Do you want to clear a room or stop a conversation fast? Talk about life insurance. Mention life insurance to someone and the reaction is something like hearing nails across a chalk board. Folks will either run for fear that you’re going to try to sell them something or their eyes will glaze over.
Most folks don’t want to talk about it. The topic is boring. And it’s kind of weird to talk about death.
Heck, when I speak with folks about planning, the inevitable phrase I hear in the conversation is “If I die …” as if they have found some secret to living forever.
So assuming that you’re not featured in the Vampire Diaries, there is a very high likelihood (about 100% give or take 0%) that you may die someday. So it only makes sense to consider life insurance as part of your overall planning.
Life Insurance Through Work Is Only A First Step
Most folks will get some insurance through their employer. It’s cheap. It’s fast. There’s no medical exam. It’s simple.
And as I’ve said time and again, there’s always a simple solution to every problem. (In this case, employer-sponsored group life insurance). And as I’ve also said before, simple solutions are probably wrong.
Now don’t think that I’m saying that the group policy that you get and pay for through your paycheck is wrong. It’s a good start. But there’s more to proper life insurance planning than simply figuring a multiple of your salary.
How Much Life Insurance Is Needed?
The reason for any insurance is to cover the costs of risks that we are either not willing or don’t have the resources to cover ourselves. That’s true whether you’re insuring a car, a home, your life or your paycheck. So first you need to know what it is that you’re covering.
In the case of life insurance, it’s usually a good idea to figure out how much money your family needs to maintain their current standard of living if you and your income are no longer part of the picture. Then add in any large expenses to cover. Typically, this would include an amount to pay off any mortgages and loans and even college funding or other similar expected obligations. Net out the amount of other insurance and investments available and this will give you an idea of the amount of insurance coverage to get.
The amount of insurance that one needs throughout life changes with circumstances. This is why it’s critical to include an insurance needs analysis as part of your regular financial planning progress reports. This is why I use a particular tool from ESPlanner that helps project the amounts of coverage needed over time.
Insurance as An Asset Class to Reduce Risks
Now I’ve said that insurance is an asset class. Why? Well consider this. When you invest, you’re likely to spread your money into different types of asset classes: stocks and bonds of large, small, US and foreign companies. This is the basis of diversification: don’t put all your eggs in one basket. You do this to help reduce risk. In this case, you’re trying to reduce the risk of having your investment wiped out by spreading your bets to other sectors of the economy and even parts of the world.
Like asset diversification, insurance is also a risk tool. In this case insurance is there to replace things that you may not have the cash or investments to cover on your own. Or maybe you feel you’d be better off investing the cash and earn a return on your money that will hopefully increase the resources you need for your lifestyle whether now or in retirement.
Think of it this way. You could hit home run after home run picking stocks but what happens if you or your family are hit with an unexpected loss? You’d have to dip into your savings and investments. You’d need to sell those winning stocks. You’d probably incur huge capital gains and have to pay taxes on it.
Life insurance is there to cover living expenses, replace in some small way the loss of income if you or your loved one dies and it does this for the most part tax free to the beneficiary.
And you can carry over the idea of diversification to insurance. Just like mixing up the kinds of stocks or bonds you own, you can carry insurance from two or more insurers. You do this by having your employer-sponsored group plan plus something you pay for on your own separate from your employer. You can further diversify by mixing up the kinds or terms of coverage dividing some between term and permanent type policies.
Kinds of Life Insurance: Term vs Permanent
Insurance comes in two basic varieties: term and permanent. Term insurance has a fixed premium for a fixed time period. It’s great for covering specific risks for a defined time period (i.e. a mortgage, college costs). Permanent life insurance has many flavors but in essence the key is that some of your premium that you pay is used to build up cash value.
Now for those who are unhappy with the stock market, you may want to consider some of the benefits offered by permanent life insurance.
- The value is guaranteed. You’ll always know how much you have. And the insurer is required to credit a minimum amount to your value each year.
- You receive dividends and their tax-free. Policyholders will receive dividends that increase the value of their account.
- You can access the cash value at any time. Unlike going to a bank for a loan, the insurer will give you access to your account’s cash value with very little delay. You pay no penalty when receiving the cash as long as you repay yourself. And if you set up the account properly, you can build up enough cash value to tap into for anything from buying a car to buying a home to funding retirement without paying a penalty or taxes. (This is described by some as the Infinite Banking Concept where you become your own banker).