In Part I of this 3-part series I gave a brief history of the life insurance industry.
Here in Part II I'll go over the main applications for life insurance policies. Next, in Part III, I'll discuss some of the behavioral issues in obtaining coverage.
So what are some of the uses of life insurance? First and foremost, a death benefit to one’s survivors. It is a risk transfer mechanism. If you die before you've been able to financially provide for those financially dependent upon you, the life insurance policy will do so. Other common applications:
It is not uncommon for a commercial lender to require that a borrower take out a life insurance policy in the amount of the loan payable to the lender.
Many cash value policies can be structured to be over-funded in earlier years, and pay out a tax-free stream of income in later years. This is a very powerful use of insurance, because the only other place to go for tax-free income in retirement is a Roth IRA.
Many policies today offer a measure of long-term care benefits. A portion of the death benefit is advanced, on a discounted basis, to the policy owner, should the insured need substantial help and assistance to perform the six Activities of Daily Living.
Florida courts have long held cash values in insurance company products as being judgment-proof in civil litigation. Now, if someone sues you, you can’t just go and stick everything into a life or annuity policy and expect to become judgment proof. Doesn’t work like that. But . . . if you are a physician who doesn’t carry malpractice insurance, this is a viable strategy as long as it is pursued over time. Seek legal advice on this one.
Many divorce settlements will stipulate that one spouse maintain a policy payable to the other spouse. It used to be that If the other spouse owns the policy on you, and this is a condition of the divorce, then the premium becomes deductible by the payor spouse and recognized as income by the payee spouse on the front of the form 1040. This feature was repealed with the 2017 Tax Act.
Say you have a substantial estate in excess of $11.4 million. You’ve worked with your team of advisers: financial planner, accountant, and attorney. You’ll owe $2.0 million in estate taxes at the second death – yours or your spouse’s. Rather than leave your heirs to liquidate assets to pay the taxes, you purchase a second-to-die policy in that amount.
You want to benefit your alma mater, church, or synagogue. The charitable entity purchases and owns a policy on your life. You make tax-deductible donations to the entity, which in turn makes the premium payments with your donations. This is a great way to gin up a lot of charitable giving with relatively small cash outlay that may be fully deductible. See my blog post about charitable giving here.
Begin by answering this question: If you dropped dead tomorrow, what resources will be available to your family to continue without you? That would include your retirement account at work and IRAs, current life insurance, and current investments. Look at the liabilities that need to be paid off – credit cards, for example, or perhaps your mortgage. Work with a good financial planner to then crunch the numbers to see how much you need to purchase.
Most people would, I think, agree with me that one’s financial responsibility to one’s family – the surviving spouse and the children one brought into being – does not end at death, but carries forward for perhaps years to come. On that score I think I’ve heard everything. One client told me that he wanted sufficient insurance to fund his children’s higher education and his wife’s income so that she’d never have to work, and could remain in their home to raise their family. Another man told me that his wife was a beautiful woman who’d certainly remarry in a few years, so he only wanted to leave enough to get her through the transition. Seriously. I heard this.
There’s a process, of course and it begins with you completing an application, which will go into your health history. Then a medical examiner will come to your home to ask more questions, draw blood, and get you to pee into a cup. For larger amounts there’s an EKG. The insurance company will check your DMV records, and then complete the underwriting process with an approval, denial, or rating.
Can you get it? For most people, sure. But if you’ve recovered from cancer or a heart attack within the last year, probably not. Insurance companies price life policies based on standard rates. There are preferred rates and super-preferred for some of us, in addition to table ratings for those who don’t qualify for standard rates. It is only after the insurance company has completed its underwriting process that you’ll get a formal offer of insurance and know what you’ll need to pay. Sometimes there are surprises, both good and bad. One man for whom I’d proposed insurance got a flat decline. It turned out that his PSA levels were high, and as a result of the insurance exam he addressed his medical issues before cancer set in. He didn’t get insurance, but the result of the process was certainly good. On the other hand I’ve proposed people as standard who ended up qualifying for a preferred rate – and lower premium.
The big debate about life insurance is term vs. cash-value. The people in the term insurance camp think that cash-value insurance is a bad deal, investment-wise. They have a point. The biggest bang for the insurance buck is in term insurance. The cash-value people talk about the guarantees of the policy, and the pot of cash that you’re building up. They have a point too. If you look at insurance cash values as part of your overall investment allocation, then perhaps these values can be the conservative part of your allocation, meaning you can be more aggressive with everything else. There’s no right or wrong here – my focus as a planner is that the client has the proper amount of insurance. The composition of the insurance – term, permanent, or some combination thereof – is the secondary consideration.
Did you miss Part I? Check out Part 3 in this series - Why Haven't You Bought the Coverage You Know you Should Have? You may also find our Insurance FAQs helpful. Also see 6 Options for life Policy I No Longer Need. Further questions? Feel free to get in touch with us at [email protected] Also follow us LinkedIn, Facebook, Instagram, and YouTube for more personal financial information relevant to you!