If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan.  Stop by the orientation class HERE first for class orientation/overviews and HERE for more information about the website.

Class Objectives: To understand the basics of life insurance and determine what type and amount of life insurance you need.
Prerequisites: none
Handout: Current Life Insurance Coverage
Assignment: Life insurance needs calculation in Excel| Google Docs (previews in lecture material)

CLASS LECTURE

Life insurance is literally an insurance policy that covers your life (or rather the potential loss of it).  The purpose of insurance in general, as we’ve learned in the 3 previous insurance classes, is to shift the risk of possibility of future financial loss from yourself to an entity (insurance company).  In return for amounts paid as premiums, you can have peace of mind that an incident of some sort will not cause you to lose a significant investment of cash or assets (in the case of life insurance this is the loss of income that is needed to support dependents).

When someone who is a primary provider dies, there is a significant financial burden placed on those that depend on that person’s income.  Not only are they dealing with the grief of losing a loved one, but also often having to find employment and cover the increased burden of housing, food, clothing and the other expenses that are necessary for life.  In addition, there are significant upfront costs in covering funeral expenses as well as medical expenses that may have been involved before the death.

Life insurance provides almost immediate funds to cover the death-related expenses and ongoing living expenses for those that depended on the insured person for support while they were alive.

The insurance company that holds the life insurance policy is taking the risk that the person may die at a young(er) age and they will have to pay a significant sum of money, but this risk is offset by the millions of people who pay for life insurance policies, but fortunately do not use them until they are much older and therefore have paid a considerable amount in premiums, or who no longer need the policies and cancel them before they ever use them.

MY EXPERIENCE WITH THIS INSURANCE

While I’ve never used my own personal life insurance (being alive still and all…), I’ve also been fortunate that I haven’t had any experience at all claiming life insurance on someone else.

We are currently a single income family, so we have a life insurance policy on my husband that would cover many years without his income if he were to die.  In addition, though, we also have a life insurance policy for me because we have such young children that would require additional care if something were to happen to me.  There is peace of mind for me that my husband’s life insurance policy would allow me time to be able to grieve and put a plan in place before I had to rush back into the workforce.  There is also peace of mind for me that if something were to happen to me, there would be sufficient money for my husband to be able to hire someone to help take care of our young kids while he was at work, help clean the house and not stress about any burdens that medical bills or funeral expenses may have created.

WHAT DOES THIS INSURANCE COVER?

There are two main types of life insurance: term and permanent.

TERM – Term insurance provides life insurance for a limited period of time only.  You will purchase the life insurance policy for a set term such as 1, 5, 10, 20 or 30 years.  If you die during the term specified, the insurance company will pay the full value of the policy, but if you survive they will pay nothing outside of the policy term.  You can renew or take out a new policy after the term is up, but the rates go up significantly as you get older.

PERMANENT – Permanent (or cash value) life insurance is permanent insurance, meaning that as long as the premiums on the policy are being paid, the insurance company will pay the total policy amount at death,  without having to renew the policy on fixed dates like term life insurance.  An additional feature of permanent life insurance is that it accumulates a cash balance over time that can help to fund future premiums to ensure the policy stays in force.

There are three types of permanent life insurance:

• WHOLE LIFE – This type of life insurance requires set, unchanging premiums for your entire life until you decide to cash in and receive your cash value that you’ve built up over the years or until your death when your dependents receive the face value (but not the cash value).  Under whole life insurance, your premiums remain constant during the time the policy is in force and you have guaranteed cash value.
• UNIVERSAL LIFE – Under universal life insurance, there are two separate parts to your life insurance policy-investments and the death benefit amount.  Premiums are flexible as long as they cover the costs of the policy and you have enough cash value to cover the remaining portion of the premium.
• VARIABLE LIFE – Under variable life insurance, the entire policy is invested and the life insurance benefits are determined by their performance.  There is generally a set minimum death benefit, but since the premiums are invested in the stock or bond market, there is more potential return, but also more risk.

Nearly all personal finance professionals recommend buying term life insurance because the premiums are so much lower.  The argument is that you could pay the term life insurance premium and invest the difference between that premium and the whole life insurance policy premium and be better off overall in the long-term.  Whole life advocates claim that people won’t actually invest the difference, so they claim that it’s better to get a whole life insurance policy and also enjoy tax-deferred treatment of investment gains.  The significantly higher premiums make whole life out of the question for many people, but one other advantage is the ability to take out loans from the cash value of permanent policies.

There are many, many variations and additional features of life insurance policies.  If you have special financial circumstances and are looking beyond the basics, you should do research or consult a financial advisor to make sure that you are covered.  A few additional things to look for include:

1. Is this policy renewable without a medical examination and for how long?
2. Can you convert the term policy to a permanent policy in the future?
3. Does the face value of the policy increase or decrease over the term of the policy? Decreasing term insurance is used primarily to pay off a mortgage and increasing term insurance is aimed at ensuring the policy keeps up with inflation or expected increase in lifestyle over future years.
4. Is there a guaranteed interest rate or dividends?

