In light of the COVID-19 pandemic, human mortality has become an increasingly “hot button” for many people. With this, we wanted to provide some education on how to offset the potential heavy financial burden of mortality risk – the risk that you will pass away earlier than expected.
Barring any major market news that would warrant discussion, our next handful of posts will be diving into life insurance. Specifically, we will discuss the various types of life insurance and how to determine if / how much you need. While the inner workings can be complicated, we are going to break it down simply so you can make the best decision for your specific situation.
One of the main purposes of life insurance is to help protect against mortality risk.
Though the topic is often avoided, as it is uncomfortable to think about, everybody faces mortality risk. However, this does not mean everybody needs life insurance.
For example, a 90-year-old widow with no children would likely have less of a need for life insurance than a 35-year-old working father with a family and large mortgage. If this 35-year-old father passes away tomorrow, his family could face major financial distress due to the loss of his income and their high debt obligation. If the 90-year-old widow passes away tomorrow it would still be extremely sad, but she would not be leaving anybody with a stressful financial situation. Each of these people faces mortality risk, but the need for life insurance is completely different.
Life insurance, just like any other type of investment or insurance, is completely dependent on your unique, individual situation. Though everyone’s situation is different, we can develop some general statements of when it may be appropriate to have different types of life insurance.
Below are the two major types of life insurance, with a brief description of what they are and when it could make sense to use the specific type of policy:
Term Life Insurance
This type of life insurance pays a death benefit if the insured person passes away during a specific period of time (often referred to as the term). The protection stops at the end of the term unless it is renewed. Due to the temporary nature of this type of policy, it is generally inexpensive, especially at younger ages (substantially less than permanent insurance). This is ideal for people who do not want to pay a high premium and have a short to intermediate term need for life insurance. Common uses for term life insurance are:
Mortgage Protection
Many families who own a home have a mortgage of some sort, but a lot of these families would not be able to continue paying the mortgage in the event of the death of one or both spouses. Going from two incomes to one (or even from one to zero incomes if the surviving spouse does not work) can be detrimental to a family’s cash flow situation. The last thing you want to worry about after losing a loved one is how you are going to keep your home. Term life insurance is a great tool to help mitigate this risk. Most mortgages are 15-30 year terms, so they will eventually disappear assuming all payments are made. Buying term insurance to match the mortgage time period and value can completely hedge the risk of losing a home due to a shortage of cash flows – you can use the insurance proceeds to pay off the mortgage and lower overall monthly expenses while keeping your home. There are even specific term policies for mortgage protection where the death benefit decreases on a schedule each year just like a mortgage would decline each year as you pay more and more towards the principal.
College Expenses Protection
Just like a mortgage, many families would have trouble paying the college expenses for a child if one or both incomes were unexpectedly lost due to death. You could hedge this by purchasing a term policy for the total amount you expect to pay for tuition in the future. The length of the policy could last until the child graduates college, and if you never needed to use it the policy would lapse as you no longer have the risk of college expenses in front of you.
Wage & Income Replacement
You are planning to retire eventually (hopefully) so your need to replace wages is temporary. Although covering a mortgage and college expenses is great, some families need even more coverage than this. If the surviving spouse cannot provide enough income to keep their current standard of living, it can create unnecessary stress on the family. To reduce this potential stress, you can calculate how much term insurance to purchase by estimating your expected earnings/income for the rest of your working career. This can take a little work to nail down as you need to determine how many more years you plan on working and how much you would reasonably be making in each year, but it can be a great use of term insurance.
Cover Short Term Debt & Needs
Sometimes you do not need a complete wage replacement, but there is a need for various short term obligations to be covered. This can include credit card debt, car loans, money owed to your friend from that bet you made a year ago and lost, and any other shorter term debts you can think of. As short term debts are not permanent, a term life insurance policy can be useful in covering them.
Most term insurance policies lapse without collection of the death benefit, which is a good thing (this means you are still alive)! Unfortunately, knowing this scares many people away from purchasing term policies in the first place as it can seem like “wasted money” when all is said and done. It is important to remember the point of term life insurance is not necessarily to collect the death benefit, but rather to create a hedge for your temporary obligations/expenses in case of unforeseen circumstances.
Permanent Life Insurance
Permanent life insurance provides lifetime protection as long as premiums are paid. Along with the typical death benefit, these types of policies have a cash value component where earnings can accumulate tax deferred and be used for loans, premium payments, or cash withdrawals. These features make permanent life insurance appropriate for people who have long-term insurance needs, a desire for a tax deferred investment option, or estate planning ambitions. Common uses for permanent life insurance are:
Generational Estate Planning
Permanent life insurance can be a useful planning tool for generational estate planning because permanent insurance policies stay in force as long as premiums are up to date. This gives you a guarantee that your heirs will receive some sort of inheritance even if you spend down the rest of your investable assets before passing away (or if you are planning on leaving a large estate for your heirs, the insurance proceeds can help pay the estate taxes and provide up front liquidity before other estate assets are available).
Tax Advantaged Savings Vehicle
Permanent life insurance policies can enjoy tax deferred growth for the cash value component. This means as long as the policy remains active, you do not have to pay any taxes on the cash value earnings. The cash value can later be used tax free, as long as you adhere to the policy rules, by taking a loan against it since loans are not considered taxable income (actual withdrawals up to the amount of premiums paid can generally be taken without being taxed as well).
As opposed to term policies, where the death benefit is rarely collected, permanent life insurance policies are typically purchased with the understanding that the death benefit feature will eventually be used (hopefully when you are older and have lived a long, fulfilling life). Also, the unique cash value components can provide an interesting investment opportunity for certain individuals as well.
As you can see, the two different types of life insurance contracts are best suited for different situations – one is not necessarily better than the other. This is why it’s important to work with a financial planner that takes a holistic approach to reviewing your specific goals and needs.
Now that we have laid the foundation for general best use scenarios of term vs permanent life insurance, in the next post we are going to get into the varying types of permanent life insurance policies (yes there is more than one kind of permanent insurance, and yes it is just about as exciting as it sounds).
Ben and Derek
Co-Founders and Owners of Aspire Wealth
*Please note, this is not intended to be advice. We are not insurance experts and you should work with your financial planner prior to implementing any strategies we’ve discussed.
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