People have car insurance because bad things can happen to their car. Heck, my window was smashed and radio taken a month ago -- insurance covered all but $500 of the $1500 cost. People have insurance on their house because a small fire can cause tens of thousands of dollars in damage. But many people don't have life insurance because they're squeamish about contemplating their own mortality.
I have no illusions about whether I'll live forever. Among my peers -- perfectly healthy people in their 30s and 40s -- nine have succumbed to heart attacks, an allergic reaction to a food additive, a bout of the flu, pulmonary edema while hiking on Mount Kilimanjaro and car accidents. As a native New Yorker, I knew several people who perished in the World Trade Center attack.
I don't sell life insurance products, but I do advise my clients on the minimum levels they should have in place. There are some straightforward formulas for calculating what that amount should be, and some additional considerations on term length. Lastly, there are both Internet and real-world places to go for the cheapest policies.
Life Cycle Analysis
Does everyone need life insurance? It depends on your stage of life and who is relying on your income. I don't see any need for a teenager, or a single person without dependents, to have life insurance. The money that you would spend on premiums is better directed toward savings.
The picture changes when you get married. Couples make decisions -- for example, obtaining a mortgage to buy a house -- which assume a continued income stream from one or both partners. Additional financial commitments appear with children: food, clothing, college tuition. With dependents in the picture, life insurance makes sense even for a nonworking spouse (because the survivor will need funds to pay, for example, for a nanny).
As a couple approaches retirement, the need for income replacement diminishes because (hopefully) the family's savings and retirement accounts are sufficient. However, families with large estates that would be subject to tax should buy specialized policies, which can be used to pay off estate taxes. (No, I'm not counting on the permanent repeal of this tax.)
How Much Insurance?
When you hedge a long stock position, you buy a quantity of puts equivalent to the number of shares. Estimating the face value of your insurance policy is trickier, because you have to make assumptions about growth of your current income stream; the investment rate of the proceeds should the policy be exercised; and the future inflation rate. In advising my clients, I assume future inflation at 2% and future returns of a diversified stock and bond portfolio at 7%. My rules of thumb for setting policy values:
10 times current income covers about 80% of the lost income.
12 times current income covers about 100% of the lost income.
15 times current income covers 100% of lost income, even taking salary increases into account.
For example, a single-income family of four, earning $100,000 a year, would be well covered with a $1.2 million policy on the primary breadwinner. A second policy on the nonworking spouse might be set at $300,000 (12 times the $25,000-a-year cost of a nanny.)
You can reduce the amount of insurance you need by the amount of liquid assets (e.g., stocks, bonds, mutual funds, retirement accounts, but not real estate), you have on hand already. In the example above, let's assume $200,000 in savings. In that case, you might reduce the policy amounts to $1 million and $100,000. However, in the event of the death of either spouse, the survivor would want to increase coverage at least until the children were self-supporting adults.
You can perform some sensitivity analysis with several online calculators. Bear in mind that the recommendations are only as good as your assumptions. A simple calculator is at Forbes, and a very sophisticated calculator, which lets you compare different types of insurance, is at Yahoo!.
What Kind of Insurance; How Long the Term?
Car insurance is very simple. Based on your driving history, residence and value of car, you pay a premium and renew the policy annually. The premium may rise or fall. If you give up your car, you give up your insurance and get nothing back. Annually renewable insurance is most like car insurance, except that on each renewal, your premium increases. The same $1 million policy might cost $660 a year for a 30-year-old, $920 a year for a 40-year-old, and $1,600 a year for a 50-year-old (example of nonsmoking male in good health, living in New York City). Some policies of this type have a conversion option to term insurance.
I prefer term, level premium insurance in most cases. This policy type establishes a constant premium for the life of the policy. Not only do you know in advance what your premiums will be, but you're also locked in, even if you develop a chronic medical condition. In the case of a client with young children, I might recommend a 20-year policy to remain in effect until after the children graduated from college. In the case of a younger client whose income is still growing, I might recommend a five-year policy with the expectation that we'd take out a larger, longer-term policy on expiration of the first policy.
Whole life insurance is similar to term insurance in that you pay level premiums, but in this case for the rest of your life. The advantage is lower premiums now, but the disadvantage is that you're locked in regardless of life changes.
Universal life insurance allows you to vary your premiums (and thus the face amount of the policy), over time, subject to restrictions including additional health exams.
Variable life insurance allows you to take over management of the investment of the premium. More aggressive investors can increase the value of the policy without increasing their premiums, and can even borrow against the cash value of the policy, but also run the risk of a shortfall should their investment strategy not work out. These policies are often sold as a way of getting back some of your premiums because you have the option of cashing out of the policy at a later date, or converting the cash value to an annuity. I don't like the uncertainty contained in these policies. I'd rather my clients take out a basic-term policy and deposit the money that would otherwise be spent on premiums in an investment account.
People take out insurance policies to fund estate taxes. For example, a couple might fund a "second-to-die" policy with a face amount equivalent to their estimated estate taxes. These situations are extremely complex and beyond the scope of this article -- you'll need the assistance of a full-time estate planner to work through your options.
Taxation
Proceeds of a life insurance policy are delivered free of federal income and state income tax to the beneficiaries. However, the value of the proceeds is added to the value of your estate. For example, if the nominee of a $500,000 policy dies leaving $1 million in assets, then the total estate is now $1.5 million. For this reason, people with substantial assets "gift" their policy to special trusts. As long as they undertake no "ownership" actions (e.g., changing the beneficiary, taking cash out of the policy), in the three years prior to death, the proceeds are not added to their estate.
How to Buy
If you work for a corporation, check with your Human Resources department to see what coverage is included in your basic benefits and whether you can extend the coverage at low cost. You can also consult with insurance brokers, both on and offline. Here is Yahoo's listing of online brokers. You'll fill out a questionnaire about age, health and residence. Theoretically, both online and offline brokers should propose a similar list of insurance companies, but not every broker represents every insurer, so get a couple of different proposals.
Once you select an insurer, you'll most likely undergo a health exam. Insurance premiums are often quoted on the basis of the "preferred" category, but only 20% of policy seekers will qualify for this lowest rate.
David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. Edwards was a contributor to Harry Domash's Fire Your Stock Analyst: Analyzing Stocks On Your Own available at Amazon. At the time of publication, his firm was held positions in Dell and Amazon.com, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback and invites you to send it to David Edwards.
