January 24, 2018

Practical Planning – Understanding Life Insurance

The basic purpose of life insurance is simple: upon your death, a policy will pay out a set benefit (income tax-free and occasionally estate tax-free) to your beneficiaries. When considering life insurance options, however, it can be difficult to determine the amount of coverage your family needs and to understand the terminology and costs/benefits of different policies.

Although this process can seem overwhelming, it doesn’t have to be! Start out by following four simple steps to put your family on the right path with life insurance coverage.

  1. Calculate your insurance needs

The easiest method to estimate the amount of life insurance needed is to measure the expenses you would like to have immediately paid off upon an unexpected death to take care of your family and relieve some stress from a difficult situation. These expenses include:

  1. Final expenses: funeral costs, administrative expenses, taxes
  2. Outstanding liabilities: mortgage, promissory note, school loans, etc.
  3. Funding of education expenses for children
  4. Replacement of income from the deceased spouse for some number of years, to allow the surviving spouse time and latitude in the years following death.

Consider a family with a child about to start at a four-year public college and a $500,000 mortgage. Only one spouse works, making $150,000 per year. Using this method, the amount of life insurance needed is estimated as follows:

  1. Final expenses – $25,000
  2. Outstanding liabilities – $500,000 (mortgage)
  3. Funding of college – $110,000 (estimate for four years, public college tuition and room/board)
  4. Income Replacement – $750,000 ($150,000/year x five years of income replacement)

Life insurance estimated need for working spouse: $1,385,000

Life insurance estimated need for non-working spouse: $635,000

2. Choose the right policy

Once you’ve settled on a ballpark figure for coverage, consider which type of life insurance may be right for your family. Purchasing the wrong type of coverage can have negative effects that last for years. Be sure to ask your insurance agent about premiums and policy fees, which can vary widely and represent a significant expense. Some of these costs increase over time while others may decrease depending on investment performance – it is critical that you read the fine print, ask for an illustration of the policy, and then discern which parts of the illustration are guarantees versus which are “estimates” based on the insurance company’s hypothetical investment returns.

Term Insurance – provides coverage for a specific period of years, with a fixed annual premium. It is generally the least expensive option for life insurance. Some term policies also offer conversion into whole life policies at the end of the term.

Whole Life Insurance – provides lifetime coverage, with a fixed annual premium and death benefit. Premiums are generally higher than term insurance, because policies have a “cash value” feature which can function as a savings vehicle over time.

Universal Life Insurance – provides lifetime coverage, with a flexible annual premium and death benefit. Premiums are generally higher than term insurance, because policies have a “cash value” feature which can function as a savings vehicle over time. The flexible premium allows for cash value contributions to be greater or lesser in certain years, depending on the policyholder’s needs.

3. Understand employer-provided benefits

Before purchasing individual life insurance, review the amount of any employer-provided life insurance coverage. Many employers offer a small amount of basic group life insurance for free. You may also be able to purchase supplemental group life insurance from your employer without having to go through the medical underwriting process. Don’t forget to compare rates; depending on your employer and your age, the relative cost of supplemental group coverage versus individual coverage is variable.

When reviewing your employer-provided insurance, also look for a “portability” provision. This will allow you to convert your group insurance policy to an individual policy if you leave your current employer.

4. Choose the right insurance agent

It is important to understand the difference between a captive insurance agent and an independent insurance agent. Captive agents (e.g., your local State Farm representative) sell insurance for only one specific company. Independent agents represent different insurers and may be able to provide a wider variety of policy options and carriers.

We are not licensed to broker or sell insurance, and we do not receive any commissions or other compensation for any insurance you might purchase from a third party, but Arnerich Massena’s planning team can evaluate your financial situation, review your employer-provided coverage, assess your coverage needs, and provide recommendations and guidance to help you make a final insurance decision. Want to learn more about protecting your family? Check out Glen Goland’s post on planning advice for new parents.