Insurance Coverage and Opportunity Cost

Recently, I have been dealing with insurance a lot — i.e., stopping my parents’ premium payments, evaluating long-term care insurance, doing quite a bit of analysis and shopping for better life insurance policies for my wife and I, etc. As expected, one of the insurance sales agents pitched a whole life insurance for my baby boy with the usual emphasis on it being dirt cheap.

Actually, he was quite a good salesman and at one point he had me convinced that I am getting a great deal by investing $23 a month on a permanent life insurance with a death benefit that goes up over time. I even picked a random number of 35 and did some quick calculation to confirm his sales pitch. Over 35 years, I would have spent $9,695 for an $84,323 policy — what a great deal!

Opportunity Cost

Fortunately, I am the type of person that likes to mull over financial decisions for a while. One thing I like to do is figure out the opportunity cost of paying for something like insurance. Here’s the definition of opportunity cost from Wikipedia:

Opportunity cost is the cost (sacrifice) incurred by choosing one option over an alternative one that may be equally desired. Thus, opportunity cost is the cost of pursuing one choice instead of another. Every action has an opportunity cost. For example, someone who invests $10,000 in a stock denies oneself the interest that one can earn by leaving the $10,000 dollars in a bank account instead. Opportunity cost is not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered.

After doing some work on a spreadsheet, this is what I came up with.

To calculate the opportunity cost, I am assuming that I would invest the $23 month premium in the stock market instead, earning 8% annually on average. In this scenario, the insurance policy is worthwhile if something happens to my son before he turns 44. From birth through the age of 44, his death benefit will be higher than the opportunity cost. If you look at the graph above, it seems like a reasonable trade off.

However, his chance of dying before the age of 44 is quite small. According to the U.S. Census Bureau, he’s expected to live to about 80 years of age. So what’s the opportunity cost versus death benefit at 80?

According to the insurance agent, the death benefit at 80 would be a respectable amount of $300,000. However, the opportunity cost based on the scenario defined above would be a staggering $1.76 million! I hope you can see how insurance companies are able to offer this type of benefits — on average they will come out well ahead.

Now let’s take it a step further. If he lives to be 100 years old (this is the maximum number provided to me by the insurance company), his death benefit would be over $600,000, but the opportunity cost would be over $8.2 million!

I know there’s emotional factors at play here — e.g., I wouldn’t want to work if something happened to my son — but I’ll let you decide if it’s worth it for you after seeing these numbers.

And in case you didn’t notice…isn’t compound interest amazing?

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About the Author

By , on Jun 5, 2008
Pinyo
Pinyo is the owner of Moolanomy Personal Finance. He is a licensed Realtor specializing in residential homes in the Northern Virginia area. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, and financial literacy author.

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Leave Your Comment (16 Comments)

  1. TMACK says:

    As with most financial advice, there are no simple solutions. When a colleague (or blogger) tells me I am wasting my money on whole life insurance premiums, it gives me pause-am I stupid or just cautious? Yes, we considered the expense and loss of commission to the agent in the decision. We are fortunate enough to be able to afford the premium and are willing the spend the money on the peace of mind. Pinyo makes unrealistic assumptions on the stock market as 8% annual returns are absolutely unattainable in the evolving global economy. Furthermore, if you think the bond market is rock-solid (which is the foundation of life insurance companies), then you are in for a serious reality check in the coming several years. Additionally, those who assume their Roth IRAs and social security payments are guaranteed to remain tax-free or an absolute certainty are very trusting souls. If you purchase whole life insurance with the understanding that it is a tool for estate planning and not as an investment, you will be taking the proper approach.

  2. Fred says:

    How’s that “opportunity cost” thing working out for you now? You shouldn’t have assumed an 8% annual return. Funny thing is….my whole life policy actually increased in value this year. my IRA and all my other investments have taken a huge hit that will take several more years to recover. In fact, my whole life policy premium was $1,200 and the dividend payment from the insurance company was $1,750. I guess in a way my life insurance premium is tax free! (you might have to really think about that) :)

    • Pinyo says:

      @Fred – I am doing perfectly fine. I understand stock market volatility and my investment portfolio is properly allocated. I recovered most of the loss from last year and I am in a much better position to move forward. Thank you for asking.

  3. bb says:

    You’re right, term life insurance is cheap and there’s a reason. Less than 1% of all polices ever pay a claim. The time to get your greatest return with a term policy is if you die on the way home from signing the contract. So, do you think term policies make them a lot of money?

    And you’re not borrowing your own money when you take out a policy loan. You borrow from the life insurance company and your cash value still earns interest. So, as you’re paying back the balance with interest on a decreasing balance, you’re earning compounding interest on the cash value within the policy.

    I guarantee you, if you research on how to utilize a whole life insurance policy in order to “be a bank”, you’ll be far ahead of the rest. Don’t buy term and invest the different. You can buy whole life, take out a policy loan, and invest in the same exact thing.

    Banks invest in whole life insurance policies (BOLI – bank owned life insurance). They understand how to velocitize their money, make it do more than one thing.

