Why We Need Life Insurance and How to Calculate Your Needs Part 1

Warning Order

Happy new year!  As we start off 2018, many of you likely have new year’s resolutions to work toward.  While those resolutions might be to save more, to pay down debt, to work out more, this article will discuss another one of those topics we prefer didn’t exist: life insurance.  We’ll go over a general discussion of the different types of life insurance and, more importantly, how to determine the correct amount of life insurance have and the stages in life where it is most important.

Situation

Any good financial plan will cover various areas of insurance depending on the particular circumstances facing a client.  An unmarried renter with few assets may only need renter’s insurance, auto insurance, and possibly some liability coverage.  A family who runs a business with multiple founders and has one or more children faces additional insurance needs.  Life insurance is an essential form of insurance for anyone with ongoing obligations to others such as income, mortgage payments, car payments, etc.  For part 1 of this article, I’m going to cover the major elements in the financial lifecycle and how insurance needs change over time as a part of that cycle.  Additionally, you will get a crash course on the basics of life insurance.  Our service members should review my article on military death benefits and include those benefits as part of their life insurance calculation.

So why do we need life insurance?  At the most basic level, any insurance is the exchange of a premium in return an insurance company paying a more substantial sum should the insured event occur.  The insurance company funds these policies by receiving insurance premiums from a significantly higher number of policies than they statistically expect to pay out.

We go through our lives owning things like cars, houses, furniture (assets) while also having obligations that might change over time including a mortgage, car payment, putting food on the table, or paying for a child’s education (these obligations are liabilities on a family’s balance sheet).  We make up the difference between our assets and liabilities with our human capital (also known as sweat equity), which is the ability of the combination of our intellect and labor to earn income in the future.  For example, when we take out a mortgage, the bank is considering our ability to continue to earn an income over the life of the loan in order to pay off said loan.  Same goes for student debts, auto loans, and any other sort of debt.

In the process of earning our income and going about our everyday lives, we face risks on a regular basis.  From driving to and from work to eating breakfast, lunch, and dinner, every activity has some level of mortal risk to it.  Although we live in one of the safest periods in human history, even for our military service members, there is always a small chance that an individual may not live to see the sun come up the next day.  When that human capital (the ability to pay the rent or the mortgage, to put food on the table, or to send kids to college) suddenly disappears, the liabilities often do not.  For this reason, we use life insurance, where we trade a small premium for a large payout in the unlikely chance we die at a point in time where our liabilities are greater than our assets.

How Needs Change Over Time

Discussing a normal financial lifecycle is helpful to illuminate how and when we need life insurance.  Generally, young people have few assets outside of human capital, but also have few liabilities.  Yes, a young person often has student debt, needs a roof over their head, and must put food on the table, but they don’t have to do that for anyone else like a spouse or child.  If an unfortunate event ends their life prematurely, their liabilities mostly cease to exist, including student debt, auto loans, etc.

As the individual progresses in life, the person often marries, has children, and purchases a home and one or two cars.  Indeed, many people follow different paths, starting families earlier or later, not getting married, etc.  But at some point, most people take on some long-term obligations.  Characterizing this period of life are low but growing assets and significant obligations.  As cars, home prices, and education costs continue increasing in price, the size of these liabilities continues to grow.  Throughout this period, though, assets increase as the family uses their income to pay down debts and to save and invest.

At some point, the kids have finished school, the mortgage has been paid off, and savings have grown to a size to fund retirement or are making progress toward that goal.  At this juncture, an individual or family has entered the final third of their lifecycle from a life insurance perspective.  In other words, outside of a few unique needs, people should have little need for significant amounts of life insurance unless unique circumstances require it, such as business ownership.

Types of Life Insurance

Someone (not me) could write a book on the different types and characteristics of life insurance, so I’m just going to cover the basic characteristics of the two types of life insurance relevant to this article: term life insurance and permanent life insurance.

Term Life Insurance

I’ll start with the most basic life insurance: term insurance.  This stripped-down life insurance provides nothing besides the prescribed death benefit if the insured individual dies within the specified term.  Once the term ends, so does any insurance benefit and the insured receives nothing even though he or she has paid premiums for the entire period: 10, 20, or even 30 years.  The upside of this type of policy?  It’s incredibly cost-effective.

Because of the simplicity of term life insurance, only a few variables affect the price for a given benefit amount.  These variables include the length of the term and the age, gender, and health of the insured.  Longer terms come with increased chances of death due to age, health conditions, and simple exposure to uncontrollable events.  Starting term insurance at a higher age is similar in that one’s exposure to health challenges increases with age.  Next, women tend to live longer than men, which also affects the cost of insurance.  Finally, specific behaviors, such as smoking, or known health problems increase the chance of death within the time the insurance policy is in force, creating a corresponding increase in premiums.  Insurance companies often offer additional options to term policies, called ‘riders,’ that provide additional benefits in return for higher premiums.

The three main types of term policies are level term, increasing term, and decreasing term.  Level term means the insurance company determines a premium based on the variables discussed previously, and the premium amount remains the same for the length of the policy.  Increasing term insurance means for a selected face value, the premiums increase as the insured ages, often adjusting annually.  The resulting premium starts out lower than level term, but can grow to a significantly higher amount toward the end of the policy.  Decreasing term, on the other hand, refers to a decreasing benefit amount.  For example, the policy benefit may be $1,000,000 at the start of the term, but fall to $100,000 toward the end of the term.  The premiums should be lower than level term premiums.  Of the three, decreasing term insurance best follows the financial lifecycle, but also can leave an individual or family underinsured if the timing of life events changes.

Permanent Life Insurance

The other primary type of life insurance is permanent life insurance, also known as whole life or universal life.  While differences exist between whole and universal life insurance, with the latter providing some increased flexibility, we’ll focus on the permanent feature of these policies.  The premiums on these policies are designed to pay for the death benefit of the insurance through age 120, at which point the accumulated cash value, which I’ll explain in a moment, is equal to the death benefit.  Some older policies may have calculated premiums based on age 100 instead.  In other words, the premiums continue until the insured dies or reaches age 120, whichever happens first.  Someone who reaches age 120 (not currently a likely event) will receive a payout of the cash value built up within the policy equivalent to the face value.

Cash value is the other main difference between term and permanent life insurance.  In permanent policies, the portion of the premium that doesn’t go toward the death benefit, administrative expenses, or the insurance company’s profits goes instead into the cash value of the policy.  This cash value builds up over time and also receives interest from the insurance company and can often be accessed through surrendering the policy or taking a loan against it.  Keep in mind, though, that upon death, the beneficiary receives the higher amount of the death benefit or the cash value, not both.  Permanent insurance seems excellent until we account for the cost, for the premiums are often 10 or more times as high as term insurance for an equivalent benefit amount.

Command & Signal

In the first part of this article, we covered the basics of life insurance, why we use it, and when in the course of our lives we need it most.  As much as we want to avoid the subject of insurance, it is a critical part of any financial plan, protecting us from unexpected events.  Part 2 will go into detail on how to calculate insurance needs.

Other Resources

Term vs Whole Life Insurance | Credit Donkey

The Differences Between Term and Whole Life Insurance | Nerd Wallet

Whole Life vs. Term Life Insurance

Why Decreasing Term Life Has Fallen out of Favor

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