Steve TeSelle, CFA, CFP ™
June 2002
How Much Insurance Do You Need?
The key concept to remember as a consumer of life insurance is that you want to protect future cash flows or the value of assets in case something bad happens. If you have a family who depends on your income, then you want to have life insurance so that, in case you die unexpectedly, your family will have something to live on.
You should not confuse insurance with sadness. Some events may sadden you,
but they do not burden you or your heirs financially. For example, buying life
insurance on your children makes no sense to me. Would I be devastated if my
children died? Yes. Would I be financially worse off? No. In financial terms,
children are more liabilities than assets.
The basic form of life insurance is term: you pay a premium to the life insurance company based on your age, the insurance company pays the beneficiary if you die. The older you get, the higher the premium.
Insurance companies have a whole raft of products in addition to basic term,
including Whole, Universal, and Variable. These are all variations on the same
theme: they all add a saving element to the basic term insurance. You pay a
higher premium, some of which pays for term insurance, and some of which goes
toward what's called the buildup of cash value. The idea is that some time in
the future you can surrender your policy, meaning you no longer have life insurance
coverage, and get your cash value returned to you.
[top]
Most investment folks, such as me, encourage people to buy term from the insurance company and save or invest with a mutual fund or investment manager. Our justification is that the insurance products have higher fees and more restrictions than most investment products. For example, the Vanguard Total Market Index Fund charges something like 0.2% per year, with no sales charges. Many insurance products come with annual fees well above that, as well as steep surrender charges in case you surrender your policy early. And while term life insurance gets more expensive as you get older, most of us don't need life insurance after retirement because there's no longer any income to protect.
The insurance folks respond that their products help people to save more, because the fixed, monthly premium payment forces people to save. Most people have a tendency to buy term and then fail to stick to a saving or investment program. Also, with the various non-term products, you can usually keep your insurance in force in retirement years at a lower cost than you could with term insurance. Finally, insurance proceeds can be handy for paying estate taxes for people who have assets that cannot easily be sold.
If you choose one of the insurance products that includes a saving or investing
component, buying from a highly-rated insurance company is even more important
than if you buy only term. If an insurance company goes bankrupt, policyholders
are unlikely to get the full value of their cash buildup. Insurance companies
don't go bust often, but it has happened before, such as in 1991 with Executive
Life. [top]
The rule of thumb is that you need seven times your annual income. But of course,
rules of thumb tend to apply to no one specifically. You need to think about
how much your family would need. For example, in the retirement article, I figured
my wife and I need about $70,000 a year in income, which translates into about
$2,000,000 in liquid assets, in year 2001 dollars. Ideally, I should have insurance
that gets our assets to an inflation-adjusted $2,000,000 if I die. But we're
a little short of that. I figure I'm in pretty good shape and I drive a Volvo,
so I've reduced my odds of dying soon. Also, my wife is a smart woman. After
the kids are on their own, she can generate an income to help support herself.[top]
There are two separate taxation issues: one is related to the cash buildup, the other to the insurance proceeds payable at death. The cash buildup grows tax-deferred, so that the individual does not pay any income tax. Once the insured individual takes the cash value, the accumulated earnings (not the original amount you paid in) are taxable income in the year of the distribution.
When an insured person dies, insurance proceeds are usually not subject to income tax (unless you're buying and selling insurance policies, you shouldn't be subject to income tax). If you are the beneficiary and you take a lump sum payment from the insurance company, you don't pay any income tax on that amount. If you take the annuity payment option, in which you receive the proceeds over a number of years, then the part of each payment that represents earnings or interest is taxable. This makes sense because if you took the lump sum payment and plunked it in a savings account, then any interest you earn is taxable.
Of course, income taxes aren't the only taxes in the world. The other biggie
is the estate tax. I will not go into great detail here; lots of attorneys and
other folks make a living helping people deal with the impact of the estate
tax. The point is that life insurance is usually included in an individual's
estate, and potentially subject to estate tax, if that individual owns the policy
and pays the premiums. If you have enough wealth to be subject to estate taxes
and you have life insurance, you could probably benefit from a little estate
planning. [top]
Whatever type of insurance you buy, you ought to understand exactly how it
works: what are the fees, what are the restrictions, what are your obligations,
what are the insurance company's obligations? And I think it's always a good
idea to understand how the agent who's selling you the policy gets paid.[top]
Can you give me just a few more minutes? I need to bump up my insurance coverage.
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