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How Much Life Insurance Do I Need?

How Much Life Insurance Do I Need?

Client question:  How much life insurance do I need?

Advisor answer:  Individuals who do not have a spouse, children, or other family members dependent on their income probably do not need life insurance.  It is likely for younger people with spouses and/or children to have a need for life insurance. An old “rule of thumb” is to obtain insurance equal to 10X your annual income; however, as you might imagine, this of course may not be an appropriate recommendation given someone’s particular circumstance.

Important questions to answer

As an exercise to get you thinking about the purpose for life insurance, think about how a surviving spouse would answer the questions below if his or her partner making a significant portion of family income passed away.

  • Would it still be possible to fund education expenses for children?
  • Would the mortgage for the home still be affordable, or would the home have to be sold?
  • Could a surviving partner still retire at the preferred age?
  • Could a surviving partner currently out of work join the workforce and earn a substantial income?  
  • How much would daycare expenses cost for younger children if a surviving partner had to leave home and join the workforce?  Would the surviving partner’s after-tax income cover the cost of daycare?

In order to answer these questions, it is important to actually “run the numbers” instead of guessing.  For example, I create financial/retirement projections with sophisticated planning software for clients assuming no one dies, but I can also adjust these projections to show what would happen if someone did die.  In many cases, the projections show a surviving partner would not be able to achieve financial independence if his or her partner passed away.  The last step is to use the financial planning software to show how much life insurance proceeds would be needed to achieve financial independence in the case of a death.

Term life vs. permanent life insurance

The four main parties of a life insurance contract are the owner, insured, beneficiary, and the insurance company.  Term life insurance is where the owner/purchaser of an insurance policy agrees to pay an insurance company a monthly/annual “premium” (i.e. a price) for a certain number of years (i.e. the term).  The insurance company agrees to pay the beneficiary of the policy a death benefit if the insured party on the policy passes away during the term. For example, John Doe might purchase a 20-year term life insurance policy on himself to provide for his children if he were to pass away.  In this case, John is the owner and insured, and his children are the beneficiaries. If John passes away 21 years after purchasing the policy (i.e after the term ends), beneficiaries do not receive any proceeds.

Permanent life insurance includes both insurance and investment components.  The most common type of permanent life insurance is “whole life.” As is in the name, permanent insurance policies do not automatically end after a certain number of years like a term life policy does since there is no set term.  In fact, these policies are designed to last until an insured’s death.  Not surprisingly, permanent insurance policies are generally much more expensive than term life policies given that there is a 100% likelihood an insured will die eventually.  In fact, according to policygenius.com:

[Whole life insurance policies] can often cost six to 10 times as much as a comparable term policy… Most policies are abandoned because they’re too expensive. Many people overestimate their ability to pay the large premiums year after year. Approximately 26% of whole life insurance policies are surrendered within the first three years and 45% are surrendered within the first ten years.

It is very rare to find a fee-only financial advisor practicing in a Fiduciary capacity who would recommend a whole life insurance policy for a common situation.  I have met with countless people who were sold whole life insurance policies (and were charged a 5% to 6% commission up front), and it almost always makes sense to surrender (i.e. cancel) these policies.  

Conceptually, it makes sense to purchase insurance for an event that is relatively unlikely to happen that would have a significant negative impact on your financial situation.  Examples include flood insurance, fire insurance, life insurance, disability insurance, etc.  Insurance is not designed to work for events that are likely to happen that will not have a significant financial impact.  For an extreme example, imagine purchasing insurance to cover you in case your young child or his or her friends spill something in the backseat of your minivan.  In this case, it’s easy to see purchasing insurance would be ridiculous because children often spill food and drinks in the backseat of a car, and it isn’t expensive to clean up.   

When compared to term life insurance, it seems like the owner of a whole life insurance policy is paying to insure the life of an older, retired, wealthy person without dependents.  In other words, whole life insurance is insuring something that’s guaranteed to happen that will not have a significant economic impact.  As long as people have a solid financial plan in place, they will usually have a significant amount of money in their older years.  Also, their children will hopefully be old enough to take care of themselves and be off their parents’ dole. Whole life insurance might make sense for very unique circumstances, but I have personally never come across such a situation.

How long of a term

As discussed above, it generally doesn’t make sense to purchase life insurance for someone’s entire life.  The specific risk we’re trying to cover is someone passing away before they have accumulated enough money pass to onto their dependents to enable them to have a satisfactory standard of living.  So, whenever there is enough money in the pot, the risk is gone, and there isn’t necessarily a need for life insurance.  The key is to have someone create a financial projection showing when the necessary amount of money will be attained.  

An important feature to look for in a term life insurance policy is a conversion feature. Imagine a situation where John purchased a 20-year term-life insurance policy on Jane’s life, and Jane contracts a life-ending disease at year 20.  A conversion feature allows John to convert the term-life policy to a permanent life policy without Jane needing to go through medical underwriting. 

How to obtain life insurance

It is a common practice amongst fee-only financial advisors who are not able to earn commissions from selling insurance to refer their clients to independent insurance agents who are not captive to a particular insurance company.  For example, an insurance agent working for insurance company “X” is required to sell insurance policies from company “X” regardless of whether other insurance companies provide better policies.  An independent agent is not captive, and therefore is able to recommend the best policies from a cost-benefit perspective.

Aside from using an independent agent, it’s important to confirm the insurance company you purchase a policy from is in good enough financial shape to actually pay-out in the case of a claim.  For example, policygenius.com only shows insurance companies with an “AM Best” financial rating of A- or better.

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