Insurance is a subject that even confounds people who know a lot
about finance. While you need it like you need food, sometimes you
don’t. Policies can be expensive. AdviceIQ contributor Rick Kahler, who
runs Kahler Financial Group in Rapid City, S.D., is a font of
common sense and practical financial knowledge – and unravels this
question.
Insurance is vital for your family’s well-being. But sometimes it
isn’t, such as when you have enough wealth to no longer need it, or your
kids are grown. You should know when you no longer need to shell out
for a policy.
You buy life insurance to protect yourself and your family with
coverage that you won’t outlive. This is one of the common selling
points for whole life or universal life, rather than term life
insurance.
At first glance, this seems to make a lot of sense. Of course, you
don’t want to outlive your life insurance. Having it pay benefits upon
your death is the reason you buy the policy.
This statement, however, misses one essential fact. Many people don’t
need to worry about outliving their life insurance, because they
outlive their need for life insurance.
We don’t all need life insurance throughout our entire lives, any
more than we do auto or homeowners’ insurance. If you no longer drive a
car, you don’t need auto insurance. If you no longer own a home, you
don’t need homeowners’ insurance.
In circumstances like the following, you may no longer need life
insurance: First, when you and your spouse have accumulated enough
assets and income streams to independently care for yourselves. Second,
when your children are self-sufficient adults. Third, when your estate
is too small to owe estate taxes or liquid enough to pay the estate
taxes.
Life insurance comes in two basic flavors. With whole or universal,
you get the protection of a death benefit and also there’s an investment
component, called its cash value. This type of policy is also known as
permanent insurance, as you can hold it your entire life. With term
insurance, the policy lasts for a given period, often 20 or 30 years,
and carries no cash value. Term usually is cheaper than whole or
universal.
The primary purpose of life insurance is to replace the future income
of a primary breadwinner. Two groups most likely to need it are
middle-aged couples saving for retirement and parents of minor children.
Ideally, most young families should have over $1 million in life
insurance to provide for the children if either parent should die
prematurely. Yet many of them are unable to afford the higher premiums
for this much “permanent” insurance. Their choices are to underfund
their needs with a smaller permanent policy or purchase an affordable
30-year term policy.
As we age, the probability of dying becomes greater. Therefore, a $1
million life policy costs much less for a 25-year-old than a
75-year-old. It doesn’t matter if the policy is cash value, whole life,
universal life or level term – the cost of providing the life insurance
component increases every year.
Yet most human brains have a psychological aversion to price
increases. To please their customers with life insurance premiums that
didn’t increase every year, insurance companies came out with level term
policies. Essentially, the premiums are averaged out: The insurer
overcharges in the policy’s early years and undercharges in the later
years.
Whole life and universal life insurance policies don’t have that same
averaging. To be “permanent,” the premiums must be much higher to fund a
savings account that grows over time and is often used to offset a
significant portion of the death benefit in the insured’s later years.
Usually, if the insured cancels the policy, a portion of the premiums is
refunded.
A cash value policy may occasionally be a good estate-planning tool,
generally for those with substantial wealth. You may use it to fund an
irrevocable life insurance trust upon the second spouse’s death, perhaps
to pay taxes on an illiquid estate like a family farm or other
property. If you want to leave the bulk of an estate to charity and
still provide income to your children, this type of policy also is
useful. These strategies rarely apply to those whose primary goal is
basic income replacement for their families.
One of the ironies of insurance in general is that it’s essential but
we hope never to need it. For most people, life insurance is not really
an exception to this. Its primary purpose is not to provide us with
investment income, but to provide our families with income if we aren’t
there.
