Chapter 23 – Life Insurance

Life insurance is unique among insurance products and is an important part of any financial plan.

Purpose of life insurance

Life insurance it doesn’t actually benefit the person insured. It is the only insurance that does this. The reason is simple: in order for the insurance to pay out, the person must die! Therefore any benefit paid must go to the people you leave behind.

This is a simple point, but one that is often overlooked. Life insurance isn’t for you! It’s for the people who depend on you financially. If you have a job, you likely depend on your own paycheck. However, in most cases there are other people depend on it too. These people are called your dependents. Life insurance provides protection for your dependents in case you die too soon. When a financial planner says “die too soon”, they mean dying before you have earned all the money you expected to earn over your life.

Do you need life insurance? To answer this question, it’s often easier to start with a simpler question: If you died tomorrow, would anyone suffer a financial or an economic loss? If you answer ‘yes’, then you probably need life insurance. If the answer is ‘no’, then you probably do not need life insurance. For example, parents of young children definitely need life insurance unless they are independently wealthy. Married individuals who share their finances also need life insurance to protect their spouse.

What needs might your family face after your death? First off, there will be funeral and burial costs. These costs range a lot, but they can be greater than $10,000. Your family may also need to replace your income and may need a little boost of money to give them a chance to take a break from work while they cope with the physical and emotional burdens of your death. Many people also want to repay their debts, leave money for your kids to go to college, or prepare for any other unique needs their family might have.

The purpose of life insurance is to fill the gap between the assets you already have and the financial needs your family will face.

Potential financial needs after you die:

• Funeral/burial & associated costs

• Income replacement for dependents

• Readjustment-period for dependents

• Debt-repayment?

• College expenses for children?

• Other special needs?

Sources of Family Funding

There are several sources of money that your family can use to meet these needs.

1. The government provides social security survivors' benefits. The payouts are typically too small to fully cover all of your family's needs, but they can help considerably. The amount of benefit paid depends on how much money you earned and how large of a family you supported.

2. Your family can live off your existing assets. A person is said to be self-insured if they have enough money saved up to cover their family's needs. These people have no need for life insurance at all. Elon Musk, for example, does not need life insurance because he has plenty of money for his family to use if he died. He is self-insured.

3. Life insurance is the third and final source of income for your family after your death. It should be used when social security benefits and your existing assets are insufficient to meet your family's financial needs.

How much insurance do I need?

Once you decide whether or not you need life insurance, you then need to decide how much insurance you need and what type of insurance you will buy. To estimate your need, you can use one of two approaches.

The first is the multiple of earnings approach. Simply take your current income and multiply it by a number between ten and fifteen. Which number you use depends on your circumstances. Those who use this approach generally don’t have a clear recommendation for what this number should be. This approach is super easy but not particularly accurate. It is appropriate to use if you just want a very rough estimate but it is generally not considered a good way to calculate your needs.

The second approach is called a needs-based approach. Under this approach, you need to analyze all the needs your family will have. What’s your mortgage balance, how much will college cost when each child reaches the appropriate age, how much income will your family need and for how long, what will inflation be? These are just a few of the questions you must answer and analyze in order to perform a need-based analysis.

This level of analysis is obviously a lot of work and requires extensive skill in financial analysis. Only true financial professionals have the necessary skill to perform such an analysis. If you are using an insurance agent or financial planner, make sure they perform a needs-based approach. That is, after all, a major part of the job you hired them to perform.

The more dependents you have, the more life insurance you need. The more assets you have, the less life insurance you need.

Types of Life Insurance

Once you know how much life insurance you need, you then need to decide what type of life insurance policy is best for you. While there are many different variations of life insurance policies, they all fall into one of two types.

Term insurance

Term insurance gets its name from its key characteristic: it gives protection over a fixed period of time (called the “term”). The contract terms are generally written for 1, 5, 10, or 20 years, but they can be longer. If you die during the term of the policy then the policy will pay the face amount to your beneficiaries. The primary advantage of term insurance is that the premiums are much much cheaper than those associated with cash value life insurance. They also are simple to understand and use and have almost no fees. The biggest disadvantage of term insurance is that it expires. If you don’t die during the term, then your beneficiaries get nothing.

