not a debilitating one? If so, then risk aversion still says the insurance is worth somewhat more to you than its strict expectation value.

2. As has been noted a few times here, even on an expectation value basis, the insurance is likely now a good deal since the premium has presumably been level while the chance of death has been strongly increasing with age. If you cancel, you are throwing away the year that is most in your favor.

3. Another consideration is whether you can truly do a penalty-free cancellation (only consequence is loss of this policy), or whether this would be considered defaulting on a contract, with additional consequences for your credit report, future dealings with this or other insurance companies, etc. Really, if you decide to cancel by withholding payment in this specific circumstance, the insurer should send you a nice thank-you gift because it's a windfall to them. But their automated customer rating system might not have enough nuance to see it that way.

Answer 4

I've noticed that it's a recurring theme of whether insurance company is overcharging etc. While it's easy to think it's a zero-sum game and the fact that they make money means you lose, reality is more complicated. For one, insurance companies have access to investments that individuals don't. Also, they mis-priced products all the time. (My guess is LTC gonna blow up for sure.)

Anyway to OP's question - one flaw in your logic is that both CDC data and the mortality table the actuaries use are based on large number of samples. That makes things easy to predict. Individual situation is the hardest to predict. That's why they don't do it.

If I were you I'd simply think about whether the premium is something I'm comfortable paying for the peace of mind (as opposed to trying to find out if there's an arbitrage opportunity). And if you are fine with the worst case scenario without the insurace payout, just drop it and stop worrying about it.

Answer 5

The problem with your logic is that both sides of the insurance contract understand that logic and the actuaries at the insurance company aren't going to let the policy get priced below its expected payout plus a healthy profit.

Answer 6

Statistics will not give you enough information for a good decision in the situation that you describe. There are enormous differences among 55-year-olds.

Supplement the statistics with the data from a recent comprehensive physical exam to get better guidance. If you haven't had a comprehensive exam in years, buy the insurance. Add to that the information from your fathers' and mothers' health histories, how much you drink and smoke (if at all) and exercise, and whether you fasten your seat belts religiously, and check your gear when you go base-jumping. If you feel good about all that, consider spending the $175 on a luxury.

Answer 7

If you look at it logically, you'd ask your kids to pay for your life insurance once they can afford to pay for it.

Say I'm 19 years old, my dad is 55, and he has a $250,000 life insurance that costs $175 per year. By paying $175 for 30 years I get $250,000 when dad dies at 85, for a $5,250 pay. But look at it from dad's point of view: He isn't making any money from the life insurance. He has no reason to pay for it (if I can afford to pay for it).

Are you sure the numbers are right?

Answer 8

Tim Harford What makes gambling wrong but insurance right? explain your dilemma in details.

Risk-sharing mutual aid societies are now among the largest and best-funded organisations on the planet - we call them "governments" <-- lengthy examples snipped> Providing insurance is no longer a mere money-spinner for governments. It is regarded as a core priority to help citizens manage some of life's biggest risks - unemployment, illness, disability and ageing.

A term life insurance is essential if there isn't sufficient social safety net for individual basic needs. If that is the case, even the odd of pass away is very odd, it is not worth to save the $175.

Additional note : In theory, if a regulated large insurance entity takes over the business of the universal risk pool than the individual private insurance company, it may reduce the term life insurance premium. Due to low-cost data collection and demography aggregation, a private insurance company will try to impose a higher premium on the high-risk group to reap more profit(insurance company may charge higher premium on an individual with a blue-collar job than one with a desk job). Sooner or later, it will transform into a similar problem like private healthcare insurance: those unlikely to use the insurance don't need it, while those who need it cannot afford it.

Answer 9

One thing to consider is that this is a type of savings account, essentially. You've been paying into it, although you hope not to get anything out of it any time soon. Depending on your policy, once you hit a specific level of payment into the life insurance account, the interest on what you've paid in may actually pay for the premiums from there on out, so you may no longer need to pay in monthly to continue to be covered.

In this way, you can stay covered until it's needed, then you essentially get your money back. Not all insurance works this way, but I've heard of policies that do. Maybe they are more rare than I expect, but it's something to look into.

What I'm saying is that if you stop your policy now, you could be losing all the money you've paid in as well as any interest you might be earning on it in the future.

Also, you might be well off now, but what if someone loses their job, gets in an accident, becomes terminally ill, or the stock market crashes your 401k and other investments.

The older a person gets, the more likely it is to get a terminal illness. In today's age of massive medical bills that health insurance doesn't always cover, what you think of as a nice nest egg could disappear rather quickly. The life insurance can be used to pay for any "leftover" medical bills after death, so don't totally discount it's usability.

Life insurance can be looked at as a lottery ticket, but is it one that you want to ignore completely? It happens to be the only one that's almost guaranteed to be worth something.