In the past few weeks, I’ve found myself in multiple conversations explaining the need and purpose of life insurance. We’ve covered this topic in previous issues of TOM, but based on the recent inquiries, I thought it appropriate to provide a succinct refresher.
So let’s jump right in…
All Different Shapes & Sizes
There are lots of different types of life insurance. Some designed for estate planning reasons, others to insure against key man risk in a business, and even more exotic solutions created for all sorts of different planning needs.
Today will not be a safari tour through all the different life insurance products available. Today we will discuss the most vanilla and straightforward life insurance product – term life insurance. For all the conversations I have been having, this is the right life insurance solution a majority of the time.
This isn’t to say that those other solutions aren’t needed or necessary, just that it is rarer to come across a situation in which they are needed.
What Are You Insuring?
In all of my discussions, each person knows they need life insurance, but few, if any, understand what they are actually insuring. Let’s think about it this way when you buy car insurance, you want coverage in case you get in a car accident. You want the damages and medical bills to be covered. When you purchase medical insurance, you want coverage in case you have a medical need. You want the surgery or medication covered.
So what are you insuring with term life insurance? You are attempting to mitigate the potential loss of income associated with an unforeseen passing. The insured person earns income, typically that income covers the living expenses for their family, and if they were to pass unexpectedly, then it would create an ongoing financial burden for the family. The death benefit of a term life insurance policy is intended to replace this loss of income.
All of these insurance products have this in common – they are intended to provide financial relief for a low probability event that you hope never happens. Yes, you hope you never have a car accident, need surgery, or lose a loved one. Insurance provides a safety net if one of these unfortunate events does occur.
Whole vs. Term
Another thematic topic in my conversations is the difference between whole life and term insurance. I will start this section off by saying this, there are rare instances where I believe whole life insurance could make sense, but a majority of the time, term insurance is the appropriate solution.
So what’s the difference between the two? For term life insurance, you are paying a fixed premium, for a fixed period, for a defined amount of coverage (death benefit). Whole life insurance, on the other hand, is perpetual. It is insurance for your “whole” life. One of the key differences between the two types of insurance is that term life insurance does not accumulate a cash value in the policy while whole life insurance does. Term life insurance premiums are used just to buy insurance coverage; whole life premiums apply some of the money towards the insurance and some towards accumulating cash savings within the policy.
Whole life insurance policies do typically pay a more sizable commission to the salesperson. This invariably leads to these products being oversold. The typical whole life presentation focuses in on the accumulation of cash value, some nuanced strategies around borrowing against the policy for tax reasons, and it is usually accompanied by an illustration showing the long term compounding benefits of a hypothetical policy.
I want to zoom in on something I mentioned earlier – insurance is intended to provide financial relief for a low probability event that you hope never happens. All of these bells and whistles associated with a whole life policy are a distraction. A family needs the insured person to have sufficient coverage, and ideally, they want to obtain this coverage in the most cost-efficient manner. Whole life, for the same death benefit, will be much more expensive.
The second item I want to reference back to is this, what are you insuring? You are insuring against the potential loss of income. Here we are referring to earned income, the compensation you receive for working. The plan is not to work your “whole” life. The plan is to accumulate a nest egg in which you can live off of passive income (dividends and interest) in the future. You are purchasing term insurance to cover these gap years between now and when your nest egg creates enough income to cover your expenses.
For these reasons, term insurance is nearly always the appropriate financial planning solution.
Where Do We Go From Here?
Ok, we’ve said a mouthful, right? Now the question is, where do you go from here? You need to sit down with your trusted advisor and review your current life insurance coverage. You need to know if the amount of coverage is sufficient for your family’s needs, and you need to know if the type of life insurance you have is the most suitable for your situation. In the past, I have provided some oversimplified back-of-the-napkin calculations for determining appropriate coverage, but I am going to refrain from doing that today. Your situation is unique, and each of your personal variables (debt, health, income, goals, etc.) needs to be factored into a tailored recommendation for you and your family. This is why you have an advisor, and you need to resource them for some of this heavy lifting.
We will leave it there for today. Maybe this discussion sparked some follow up questions, and if so, I would encourage you to email me at email@example.com. Our team is happy to be a resource in any way that we can.
This is TOM signing off… Until next week…