Everyone has heard of life insurance and most people have some; it’s not an exotic concept. Yet for the average person, buying life insurance means signing the most complex contract you’ll ever enter into. This will be the first of a series of short primers on life insurance: why people need it, how it works, how much to buy, what kind to buy.
One of my favorite graphics is this one, which originally appeared in the August 2006 National Geographic. It illustrates a fundamental fact: although we don’t know when we will die, we each have a 100% probability of doing so.
The National Safety Council compiles all sorts of statistics on the probability of dying from various kinds of accidents. The statistics reveal a few surprises; for example, your lifetime odds of dying as a consequence of a surgical/medical procedure (1 in 1,308) are considerably lower than your chances of accidental death while occupying an automobile (1 in 247), but most people are more worried about having an operation than about getting into a car.
Most people recognize that if they die from a cause other than old age, their death could have negative economic consequences for others. Although there’s no way to replace the personal value of a life, life insurance does serve as a way to provide for our loved ones and/or pay our debts after we die.
I can think of at least six reasons that a person might need life insurance:
- To replace one’s ability to earn income
If your income is needed to support family members (particularly minor children), your death causes an economic shortfall. Unless your family has significant surplus financial resources and/or other extended family can provide support, you probably need some life insurance.
- To replace one’s ability to care for others
If you’re involved in the daily care of a household, your contributions have an economic value and your death would cause an immediate need for replacement care. Again, the presence of young children in a household means that the loss of a caregiver (usually a mother) has economic consequences. If the Mom Salary Wizard at Salary.com is correct, a stay-at-home mom with two school-age children does work with a salary value ranging from $64K to 174K, depending on where the family lives. Alternatively, if you’re responsible for the care of an elderly relative or an older child with special needs, life insurance could be needed to provide continued care in the event of your death.
- To pay for expenses arising as a result of death
This could include anything from the cost of burial to the payment of estate taxes or the repayment of your debts.
- To provide for special business needs
If your contribution is critical to the success of a business (especially a small business), there would be serious consequences if you die suddenly. Banks sometimes require life insurance on a key person in a business as a condition of extending business credit. Life insurance may be needed to enable the business to survive the transition when a principal dies, or there may be a need for ready cash to enable the remaining partners in a business to buy out the heirs of a deceased partner.
- To fund a charitable interest
If you desire to support a charity, life insurance can be a way to make gradual payments that eventually result in the provision of a significant charitable gift.
- To provide supplemental income later in life
Some types of insurance policies are considered permanent insurance (in contrast with term insurance, which has a specified duration). Such policies, in addition to providing for a death settlement, have a cash value which can be used in various ways. In some instances it may make sense to fund a policy so that it contains an excess of cash value that can subsequently be withdrawn or borrowed during retirement. Using an insurance policy for this goal requires particularly careful planning. This use of insurance will not apply to most people, since there are several other tax-advantaged ways to provide for retirement income.
Life insurance is one way to provide for any of these needs. Some of these needs may exist for a limited period of time, in which case term insurance is almost certainly the best choice.
Right away, this should make certain things evident. For example, there’s no obvious reason to buy life insurance for a child; although you can do so, a child’s death typically doesn’t cause an economic shortfall. Still, the insurance industry used to sell quite a few such policies, and I still see people with small policies that their parents bought forty years ago. Similarly, many single people don’t need life insurance.
It should also be evident that buying life insurance requires an analysis of a household’s total financial situation in order to determine the amount of insurance needed. It’s wasteful to buy more than you need. If your goal is to replace lost income, you need to estimate the actual economic impact of a death rather than buying what sounds like a good number or using a “rule of thumb.” $500,000 of coverage might be a lot more life insurance than you need, or it might be far short of being sufficient. I’ll address the “how much do I need” question later in this series.
As I noted at the beginning, life insurance contracts are complicated. Life insurance policies have special characteristics, such as the tax consequences of the benefits received (often, a death benefit is received tax-free) and the estate tax consequences (the value of a life insurance death benefit may or may not be included in the estate of the deceased for estate tax purposes). I won’t be able to discuss these aspects of insurance in detail in this series of posts, but I’ll try to point the way to some helpful resources that provide further information.
Part 2 of this series, “How Does Life Insurance Work?,” is found here.
Part 3 of this series, “How Much Life Insurance Do I Need?,” is found here.