The major need for life insurance is to protect those who are financially dependent on others. Usually this financial dependency is found in nuclear families raising children. My experience has been that most family income earners are substantially underinsured because life insurance is too often sold primarily for its living benefits, not with full concentration on buying it because of the financial risk to a family when income earners die. My theory of why most life insurance sold to consumers needing family protection concentrates instead on the living benefits is because many sellers of life insurance probably believe that selling death benefits isn't appealing. However, selling college education funding, exotic vacations and boosting retirement income is. In addition, selling the living benefits of life insurance justifies selling permanent cash value life insurance as opposed to term insurance, which is the preferred marketing plan of many agency-strong companies.
Advisors working with clients about life insurance for family protection would do well to think of it as death insurance, which focuses primary attention on planning designs that seriously consider the possibility that family income earners can die. In such situations, I generally shock clients by asking them how much income their family will need each month if they have the bad judgment to die. The usual reaction to such a question is, "No one has ever asked me that before." But what could be more fundamental?
While I have seen various spreadsheet programs available for making such family protection death insurance calculations, I use a less formal format. Let's say the client, John (age 35), says he would like his family to have a monthly pre-tax income of $5,000, or an annual income of $60,000. I ask if he wants to reduce this amount by income his wife, Jane (also age 35), might earn. John decides that he doesn't want Jane to have to work, so the $60,000 isn't offset. We agree on a conservative investment yield of six percent, so the $60,000 is divided by .06, resulting in a principal need of $1 million. I then ask John to list the family's invested assets and existing insurance on his life. These items add up to $200,000. They can be part of the $1 million principal needed, but John would like to have an additional amount available for his two children's college costs, so he decides to purchase death insurance of $1 million, giving his family a cushion of $200,000 over his goal. Our family protection heavy lifting is done, but other significant issues need to be considered:
- What form of death insurance should be purchased? Low-load universal life set up to endow at age 95 will cost around $4,800 a year based on current pricing assumptions for a $1 million level death benefit. John has borderline hypertension, so we know he can't qualify for super preferred term. But he can qualify for a standard rated 20-year, level-term policy, with a projected cost of $1,200 annually for a $1 million policy. Given the family budget, especially because most invested dollars go to John's 401(k) plan at work, it is decided to purchase the term insurance.
- Jane is not currently working outside the home, but John realizes that if she were to die in the short term, his child-care expenses would be significant. He decides to insure Jane for $200,000 (probably preferred) for a period of ten years, at an annual cost of $400.
- These combined new insurance purchases of $1.2 million will increase their estates to around $1.5 million. The question is whether they want to go to the expense and complication of executing irrevocable trusts to keep the insurance proceeds from being subject to the estate tax in the event they both die. They don't.
- Jane is asked if she would like to have John's life insurance set up so that any remaining principal will definitely go to their children, and not to a potential new husband. She would. This can be done by creating either a living or testamentary trust in which the first $600,000 would go to a family credit shelter trust and the remaining proceeds to a QTIP marital trust. This will protect any death insurance principal remaining from the claims of the second husband either at the time of a divorce or at Jane's death.
John and Jane now can feel secure that they have the amount of death insurance that will provide the family with financial security in the event either or both of them die. They have avoided the sales pitch of creative agents who might end up selling John a $150,000 whole-life policy with an annual premium of $1,800 that will produce very nice living benefits in the years ahead, but would leave his family very vulnerable in the event John dies, which is why the insurance is purchased in the first place.