  4. Dewey says:

    Ok so with a whole life policy you are paying for two things, 1. Insurance(Death benefit and 2. Cash value. If you die you get only one…the death benefit. The cash value goes to the ins company. Now in the above example where you they say you can access your cash value at any time, tax free…that is exactly right. How ever what they failed to mention is that the insurance company requires you to pay interest on any money you borrow from your cash value. You must pay the ins company interest for borrowing your own money! God forbid you still owe at the time of your death they subtract what you owe from your death benefit. If you don’t believe just consult you policy, its all in there in black and white. All of this isn’t the real issue. I don’t think whole life is something anybody should have let alone a kid. No parent wants to profit off the death of a child, however at a time like that you don’t want to be passing around a collection plate at the funeral. Term ins is all most always cheaper then whole life and for a child $12K is all you would need, I have a child rider on my TERM policy and its $7 for all the kids listed on the policy. Also the our ins company cover them until age 25 at which time they are guarruteed a policy of their own without having to prove insurability. You are better off getting ONE TERM policy with a spouse rider and child rider. Agent that sell whole life most always do separate policy because there is a policy fee attached to each one so they get paid more if they do individual polices on the whole family. Ask your agent what he makes the most commission on Whole life or Term. He’ll probably tell you Term is “discount ins” for people that can’t afford it. Buy term ins and with what you save invest that and you’ll be better off. That’s what we did. Sorry I got carried away…LOL

  5. bb says:

    I’m not an insurance agent either. But whole life insurance is a product that I love. It is the backbone of our financial plan. The problem with whole life insurance is that many people don’t understand it…even insurance agents! There are many “living” benefits to whole life that many don’t know. For example, you can access your cash value whenever you want tax free, it is protected from creditors in most states, there is a guaranteed rate of return, and velocitizes your money. Can a 401k provide any of that? No.

    Best of all, you can create your own personal bank where you can recapture the interest you pay to financial institutions (The Infinite Banking Concept). We conducted an interview with R. Nelson Nash, author of Becoming Your Own Banker. He offered some insight and provided us some free downloads. Check it out at http://www.choose-financial-fr.....-nash.html. Before you shut down whole life insurance, investigate it because it may be the best financial decision of your life.

  6. if your child dies, you likely will not want to work, but you will also have that bank account that covers that time off. When your child is an adult, he can do something else with that money, fund retirement and put a beneficiary on the account that will get it when he dies. You can keep a small portion of what you saved for him in an berevance account for yourself to take time off for any deaths in the family. (your parents, children, siblings). In the meantime, when everyone is healthy and young, I agree that saving the money is a better choice, (if you actually follow through and save it for him).

  7. Ralph says:

    I really enjoyed the breakdown. Ultimately, the purchasing of peace of mind is an intangible that is difficult to measure, but on a purely financial basis the death benefit is certainly the clear loser. Looking forward to hearing what you decide in the end.

  8. Pinyo says:

    @J – You do sound like an agent. :-)

    But that’s a good point about subtracting term from whole to isolate the insurance money from investment money. I’ll have to ask my agent. I think he’s not too happy with all the questions I’m asking lately. :-P

  9. J. Hildreth says:

    And how much would it have cost to maintain the same coverage in term insurance? Given that you think you need to insure him (to cover funeral costs and, say, assuage grief) then you really have to say that you only have the difference in cost between the whole life and term to invest. That way you separate the insurance part from the investment part. That would reduce the difference. Especially if you consider term premium would rise.

    Now life insurance will probably never show up as a very good investment but even if you stop contributing at age 14 you’ve only spent $3900 which has a present value of about $2300 @ 8%. So for $2300 you’ve purchased $60,000 of life insurance for his complete lifetime – about $30/yr of coverage. Sounds like a nice gift to me. And there is the bonus that it will have some cash value he can tap in an emergency or retirement. And he’ll always need some insurance – even after his kids are grown – to cover funeral costs and, say, assuage grief.

    Now I sound like an agent….

  10. Pinyo says:

    @J. Hildreth — Good point. In fact, I asked the agent about the plan paying for itself. He said that the plan will pay for itself at the age of 14. Of course, if I do this the death benefit will rise much slower.

    But assuming the same death benefit, the first break even point will now be at 52 instead of 44. If invested for 14 years then stop contribution, at 80 the investment is projected to be $1.16 million (versus $1.76) and $5.46 million at 100 (versus $8.2) — still well above the death benefit.

  11. J. Hildreth says:

    I’m not an insurance agent. However, it may not be as bad as you think. First, why would you pay for an insurance policy for your son when he’s 44 years old? He should have his own insurance by then. If you make him the owner and pay the premium right from the start then a more likely scenario is that at age 25 he gets married and you give him the policy to pay. Now he starts paying the $23/month which is probably substantially lower premium than he would pay if he took out his own policy for the same coverage at that point. He continues to pay in until he’s 44 which by then the dividends on the policy probably exceed the premium so he then puts it on dividend off-set and the policy is essentially free. This might even occur before age 44. At the same time you’ve saved your $23/month between his age 25 and 44. At age 44 he can start saving the $23/month also. Now when his kids go to college he has some cash-value he can tap that both you and he partially paid for (when he’s, say, 50) – or he can leave it alone until retirement. Of course, he’ll probably have bought a few $100,000 of term coverage when he had his first child also – but he’ll need $60,000 less because of your gift.

    I’d be interested to see your overall analysis of that.

  12. Pinyo says:

    @B Smith – Thank you. I think that’s what we all need to do — understand the alternatives — before making financial decisions. Regarding, insurance is in the business of making money…no kidding…the insurance agent even use that to explain the price differential between whole life and term life insurance.

    @David – Exactly. I wouldn’t even call it an investment.

    @Curt – Thanks.

  13. Curt says:

    Excellent article. I totally agree. Whole life insurance is not the best way to invest your money. Excellent explanation.

  14. David Hicks says:

    Unless whole life products have changed radically over the past few years, it’s a bad deal and a poor investment — basically because it’s an old, old product with the odds stacked decidedly in favour of the old boys of insurance. Term insurance is the way to go for risk protection — you’re right, do your investing elsewhere.

  15. B Smith says:

    Pinyo-I love how you apply basic business tools to personal finance decisions. When you look at the long term picture whole life is a bad deal. Another way to view it is that the insurance company is in business to make money. There is a reason they push whole life so hard. The premium is based on your age and health. The younger you are the less per month you pay so it makes sense that it only costs $23 per month!

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