Term life insurance comes in several varieties.

1. Guaranteed renewable policies can be renewed when they expire, no matter your age or health. Many people prefer guaranteed renewable policies because they don’t like that term insurance expires. A guaranteed renewable term policy makes it so that you can continue to extent the policy for as long as you like.

2. An ordinary term insurance policy has premiums that increase each year as your likelihood of dying during any given year increases. Level premium policies have a fixed monthly premium for the entire term of the policy. This is convenient because it makes your budget very easy to predict, and you don’t have to worry about increasing premiums.

3. Decreasing term insurance causes your level of insurance to decline over time. Remember that your existing assets can be used to meet your dependents’ needs. This means that the more assets you have, the less life insurance you need. Since you should be accumulating assets and losing dependents as you age, your life insurance needs should also decline with time. This makes decreasing term insurance an ideal way to cover your family's needs without overpaying.

4. Group term insurance is offered to groups, such as groups of employees, and can usually be converted to an individual policy.

Cash value life insurance

Cash value life insurance policies combine the protection of term insurance with an investment account. The balance of the investment account and the value of the insurance will always add up to the face amount of the policy. The cash value investment account always belongs to the policy owner, not the beneficiary. This account grows over time just like any other investment. When you die, your beneficiary gets the face amount, some of which is your accumulated savings and some of which is insurance benefits.

Many people prefer cash value life insurance policies because they do not need to be renewed like term insurance. These policies are sometimes also called permanent insurance because they never expire! This is nice because, as long as you make your monthly payments, the policy can never expire.

The problem with this is that since the policy never expires, neither do the premiums. Life insurance is almost never needed in old age because the elderly rarely work. No one depends on their paycheck because they don't have paychecks! They live on existing assets and their children are all grown up. Cash value policies cause the insured person to pay very expensive premiums for a policy they no longer need.

Some policies offer a fixed return on investments (like whole life), and some polices have variable returns (like variable life), and some even offer variable premiums (like universal life). Research has shown that most people are better off not investing money in cash-value insurance policies. This is because they can get the same or higher returns in a retirement account for substantially lower fees.

Term insurance policies are the most economical way for young families to purchase large amounts of coverage and provides for needs that will lessen or disappear over time.

Cash value insurance is good because it can provide you a way to shelter assets over and above those in your retirement accounts from creditors even before you die. They also provide tax savings on the money invested inside of them. This makes them ideal for high income households who benefit greatly from the tax savings and are likely to have exceeded the annual contribution limits imposed on traditional retirement plans.

Households that earn less than $250,000 per year generally have no need whatsoever for cash value life insurance policies. Once you are rich enough to need some extra tax benefits, then it becomes appropriate to consider cash value life insurance policies. At that point, it is generally recommended that you hire a financial planner to help you navigate the complexities of cash value life insurance policies.

Buy term insurance until you earn a very high income!

Where can you buy life insurance? You might get some for free at work as an employee benefit. If you need more, don’t automatically buy the policy offered by your employer. Shop around and find the insurance company that offers the best coverage for the lowest price. Since term policies are all nearly identical it’s easy to comparison shop.

Lecture:

This is an excellent time to watch Lecture 15 from the course pack.

Definitions:

Dependents: People who depend on your income to maintain their lifestyle.

Self-insured: People who have enough accumulated assets that their family would be financially unaffected by their death

Multiple of earnings approach: A simple approach for calculating life insurance needs.

Needs-based approach: A mathematically complex but accurate approach for calculating life insurance needs.

Term insurance: A simple life insurance policy that expires at the end of the specified term.

Guaranteed renewable term: Term insurance that is guaranteed to be renewed upon expiration.

Level premium term: A term insurance policy with policies that remain fixed for the entire duration of the term.

Decreasing term: A term insurance policy that provides a benefit that decreases gradually over time.

Cash value life insurance: A life insurance policy that never expires and provides a tax-free investment in addition to insurance benefits.