Along with estate planning, insurance planning can be a difficult wealth planning topic that most people would rather not talk about. There are legitimate reasons for this;
- People do not like to talk about dying,
- Insurance salespeople have been known to put their interests above yours,
- There are so many types of insurance that people do not understand what they mean or what they should be used for.
If you can find an advisor to work with that you trust and who places your interest before theirs, I think most people can get past the first two points. I want to provide you with the knowledge to understand the who, what, when, where, and how of life insurance products.
Having a basic understanding of the different types of insurance should allow you to make the best decision for you and your family when integrating insurance planning into your wealth management plan.
There are six main reasons for having Life Insurance:
- It provides cash that replaces your current income for living expenses to support your dependents instead of your family having to sell the family home, the business, or other property they might want to keep in the family.
- It protects against the loss of future income and savings that would have paid for future expenses such as college, weddings, etc.
- It pays off your debts (mortgages, credit cards, personal or business loans).
- Life insurance proceeds can help pay estate taxes, thus protecting your other assets.
- If your significant other is the stay-at-home child caretaker, and you are the sole income provider, getting life insurance on the caretaker could be wise. This allows you to continue to work, and their death benefit payout can pay for a nanny or other childcare, so you can keep working without undue hardship on your family.
- The death benefit can provide a lump sum, a tax-free donation to one or more designated charities that depend on your ongoing contributions.
How Much Life Insurance is Enough?
There are two primary approaches to determining how much life insurance an individual or a family might need.
- Human Life Value
- Determines the present value of a life which involves projecting an individual’s income through their remaining work-life expectancy, including raises and using a discount rate such as the risk-free rate or the expected investment return rate.
- Needs Approach
- Examines all the needs, both recurring and nonrecurring, of dependent survivors, including but not limited to the following; loans, debts, and mortgages, income to the survivors, final expenses such as medical and funeral expenses, emergency fund, education needs, and any other special needs
I use and prefer the needs approach. I have found that trying to value a human life is somewhat tricky and not as straightforward as it may seem. Also, this method usually requires more life insurance, which is costlier than you may need.
Building a base case from what you may need helps open up what goals should be planned for, which previously may not have been considered or discussed.
Types of Life Insurance
At its root level, there are only two types of insurance, temporary and permanent. As you will see, term insurance has immense flexibility with the length of a policy or need, while there are various forms of permanent policies as well.
Term life insurance provides death benefit coverage over a fixed term, such as 10, 20, 30 years, or any year in between. It would help to consider term insurance similar to your homeowners or renter’s insurance. It is there when you need it, but you still pay for it even when you do not. It has no cash value except at death. If you die after the term expires, your beneficiaries get no payout.
Term premiums are much less than permanent life insurance because you only seek coverage for a specific time vs. your entire life. However, most term policies can be converted to a permanent policy later. The owner of the policy can cancel the policy at any time, but your policy cannot be canceled due to poor health.
Most term policies are fixed policies, in which case the annual cost of your policy is the same each year over the life of your policy. Your premiums will never go up, which is another reason to lock in your insurance policy when you are young. Additionally, your policy automatically renews annually.
If your term life insurance is purchased through an employer, your insurance coverage will most likely end when your employment ends. This is one reason why I encourage you to consider owning your own term policy.
Like any life insurance policy, term insurance gets more expensive as you age. For example, if you have insurance through your employer and you change companies ten years later and need insurance, that insurance just got a lot more expensive. Also, most employee insurance plans can cap the dollar amount of coverage, which may be less than you need.
Overall, term insurance is best used when you have a known specified length of time and a significant amount of insurance needs. For example, a young family with multiple financial priorities would struggle to get adequate coverage for their needs, including income replacement, paying off debts/mortgages, and funding future college education expenses. Term insurance would allow them an affordable option when their children are growing up.
Permanent life Insurance provides continuing coverage for the insured’s entire lifetime (if the premiums are paid) rather than for a set number of years as with term insurance. The annual premiums stay fixed; at death, it pays out a lump sum death benefit.
