2. Insurance Is a Hedge for Human Capital
“...I am young and healthy so I don’t need any life insurance, yet. I’ll think about it more seriously once I get much older and am more likely to die....”
—Myth #2
A few years ago an older MBA student in one of my courses complained to me during a lecture on insurance that he had been diligently paying premiums for years on a multimillion-dollar term life insurance policy. With the benefit of hindsight, he was frustrated at all the money he had wasted on the life insurance policy, with no investment return to show for it. I replied, jokingly, that my wife was actually Italian with strong family connections in Sicily, and I might know some people who know some people who might be able to arrange for a large return on his investment; in the style of Tony Soprano.
Life insurance policies, and for that matter, almost all financial instruments that we purchase for risk management purposes, should not be viewed as investments, but as hedging instruments. Oddly enough, the goal for most of these hedges is, in fact, to lose or waste the money. After all, wouldn’t you and your family rather have you and your human capital, as opposed to the million-dollar payoff? I certainly hope the answer is, “Yes.”
Nevertheless, to understand the role and pricing of insurance in a more detailed way—and to see how it fits in the “are you a stock or a bond” theory of human capital—in this chapter, I explain how this hedge works in theory and in practice. You will gain a better appreciation for why life insurance is so important when you are young and especially when you have dependents who rely and depend on your human capital. The same ideas apply to disability, critical illness, or any other risk factors that might impede your ability to extract the most value from your human capital, but my remarks will be focused on life insurance.
The Odds of Living and Dying
When you toss a coin, spin a roulette wheel, or shuffle a deck of cards, computing or calculating the probability of getting heads, reds, or spades is straightforward. This is because the underlying “probability distribution” is well known. In fact, regardless of whether the coin, wheel, or deck is new or old, in Las Vegas or Atlantic City, the odds are much the same, and all mathematicians will agree on them.
For example, the probability of tossing two heads in a row is 25% anywhere on planet Earth, regardless of who is tossing the coin. However, when it comes to matters of life, health, and death, the situation isn’t as clear. There isn’t a well-defined probability distribution from which to calculate the relevant odds. The more a doctor knows about your health, income, and educational level, the better the estimate she can give you; however, it truly is only an estimate.
In the absence of detailed information, all we can do is talk about upper and lower bounds on the probability. For example, knowing only that you are a 40-year-old male living in the United States, one could say that the probability of your dying prior to your 41st birthday is somewhere between 0.10% and 0.26%. We can think of these as optimistic versus pessimistic estimates of mortality rates. If you then tell me that you are wealthier than average, or perhaps less wealthy or healthy, I might skew the number toward the lower or upper bounds. Obviously, countless factors influence how the mortality odds of any one individual look. Your education, ethnicity, health status, habits, and even your marital status all influence your probability of dying in any given year. For example, Tables 2.1 and 2.2 summarize how the level of education influences the mortality of males and females in different age groups. You can see that the probability that a male in the 35–49 age group who has not completed a high school education might be 1.56 more times likely to die in the next year compared to the rest of his age group. Compare this scenario to a male in the same age group who has completed a college education: His probability of dying is only a fraction of the rate that applies to the rest of the group.
Table 2.1. Education Versus Mortality: Males
Table 2.2. Education Versus Mortality: Females
Source: J.P. Cristia, August 2007, Congressional Budget Office, Working Paper 11, “The Empirical Relationship Between Lifetime Earnings and Mortality.”
With all these studies, it is important not to confuse a statistical correlation between two factors, and actual causality. That is, numerous other factors might impact the education-longevity relationship. As an extreme case, a high school dropout who develops a sudden heart condition won’t miraculously get better if she completes her GED or re-enrolls in high school. All we can say for certain is that mortality rates are lower among groups of people within the general population who have completed high school and are even lower for the college educated, compared to people who have dropped out of high school. And so, from a practical perspective, if you are a member of the groups identified as having more favorable mortality experience, you should plan for a much longer retirement compared to the average person in the population. Remember that if the mortality rate is lower, fewer people from this group are dying prematurely, which means that they have greater odds of reaching an advanced age of 90 or even 100.
My main point is that the true probability of living and dying is never knowable and very much depends on specifics. The best we can do is to rely on generalized estimates.
