Planning for the future can be a fun activity. Hopes and dreams can be explored. Goals and aspirations can be mapped out. The impossibility can become possible when we put our minds to making our dreams a reality. That is until the unthinkable happens and a catastrophic event, like a premature death, stops us from reaching our potential. Now imagine the goals you were planning for were not just your own. In fact, they included the goals of your spouse, children, and maybe even parents or siblings. What happens to those individual’s lives if they do not have the financial support you were once providing? It’s in times like this that protecting yourself, and those you care about, with life insurance for a limited period of time can make sense. In this article we will tackle the crucial topics related to term insurance like what is term insurance, how does term insurance work, who is term insurance best for, and how much term insurance do I need?
What Is Term Insurance
In the life insurance industry there are many types of life insurance, each with their own bells and whistles. However, of all the derivations of life insurance that exist all of them fall into one of two categories: term insurance or permanent insurance. For this article we will cover term insurance and delve into permanent insurance in another article.
Term insurance at its core is simply an insurer agreeing to pay your heirs a lump sum of money during a specified period of time in the event you die. In exchange for the lump sum of money you agree to pay a premium monthly, quarterly, or annually. This premium is used by the insurer to offset their payout liabilities.
In nearly all cases the amount the insurer pays out is in excess of the premiums you pay, if you die. Essentially small dollars (your money) buys big dollars (insurer’s coverage). As you might imagine this business model would implode if the insurer was paying out more in claims than they were bringing in with premiums. This points to a critical observation with term insurance… over 99% of term insurance policies NEVER pay a death benefit. Wait, if 99% of term insurance policies never pay a death benefit then isn’t buying term insurance akin to throwing money away?
I guess that depends on who you are speaking with. If you are speaking with a single individual then they may say “yes”. Alternatively, if you are speaking with a single individual who has people relying on them (i.e. children or parents) then they may say “no”. Perspective changes the conversation dramatically.
If we all new the date we were going to depart this earth then we would only purchase insurance for the least amount of time needed. Of course in situations like this life insurance companies wouldn’t exist because they would never be able to afford to payout benefits to everyone. It is the premiums associated with the 99% of policies that do not payout which pay for the 1% of policies that do require a claim to be paid. Therefore, since we do not know when we will die we need to insure our lives for a period of time, usually the longest period, for the cheapest price.
Today most insurers provide term insurance coverage for as little as five years and as long as forty years. Of course the cost of coverage will be higher the longer you require insurance but the total premiums you pay will still be far less than the face value that will be paid.
Who Is Term Insurance Best For
Term insurance is appropriate for someone who has, or will have, people reliant on them. This could be someone with family, someone with a business, or someone who has been donating to charities and wants to ensure those charities receive funds after they are dead.
As financial planners we see clients use term insurance for a multitude of reasons like:
- Provide income replacement to a spouse for lost wages.
- Payoff the household’s debt obligations (e.g. house, credit card, student loans, etc.).
- Securing the family’s goals like a spouse’s retirement or the children’s education.
- Transferring wealth to children and grandchildren.
- Funding their business with enough capital to keep the business going.
- Creating an executive compensation package with golden handcuffs.
- Leaving a charitable legacy to organizations reliant on donations.
Each of the aforementioned reasons are personal to the individual making the need for term insurance also personal to the individual. In other words, thinking term insurance is just used to make someone else wealthy at your expense is not the correct way to think about term insurance. Instead, applying a purpose for what, or how, the coverage will be used tends to create urgency behind needing the correct coverage. While it is easy to say “you don’t care what happens to others when you are gone” the reality tends to be the opposite. If you cared during life you will most likely want to help after you’re gone.
Bottom line, term insurance is appropriate for anyone who has a purpose AND believes in that purpose while they are alive AND when they are gone.
How Much Term Insurance Do I Need
Determining the amount of term insurance you need is directly tied to the goal you are trying to protect. As mentioned above, a person’s purpose, or goals and dreams, can vary widely; therefore it is important to pin down the things you want to protect before applying for insurance.
