Few months back when I asked my friend whether he has bought any life insurance for himself, he replied, Why do I need life insurance now? I am still in my mid 20s. I don't need insurance at this age. I know most people think this way but for me the surprising thing was that my friend was a business graduate with a major in finance.
The logic behind this thinking is that at young age probability (chance) of death is very low so one does not need to buy life insurance. One needs life insurance when one is old because at that age probability of death is relatively high.
Now I tell you that financial theory tells us exactly opposite to this thinking. At young age you need life insurance and as your age increases the need of life insurance decreases. How?
The best way to describe "Personal/Behavioural Finance" concepts is through example. Consider Mr. John who married at the age of 26 and have 2 children. He will retire at the age of 60.For simplicity we assume that his salary will remain constant throughout his career. His annual income is $200,000 (in short 200K where K stands for thousand).
Now suppose Mr. John is now 59 years old and today is his birthday. He will work for one more year and hence will earn $200k if he does not die. At this age there is a strong chance that he must have saved enough so his bank/balance would have been good. Secondly, his children must have been independent of him, I mean they would be having their own job. So, if Mr. John dies now what will happen? He has good bank balance which will be more than enough for his wife. Since his children are also independent, their will be no significant financial impact on their future because of his death. So I am coming to the point, if Mr. John has life insurance then it would be good for his family since they will get "more money" but if he has not bought life insurance no one suffers because his wife can depend on his "bank balance" and his children are also having jobs so they would not suffer from not having life insurance of their father.
Now, suppose Mr. John is just 30 years old. One of his children is 3 years old and other is just 1 year old. Since Mr. John is still early in his career he hasn't saved enough so he doesn't have a good "bank balance" at this stage. If Mr. John want to retire at age 60 and if he does not die before retirement he will earn (200K * 30 = 6000K) 6 million. Now it is from this "future income" that he will pay for the "health, education and other basic life expenses" of his family. Now suppose if Mr. John dies at age 30 and he does not have life insurance then what would be the consequences? Do I need to explain? Now, the same 6 million that he was supposed to earn and spend for "life necessities" of his family is lost. His family has nothing but a small bank balance. Remember, the purpose of life insurance is to save all or at least part of the 6 million, in other words, life insurance save your future income even if you don't earn it because of early death.
Let me tell you that this is true that probability of death at age 30 is low, but the problem is consequences of death are disastrous at this stage for family. Family has a double blow, first it lost it's loved one and financial consequences is a second blow. Insurance saves the family from the second blow, the financial one. The situation is not much different when Mr. John is 40 years old, at this stage probability of death has increased further and his family is still dependent on him.
Finally, keep in mind that death can also be because of accident. So when you are buying life insurance you are hedging yourself against death either by disease or accident.
CONCLUSION:
At young age, the need of life insurance is great and as your age increases the need of life insurance decreases and this is exactly opposite to what most of the people think.
HOW MUCH LIFE INSURANCE TO BUY?
Well, it depends on your salary level but financial theories say that one needs to have a life insurance of at least 6 years salary. For example if Mr. John want to buy life insurance than the face value of his life insurance should be at least 1200 K or 1.2 million. I am not saying that this is the optimal but one must have "at least" this much.
I would be extremely happy for any feedback.
Thanks,
Tahir Adeel
DISCLAIMER: Please note that all the concepts regarding Insurance have not been explained. I have described what I believe is enough to explain the "basics" of life insurance. I am not an Insurance agent and not soliciting clients.