HOW MUCH OF THIS INSURANCE DO I NEED?

As life insurance’s purpose is to provide for people who depended on your income while you were alive, it makes sense that everyone has varying levels of need for their insurance policies.  In addition, many young people just starting out, those with significant other means for providing for their families without insurance, and older people who are single may not need any life insurance at all.

A very simplistic approach to determining how much life insurance you need is to obtain coverage for a minimum of 5-7 times the annual income of the person needing the insurance.  This approach also suggest 25 times annual income for those wanting to cover the remaining life of the beneficiaries.  However, this doesn’t take into account existing savings and resources or numerous other factors that are important to consider.

When considering the amount of life insurance you need, you should consider a variety of factors including:

• The total annual net income that you wish to replace
• Your regular living expenses, including your mortgage, food costs, etc.
• The length of time that you wish to cover the expenses for your beneficiaries
• The amount of debt you have (that you would be required to and wish to be paid off upon your death)
• The ability of dependents to provide for themselves in the near future
• The amount of social security survivorship benefits your dependents may be eligible for
• Other amounts that you want to leave for special future situations such as education, charitable gifts and inheritances

If you wish to go beyond simply obtaining life insurance at 5-25 times annual income (yes, you do!), then you will need to make several different calculations:

1. Funds needed immediately at death including final medical bills, funeral and burial costs, attorney and probate fees and estate taxes.
2. Funds to pay off debt (mortgage, auto loans, etc.)
3. Income needed to pay for immediate living expenses during the immediate adjustment period, including increased expenses for childcare, etc.
4. Income needed to pay for ongoing living expenses after the adjustment period based on the remaining stages of the beneficiary’s life such as supporting young children, after children have moved out and during retirement.

Calculating how much life insurance you need is the most difficult part.  Of course, I’ve got a spreadsheet for you to help streamline the process.  I’ve included a few different methods for you:

Method 1: Simply calculate your after tax income and use a multiplier to calculate how many year’s income you want to replace with the policy.

Method 2: Use the “DIME” method and factor in debt, income, mortgage and education goals together.  This is only just slightly more complicated than the first method and includes Debt, Income, Mortgage and Education components.

Method 3: Do an in-depth calculation of the funds you’ll need immediately at death and future projections of income needed throughout all the remaining years you which to cover for your dependents, including components of all the factors previously mentioned.  This method takes into consideration current resources as well.  This method is for the analytical person, as it requires a significant amount of analysis and work to determine different scenarios as well as an annual budgeted amounts.  To use this spreadsheet, you need to enter the current salary, investment and other income for the surviving spouse and then project income and expenses into the future for each year until the person’s expected death (assuming 100 years old is a conservative way to do this).  On the calculation spreadsheet, you will enter all of this information and determine the “gaps” that need to be covered by life insurance.  The most significant will be the first year gap, when a lump sum is determined that should generally include paying off all debt to lower expenses for the surviving spouse in the future.

WHAT ARE OTHER FEATURES OF THIS INSURANCE?

An enormous benefit of covering the future needs of dependents through life insurance specifically is that proceeds are not generally taxable by federal or state governments.  Any interest received in addition to the life insurance face amount is taxable, which will be applicable if the beneficiary chooses to receive monthly payments instead of a lump sum amount.  Because the proceeds are not taxable, you would only have to replace the after-tax income of the insured person, not the gross income.  So take an example where the husband makes $100,000 annually and has the following taxes:

• 7.65% FICA payroll taxes ($7,650)
• 15% tax rate after deductions (approximately $15,000)
• 5% state tax rate (approximately $5,000)

After federal and state taxes, replacing a full year income would only take $72,350 and not a full $100,000 of life insurance coverage.  The spreadsheet above takes this into consideration.

Another tax benefit is that the investment income on the cash value portion of permanent life insurance policies is not taxed until the time that the person cashes out the life insurance policy.  This can result in substantial tax savings, similar to those on retirement accounts.

HOW MUCH DOES IT COST?

The factors that affect how much you personally will pay for life insurance include:

• Type of policy (term or permanent)
• Face value of the policy needed (referred to as the death benefit)
• Your age and gender
• Your current health
• Whether or not you smoke currently or have smoked in the past
• Your family medical history
• Your occupation and hobbies
• The state where you live

Although you can get life insurance policies that allow you to enroll after you answer a series of medical questions, you’ll likely get a better rate if you go through the process of allowing them to examine your medical records and take blood samples.  The policy I applied for required this and a nurse came directly to my home to complete the blood tests.

A great, quick resource I’ve found to compare insurance rates on term life insurance is Nerdwallet’s Life Insurance Comparison Tool.  When estimating my own life insurance (healthy female in 30’s with no significant family history) I found that a 20-year term life insurance policy of $500,000 would cost me around $25 per month.  If I were to apply for whole life insurance, I would probably pay over $350 per month for $500,000 of coverage, although my premium would never go up and I would accumulate some cash value.