Premiums on permanent policies are much higher than term because the policy is designed to last a lifetime and builds up cash value on a tax-deferred basis. If you cancel the contract, you will get paid your cash surrender value, but if you have any gains, they will be taxed as ordinary income.
As I mentioned previously, there are several variations on Permanent Life Insurance:
- Whole Life
- Whole life premiums remain fixed and are guaranteed. Part of the premium payments goes towards a cash value savings build-up, which grows tax-deferred.
- You can take out a loan against the cash value. If you die before you pay the loan back, the amount borrowed is deducted from the death benefit payout.
- Annual dividend payouts, if made by the company issuing your policy, may be sufficient to fund the annual premium payments over time.
- The insurance company bears the risk of maintaining the death benefit. Typically, your death benefit will grow over time in a traditional whole life policy.
- Universal Life (UL)
- UL offers flexible premiums, which can be adjusted up and down and are not guaranteed. The death benefit can also be adjusted annually over your lifetime.
- UL does not pay dividends.
- A percentage of the premium paid is applied to your policy’s cash value. Cash values are interest-sensitive, based on market interest rates and financial indices pegged by the insurer. They fluctuate accordingly.
- Some of the risks are shifted to the insured for maintaining the death benefit payout if the cash value or premium payments dip too low to cover the cost of the insurance. UL allows two death benefit options:
- Option A: the death benefit stays the same, and the cash value is part of the death benefit (the cost of insurance is less, so your cash value will be higher.)
- Option B: pays the death benefit stated in the contract, plus any cash values build-up (the cost of insurance is more, so your cash value will be lower).
- Variable Universal Life (VUL)
- VUL allows you to direct a part of your premium dollars to a separate account comprised of various equity, bond, and money market funds in the insurance company’s portfolio.
- The death benefit and the cash value will fluctuate based on the performance of the funds you have chosen. VUL does not pay dividends.
- Most VUL policies will guarantee that the death benefit will not fall below a certain point. However, a cash value minimum is rarely guaranteed. You can withdraw from the cash value during your lifetime via a loan.
- You bear the investment risk. If the funds perform poorly, less money is possibly available for premiums, cash value, and death benefit.
Overall, permanent insurance can be a useful planning tool for legacy and gifting planning in addition to the previous reasons we discussed as to why most people need life insurance. Given their current tax advantages, permanent insurance can also be utilized for tax and retirement planning purposes.
Why Term Insurance is Likely Your Best Option
A term life insurance policy is the better option for most people, especially the 45% who surrender whole life insurance policies. You’ll get more coverage at a cheaper rate than whole life insurance, making it more affordable for the decades you’ll be paying premiums.
The purpose of life insurance, from my viewpoint, is that it helps to cover a major need over a certain period. Therefore, term insurance becomes an ideal and affordable avenue for families who, if a parent passes away, has the financial resources to pay the mortgage, college tuition, and other life goals. Whole life is too expensive to cover this type of need.
It is a good idea to avoid combining insurance and investment or savings. Insurance is not an investment and shouldn’t be treated as an investment vehicle. Insurance should be a risk management tool within your wealth management plan.
Final Insurance Points
In summary, I would like to make a few final points when it comes to life insurance;
- The death benefits are income tax-free.
- The cost of life insurance is based on your age, your gender, and your health. The younger and healthier you are, the less expensive. All things equal, men generally have higher premiums than women because their life expectancy is shorter.
- Life insurance death benefits increase the size of your estate upon death by the death benefit amount.
- You should review your policies at least every five years to ensure they have not lapsed and all assumptions are still applicable.
- If your contingent beneficiary predeceases you and you have not removed them as beneficiary and named someone else, the death benefit could go unclaimed.
Consider this an introduction to the world of life insurance planning. Given the uniqueness of any particular wealth planning case, there could be various solutions utilizing the different life insurance forms covered. However, understanding the essential features of these potential tools can have a lasting impact on both your financial and lifestyle goals.
Working with a professional such as a Certified Financial Planner®, who puts your best interests first and not commissions, should be able to guide you to make the right decision for you and your family.
For questions about wealth planning, portfolio management, and tax planning topics, do not hesitate to contact me to find out what options may be best for your family.