Life insurance, for those who qualify, is a powerful tool to help meet a wide range of personal and financial objectives. Most people are familiar with life insurance as a way of providing funds to replace lost income in the event the family “breadwinner” passes away. It can also be used to pay off existing liabilities such as mortgages, and can provide funds for future expenses such as college costs for children or grandchildren.
It also can play a significant role in business planning and succession. Banks and other lending institutions may require life insurance on a borrower’s life as collateral for loans.
Income replacement is especially pertinent for younger families when the family relies heavily on the income of one individual to meet the day-to-day expenses, such as mortgage payments, property taxes, medical bills, utilities, groceries, etc. These families are typically younger families, with the parents in their early 30s to late 40s, where, if the income earner passed away, it would be very difficult for the remaining family members to continue their lifestyle.
That could mean that the children might not be able to attend their desired college, or more fundamentally, it could mean that the family might not be able to meet its basic needs.
A common strategy used to address income replacement needs is through the use of a term life insurance policy. A term policy generally is designed to provide coverage for a specified period of years, assuming premiums are paid on a regular basis. Term policies for income replacement needs can be structured as level pay annual premiums with a term of 10, 15, 20 or 30 years.
Factors to consider include length of time replacement income is needed, health, age of parents and children, risk of becoming uninsurable in the future and affordability. At the end of the term period, the policy may terminate according to its terms, or the premiums may become prohibitively expensive so the insured terminates it voluntarily. If individuals wish to obtain a new policy at that time, they would need to reapply for new insurance subject to new underwriting requirements.
One factor to consider is the risk that health issues may arise over the period that a term policy is in force. This may present a complication when applying for additional insurance or new insurance after a term policy terminates.
Fortunately, most term policies have a feature that allows the owner/insured to convert the policy prior to termination into permanent coverage based on age, regardless of health. The initial premium for permanent life insurance is generally higher than term. However, permanent policies are designed to stay in force throughout the life of the insured and may offer a better long-term value.
The need for income replacement may seem straightforward, but when considering the broader family impact of one spouse’s death, complexities may arise. For example, even in families with only one primary income earner, s/he may not be the only individual the family should insure. The need for insurance on the non-income earner — the parent who stays at home to care for young children — is often overlooked.
Preserving the Proceeds
There are other issues to be considered, such as who owns the policy and whether proceeds are preserved for the intended beneficiaries. When young couples are involved and one spouse passes away, there is a reasonable likelihood that the surviving spouse may remarry, and the new spouse may have children as well.
Individuals other than those for whose support the insurance was originally acquired may then have access to the insurance proceeds, and to further complicate matters, in a subsequent divorce, a portion of those proceeds could end up being diverted away from the original family entirely.
Families may therefore want to consider holding life insurance policies in trust structures designed not only to preserve assets for the intended beneficiaries, but also to protect assets from creditors and “predators.”
If a life insurance trust is under consideration, attorney fees would need to be factored into the decision because an attorney would need to draft trust documents. While it is more common for permanent policies to be held in a trust, term policies can often benefit from a trust structure as well.
One last issue to bear in mind: When considering the purchase of life insurance, individuals often are forced to confront difficult personal issues and decisions for the first time, which may lead to procrastination.
A sudden illness during this time may prove to be very costly and in some cases may preclude obtaining any type of coverage at all. A financial adviser can act as a valued resource to help you work through such issues and reach appropriate decisions in a timely manner.
Frank Cannon is the first vice president of wealth management; Richard Scarpelli is the executive director of financial planning; and Roderick Kennedy, III, is a retirement consultant, at UBS Financial Services in Baltimore. They can be reached at [email protected], [email protected] and [email protected], respectively.