Life Insurance Awareness Month: Back to the Basics

September is Life Insurance Awareness Month. This is a great time to take a step back from the technical work that fills our days, the illustrations, internal rate of return (IRR) calculations, trust structures, tax regulations, in-force policy reviews, and get back to the original purpose of life insurance. During the Industrial Revolution of the mid-19th century, life insurance was commonly marketed to protect widows and orphans. Today, it is used for much more, but the origin of this financial tool still holds true today.

In 22 years of doing this work, no beneficiary of a policy has ever asked: What type of policy was it that paid the life insurance benefit? Often they don’t even know the life insurer; they’re just appreciative that their loved one planned ahead for the unexpected. Early in my career, I hand-delivered a $20,000,000 life insurance check to a grieving widow. It was a term policy that my client purchased just 3 years earlier. The claim the insurer paid was far larger than the premiums it had received, but to this day I’d argue all day long that the family lost. They lost a great, great man far too early. $20,000,000 didn’t begin to account for the impact he would have had on his family, his business and community had he been here to see his vision through. One thing wasn’t lost on me: the way he loved his family and never wanted them to struggle.

This is a single client experience. It is not representative of any other client’s experience and is not a prediction of any particular outcome. Term insurance provides coverage only for a stated period; if the insured survives that period, no death benefit is paid.

Life insurance behaves differently from other assets in a client’s portfolio: a death benefit payable regardless of market conditions, an effective return on premiums that is highest early and declines the longer the policy is held, and, when structured correctly, tax characteristics many other assets do not offer.

Life insurance also carries costs, underwriting requirements and surrender charges that other assets do not.

1. Income Replacement

The original purpose, and still the most common. When an earner dies prematurely, the household loses income it was relying upon. Quantifying that loss is where the discipline lies, and there are three broad approaches:

• Human life value: Capitalize the insured’s projected future earnings, net of personal consumption, and discount to present value.
• Needs analysis: Build the survivor’s requirement from the ground up, covering income replacement, education funding, and final expenses, then offset existing liquid assets and replace the remaining need with life insurance.
• Multiple of Income: The familiar rule of thumb, most often ten times earned income.

The multiple is a screening tool, not a conclusion. It is silent on existing assets, dual-income households, the ages of the children, and whether the surviving spouse intends to continue working. We find that even when the surviving spouse has a successful career, his or her career takes a back seat when a spouse is lost to take care of their children. When spouses have young children, it is important to insure both spouses with amounts that are commensurate with their household contribution.

2. Retiring Debt and Personal Obligations

Mortgages, business loans, lines of credit, and personal guarantees do not terminate with the borrower. A guarantee typically survives the guarantor and becomes a claim against the estate, which is why the first question is whether the obligation belongs to the entity or to the individual. We see this all the time with closely held family businesses: the founder has a personal guarantee for the business operations. Life insurance is one commonly used tool to help protect the founder and his or her spouse, both in maintaining the business and in reducing the risk that a surviving spouse is left encumbered with business debt. Whether it is appropriate depends on the individual’s circumstances.

3. Estate Liquidity and Equalization

When working with business owners, we understand that a substantial share of the owner’s net worth is tied up in the business. This holds true for land owners, farmers, real estate developers, families with closely held stock, assets that cannot be divided neatly nor sold quickly in a matter of months. There are two common uses in these situations:

• Liquidity: Obligations at death such as the estate tax and settlement costs must be paid in cash, typically within nine months of the date of death (unless extensive estate planning has been completed). Life insurance is commonly used in these situations to provide liquidity at the moment it is needed most. Death benefits are generally received free of federal income tax. They may still be includible in the insured’s taxable estate depending on how the policy is owned, and certain transfers of a policy can cause proceeds to become taxable. Clients should consult their own tax advisor.
• Equalization: Commonly used to create a sense of fairness (not necessarily equal) when children are working in the business and will be successor owners vs. outside the business.

In both of these uses, owning and administering the policy properly is paramount and should be discussed with the advisory team.

4. Business Continuity and Succession

This was our focus in February and is a key use of life insurance for closely held businesses when considering funding for the buy-sell agreement, the key person plan, and the succession plan. The purpose of life insurance in any of these situations is to protect the business and the ones working closest in the business.

5. Hybrid Life and Long-Term Care Planning

A comprehensive financial plan makes a proactive plan for long-term care. The plan may be to self-insure, or it may be to use long-term care insurance. Regardless, it should be well documented. A policy with a long-term care rider addresses care costs and death benefit from a single contract. Benefits paid under a long-term care rider reduce the policy’s death benefit and any cash value. Riders are optional, carry an additional cost, are subject to underwriting, and pay only when the contract’s benefit triggers and elimination periods are met. The design details matter: how will the insured receive benefits (indemnity or reimbursement)? Does the contract need to be more focused on the life insurance component or long-term care component? How will the policy be funded and what are the available resources (think old whole life policies) for funding? How is the proposed insured’s health and which solution gives them the best possibility of coverage?

The structures have grown more sophisticated since the widows and orphans policies of the 1800s. The purpose has not changed: someone plans ahead so the people they love can continue living.

Use this month for the conversation that is easy to postpone. We are here to help.