Life Coverage Need
Some people equate life insurance with tragedy and death. In truth, life insurance is for the living. Without it, the sudden demise of a key breadwinner could leave a family stranded without the resources to maintain their lifestyle – or even retain their home.
Not so long ago, experts recommended that families carry a life insurance policy with a death benefit of between five and seven times their annual household income. Today, however, in light of rising house prices in many parts of the country and spiraling college costs, most advisors now recommend eight to 10 times income.
Unfortunately, most American families are underinsured. According to statistics from industry research and consulting firm LIMRA International, the average American household carries just $126,000 in life insurance – approximately $300,000 less than they actually need – and only 61% of adult Americans have life insurance protection, a decline from 70% in 1984. (1)
A Cornerstone of Sound Financial Planning
Financial experts generally consider life insurance to be a cornerstone of sound financial planning, for two key reasons. First, it can be a cost-effective way to provide for your loved ones after you are gone. And second, life insurance can be an important tool in the following ways:
- Income replacement — For most people, their most valuable economic asset is their ability to earn a living. If you have dependents, then you need to consider what would happen to them if they could no longer rely on your income. A life insurance policy can also help supplement retirement income, which can be especially useful if the benefits of your surviving spouse or domestic partner will be reduced after your death.
- Pay outstanding debts and long-term obligations – Without life insurance, your loved ones must shoulder burial costs, credit card debts, and medical expenses not covered by health insurance using out-of-pocket funds. The policy’s death benefit might also be used to pay off a mortgage, supplement retirement savings, or fund college tuition.
- Estate planning — The proceeds of a life insurance policy can be earmarked to pay estate taxes so that your heirs will not have to liquidate other assets to do so.
- Charitable contributions — If you have a favorite charity, you can designate some or all of the proceeds from your life insurance to go to this organization.
Determining How Much: A Four-Step Process
Determining how much life insurance coverage you need is a four-step process:
Step 1: Determine Your Family’s Short-Term Needs
Short-term needs are financial obligations and/or expenses arising within six months of death. Examples of short-term needs include expenses you pay now such as:
- Loan balances (automobile loans, etc)
- Outstanding credit balances (credit cards, revolving lines of credit, etc)
- Mortgages (first and second mortgage, home-equity loans, lines of credit)
Add to these current expenses any death-related expenses that must be paid in the short term:
- Funeral expenses
- Final medical costs
- Estate settlement costs and probate
- Estate taxes due
- Charitable requests you would like to make upon your death
If you don’t already have one, your survivors should be left with a liquid emergency fund sufficient to get them through any unexpected financial needs. Most advisors recommend between three and six months’ worth of living expenses.
Step 2: Determine Long-Term Needs
In addition to covering your survivors’ short term needs, some level of monthly income will be needed to maintain their current standard of living and meet financial goals such as saving for retirement and funding college for children.
The value of these future obligations is discounted back to present value amounts to provide a dollar amount that, if invested, could provide an adequate income stream to fund all of your long-term goals.
Step 3: Calculate Your Total Available Resources
By this point, you should have a good idea of your family’s total cash needs in the event of your untimely death. With any luck, you have already begun to set money aside to cover some of these costs. Other resources that may be available to your family include pensions, annuities, funds from retirement accounts, employer-provided life insurance, and Social Security.
The Social Security program offers benefits to survivors under age 17, and those whose spouses were receiving retirement income from Social Security can also count on survivorship benefits.
The total value of these future resources is discounted back to present value amounts. This gives us a single dollar amount that we can use to offset your total needs.
Step 4: Provide Funds To Cover A Shortfall
In most cases, comparing total needs to total resources will result in a shortfall. That’s where life insurance comes in. Without it, your survivors will be left with the choice of either finding or creating additional resources (such as having the surviving spouse return to work) or experience a decline in the quality of their lifestyle.
Life insurance is uniquely suited for covering such a shortfall. It is a means of sharing the financial risk of premature death with many, many others who have similar concerns.
You pay a relatively small premium to an insurance company in exchange for their promise to pay your beneficiaries a specified death benefit in the event of your death. You may find it ironic that a financial need arising from death can be alleviated by a financial resource that is created after death. That’s why life insurance, although something no one hopes to ever need, is indeed for the living. It’s also a vital issue we can help you investigate in greater detail to ensure your family’s financial future will be protected.
(1) “Life Insurance Awareness Month,” LIMRA International, August 2004
Term Life Insurance
Term life insurance is often referred to as “pure insurance” because its premise is very simple: You pay a premium to an insurance company in exchange for their promise to pay a death benefit to your survivors if you die while the contract is still in force.
Term life insurance provides protection for a specified period and is usually renewable at the end of each period at progressively higher premiums. As you get older, your risk of dying increases, so the cost of term insurance goes up. Term insurance carries no cash value element, making it less expensive than permanent alternatives.
Annual Renewable Term — Annually renewable term, or “ART” (sometimes called yearly renewable term, or “YRT”), is an example of a term insurance policy that has a constant face value and premiums that are adjusted upwards each year to reflect the increasing probability of your death in any given year.
Decreasing Term — Decreasing term insurance refers to a type of annual renewable term life insurance policy with a decreasing death benefit (face amount) and level premiums. Decreasing term is ideal for insuring a liability that is gradually being paid off, like a home mortgage.
Level Term — If you prefer, you may select a “level term” policy which guarantees that you will pay the same annual premium for a set number of years (usually 5, 10, 15, or 20) for the same amount of death benefit. The longer the guaranteed term, the greater the initial premium, but the longer the premium stays fixed. In most cases, if you know you will need your term insurance for an extended period of time, a level term policy will prove less costly than an annual renewable term policy.
Return of Premium – A relatively new type of policy, “return of premium” life insurance provides the benefits of traditional term life while the policy is in force, and then at the end of the policy period, pays back all the premiums you have paid. The catch, of course, is that you must still be alive to collect your premiums.
As the name implies, permanent (cash value) insurance is best suited for the individual with a long-term (often indefinite) need. A permanent policy is really a combination of “pure insurance” and an asset accumulation element. Premiums are considerably higher than term rates in the beginning years, but may drop significantly, or even disappear, in later years. Other differences may include an increasing death benefit, a “cash value” associated with the policy, and tax-advantaged borrowing privileges against your cash value.
Whole Life — This type of coverage covers you for as long as you live, as long as you make premium payments. Usually, this type of policy has a level premium for the life of the policy. Initial premiums are generally high compared with term insurance premiums, but eventually they become lower than the premiums you would pay if you had kept renewing a term policy. Over time, a whole life policy builds cash value at a rate of interest set by the issuing insurance company.
Universal Life — With universal life coverage, which also covers you for as long as you live, you can vary your premium payments and the face amount of your coverage. Most of your premium payment goes into an account, which earns interest. You may borrow against the cash value, but eventually, if the balance continues to drop, your coverage will end. To prevent that, you would have to start making premium payments again, increase your premium payments, or lower your death benefits. Generally, your policy will state that it will pay the premiums from the cash value of your policy. Variable universal life also falls into this category; the difference is that a portion of your premium in “invested” in subaccounts that resemble mutual funds and can own stocks, bonds, cash, or some combination thereof.
Of course, your insurance needs will be determined by your individual situation. And keep in mind, the cost and availability of the type of life insurance that’s right for you depends on factors such as your age, health, and the type and amount of insurance you need. If you are considering purchasing life insurance, we recommending consulting us to explore all your options and determine the solution that best fits your unique needs.