Financial Planning for Businesses

Whole Life Insurance & The Theory Of Decreasing Responsibility

The theory of decreasing responsibility is a theory in financial planning which basically says that you should purchase enough life insurance to meet your financial responsibilities and no more and that those financial responsibilities will decrease as you become older. Therefore, your need for life insurance is temporary.

Would you agree with that statement, in general? I would. I would say that your financial liabilities generally decrease over time when you stop making financial obligations to other people and to yourself.

For example, you buy a home. You take out a mortgage. That mortgage is scheduled to be paid off within 30 years. Over time, your financial responsibility to the bank is decreasing. When your loan is paid off, your responsibility ends. The same holds true with financial obligations to your family. Your young children depend on you and your spouse may even depend on you financially for support. But, eventually, this dependency ends (perhaps there is an exception in certain instances).

The entire idea behind the theory of decreasing responsibility is that you will build up a savings over time, outside of your insurance policy, to offset those responsibilities you have incurred. This savings eventually eliminates your need for life insurance.

This is why advocates of the theory of decreasing responsibility advocate buying insurance on a temporary basis. In other words, they advocate the purchase of term life insurance and only term life insurance. In fact, they despise whole life insurance and any other kind of permanent life insurance along with the advisers and agents selling these policies. After all, why buy whole life insurance when you won’t need it in your old age?

But wait…

What the antagonists do not realize is that permanent life insurance is completely compatible with the theory of decreasing responsibility. How? Simple. Whole life insurance is a unique form of savings. Some people call it a death benefit with a savings component.

The savings is actually a cash reserve. As the cash reserve builds up against the death benefit, it replaces it. This is known in advance and, in fact, the actuaries designing these policies fully understand the implications of such a design. As the savings builds up, the amount of insurance being purchased decreases.

The “gap” or “corridor” between the cash value savings and the death benefit of the policy represents the “net amount at risk” to the insurer. This is the actual amount of insurance you are purchasing. This is also the risk that the insurance company takes on for insuring your life. The net amount at risk is the amount of money the insurer stands to lose if you die before the insurance company is able to successfully invest your premiums to pay for the death benefit claim in full.

Your financial responsibilities will (in all likelihood) decrease over time. I do not think they will completely disappear (i.e. you will have a funeral bill that needs to be paid which will be paid out of your personal savings or a life insurance death benefit after you’re gone). But, to the extent that your responsibilities do decrease, whole life insurance (and other forms of permanent insurance) account for this. In other words, if you have a death benefit of $100,000, and $75,000 of that is cash value, then you only have $25,000 of actual insurance. The rest is a cash reserve that is fully earned.

Perhaps the advocates of term insurance mean to say that it’s not as effective or efficient to purchase whole life insurance as it is to buy term and invest the difference you save outside of the insurance policy. Honestly, that is an entirely different argument.

March 12th, 2011 | by David | No Comments

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