Insurance Needs Analysis

Why should you own both life and long-term disability insurance policies? Life and disability insurance provide crucial protection for your family in the case that you die prematurely or become disabled during your working years. These products provide your family with income to help offset the loss of income from death or disability. For homeowners and parents, I recommend owning both a life insurance and long-term disability policy. These policies are reasonably affordable and will allow you to sleep better at night, knowing your family will be taken care of in case of a tragic emergency. My wife and I both own 30-year term life insurance policies and a long-term disability policy. 

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Types of Life Insurance

There are two major types of life insurance, permanent and term. Permanent life insurance is funded by annual premiums, which are usually fixed, and provides you with coverage for life. Permanent life insurance also combines an investment aspect where a portion of your premiums are invested and can be withdrawn tax-free at a later date in time. On the other hand, term life insurance involves premiums paid for a set number of years, typically between 10 and 30 years, where premiums are also usually fixed. At the end of a term life insurance policy, you would no longer be insured, unless you purchase a new policy. Term insurance policies also do not have a cash value component as permanent insurance policies do.

Benefits of Term Life Insurance

So why do I recommend that most people purchase term insurance? Firstly, term insurance is substantially less expensive that permanent life insurance. Per the below chart, a 30-year-old male non-smoker could purchase a 30-year term policy with a $250,000 death benefit for roughly $518/yr. while a similar whole life policy could cost 5-15x more, or roughly $2500-$7500/yr.

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Additionally, most people only need life insurance during their peak working years, to hedge the risk of dying prior to retirement or accumulating enough assets to self-insure. As a result, most people only need life insurance coverage for 20-30 years at the most. In fact life insurers pay death benefits on less than 2% of term policies, as very few people die during the 10-30 year typical term period. On the other hand, life insurance companies will always need to pay death benefit on a permanent life insurance policy, and therefore premiums are much higher. As a result, life insurers earn substantially higher commissions on permanent life insurance policies due to the much higher premiums. This leads life insurers and their agents to push consumers into purchasing permanent life insurance. Premiums are also much higher for permanent insurance policies due to the investment component I mentioned above, so effectively part of your premiums are a hidden investment fee for managing the underlying investments. Permanent life insurance policies may also contain guarantees related to investment performance, which again results in higher premiums. All of which are good for life insurers and their agents, but worse for consumers.

Potential benefits of Permanent Life Insurance

The main reasons to have a permanent life insurance policy would be for estate tax reasons or for liquidity purposes for a privately owned business. However, federal estate taxes don’t kick in until an estate is over $11.58mn in 2020, although 18 states also levy their own estate taxes. If you expect to be subject to federal and state estate taxes, you could consider permanent life insurance, but please speak with a CPA and an estate planning focused attorney too! It can also make sense for a privately held company to purchase permanent life insurance on key employees to provide funds in case of their premature death. Outside of these two exceptions, most people should opt for term life insurance.

Determining your life insurance amount

So how much life insurance do you actually need? Many people have life insurance policies through their employer, but these policies typically max out at 1x your salary, which does not provide enough coverage. It is critical to own a policy outside of work, as you lose your employer coverage when switching jobs. The insurance needs calculator will help you determine your life insurance needs. You will also want to think about the term length of the policy. As I mentioned above, my wife and I each own a 30-year term life insurance policy, although we will likely cancel the policies prior to their expiration depending on our financial situation. A longer-term length policy increases your flexibility but at a higher cost. You may only need the insurance for a shorter length of time such as 15 or 20 years, which would reduce your annual premiums.

Once you have determined your life insurance needs, it is crucial to shop around for a quote. Term life insurance is a highly commoditized product at this point in time. As a result, quotes should not vary much from one life insurer to the next, unless you have major health concerns. Certain insurers offer better rates for specific demographic groups based on how they decide to underwrite that risk.

Another consideration when buying any type of insurance product is to look at the credit ratings of the companies. There are three major credit rating agencies (S&P, Moody’s, and Fitch) who assess the creditworthiness of companies, by assigning credit ratings, which look at a company’s profitability, capitalization and how well the company is managed. All things considered equal, a higher credit rating is better for the policyholder, and insurers aim to maintain high credit ratings to give confidence to policyholders as to how well they are managed. While the major credit rating agencies aren’t infallible (anyone remember the financial crisis?), their credit ratings do correlate pretty well with company outcomes over the long term. In addition to price, credit rating should be the other major consideration when purchasing a policy. Here are the insurance ratings for several major life insurers:

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It is also important to note, that there are two major types of insurance companies, public companies such as Prudential Financial, MetLife and AIG, as well as mutual companies such as New York Life, MassMutual and Northwestern Mutual. The key difference is that the shareholders own public companies and aim to maximize the value of the company, while the policyholders' own mutual companies and the solvency of the organization is typically more important than growth. At a mutual insurer, dividends are paid to the policyholders. As a result, mutual companies tend to be more conservatively managed with fewer conflicts of interest compared to public companies, which generally leads to higher credit ratings from the major Credit Rating Agencies.

Disability Insurance Considerations

Switching gear to disability insurance, I also recommend that most people purchase long-term disability policies as well, hedging the risk of a major disability during your working years. Premiums are reasonably low for these policies, which cover 60-80% of your after-tax income for a set period of time if you are disabled and unable to perform your job. Benefits are not taxed as income and as a result can offset nearly all the lost income for a set period of time. Many companies also offer short and long-term disability insurance to employees, but again it makes sense to have a policy outside of your employer.

As long-term disability insurance is more straight forward, no separate calculator is needed. I recommend an emergency fund to handle 3-6 of expenses, and then the long-term disability policy would kick in for longer disabilities. Typically the only options involve the length of the benefit period, and the percentage of your income that is covered by the policy. Similar to life insurance, it's worth shopping around as long-term disability has become a commoditized product. Additionally, it's worth considering the credit rating of the insurance company providing the insurance.

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