Bowen Thigpen, CFP®, Wealth Advisor
“I hate insurance.”
“I don’t want to jinx myself.”
“Nothing is going to happen to me, so why would I ever buy it?”
“My wife is going to remarry someone, hopefully someone rich. She’ll be fine.”
Back in my insurance days, I heard countless variations of these remarks. Some were even more outlandish. But if we are being honest with ourselves, many of us have probably had similar thoughts. Life insurance is an area that seems very simple on the surface, but we often have conversations with clients and prospective clients that have more questions than answers regarding their insurance plan.
What is Life Insurance?
Life insurance covers a specific risk- mortality, or the risk of death. The primary objective of life insurance is to provide resources to cover the financial impact of death. Financial impacts can vary greatly from person to person. For some, life insurance is needed to cover the risk of a premature death, to provide for those who depend on their income or their value to the home. Others need life insurance for liquidity purposes, perhaps to pay estate taxes or final expense planning. Business owners often need life insurance to fund buy-sell agreements for succession planning purposes. There are many uses of life insurance, but at its core, life insurance is a leveraging tool. You pay relatively low premiums to the insurance company. If, or when, you pass away, the insurance company writes a check to your family that is often much greater than the premium dollars you have paid. Having the appropriate type of life insurance based on the specific need is, therefore, extremely important.
Term Life Insurance
There are 2 basic types of life insurance, with subsets beneath each. Term insurance is pure insurance. A premium is paid, and if death occurs while the policy is active, an income tax-free death benefit is paid to the beneficiaries of the policy. The main advantage of term insurance is that you can get much more death benefit coverage in relation to your premium dollars. The insurance company knows they are only covering a specific time period, or “term”. If you do not die during the term, the policy generally lapses, and the insurance company has not had to pay out any benefit to your loved ones. Many people might say that the insurance company wins, and the policyholder loses. I would argue it is in fact a win/win proposition. The insurance company gets the premium and doesn’t have to pay out a benefit, and you have covered the risk of financial catastrophe and have not left your family/business partner/estate in a financial bind.
Types of Term Insurance
Term insurance can be structured in a variety of ways. Level premium term (LPT) guarantees a fixed premium for the life of the term. The longer the term, the more expensive the premium, as the insurance company is exposed to more risk the longer the time period.
Annual renewable term (ART) premiums increase annually based on your age but typically have a guaranteed schedule of premiums over a period of years. This is helpful for those who are budget-conscious and need a cheaper premium initially.
Return of premium (ROP) term helps alleviate some concerns of the “use it or lose it” nature of term insurance. If you have not died within the term of the policy, all premiums have been paid, and no changes to the policy have been made, you can have your premium refunded to you. The downside is this type of coverage is much more expensive as compared to a standard LPT policy.
Term insurance is often an appropriate solution if the insurance need is not permanent or if there are budget constraints.
Permanent Life Insurance
Permanent insurance is more complex. For one, the policy is often meant to be permanent in nature. The use of these types of policies should primarily be because there is a permanent insurance need. Because of this, premiums are much higher as compared to term policies. From the insurance company’s perspective, it is a matter of “when”, not “if”, they will pay benefits. While term insurance premiums only cover costs of insurance and policy expenses, a portion of permanent insurance premiums cover costs of insurance and other fees, and the other portion is used to accumulate cash value. Cash value is an account within the policy that can grow over time. This cash value can be accessed during life by either cash surrenders or loans.
Types of Permanent Life Insurance
How cash value grows is dependent on the type of permanent insurance. With traditional whole life (WL) insurance, the cash value is “invested” in the insurance company’s general account. Therefore, there are guarantees associated with cash value growth and death benefits for WL policies. Additionally, if the insurance company is a mutual company, dividends can be paid which can also be used to increase cash value via paid up additions.
