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Should I Buy Life Insurance?

Q. I own a small business with a partner. We’ve been thinking about taking out life insurance policies on each of us so that if one dies, the surviving partner will have the money to buy the business from the other’s estate. Does this make sense to you? A. Arrangements like the one you are describing can make a lot of sense. Let’s begin with a clear understanding of the deal. Premiums will be paid to the life insurance company and the life insurance company will pay money to your beneficiary upon your death (in this case, your business partner). With the money your partner receives, he/she will buy your interest in the company from your estate.

But let’s be clear, on average, your partner would have more money if, rather than buying life insurance on you, he/she had wisely invested the money that would have been spent on premiums. If this were not true, the insurance companies would be bankrupt and they most assuredly are not. Indeed, life insurance policies are very profitable for the insurance companies. Think about it. The insurance company takes the premiums and invests them. Assuming you live to your normal life expectancy, the insurance company will have X number of dollars at the time of your death. Had the premiums been invested, your partner would have the same X number of dollars upon your death (assuming your partner invested as well as the insurance company). If your partner invests the premiums, he/she gets all of the X dollars. However, the insurance company cannot pay your partner all of the X dollars. It first has to pay all of its operating expenses—the salaries of its executives, back office and administrative personnel; the rent on its big office buildings; the cost of its salesforce, etc. After that, the company has to make a profit for its shareholders. The company can only afford to pay your partner a number that is less than X—considerably less. For the company to remain solvent, the amount it pays your partner will be equal to X minus a pro rata share of the company’s costs and profit. Assuming you achieve your full life expectancy and your partner invests as well as the insurance company, your partner would have more money if the premiums were invested rather than turning them over to the insurance company. Therefore, on average, life insurance is a losing proposition—it has to be. Obviously, if you die sooner, the purchase of a life insurance policy is a better deal. Conversely, if you live longer, the purchase of life insurance is a worse deal. But on average, your partner will have more money upon your demise if he/she invested the premiums rather than giving them to the insurance company. On average, life insurance is a losing proposition. However, the reason for buying life insurance is to protect yourself and your partner in the event that one of you doesn’t live to your full life expectancy (i.e., one of you isn’t average). The life insurance policies you are proposing to buy may be a very good idea to protect you and your partner from this eventuality. There are other options you might consider. For example, each of you could agree to leave your share of the business to someone who would step in and fill your role in the company upon your demise. Alternatively, you and your partner could agree contractually that upon either of your deaths the surviving partner would purchase the interest of the deceased partner from his/her estate with a note. The terms of the note would allow the debt to be paid over a period of time. This would save the cost of the insurance (i.e., paying the life insurance company’s expenses and profit). However, it would also mean that the decedent’s estate would be paid over time rather than in a lump sum. If, upon the death of one of the partners, the other will purchase the decedents interest in the business from the estate, it is important to agree on how the purchase price will be set. This is true whether the purchase is to be made with a note or with the proceeds from a life insurance policy. The life insurance policies you are proposing may be a very good idea. On the other hand, they will be a losing proposition on average. Therefore, we suggest considering other options before purchasing the insurance. If none of these are viable, pursue the deal you described.

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