Sometimes in this book I will select either the pessimistic, optimistic, or moderate estimate and only display that number, just to make a point or to put the number in perspective. Table 2.3 shows the impact of the assumption on the survival chances.
Table 2.3. What Are the Chances of Dying During the Next Ten Years?
Source: U.S. Social Security and 1996 Annuity 2000 mortality tables; IFID Centre calculations.
As you can see, according to both optimistic and pessimistic tables, the probability of dying during the next 10 years is much higher at age 80 than at age 40. Using optimistic estimates, an 80-year-old female faces nearly a 50% probability of dying during the next 10 years. Effectively, this means that roughly half of the 80-year-old females alive today will not survive 10 years.
A sad thought, but does that mean that an 80-year-old female should have a huge life insurance policy, because she is quite likely to die soon? No, absolutely not! It all comes down to the value of human capital, and not necessarily the odds of death.
To understand why, start by thinking of the way a standard 10-year term life insurance policy works. You pay a relatively small monthly premium in exchange for a very large payout to your beneficiary in the event of your death. The probability of dying during the next few years might be extremely small (say, 1 in 10,000), but the magnitude of loss is enormous, due to the loss of human capital.
Recall from Figure 1.3 that as you age, the value of your human capital is usually converted into financial capital. During your working life, you manufacture wealth and money by spending effort. You want to insure all the effort you will be investing during your working years, which is precisely why you purchase life insurance. Figure 2.1 illustrates this point in a graphical manner.
Figure 2.1. Crude, but you get the point.
On the horizontal axis of the figure is your age, while the vertical axis shows the value of your human capital. Imagine that you have just graduated from school and are about to embark on a 30- to 40-year career. You have many productive work-years ahead of you, so the discounted value of your human capital is quite high. If you die (or become permanently disabled, unable to work, and so on) during your thirties, forties, or fifties, your family and dependents lose many years of your human capital. Although the probability of this loss is generally small, the relative magnitude of this financial loss can be enormous and devastating. If these two elements are combined, the need for life insurance falls in the upper-left corner of Figure 2.2, and you should buy insurance to cover this risk.
Figure 2.2. Insurance theory—don’t waste your premiums.
This might seem like a very cold and detached way of looking at the value of a human life. After all, humans are worth far more than the value of our future wages and pensions. We would give many millions of dollars to bring our loved ones back, much more than what they could have earned or the value of their pensions. But my single most important comment about life insurance is that it is a risk management instrument meant to financially protect your loved ones upon your passing, not to compensate them for the psychological pain associated with your demise. No sum of money can do that.
So returning to the 80-year-old female in Table 2.3, whereas her probability of loss (or death) is large, the financial value of her future income (also known as human capital) is greatly reduced. Therefore, the relative magnitude of loss is much lower as well, and her need for insurance lies in the lower-right corner of Figure 2.2. In sum, you have to balance these two dimensions and think of them as the critical ingredients of prudent risk management for You, Inc.
How Much Does Life Insurance Cost?
Say that you have assessed your position on Figure 2.2 and have determined that the financial well-being of your family members needs to be protected. How much life insurance do you actually need and what price should you be prepared to pay?
In theory, the insurance premium should reflect the present value of the insurance benefit, adjusted for the probability that the insurance “event” might occur. This is called pricing via the expected present value. In reality, however, price is not so neatly related to the value of insurance benefits for several reasons. First, remember that no product is sold at cost, for zero profit. Your premiums can be, in fact, much higher than what the company expects to pay out, because it is in the business of generating returns for its shareholders. The second reason for the discrepancy is asymmetric information problems between policyholders and insurance providers. This stems from the exact same issue that I mentioned earlier—true mortality rates for two specific individuals are not knowable and the insurance company might be unable to distinguish clearly between high-risk and low-risk policyholders. I might think that a young male driver is likely to take more risks than a 50-year-old woman, but that’s a generalization.
