Approaching the Unpleasant (and Confusing) Topic of Life Insurance

 
Life Insurance
 
 

Quick disclosure: In my role at The Johnston Group, I do not sell life insurance or profit on referrals to outside insurance agencies.  I work with clients in a fiduciary capacity to identify any life insurance need and to develop the most beneficial strategy to solve this need.  I believe life insurance is incredibly important and often misunderstood by the general public.  All life insurance discussion should take place with the context of each individual situation so this article is not intended to be specific advice.    

A recent report by the Federal Reserve Bank of Chicago noted that just 60 percent of US households owned life insurance in 2013, down from 77 percent in 1989. The study analyzes decades of data related to demographics, family structure, education and income levels associated with life insurance owners and ultimately concludes that that dramatic decrease in life insurance is something of a puzzle. There is no clear explanation for why fewer Americans own life insurance today than they did 30 years ago. 

Life insurance is a confusing topic for most Americans. This can be attributed to a number of factors, some of which include:

  • Our country as a whole overwhelmingly lacks basic personal finance education
  • Life insurance is a grim topic that is much easier to avoid than understand
  • Most people’s first impression of life insurance is that of a complex investment product pushed upon them in their early 20s by an aggressive salesman posing as a financial advisor

The starting point for any discussion on life insurance is necessarily asking the question: Do most people actually need life insurance? The Wall Street Journal broached this question in a recent article debating the need for life insurance and its overall role in a comprehensive financial plan. The article featured two financial advisors representing each side of the argument for and against life insurance.   

Like any financial topic, there is no one-size-fits all solution to the issue of life insurance. The correct approach is unique to each individual situation and should be made with full perspective of one’s entire financial landscape (goals, family demographics, cash flow, balance sheet, investment portfolio, etc.). Only after taking all of these factors into account can someone make an informed decision about life insurance and its role in their comprehensive financial strategy. 

Below, I will attempt to answer some of the most common questions we receive on life insurance and offer some concluding thoughts on how this topic should be approached by individuals and their families:

1. What Exactly Is Life Insurance?

In its purest form, life insurance is simply a contract between an individual and an insurance company where the insurer promises to pay a specified death benefit to a beneficiary upon the death of the policy owner.  Similar to car insurance or homeowner’s insurance, the policy owner makes annual premium payments to the insurer and the policy only pays out if a certain event is triggered (in this case, the death of the policy owner).

2. Who Needs Life Insurance?

Life insurance is appropriate for individuals that maintain financial obligations beyond their own lives and don’t have sufficient existing assets to meet those obligations.  In most cases, this applies to parents with dependent children who would require ongoing financial support in the event of the parent(s) unexpected death.  High net-worth individuals might require life insurance to provide liquidity for estate taxes and business owners may choose to carry life insurance to provide the company cash upon their death. 

3. What Type of Life Insurance is Most Appropriate?

This is by far the most common question on the topic of insurance and the largest source of confusion among the general public.  There are essentially 2 types of life insurance available on the insurance market: term life insurance and permanent life insurance.  As their names imply, term life insurance covers only a specified period of time in the policy owner’s life whereas permanent life insurance covers their entire life (assuming all premium payments are made).  As mentioned earlier, the appropriate insurance product is unique to each individual and should be approached with full perspective of an individual’s goals and assets.  That being said, for the vast majority of people, simple term life insurance is the appropriate vehicle to support their life insurance need.

4. Why Term Life Insurance?

Most people only need life insurance for a specified period of time.  Term life insurance can fill this need and does so at a much more cost-effective rate than permanent life insurance.  For example, let’s take a look at John and Jane Doe.  They are 30 years old, just starting a family, recently purchased a home and both work to provide income to fund their lifestyle.  Since they are relatively young, they do not yet have sufficient assts to meet ongoing obligations in the event of their untimely deaths.  Over the next 20 to 25 years, they expect to be taking care of dependent children, wish to provide for their college education and also will be paying a mortgage during this time span.  In their case, a 30-year, $1 million term policy (for each of them) is an appropriate insurance vehicle.  It is relatively inexpensive and the death benefit will provide financial support to the surviving spouse and children if either of them were to die between the ages of 30 and 60.  Upon the expiration of this term policy, neither John nor Jane have a life insurance need.  Their children are adults and no longer dependent on them and they’ve also built a solid investment portfolio to support the survivor upon the first spouse’s death.

The main problem with permanent life insurance is that the premiums are much higher than term life insurance (often more than twice the cost!) and the death benefit of the policies are significantly less than most individuals require to meet their life insurance needs.

5. Then Who Should Get Permanent Life Insurance?

While most people only require term life insurance, there are situations where a permanent policy is appropriate.  The most common situations include:

  • Parents who have children with special needs might choose permanent life insurance because they expect that child to be dependent on them their entire life.
    • Note: this can also be accomplished through trust planning and other investment vehicles.
  • Individuals with strong legacy or inheritance goals (again, could be accomplished through other strategies).
  • High-net-worth individuals that need to pay estate taxes (although with current federal estate tax exemptions over $11M per individual, the number of people needing to plan for estate taxes is very small).
  • Business owners often purchase permanent life insurance to provide the business cash upon their death to either run the company or buy out the deceased owners remaining equity.

6. But What About Cash Value?

The term “cash value” sounds fantastic! Cash value is the component of permanent life insurance policies that accumulates cash over time as premium payments are made into the policy. Whereas a term life insurance policy expires with no built-up value, a permanent life policy grows as an asset over time. This money can be accessed, used as collateral for a loan or left in the policy. So, compared to term life insurance, why wouldn’t you want a policy that allows the accumulation of cash value? First of all, these types of policies are more expensive. While a 30-year, $1 million term policy for a healthy 30-year old might cost $50/month, a permanent life insurance policy for that same individual might cost $125/month. And that increased cost might only purchase a policy with a $150,000 death benefit, which is likely far less than the individual needs (and significantly less than the $1 million death benefit provided by the term policy). Moreover, the internal costs of the permanent policy are expensive (fees and investment costs) and the cash value component likely doesn’t grow as efficiently as other investment options in the marketplace. Unless the need for permanent life insurance exists (see above), I would generally tell an individual to buy the cheaper term life insurance and save that $75 difference each month into a lower-cost, more effective investment vehicle. This would allow the individual to meet their life insurance need while accumulating asset growth separate from their insurance activity. 

7. Do Only People with Kids Need Life Insurance?

No. While life insurance policies are often associated with people who maintain support over dependents (i.e. spouse and/or children), life insurance can be applicable for any individual. Life insurance policies can be put in place to pay-off existing debt (mortgage, student loan, car loan, etc.) or simply provide for funeral costs or other legacy interests. Moreover, it often makes sense for single people to get life insurance in place if they plan to get married or have children in the future. Life insurance premiums get more expensive as you age (and potentially develop health issues) so putting a policy in place when you’re young and healthy can significantly reduce the premiums over the length of the policy. 

Some final takeaways on this topic based on my experience and perspective:

  • Life insurance is an incredibly important piece of a comprehensive financial plan and most people lack proper perspective on how to approach this topic.
  • Low-cost term life insurance solves the life insurance need for 95% of the marketplace.
  • Life insurance and saving/investing should be approached as separate activities rather than through a hybrid vehicle.  Combining these activities often results in both insignificant life insurance coverage and inefficient investment growth.
  • Individuals and their families are much better off engaging the topic of life insurance rather than avoiding it due to confusion or the grim nature of the topic. 
 

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