Let’s talk life insurance. Most of us need it, many of us hate it, and far too many of us pay way too much for far too little of it.
Many consumers rely on their financial advisor to help calculate insurance costs and come up with rules of thumb to balance annual income and estimated needed life insurance coverage to cover income replacement and other needs such as child care and funereal expenses. Many families buy term life insurance or even universal life, which they keep for a number of years, some for 20 years or longer, a period which can exceed the actual period of time needed for insurance. Figuring a reasonable amount of life insurance keyed to a breadwinner’s annual salary, and considering the cost of having to replace child care from stay at home parents can be a mysterious process, and consumers can be confused about the best way to go about buying life insurance. Personal finance can be complicated, and consumers are advised to consult life insurance calculators or even a competent financial planner to help assess their needs.
We’ll begin with the basic quantifiable thing we insure when we say we’re insuring our lives: our ability to produce income and bring it home to those who depend on us for it. This is called the economic value of a human life approach to life insurance needs analysis.
If you think of a person’s income as the cash flow it will produce over the expected working life – kind of like an investment that will render payments for some fixed period before being fully paid out – you have the notion. So, when we insure our life, we are really insuring that the money will keep coming in if we are not there to earn it.
From a financial standpoint, that’s what the insurance is for.
For many reasons – the commission motivation of some insurance agents sometimes not the least of them – the financial need is often clouded by other considerations, such as emotional distortions and the transmutation of insurance from insurance into some kind of tax-magic investment, which it really is not.
Most of us love our families and consider each other priceless. But money can’t replace those treasures. On the other hand, if income stops when a breadwinner dies, the results in compromised lifestyle, children’s education options, retirement trajectory for a surviving spouse, even ability to afford healthcare, can be tragic.
Insurance against this risk is what life insurance is best at, and must be purchased for.
But this means – and remember this forever – that you only need insurance for so long as you’re earning a living that other people would miss if it stopped. So, once we retire – assuming that we have enough to retire on, and that if we died enough pension or social security or whatever would remain for our spouse to live on – the need for life insurance goes away. In this situation, why pay for it? Better to use those dollars earmarked for life insurance premiums for other needs, such as investment accumulation, retirement income, college funding, or whatever.
Many rules of thumb suggest one needs life insurance equal to about ten times income. While this is useful, like most rules of thumb, it’s only a rough approximation.
The best way to figure how much insurance you need, we think, is to do a discounted cash flow analysis. In other words, figure out what the future cash flows from the breadwinner’s expected career would produce – likely growing over time, and then ceasing at retirement – and then figure out what lump sum, invested at a reasonable return, would be needed to replicate the cash flows. Of course, if there are two (or more) breadwinners, an analysis would be needed for each one.
More sophisticated scenario analyses take current assets and future needs, such as children’s education, debt repayment, and surviving spouses’ retirement and long-term care needs, into consideration.
While such an analysis may seem daunting, the financial math is really quite simple. Moreover, it is absolutely critical to determine what the need for insurance is.
You may click here to enter your basic information to obtain an estimate of your life insurance needs based on your personal economics. This service is complimentary. We do not sell insurance, and we will not share your information with those that do
For other types of insurance, such as homeowners or auto, the amount at risk seems fairly obvious, and the decision relatively easy. With life, the process is quite mystifying, and even life insurance agents may have trouble properly assessing it.
For instance, we often find retired folks who still pay on life policies long past the need for insurance – even if one of them dies, there are still plenty of assets and income for the survivor. I tell them this is like keeping the auto insurance long after they’ve sold the car!
Buying the wrong kind of insurance can leave consumers on very dangerous ground, who can often find themselves in the double jeopardy of overpaying for the wrong policy that can not only bleed resources from other goals like retirement, but actually at the same time leave them underinsured and relatively destitute if a breadwinner dies.
There are two basic types of life insurance:
- Term Life Insurance. Only stays in force for a specific term – like so many years until retirement – and is priced that way. The cheapest type, since you are statistically more likely to still be alive at the end of the term period. Usually the best buy for most of us. In other words, you are only insuring a portion of your life, and since the insurance stops before you are expected to die, the premiums are generally the cheapest compared to other forms of life. This is typically the best product to match insurance to the economic value of a human life model, and the best buy for most consumers.
- Cash Value Life Insurance combines a death benefit with a savings or “investment” component. These products are extremely complicated, confusing, and often the subject of abusive sales practices, since the commissions paid by the insurance companies to acquire this very profitable business are generally very high. There are many sub-types, but a cash value account is the defining characteristic.
- Whole life. Designed and priced to stay in force until age 100, and therefore much more expensive than term. Builds cash value – slowly – but the cash value is actually just a part of the ultimate death benefit. Usually a poor buy, unless you actually need to have insurance in force at advanced age, which is most unusual these days. Agents will often use estate tax liability to justify the purchase of Whole Life and other cash value forms, but in the early 21st Century the estate tax net worth bar is so high, and the planning techniques to avoid estate tax so effective, that this is often merely a cloak for a commission motive. A legitimate use of cash value life can be the so-called pension max technique, where a valuable pension was selected to maximize the payment for the pensioner’s life, but where payments cease at his (usually his) or her death. Still, more elegant and cost-effective coverage can usually be accomplished even for this need using laddered or decreasing term (since the value of the remaining pension payments decreases with the increasing age of the aging pensioner).
- Universal life. A derivative of whole life with flexible premiums, but fewer guarantees and more risk for the policy holder. These risks include low interest rates (such as obtained in the early 21st Century!) and increasing insurance or “mortality” costs. Guaranteed maximum insurance rates are often much higher than those illustrated (or actually charged), and guaranteed minimum interest rates are often very, very low, especially for newer policies. Riskier than Whole Life, but potentially cheaper. Otherwise, generally similar to whole life. Often pays very high commissions to the salesperson on much higher premiums than for term, which can be a big “recommendation” motivator.
- Variable vs. traditional whole and universal life: these phrases relate to what you can do with the cash value which ultimately becomes part of the death benefit. Variable lets you use mutual fund-type instruments. Traditional pays fixed interest. Costs are typically far, far higher (and harder to find) than in non-insurance alternative investments.
- Hybrid Long Term Care combines some (usually very, very limited) long term care or “living benefit” into life policies. In most cases this is a very poor substitute for “real” long term care (LTC) insurance, and, again, often pushed because commissions are high. Particularly vulnerable are consumers who want or need LTC but are unable to obtain it because of health issues. In these cases hybrid policies may seem appealing, but are often too good to be true. If you can’t qualify for real LTC, insurance companies probably won’t risk building a real benefit into a life policy, at least not at premium levels that confer any meaningful insurance.
Many people are sold inadequate amounts of whole and universal life because the commissions are high. Avoid this trap. Get cheap term, get enough death benefit to cover the need, and keep it only so long as you have an economic need.
Again, you may click here to enter your basic information to obtain an estimate of your life insurance needs based on your personal economics. This service is complimentary. We do not sell insurance, and we will not share your information with those that do.