Before engaging in virtually any behavior, we tend to quantify the risk to see if it’s worth it. Whether it’s crossing a busy street, making an investment, asking someone out on a date, or considering the latest diet fad, we are always trying to discern the risk/reward of the particular behavior.
The first step in quantifying risk is establishing probabilities. The investment arena has numerous tools that are designed to help quantify the risk of a particular stock or bond, each with varying degrees of accuracy.
Risk in buying life insurance doesn’t work quite the same way. That’s not to say we don’t try to quantify the risk before we buy, we just measure it differently. We can consult a life expectancy table, but that really doesn’t do much to quantify the risk for us individually. It just shows the risk as a group.
Does knowing the number of deaths of a person our age in any given year really help us in deciding whether or not we need life insurance? Most people will not choose to go uninsured just because the probability of dying in the coming year is low. Why? Because that is exactly the type of risk that should be insured, one that has a low probability of occurring but catastrophic consequences should it occur.
I hope I explained that clearly. That is, you need life insurance when someone is dependent on your income. The fact that there is a low probability of you dying in the early years of the policy shouldn’t be a reason not to buy. In fact, if there was a high probability of you dying in the early years of the policy, the insurance company wouldn’t offer you the coverage.
Okay, so we shouldn’t use risk quantifying techniques to decide if we need insurance, but can we use them to help determine the type of life insurance we should buy? I believe it is permissible in that case.
In the vast majority of cases, I find that the individual’s personal risk tolerance is the primary factor in deciding which type of policy to buy. That is, individuals with a high risk tolerance tend to buy term while those with a low risk threshold lean toward whole life.
Although I find that risk tolerance is usually the primary factor, I see nothing wrong with using math and probability to help with the decision process. As long as an appropriate amount is procured, whether it is term or whole life is of secondary concern.
So in conclusion, probability and risk quantifying techniques can be used to help determine the type of policy to buy, but they can’t be used to determine if you should buy.