Once you have assessed the areas of importance you can begin adding up the amounts to be left to each person or group. Let’s go through two examples using the list above:
Term Insurance Example #1
I have a family who I deeply care for. I want to make sure they are provided for should I die prematurely. That said, I do not want to make them independently wealthy. I am not raising trust fund babies!
Thinking about my children I acknowledge I want to pay for their college and provide a little additional money to help them purchase a house. I know the cost of college will be approximately $150,000 and the desired downpayment would be $100,000.
Since I do not have a spouse I am not worried about replacing someone’s income, or securing their retirement, any time soon. However, I do acknowledge I want to remarry in the future and I would like to have some coverage in place now that might support them in the future. Therefore, I elect to add another $250,000 of coverage that I can earmark for them later.
Finally, I know that when I remarry the household will have debt on our house. Unfortunately, I do not know what that will amount to so I can only guess the amount now. Knowing what I have in equity today and knowing that they will have some assets of their own I decide to add another $500,000 of term insurance coverage. This amount will be earmarked to payoff the mortgage if I died prematurely.
This means I need to apply for $1,000,000 of term insurance coverage. Taking a policy out in my early 40’s for 30 years, assuming I receive a standard rating from the underwriters, would mean my cost for the term insurance could cost up to $2,500 per year, depending on the insurer I choose. If I qualified for a preferred rating the annual cost could be as low as $1,100 per year. The difference between a standard and preferred underwriting rating is directly related to your health, weight, and risk classifications. There are a few other underwriting classifications that may impact the rating but those three are the big factors.
Term Insurance Example #2
In addition to the family mentioned above I own a few businesses. It is my goal that the businesses continue on until my family agrees to sell them, or until management decides another party would be a better fit to grow them. To help my management team continue on with our mission of helping entrepreneurs and executives I need to make sure my businesses have the necessary capital to secure my future replacement, or to hire people that can help scale the companies beyond their current limits.
In addition to supporting my management team with operating capital I would also like to provide them with some liquidity to purchase a portion of equity from my heirs, should my heirs request the cash infusion. In the event my heirs do not request to liquidate a portion of the businesses the management team can put the proceeds to work within the businesses.
Of course the question now becomes how much should I be insurable for? There is no perfect answer but a general rule of thumb would be to obtain enough coverage to pay your replacement for a period of three to five years. The amount you pay your replacement can be gauged on how much you would need to pay someone today to perform your tasks. Let’s say, in this example, you would need to pay someone $250,000 to perform your tasks. This would mean you would need $750,000 to $1,250,000 of insurance coverage. Additionally, if you wanted to allow your heirs to take a portion of their inherited equity from the business and liquidate it you would need to estimate a dollar value for that as well.
Keeping the focus on you for a moment, if we combine the amounts associated with the equity liquidation and funding your replacement you may need between $1,500,000 and $2,500,000. Based on the previous example’s underwriting ratings you might expect the cost of this policy to range between $1,500 and $3,000 per year.
This type of policy is typically referred to as a “key person” policy and is typically owned by the company. Since it is an asset, and expense, of the company the cost of coverage is a write-off to the business. Unfortunately, the proceeds do not receive the same preferential tax status as in the case of the policy being owned and paid for by an individual. I won’t get into the nitty gritty details of this nuanced differences now. Instead, I would strongly recommend speaking with a qualified tax, legal, or financial professional to understand the ramifications to you and your business.
Life insurance is purpose driven. If you do not have a purpose, or need, to protect then the cost associated with acquiring coverage will always be viewed as an expense. It is only when you are purpose bound do you realize the cost is akin to an investment in protecting your future goals, dreams, aspirations, or more. If you find yourself needing a term insurance quote, if you need help designing a cost efficient term insurance strategy, or you want to discuss how to combine term insurance with permanent insurance within your executive financial plan, feel free to reach out to our team at C-Suite Planning™!
The material contained in this article was created for educational and informational purposes only and is not intended to provide specific recommendations, tax, or legal advice. The author, and the author’s firm, strongly encourages you to speak with a qualified professional before taking action on anything mentioned in this article.