Our clients often ask us if they are sufficiently insured. When they ask this question, they normally don’t understand the breadth of the question and the depth that one can go into when it comes to insurance planning. Typically, they are asking if they are sufficiently insured from a life insurance perspective. That said, there are plenty of other valuable insurance coverages available that may or may not apply to your situation. In the beginning paragraphs, we’ll mention a couple of the other primary forms of insurance that may make sense, but for purposes of this article, the conversation will mostly revolve around life insurance and protecting one’s loved ones in case of an untimely death.
Umbrella Liability Insurance
Umbrella liability insurance is not as well-known as some other forms of insurance, but is really quite important when it comes to protecting one’s assets. Umbrella liability insurance protects you were you to get sued by someone for a very large amount. It is designed to kick in when the liability on your other policies (auto, boat, homeowners, etc.) has been exhausted.
Many times, it comes into play when dealing with automobile accidents. If your teenage son decides to steal your car keys for the night and ends up doing the unthinkable while driving, such as committing manslaughter, the party that sues you may come after you for millions of dollars. Without umbrella liability protection, you may face the risk of financial ruin. There are certainly dozens of other scenarios where umbrella liability is needed. For the most part, conventional thinking when it comes to umbrella liability insurance is that you start with $1,000,000 of protection and increase it in million dollar increments to match your net worth as it grows above $1,000,000. Because it is used so infrequently, the rates are very favorable on this type of policy. The national average for $1,000,000 of this type of coverage is approximately $15/month. It’s often considered the “best buy” in the insurance industry.
Disability insurance protects you were you to suffer a serious injury or debilitating sickness that would prevent you from working for a period of time. There is both short-term and long-term disability insurance. Short-term disability typically covers a monthly amount that is a percentage of your gross income. This lasts for a period of time while you are disabled. If your disability happens to be of a longer-term variety, long-term disability would cover your needs. Long-term disability insurance pays one a monthly benefit if one is unable to work due to a disabling accident or sickness. There are many things to consider when purchasing long-term disability insurance. They include but are not limited to:
- What amount of monthly benefit would be necessary?
- How long would you like the benefit period to last?
- How long would you want to wait until the benefits kick in? This is called the elimination period and can be either 60, 90, 180 or 365 days.
Younger individuals with relatively high incomes (and high expenses) are those who have the biggest need for disability insurance. This is because they have so many working years left that if they happened to become severely disabled, they would lose out on a major portion of their earnings. Disability insurance is considered by many to be quite expensive. Because of the cost (or sometimes simply out of ignorance) plenty of individuals choose to stay exposed in this area, roll the dice and hope for the best.
Most people don’t realize the relatively high probability of becoming disabled, permanently or temporarily, at some point in their lives. But the reality is that at age 40, your chances of becoming disabled for 90 days or more prior to age 65 is 43%.
When it comes to how much life insurance one needs, there is a multitude of factors to take into consideration. Just like most financial dilemmas, there are simple rules of thumb while at the same time there are plenty of complicated formulas to determine this answer.
One simple rule of thumb states that you should take your annual pre-tax income, multiply it by a factor of 10 and purchase that amount of life insurance. This rule is a bit oversimplified and fails to take into account many of the factors that can increase or decrease the amount of insurance that one needs.
When looking at life insurance, we like to look at something called a survivors’ needs analysis. This takes into account the heirs’ financial situation were the main income earner to pass away prematurely. In essence, we take the family’s existing financial model and eliminate the future income of the main income earner. The expenses would stay and this would then give us a starting point for how much insurance is needed. Some of the major expenses to keep in mind are college savings, paying off any existing mortgages, paying off any other outstanding liabilities, and funding a lifestyle similar to what one’s family was accustomed to before the untimely passing.
Let’s take a look at a hypothetical example to help illustrate how an insurance need can be calculated. For ease of use purposes, let’s assume a four person household with one income earner, one stay at home parent and two children. Let’s assume the main income earner nets $100,000/year, they have a $200,000 mortgage, $50,000 in other liabilities and they’d like to have between $100,000-$150,000 saved up for each of their teenage children for their education expenses. Let’s assume their annual living expenses are $75,000/year; both parents are 45 and both children are 15 (twins run in the family for this hypothetical household!).
In this scenario, there is an obvious and immediate need of $500,000 to cover the mortgage ($200,000), the other debt ($50,000) and the children’s educations ($125,000 * 2). Additionally, assume the main income earner was planning to work until age 65, there is a need to replace his/her $2,000,000 of future earnings. This is not to say that the need is $2,500,000, however it is certainly much higher than the $500,000 number. Also, if the main income earner passed away, would the stay-at-home parent be willing and able to go back to work? If so, at what salary? If the answer is no, then the insurance need would obviously go up.
Again for ease of use purposes, let’s assume the stay at home parent does not intend to have much in the way of earnings. Let’s also assume the insurance proceeds would be invested in such a way as that they would earn 5% after tax. Therefore, you can take the $75,000/year lifestyle need and divide it by 5%. This calculation gets you to your answer, which in this case would be $1,500,000. This method would allow the remaining family members to essentially live off of the portfolio (consisting of the invested life insurance proceeds) without touching too much of the principal. In theory, none of the principal would be touched, but that is an assumption over the long-run. The returns would not be a linear 5% after-tax return, so there is a reasonable probability that at some point the principal would need to be touched.
In summary, the total need is calculated by taking the $500,000 “immediate need” number and adding it to the $1,500,000 “lifestyle need” number for a total insurance need of $2,000,000. Clearly, these calculations are not meant to be ironclad and are simply ballpark calculations intended to show a quick back of the envelope method of determining one’s life insurance need. You can certainly get as detailed as you would like when it comes to figuring these numbers out, but this cursory process tends to get you to a number that is somewhat reasonable and passes the “sanity test.”
Whole life insurance versus term life insurance
Lastly, once one determines that life insurance is needed, the type of life insurance must then be determined. Whole life insurance and term life insurance are very different products. If one is primarily concerned about replacing lost income were they to pass away prematurely, then term insurance is probably the most reasonable way to go about accomplishing this goal. If one is worried about estate taxes after death, or possibly replacing the destroyed value of a business after death, then there is greater potential that whole life insurance should be given much stronger consideration.
Whole life insurance is also called permanent life insurance. A portion of the premiums go into what is essentially a savings account and create a cash value in the policy. Some see whole life insurance as a forced savings vehicle and see that as an advantage. Whole life insurance also features guaranteed level premiums and guaranteed death benefits. Because of the many features of whole life insurance and because of its store of cash value, this type of policy is much more expensive than term life insurance.
Term life insurance is a much more affordable way to protect one’s loved ones. The purchaser specifies the number of years of the term and the face amount of the policy. For instance, in the above example, the individual could purchase a 20 year level term policy to cover the families’ needs during his/her working years. As the individual moved along in years, he/she could lessen the face amount as the need should become less as debts are paid down and fewer years of expenses are needed.
Hopefully the above paragraphs serve as a bit of an educational primer in insurance needs planning. For those who already have insurance, it makes sense to periodically review your various insurance policies with your advisor to make sure that your coverage is still appropriate for your level of need.
 2004 Field Guide, National Underwriter.