How Pareto's Law Applies to Insurance Planning

Tuesday, 10 March 2009

You are probably familiar with Pareto’s Law.  It says, in effect, that almost everything in life somehow breaks down to an 80/20 ratio.  For example, 20% of the people accomplish 80% of the work, or that 20% of the people earn 80% of the money, and that losers outnumber winners by 4 to 1.

Vilfredo Pareto was an Italian economist who died in 1923.  More than sixty years later, we are finding ever-new applications of his “law” in modern economic circumstances.

No one really knows how Pareto’s Law holds up under scientific scrutiny.  However, we do know one place where it seemingly does have validity and that is in a mortality table.  We know, for example, that about 20% of males who reach adulthood will die before age 65 and the remaining 80%, of course, will die thereafter.

The only thing we do not know is which people are going to end up in that 20% category.  Not knowing into which group a person is destined to fall, makes it necessary to prepare for both the short term and long term problems.

Those who fall in the 80% category - who are going to make it to retirement age - have a more complex, but no less acute problem.

This larger group needs money for two reasons:

• To provide income during retirement years
• To provide for the inevitable event, death after age 65

They need to create an estate, conserve an estate or provide income to a surviving spouse.  In planning one’s estate, there are two kinds of death to contend with:

• Premature death (the 20% problem)
• Death somewhere around life expectancy (the 80% problem)

Term insurance can be a most effective way of solving the 20% problem.  Unfortunately, it is completely ineffectual in solving the death-at-life-expectancy problem.  Not only does the cost of term insurance become prohibitive over the years, worse yet, the coverage runs out.

Term insurance is actuarially calculated to expire about five years before the holder.  In New York, for example, term insurance is available only to age 70.  Just when the insured is getting ready to expire, the insurance company by law must take the coverage away.  To guarantee that term life insurance will be in force at death, no matter when it may occur, one had better make it a point to die before age 70!

Contrary to a popular misconception, life insurance companies make a lot of money on term insurance, because rarely are they at risk when the time for the pay-off of a death claim arrives.

In some states, a product called “Term to Age 100” is available.  Not only is this a most expensive form of term insurance, it is essentially a graded premium Whole Life contract without any of the inherent advantages of Whole Life, such as guaranteed cash values.

Application of Pareto's Law

How can one, with any degree of certainty, protect against both the 20% problem and the 80% problem and gain some important tax advantages along the way?  Well, that is precisely what permanent insurance is all about.

Financial advisors can now fashion life insurance policies that use both term (for high initial death benefit) and permanent (for cash accumulation and long term cost) elements at the same time.  The underlying investments (cash values) can be based on either an equity (variable) or fixed investment account.

The newest policies are children of the computer age.  Before cheap calculation was available, it was impractical to custom design a policy with precisely the death benefit, outlay and cash accumulation desired for each customer.  Now the consumer no longer must settle for a standard package, but may have a policy crafted for specific, personal needs.

In response to Pareto’s Law, it is now very easy to allocate 80% of the premium for the cash accumulation portion of an insurance policy, yet allow the 20% to pay for a full 80% of the death benefit!

Brock and Associates, LLC is a St. George, Utah based financial planning firm specializing in asset protection and generational wealth preservation.

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