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!
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?