Because of this information gap, the insurance company charges a single premium to all policyholders in a certain class; for example, those in a specific age, gender, or geographical group. Typically, the premium charged will be somewhere in the middle of the company’s risk assessment analysis. Effectively, low-risk individuals will be over-charged when they purchase insurance, whereas high-risk individuals will be undercharged. As a result, if buying coverage is optional, then more high-risk consumers will purchase insurance than low-risk consumers. After all, they’re getting a bargain. This effect is known as adverse selection in the language of insurance economists. The insurance company might be taking on more risk than initial estimates of the population would suggest, because it will have a disproportionate number of high-risk clients. This could place the company in a potentially ruinous situation, because it will have to pay out more claims than it expects. Hence, the resulting price-it-in-the-middle approach diverges from the “fair” price of the insurance—the present value of expected future benefit payouts.
The bottom line from all this “insurance theory” is that buying any type of insurance, and life insurance in particular, is more than just a matter of probabilities. There is a real “game” that goes on between the buyer and the seller, which impacts the pricing as well. I come back to this topic later in the book when I discuss the many ways of insuring your investments and your retirement income.
How Much Life Insurance Do I Need?
Although the pricing of insurance is a rather scientific discipline, determining the amount of insurance coverage that you require is not as rigorous. Many people mistakenly believe that you can never have too much insurance. Many in the industry who sell insurance for a living might want you to believe that as well. I disagree. I think that there is an upper bound (called the income approach) and a lower bound (called the expense approach), and anything in between is fair game (see Figure 2.3). By upper bound, I mean the most amount of life insurance that you can possibly justify buying without effectively over-insuring yourself. By lower bound, I mean the least amount of insurance you can possibly justify without under-insuring: also known as placing your family and loved ones at risk.
Figure 2.3. It’s not a science, but stay in the ballpark.
The income approach attempts to estimate how much money you can expect to earn over the course of your working years and beyond, which is the value of your human capital. Some practitioners have refined the income approach by subtracting from the previously mentioned number a fixed amount to take account of income taxes (because the death benefit is not taxable) and also subtract the expenses you would have incurred had you been alive—this gives you the amount of insurance you require. Here is a simple example.
Assume that you have estimated the value of your take-home pay over the course of your career, discounted to your current age of 30, and it equals $1,000,000. This is the value of your human capital. A simple application of the previously mentioned income approach would dictate that you purchase $1,000,000 of term life insurance, assuming you have dependents, of course. A more refined approach would be to realize that this $1,000,000 would be received by the family tax-free, and that the family would not incur as many expenses if you are no longer alive (as morbid as this sounds), so you might decide to reduce the $1,000,000 by 20% or so. This is obviously ad hoc and not very scientific, but the point is that the income approach provides an upper bound.
The second approach, which usually results in a low amount of insurance, is the expense approach. This method does not focus on the value of human capital per se, but instead focuses on the expenses your family will incur over the course of their lives. You then buy life insurance to cover those expenses rather than to replace your income. As you can imagine, a wide variation exists between the amounts of insurance you think you need if you use the (family) expense method as opposed to the income approach. And the wealthier you are and the larger your income, the larger this gap will be.
Here is an example of how the expense approach might work. If you earn $100,000 per year, and you expect this number to remain fairly constant in real terms (after inflation) for the rest of your life, the income approach might lead to about $1,000,000 in life insurance coverage, which arguably could be the present (discounted) value of your wages and salary. The expense approach might compute the costs of living expenses for your family, such as feeding and putting your kids through school, which might only be $500,000. Thus, any number between $500,000 and $1,000,000 would be acceptable as a death benefit on a life insurance policy. Either way, before you get life insurance, sit down with your family members, and possibly an insurance professional, and do an income and expense analysis. The process will be quite revealing.
Can We Put a Value on What a Life Is Worth?
After the tragic events of 9/11, a program created by Congress and headed by retired Judge Kenneth Feinberg was assigned the extremely difficult and unprecedented task of allocating a compensation fund to the families of more than 5,500 dead and injured victims in the terrorist attacks. Although it was a challenge to select the appropriate process, ultimately, a human capital–like measure was used to allocate the funds, in which it was the victim’s expected income that had a critical role in determining the award by the program. The average award that was paid for each income level category is listed in Table 2.4. Again, no award, of course, would have been sufficient compensation for the resulting loss and grief. However, this process attempted to arrive at a fund allocation that would be linked to economic loss.
Table 2.4. 9/11 Compensation Fund: Award for Deceased Victims by Income Level
Source: K. Feinberg, June 2005, What Is Life Worth?: The Unprecedented Effort to Compensate the Victims of 9/11.
