Sept. 27, 2018
“There are worse things in life than death. Have you ever spent an evening with an insurance salesman?” – Woody Allen
Life insurance is a very important part of every estate plan, and in many cases life insurance decisions have not been in the optimum interests of a client or their family.
Oftentimes, clients will come to us without knowing the specific benefits or policy terms of their life insurance plan, but they will know how much life insurance coverage they have. This often happens because the insurance agent they originally purchased the coverage from is either no longer with the policy carrier or because the agent did not have a full picture of the client’s financial situation at the time of the purchase.
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There are many different kinds of permanent life insurance, and it is most prudent to spend a few hours to clearly understand the choices and the pros and cons before making a significant permanent life insurance purchase.
The key to getting the right life insurance is to determine three things: (1) the ideal amount of life insurance coverage, (2) the period of time you expect to need the coverage, and (3) if your current policy is sufficient to meet the amount you need to provide over the time period you decide. If you do not have enough, then you need to decide whether your policies should be replaced or supplemented with new policies.
Rule of 6/3
When determining how much life insurance coverage you need, we always want to make sure there is enough coverage for family members to be financially stable in all aspects of their lives. Several financial institutions will generate lengthy reports on how much life insurance coverage you need. However, many people simply use something called the Rule of 6/3 to help you decide how much coverage is enough. It was developed by Michael Davis of Resource Consulting Group in Orlando, Florida.
The Rule of 6/3 works as follows:
1. Estimate the continuing income needs of your family.
2. Assume that they will receive a 6% rate of return on investments at best and a 3% rate of return on investments at worst.
3. Divide the annual income needed by 3% to determine after death investments.
4. Take the difference between the total amount of investments needed and what you have now in order to determine how much life insurance you need. Based on this, you may want to add more life insurance to account for a margin of error and other unexpected expenses that may arise.
For example, if your family needs $180,000 a year to live comfortably, then, at worst, you would take $180,000 ÷ 0.03, which equals a $6,000,000 life insurance coverage policy to provide this support. In a best-case scenario, your family would be able to earn 6% on investments, which would provide them with $360,000 a year. So, if you only have a $4,000,000 life insurance coverage policy with this situation, you may need to add extra coverage for your family to be financially sound.
Even though your family might receive the 6% rate of return, it is always best to be prepared to live on the 3% rate of return and possibly use the rest of the 3% for luxury items that could be cut back if necessary.
How much coverage you need now is not the only factor that should be taken into consideration when purchasing your policy. It is always best to plan for the future by predicting how much you might need. For instance, if you are planning to have children, their needs change dramatically, so it would be best to purchase enough life insurance to cover those needs.
Term Life Insurance v. Permanent Life Insurance
You really have two options when choosing life insurance policies, term life insurance or permanent life insurance. Term life insurance is a popular alternative to permanent life insurance because it is less expensive, has a fixed annual premium, and is available for a limited amount of time. The insured designates a beneficiary so in the event that the insured dies during the term, the death benefit will be paid to the beneficiary.
Although term life insurance policies may be enough to provide coverage in the near future, they often expire or require costly conversions to permanent life insurance policies. Many term life insurance policies expire several years after the deadline for conversion, which is why it is important to read the policy carefully and note the dates by which you have to convert the policy to make sure that your coverage will not lapse if you are unhealthy and cannot find a substitute policy.
On the other hand, permanent life insurance policies are generally more expensive, but they have a few advantages. In many states, permanent life insurance policies are protected from creditors if the policy is owned by the person who is insured, but are not protected from creditors if it is owned by an irrevocable trust. In order to protect the family, if the beneficiary of the policy is a trust, then the policy would remain protected from creditors, family member creditors, future divorce or other threats to wealth, and federal estate tax.
It is also important to periodically request computerized projections of each permanent life insurance policy to see how it is performing and to project actions for the future. Typically, carriers will provide you with illustrations that take projected mortality costs and administrative costs, but the carrier will not guarantee that premiums will not increase even though when the policy was originally illustrated the purchaser thought that they were “set in stone.” It has been very useful to run spreadsheets showing both the projected and guaranteed policy results in order to help clients decide which policy to buy, and understand where it fits in with their overall financial asset planning. Insurance agents and agencies are prohibited from illustrating many spreadsheet scenarios that CPAs and lawyers are able to provide because of the federal law concerning what an insurance carrier or agent is allowed to show.
Laddering Life Insurance Policies
A popular option is to purchase term life insurance policies with different lengths of coverage to create a “ladder”-like structure with their policies. For instance, if you have young children you might purchase $3,000,000 term life insurance with $1,000,000 at 10 years and $2,000,000 at 20 years. This would ensure that, in the event of your death, your spouse and children are well provided for until the children reach college age.
If you think you may want to reduce your coverage later, a viable option is to purchase several life insurance policies. What many people do not realize is that you cannot reduce or increase a life insurance policy once it has been purchased. So, if a you are looking at buying a $3,000,000 policy, but think you may want to reduce the policy by $1,000,000 or even $2,000,000 in the future, your best option might be to purchase three separate $1,000,000 policies or six $500,000 policies, which would provide you flexibility if you decide to reduce your coverage amount in the future.
Physical Examination Requirement
Carriers of significant life insurance policies will usually send out a nurse to conduct a physical examination to verify the insurer’s physical condition and the proper completion of a health status questionnaire. When going about this process, you can ask an independent agent whether they can provide an “informal application” to get a quote from one or more carriers without the data from the physical finding its way to the bureau that makes all of your examination data available to all insurance carriers for eight years.
Our clients normally prefer to have their health insurance examination data remain strictly confidential unless or until a carrier accepts them and issues a policy.
We advise our clients to obtain a physical before shopping for coverage costs, because policy costs are not really known until the insurance carriers know what your health situation is.
There are many plans and carriers to choose from when deciding what life insurance to get. It is important to consider the current financial needs of your loved ones, as well as possible future financial needs and inflation, to ensure you get enough coverage to fully take care of your family when you pass. Your physical health has a dramatic effect on the policy options available to you, so you may want an agent to help you get informal quotes to see what your options likely are. But remember that once you buy a policy you may not be able to reduce the policy’s coverage, and can almost never increase coverage without a new physical, so you may want to consider buying multiple policies instead of just one large one so that you can give up one small policy at a time to allow your coverage to be reduced.
There is no one right answer as to which life insurance policy or policies will be best for you, but asking questions to make sure that you understand the situation and options can be very important.