Life Insurance

Life insurance is one of those things that many people don’t like to think about. My wife hates it when I talk about life insurance because it makes her think about me dying (I guess that’s better than having a wife who wants as mush life insurance as possible on her husband). There are many people like her who would rather not think about the inevitable actually happening. But life insurance offers protection for the economic value of human life.

A person’s life has value in many different ways. From an economic standpoint, a person’s life has value from both an earning capacity and the financial dependence of other people’s lives on that earning capacity.

A simple way of understand this is to think of yourself as a money machine. Let’s say you have a machine in your basement that prints money, and it prints $100,000 per year. Would you insure that machine in case it was lost or broken? Of course you would! You are that money machine. You earn money each year that provides for you and your family. If you are no longer able to do that because you are not here, that income would be gone. But you can protect your family from the loss of that economic value.

A 30 year old male has a life expectancy of about 46 1/2 years. If he earns $50,000 per year, assuming he never gets another raise, he could earn $1,750,000 by the age of 65. Most 30 year-olds probably don’t put a $1.7 million price tag on themselves, but that is really true!
Let’s talk about the different kinds of coverage and the pros and cons of each.

Term

Term insurance gets its name from the fact that it only last for a limited period of time. The face amount is only paid if the insured dies during that period of time. If the insured is still alive at the end of the time period (this is a good thing), then nothing is paid. Term does not build up any cash value, it just gives you cheap protection. The typical terms are 5, 10, 15, 20, and 30 years. These policies also give the owner the option to renew the policy annually at the end of the initial term, but the cost goes up significantly. Term is very popular with young families who need low cost life insurance.

whole Life

Whole life pays the policy death benefit upon the death of the insured, regardless of when it happens. As long as the premiums are paid up, this type of policy will gives protection for the “whole life” of the insured. Premiums can be paid on an annual basis, or in lump sums. Once the policy is started and the premiums are calculated, they generally never increase for the rest of the insured’s life. Whole life gradually builds up cash value inside of the policy that will eventually equal the death benefit. When the insured dies, only the death benefit will be paid out. For this reason, you’re actually paying for less insurance each year as your cash builds up inside.

Whole life policies (and all other permanent type policies) allow for policy loans. Whole life is a type of cash value life insurance. The policyowner can take a loan from the cash value of the policy. In most policies over 90% of the cash value is available for loans. You do have to pay interest on the loan balance while you have a loan balance. This interest can be added to the loan value, or the policyowner can pay it in cash. In the event that the insured dies while there is an outstanding policy loan, the loan balance is deducted from the death benefit of the policy.

With any time of “cash value” life insurance, you need to be aware of rules regarding Modified Endowment Contracts, or MEC’s.

Universal Life

Universal life was introduced in 1979 as a revolutionary cash value life insurance product. It was the first variation of whole life that allowed for flexible premiums. Universal life also pays an adjustable interest rate on the cash value building up inside the policy. This interest rate will vary based on prevailing interest rates in the market. This feature made these types of policies very popular back in the early 80′s when inflation and interest rates were hovering around 20%.

With this type of policy, premiums can be skipped in a given year if the policyowner wishes to (and assuming there is enough cash value built up to keep the policy alive).
Universal life also has the option of providing a fixed death benefit that never changes, or an increasing death benefit. An increasing death benefit rises as the cash value rises. As an example, lets say you have a $500,000 death benefit. If there is $100,000 of cash value built up inside the policy, and the insured dies, the beneficiary would get $600,000 (the death benefit plus the cash value). This type of death benefit increases your annual premiums because you are always paying for $500,000 of insurance no matter how much cash value is inside the policy.

Variable Universal Life

Variable Universal Life is very similar to Universal Life in that the premiums and death benefit can both be flexible. It is another type of cash value product. The major difference is that the cash value built up inside the policy can be invested at the policyowners discretion into a choice of mutual fund-like investment accounts. These investment accounts are each managed by a fund manager and will have performance similar other mutual funds. This means that the policyowner can either make more money, or lose money, based on what their investment choices do. Many insurance agents will try to sell this type of life insurance as a retirement savings plan to people. You need to be aware that while you can build up significant cash value over time in this type of policy, you are still paying for the life insurance. At the same time, the investment accounts inside these insurance policies can have higher than normal internal fees. This will slow down the growth of the cash value significantly compared to saving through regular mutual funds.
Also, in a very bad down market, your cash value could decrease so much that your policy will collapse. This means that you would have to dump in more cash to keep the policy going, or just surrender it and start over. This could potentially be devastating, especially if you no longer qualify to buy life insurance at that time.

However, one major benefit is that the cash value inside life insurance does accumulate tax-deferred. This means that you don’t have to pay taxes each year on the dividends or capital gains that your policy earns. And if you don’t surrender the policy early, the death benefit proceeds of life insurance are received income-tax free to your beneficiaries. From this standpoint, life insurance does have some very attractive tax advantages, especially in a high-tax enviornment (which we could easily be going back into in the next few years).

Equity Indexed Life

Equity Indexed Life is another type of cash value insurance. This is the most recently developed variation of Universal life. These policies work very similar to Equity Indexed Fixed Annuities in that the interest paid is tied to a particular market index. If the benchmark index is up in a given year, the cash value earns a certain percentage of that increase (these amounts are set by the insurance company and can vary each year). If the index is down however, the cash value doesn’t lose value in that year, it stays the same. These types of policies are very attractive for younger individuals who have time on their side to let the cash value grow, and take advantage of the equity markets over time. The protection from down market years offers a very nice alternative to traditional variable universal life insurance. Many people like this protective feature because you don’t have to worry about a down market eating up all your gains. These types of policies are much less risky than variable universal life.

How Much Life Insurance Do I Really Need?

This is an age old question that probably has as many answers as there are insurance agents. The answer really depends on a lot of variables like: How much do you already have saved? What other sources of guaranteed income would your family have? But assuming you don’t have any other resources, I think a good rule of thumb to use is 12 – 14 times your gross annual earnings. So if you earn $100,000 per year, you should have somewhere between $1.2 million and $1.4 million. Sound like a lot?! It’s not really.
If you figure that your family would spend 5% of the value of the life insurance proceeds each year, it’s not as much as you might think. 5% per year from $1.2 million is $60,000 per year. 5% of $1.4 million is $70,000 per year. By spending 5% or less per year, your family should be able to keep the principal in tact over time and possibly even keep it growing a little each year (Depending on how good of a money manager you have).
If you have other sources of guaranteed income, or other assets that they will be able to draw on, then maybe you won’t need that much.