As you can see, although estimating the economic value of a human life is quite difficult, in some cases it must be done. Notice from the table how victims whose salary and wages were higher tended to receive greater compensation compared to those with a lower income. Although some might not consider this to be fair—and strong arguments can be made both in favor and against this policy—the bottom line is the strong link between the value of human capital and one’s wages and salary.
Types of Life Insurance Policies
Finally, when thinking about insuring your human capital, you must decide between two basic categories of life insurance, which go under the odd names of temporary and permanent. The two are quite different approaches to insuring yourself, and understanding the difference in the context of your financial risk management process is important. From a practical point of view, I think having a combination of both types of insurance and varying this mix over the course of your life is important.
Temporary life insurance, which also goes under the name of term life, is a no-frills way of insuring yourself for a specific period of time—for example, one, five, or ten years. Your monthly premiums are guaranteed for the term of the insurance, and at the end of the term, the insurance coverage ends. There are no refunds, cash-backs, or cash-values in your policy. It’s like car insurance, home insurance, or an extended warranty one day after the coverage expires. You have nothing. Within the context of life insurance, if you survive to the end of the coverage period, the policy is worthless. Of course, if you die during the coverage period, your beneficiaries will receive the face value (also known as the death benefit) of the policy. When the term of the insurance is over, you might want to get another insurance policy—after you evaluate your needs—for another term, and so the process continues.
Temporary coverage, as its name suggests, is great for temporary needs. For example, if you have just purchased a house and financed it with a large mortgage, you might want some temporary insurance to cover the liability in case something unfortunate happens to you over the life of the mortgage. Temporary insurance makes sense for young couples who have growing children, or if the family would face a serious financial crisis if something were to happen to the primary breadwinner. Remember, the value of your human capital is considerable earlier in your life, and you want to protect it. I envision the young couple having a substantial amount of term life insurance while the children are young, perhaps eight to ten times their annual salaries, as per the two approaches I previously described, the income approach or the expense approach. But regardless of whether you take the income or the expense approach shown in Figure 2.3, your insurance needs will change over time. As you move along the time-line in Figure 2.1, the value of your human capital declines. Likewise, family expenses will decline as children grow up and leave the nest. Of course, there are exceptions to these rules, such as more responsibilities, new dependents, and perhaps even a large jump in the value of your human capital. However, as you age and renew your term insurance, the premiums will increase. Why? Well, the probability of dying increases, so the insurance company must charge more to cover this risk. In most cases, there is no justification for buying more and more life insurance as you age.
When discussing replacement of human capital, I am not only referring to “official” or explicit income. Stay-at-home parents, homemakers, and caregivers provide valuable services to the family—services that are costly to replace.
In sum, the important characteristic of a term policy is its temporary nature, as well as the fact that it has no savings component. This might seem an odd comment at first, because insurance should have nothing to do with savings. But you will see that permanent life insurance does have a savings component.
What is permanent coverage? This type of coverage sometimes goes under the industry name of whole life, universal life, or level life insurance. There are various types of permanent coverage, but the main idea is that your monthly or quarterly insurance premiums remain the same and also contain a savings component. So if you pay $100 per month, perhaps $60 goes toward the insurance premiums, while the remaining $40 goes to a side savings fund. Practically speaking, your policy contains more than just insurance coverage—it also includes investment value.
Why the savings? With term insurance, your premiums increase each year because the probability of dying increases as you age. In fact, when you are in your seventies and eighties, not only are the premiums prohibitively expensive, but you might not be able to purchase coverage at any price. Level, or permanent, insurance is a system whereby you overpay in the early years to subsidize the later years. Level insurance premiums are higher than term premiums for the first part of your life, while term premiums exceed level premiums later on. This is where the savings come in. Because you are overpaying in the early years, the excess over the pure premiums is being invested in a side fund. In some cases, you can actually control where those excess premiums are invested. As you age, some of the savings will be depleted to make up for the fact that your annual level premiums are lower than what they should be. With these so-called universal policies, you can withdraw, or cash in, the excess savings at any time, so you have access to an emergency fund in times of need.
