Life Insurance

May 12, 2009

How much life insurance you need is a function of many factors including your liability (not just debt but also protecting loved ones), your earnings, your other assets, and your time horizon.

Now that we have discussed an overview of both the financial planning and portfolio management components of wealth management, I would like to drill down a bit deeper to cover individual elements of each discipline.

We’ll start with financial planning and review the critical area of risk management with a particular focus on life insurance. For this discussion, we will consider life insurance for protection purposes and not for estate planning (tax) purposes.

There are at least five important questions to ask yourself with life insurance:

1. How much do you need?

2. How long will you need it for?

3. What type of insurance should you buy?

4. Who should own the policy and who should be beneficiary?

5. Which company should you buy insurance from?

First, how much life insurance you need is a function of many factors including your liability (not just debt but also protecting loved ones), your earnings, your other assets, and your time horizon. Typically, you calculate your capital needs by taking a present value of your current and future debt and liabilities, and compare that number to your current assets. The shortfall sets a baseline for the amount of insurance you need.

With regard to how long you need it for, you need to look at the length of your debts, the length of your commitments to loved ones like children, and the length of your earning years, and you need to make sure you have the proper insurance to cover those time periods.

The next question, with regard to what type of insurance to purchase (term vs. permanent) depends on your situation and goals. The short explanation is that term is for a portion or “term” of your life and permanent insurance is for the remainder of your life. In general, term should be used to cover the large needs like taking care of loved ones, protecting your earnings capacity or protecting a debt. Permanent insurance should be used for your very long term needs such as burial, estate planning, cash value accumulation, etc.

Ownership of the policy is primarily an estate planning issue. If the policy is owned by the insured, the death benefit is included in the insured’s estate for the estate tax calculation. If the policy is owned by a trust (irrevocable life insurance trust or ILIT), then the death benefit is not part of the insured’s estate (or the beneficiary’s estate) and is not part of the estate tax calculation. For estates that may be subject to estate taxes (currently $3.5 million or more) this is most likely the preferred method of ownership. As far as income tax, in general the death benefit is income tax free (unless the premium is paid by an employer).

Finally, large insurance needs should be met by multiple policies from multiple companies. This provides more flexibility in your planning and protects you from having all your insurance needs met by only one company (should that company fall on hard times in the future). At the end of the day, an insurance policy is no more than a promise to pay from the insurance company. Diversifying that promise is as good an idea as diversifying your investments.

Tom Orecchio, CFA, CFP, CLU, ChFC, AIF, is the president of Modera Wealth Management, which offers fee-only wealth management services.