Insurance: When It Pays To Buy Protection Anne by Bucciarelli and Heather George, AllianceBernstein

You buy health insurance because you can’t know how healthy you will be, and you don’t want to be ruined by huge doctor and hospital bills. You buy life insurance because you can’t know how long you will live and be able to provide for your children or other dependents, and disability insurance because you can’t know how long you will be able to work.

Quantifying the amount of life insurance you need may be difficult—and could change over time. For example, once your children are nearly grown, you may not need as large a life insurance policy (adjusted for inflation) as when they are infants, since the benefit needn’t support them for as long.

We encourage clients to put in place an insurance plan that meets their family’s particular needs, rather than trying to find a one-size-fits-all policy. The case study below shows how we help clients to decide how much insurance they need. It is important to talk to a licensed insurance agent about the cost and features of the policies available.

Mind the Insurance Gap

Larry and Layla are a married couple, ages 42 and 39, respectively, with two daughters, a five-year-old and an infant. Larry’s job in software sales supports the family. After the birth of their first child, Layla left her position in marketing to be at home full-time. They want to know if they are on track to meeting their retirement goals and how much insurance they might need.

Larry earns about $247,000 a year and expects his salary to grow with inflation. He and Layla spend about $100,000 a year after taxes. Layla has $50,000 in her former employer’s 401(k). Larry’s balance is currently $250,000. Both balances are invested in portfolios with moderate-growth asset allocations.

Larry plans to continue to contribute the maximum amount each year to his 401(k), which is $18,000 today and will grow with inflation (including a catch-up payment at age 50 of $6,000). He expects his company to continue matching his contributions up to 3% of his annual salary. With help from their parents, the couple have been able to save what they expect will be enough for their children’s college education.

We determined that if Larry and Layla stick with their current spending and saving rates, they should hit their target financial capital when Larry is 66, which would allow him to retire then.

But what if something happens to Larry? The couple has disability insurance through Larry’s employer. But Layla’s best friend recently died in a car accident; that made them wonder if they might need life insurance, too.

Our analysis generated estimates of the value of Larry and Layla’s growing savings over time, and of the value of the assets that they would require over time to support future spending. We refer to the difference between these two values as the insurance gap.

Because the life insurance would provide for Layla and the children immediately if Larry were to die unexpectedly, we solved for the insurance amount that would allow Layla to continue spending $100,000 a year in today’s dollars, assuming she didn’t return to work. The Display below shows that if Larry were to die later this year, Layla would be left with about $400,000, but would need $3.9 million in nominal dollars to support the family’s inflation-adjusted spending of $100,000 for the rest of her life. Hence, she would need $3.5 million from a life insurance policy to fill the insurance gap.

Insurance

As you might expect, the longer Larry is able to work and save, and the longer the couple’s investments grow, the less insurance is needed to fill the gap. Ten years from now, the couple would require $3 million in coverage. Twenty years from now, they would need only $1.4 million.

Larry and Layla constructed a plan that included several insurance policies with different terms to fill the gap. The longest policy has a 25-year term and a $1.4 million death benefit. The shortest has a five-year term and a $0.2 million death benefit.

Larry and Layla worked with an insurance agent to find a package with attractive pricing. Because term life policies are generally inexpensive,* this coverage did not add meaningful to their living expenses but provided great comfort to the family.

*A 20-year policy typically costs between $1,000 and $1,500 a year per $1 million in coverage, depending on the insured person’s age and health conditions.

The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.