To summarize the risk management process that you should be taking throughout your life cycle, I offer the following slightly more sophisticated way to think about life insurance and risk management, as shown in Figure 2.4. When you are young, the risk that you and your family face is that your mortality or hazard rate will “spike up” and your family will lose its source of human capital. This is why you purchase a financial security that is “long” mortality when you are young. By the word long I mean that if the mortality rate spikes, the insurance company pays the death benefit to your family. When you are (very) young and have (numerous) dependents, you probably want to have millions of dollars worth of a position that is long mortality, because you want to hedge millions of dollars worth of human capital that potentially could be lost if the family loses its breadwinner. Then, as you age, you reduce the magnitude and size of the long position because (hopefully) your financial responsibilities and commitments start to decline when (hopefully) the kids move out of the house and your family has enough financial capital to protect themselves against the risk of your death and disability. In fact, when you are close to retirement, you might not need a long position in mortality at all, because the family might not have any financial exposure to the demise of your human capital. At that point they should only have the emotional loss.
Figure 2.4. Day-trading shares of your mortality.
But then, after you are well into retirement, your risk might shift in the other direction. This risk is that your mortality rate spikes down! You now have converted most of your human capital into financial capital, and in all likelihood you have lost your ability to generate any more financial capital. What you do have is a finite nest egg that must last for the rest of your life. The risk you face is that you live much longer than you expected and your nest egg can support. Also, you face the risk—yes, this is a risk—that one of the major pharmaceutical firms develops a drug that extends your life, which again reduces your mortality rate. All of this means you should be “short” and not “long” mortality as you age, and the best way to do this is with longevity insurance and annuities.
I discuss this topic further and in greater detail in Chapter 8, “Spending Your Retirement in a Risky World,” and Chapter 9, “Annuities Are Personal Pensions,” but for now it’s important to remember and understand life insurance’s role as part of a life cycle financial plan. As you progress through this cycle, your need for insurance must change and adapt. Remember the rate of return on basic life insurance is negative. It is a lousy investment in the traditional sense of generating positive investment returns. However, your human capital is a very valuable asset that should be protected. Although the returns from your insurance policy might be negative, the returns from your human capital are certainly positive. This negative correlation translates to insurance being a great risk management or hedging instrument. In the language of what is often called modern portfolio theory, the correlation between the returns on life insurance and the returns on human capital are quite negative. This is good news for reducing overall portfolio risk, as I will elaborate on in later chapters.
Summary
• The purpose of basic life insurance is to hedge your human capital when you are young and have financial dependents that rely on you for income and support. It is primarily a risk management instrument.
• Basic life insurance isn’t meant as an investment. Oddly enough, the best outcome is that you waste all the life insurance premiums and you earn a –100% rate of return.
• In the language of capital market investing, when you are young, you should be “long” mortality risk. If mortality spikes, your dependents get a financial payoff. But, as we shall see later in the book, after you are older, you should go “short” and hedge the risk of a long life. That can be achieved with a pension annuity.
• Later on in life, you reduce the need for life insurance to hedge human capital and mortality risk. You might want to maintain some level of life insurance for estate planning purposes, but that is driven primarily by tax considerations. As you age, the risk management focus should shift to the risk of outliving your wealth.
Endnotes
Some of the material in this chapter is based on the joint research work I did with Aron Gottesman, referenced under Milevsky and Gottesman (2004). The concept of human capital applied to life insurance was first pioneered by Professor Solomon Huebner at the Wharton School of Business, almost 80 years ago. See Chapter 6 of the book by Milevsky (2012) called The 7 Most Important Equations for Your Retirement for more information about S.S. Huebner and his work. He called it human life value. For extensive details on the various insurance policies available in the U.S. market, see the book by Baldwin (1994), which provides an in-depth description of their relative merits and benefits. Ostaszewski (2003) delves further into the idea of life insurance as a hedge against a catastrophic loss of human capital. Finally, the CFA Institute monograph by Ibbotson, Milevsky, Chen, and Zhu (2007) provides many more case studies and numerical examples, albeit on a more technical level, in which the optimal amount of life insurance is derived and calibrated for given individuals, their risk tolerance, and career characteristics. Much of the work in this chapter is inspired by these references, and I encourage the interested reader to follow up on these sources for more information.