Who Needs What: The Basics of Life Insurance

Some years into adulthood, often spurred by life changes such as purchasing a house with a mortgage or having a child, many people begin to think about purchasing life insurance.  However, the questions of who needs life insurance, what type of insurance, and how much to purchase can be confusing, and frequently those most eager to answer the questions are the ones looking to profit from selling it to you.  Therefore, we present this basic primer below.

Who.  The primary purpose of life insurance is to protect your income when others depend on it or to cover expenses that would be incurred if you were to die.  Thus, it is particularly important for those who, first, are earning income, and second, have dependents.  For those who are not working such as stay-at-home moms or dads or retired persons, life insurance may still be helpful to dependents who are left to pay end-of-life health care expenses, funeral and burial expenses, and possibly outstanding bills prior to the settlement of the deceased person’s estate.   (Additionally, for stay-at-home moms or dads, there may be a need to cover child care costs if they passed away.)  However, life insurance is critical for one earning income when others (typically, though not always, a spouse and/or children) depend on it for the necessities of everyday life.  Even for couples in which both parties are working, consider whether the remaining spouse could continue maintaining their household and current standard of living if one income disappeared.

What.  There are many flavors of life insurance available today, but in most cases, we advocate term rather than permanent life insurance. Term life insurance provides income protection for a certain period of time (e.g. 10, 20, 30 years) and then expires. Some people bristle at the idea of paying premiums for decades and getting nothing at the end of that time period. But, just think of the alternative (your family receiving a payout because you’ve passed away) and be grateful that you’re family never had to put in a claim!  (Insurance is an expense.  We should always be grateful that we don’t need to put in a claim–whether for life insurance, auto, or any other type.)  Term insurance is sometimes referred to as “pure” life insurance because you are paying simply the amount necessary to cover the probability that you will pass away during that time frame and require a payout. In contrast, permanent life insurance (which comes in many forms, including whole, universal, universal variable, etc.) mixes insurance with some type of savings/investment component. It generally involves significantly higher premiums, but your policy accumulates a cash value over time, in addition to receiving insurance protection. From our perspective, most investors would be better off paying for insurance and making investments separately because of the relatively high cost and limited control that saving and investment through permanent life insurance often entails.

How Much.  Just as there are many types of life insurance, there are many ways of calculating the needed amount, which can and should be adjusted based on various factors such as one’s health history, other assets that would be available to dependents, risk tolerance, etc.  One method of calculating needed life insurance uses one’s future earnings, suggesting that the amount of insurance should equal the present value of all future income, discounted back to the present day. Another looks at the lump sum cash needs that your dependents would have in the case of your untimely death, adding up, for example, projected end-of-life expenses, outstanding mortgage, education expense needs, lifetime spousal income needs, etc. An even more conservative method calculates the amount that one would need so that dependents could live simply off of the investment returns provided by that sum. For example, if you currently earn $100,000 per year (after taxes) and your dependents could safely earn 5% return, then you would need $2 million in life insurance ($100,000 / 5% = $2 million) to replace that income.

Navigating through the murky waters of life insurance can be a difficult task, but we are always available to help clients understand their options and make recommendations to ensure that their loved ones are well protected.