Secondly, universal life (UL) insurance is a type of permanent insurance in which the cash value portion is subject to a crediting interest rate. UL has a flexible premium structure, meaning there are not the same level of guarantees as compared to a traditional WL policy. Premiums are paid, costs of insurance and expenses are debited, and the remaining portion is added to cash value. If there is enough premium/cash value to cover cost of insurance and expenses, then the policy will remain in force. UL policies must be closely monitored to ensure current projections of premium payments and crediting rates of cash value are enough to maintain the policy as intended without risk of lapse.
Variable universal life (VUL) is like UL except for how interest is credited. With VUL policies, the policyowner can dictate how the cash value is allocated to investment subaccounts available from the insurance company. There is substantial risk with these plans, as there are no guarantees on cash value or death benefit.
Finally, indexed universal life (IUL) credits interest to cash value based on an underlying index, such as the S&P 500, of the policyowner’s choice. There are usually participation rates and cap rates that limit the upside potential of these policies. In exchange, there is also typically a floor of 0%, meaning the crediting rate will never be negative, regardless if the index had a negative return.
In addition to individual policies, permanent insurance policies can also be structured on a second-to-die structure, which will not pay a benefit until the second insured dies. These policies are often used for estate planning purposes or if one spouse has poorer health and would have a harder time obtaining coverage on their own. Permanent insurance policies can be very complex instruments, so one must be careful and ensure they understand the unique advantages and disadvantages of their specific policy.
How Much Do I Need?
Now that we have a baseline understanding of the types of life insurance, it is important to consider how to determine the appropriate amount of coverage. There are multiple approaches to help determine what your coverage amount should be.
The first is a simple multiple of income of approach. Assume you make $75K/year in income and determine you want to replace 10 years of income. You would need $750K of coverage under this method.
Secondly, there is a more precise approach known as the human life value method, in which you account for the income earning ability over your lifetime, including projected changes in income, and discount the amount into current dollars, factoring in inflation and growth rates.
Finally, and our typical recommended approach, would be a personalized needs approach. In this method, you determine the various needs you want covered and the life insurance need amount is backed into. A common starting point in helping determine those needs can be summarized through the acronym LIFE: Liabilities, Income Replacement, Final Expenses, and Education.
Monitoring Your Insurance Plan
As you enter different seasons of life, your needs very likely will evolve. It is, therefore, important to monitor your insurance planning at scheduled review meetings. A good way to think about monitoring your insurance plan- review your policies any time you have a life event (marriage, new house, new child, new job/promotion, empty nesting, retirement, elder planning, etc.). Perhaps you addressed life insurance when you first were married but have not reviewed policies since, and now you have moved, have children, and have changed jobs. More than likely, your insurance plan needs updating. An often-overlooked element of reviews is ensuring beneficiaries are reflective of your current wishes, including contingent beneficiaries.
To conclude, we thought it would be helpful to provide some real-life questions we get regarding life insurance. While you may not know the answers to these questions, considering if any applies to you is a good exercise. We can help determine what is appropriate for you based on your unique personal financial plan.
- When should I first explore purchasing life insurance?
- How does my coverage offered through my employer work? Will it come with me if I change jobs?
- What length of term insurance should I purchase?
- Should I bundle my life insurance with my homeowners and auto insurance?
- Does the insurance company that I purchase from matter?
- Is cash value a good investment?
- Should I self-insure or purchase insurance?
- I have poor health factors. Is life insurance a viable option?
- Should I convert my term policy to a permanent policy? How does that work?
- What are the tax consequences associated with life insurance?
- Do I need life insurance as I approach retirement? After I am retired?
The best time to consider your insurance planning is when you don’t need it. The worst time is when you must have it. As we addressed in the last blog, these conversations can often be uncomfortable, but the alternative could have even worse results. When is the last time you have reviewed your life insurance plan? Let’s find time to review so you and your loved ones can Live Your Life.
S&P 500 – A capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
This piece is not intended to provide specific legal, tax, or other professional advice. For a comprehensive review of your personal situation, always consult with a tax or legal advisor.