WHERE DO I OBTAIN COVERAGE?

Often, life insurance is included as an employee benefit under a group life insurance plan.  The most typical amount provided by employers is 1-2 times the employee’s annual salary and most group plans offer employees the option of purchasing additional coverage.  Another common place to obtain life insurance is through a professional association to which you belong.  For example, as a CPA I am a member of the American Institute of Certified Public Accounts (AICPA) and I could obtain group life insurance coverage through my membership with them.

In addition, you can buy personal policies directly from an insurance company or from an independent licensed life insurance agent. It is highly recommended that even if you have group life insurance through an employer, you purchase your own term life insurance as well. If you leave or lose your job, this will ensure that you still have the coverage you need.  As with other types of insurance, be sure that you purchase from a reputable company with an impeccable rating.  Some of the best-rated life insurance companies include Metlife, TIAA Life, New York Life, State Farm, Amica Life and Transamerica.  These insurance agencies all have online websites where you can calculate quotes or contact an agent to get a quote.

HOW DO I MAKE A CLAIM?

In order to make a life insurance benefit claim after the death of the insured person you should follow these steps:

1. Contact the service department of the insurance company as soon as possible after the death of the insured person.
2. File the claim form, which includes filling out information, signing a statement and attaching a certified copy of the death certificate.
3. Choose whether you would like to receive the payment as a lump-sum or another settlement option. Other settlement options include interest only payments which preserve the principal balance, regular fixed payments of principal and interest or an annuity for life.
4. Wait for the policy payout, which is generally a very short period of time of around a week or two.

SUMMARY

If you have anyone depending on your income, you should have obtain life insurance.  Life insurance can cover death-related expenses such as funeral and burial costs and final medical costs.  It can also provide for your dependents in the short and long-term depending on how much insurance you purchase.  Making sure you understand the different types of policies and calculating exactly how much you need are vital to making sure that your family is taken care of if something were to happen to you.

EXAMPLE: THE SMITH FAMILY

Although the Smith family has a small amount of life insurance through Jim’s employer, they know that this would probably not even be enough to cover a full year of expenses after factoring in medical, funeral and burial costs.  Mary doesn’t currently have any life insurance in place.  They use method 1 and 2 first to calculate and find that they need an additional $184,000 of coverage under method 1 (5 times current income) and an additional $567,000 of coverage under method 2 (DIME method).

Under method 3, they run 3 different scenarios:

1. SCENARIO 1: They will need $373,000 of additional life insurance if they obtain enough coverage to pay off their mortgage, credit card debt, auto loans and student loans as well as covering $100,000 for each child’s college costs.  This assumes that Mary will keep working part-time at the same rate as before and both her income and social security survivorship benefits will be enough to cover monthly bills after the first year (which are much, much lower due to the debt payoff).  This scenario is previewed below.
2. SCENARIO 2: If instead they want to assume that they obtain enough coverage to pay off all debt and also that Mary can quit her part-time job as well, they will need an additional $520,000 of life insurance coverage.
3. SCENARIO 3: Last, if they want to purchase enough coverage to pay off all debt and provide for $50,000 per year for the family, they will need an additional $943,000 of life insurance coverage.

The Smith family determines after looking at these different methods and scenarios that they will for now purchase an additional $250,000 of life insurance for Jim and a $100,000 life insurance policy for Mary.  They have decided on this amount for Jim by looking at the first scenario under method 3 and determining that since both of their children are still very young, they would be able to invest some of the proceeds and use them to pay for college in the future for the kids.  However, they will periodically assess their life insurance needs and purchase additional amounts if needed in the future.  They also decide to purchase a 20-year term life insurance policy based on cost and other considerations and will pay around $25 per month for coverage for both of them.

HOMEWORK ASSIGNMENT

If you aren’t sure whether you have sufficient life insurance, you should do some calculations to make sure that your dependents will be well-cared for under any circumstances.

• IMPROVING– At a minimum, make sure you have 5-10 times your annual salary (after taxes) in term life insurance coverage.
• INVESTED– Calculate method 1 and method 2 both in the spreadsheet and take into account any other additional needs and resources specific to your situation.  Purchase term life insurance in the amount you feel would cover the needs of your family.
• UNSTOPPABLE– Calculate your insurance needs under method 3 (above) using the needs of your dependents at the time of your death and the following stages or readjustment, adjustment, pre-retirement and retirement.  Analyze whether you should purchase a term or permanent life insurance policy (I recommend term and to use alternate savings methods instead of taking advantage of the cash value portion of permanent insurance).

Make sure you keep a copy of your calculation saved as an excel file and also in your Financial Plan binder under the Tab Insurance-Life.  You should analyze your insurance needs periodically throughout the future as your needs change.

HANDOUT

Here is a handout you can use to write down the details about your current life insurance policies and keep notes about any changes or adjustments you want to make in the future or questions you have about your coverage.  In the notes section, I recommend writing down how much your insurance covers and the method you used to determine the face amount of the policy.

Do you have a term or permanent life insurance policy?