Top things to consider when purchasing life insurance

Having adequate life insurance is a critical component of managing risk and providing financial security for you and your family. 

Many times this insurance is sold without proper planning or we find that individuals use rules of thumb, such as coverage for 10 times your salary.  This can lead to improper coverage, expensive coverage, and significant gaps and deficiencies. We think a better approach is to identify the physician’s true insurance need by thinking through the impact on all areas of his or her financial plan should something happen to the physician or his or her spouse.

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It is important to note that a good life insurance plan relies on having good disability insurance in place and coordinating the two.  Suppose, for example, that you have a 10-year term policy. Having that policy assumes that you will also save a certain amount over that 10-year time frame, given that the policy expires in 10 years. 

But if you were not able to save because you became disabled,  you would probably need more life insurance or a longer term for the coverage.  Many disability policies today offer riders that continue to make retirement contributions or separate policies can be purchased to cover this need fairly inexpensively.  So in our view, they work hand in hand.

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The key items to consider in a life insurance analysis are the impact on goals and life changes, providing adequate living expenses for the surviving spouse, paying off debt, funding kids education, and future major one-time purchases or items unique to your situation.  Examples of these items to consider are new homes, weddings, more children, business considerations, and insurability risk.  If you are in a taxable estate situation, it gets more complex. 

Next: What to consider

Consider goals and life changes, if you have a stay-at-home spouse, will you continue to work or do you need life insurance to allow you to stop working and focus on the kids if the stay-at-home spouse passes away?  If you continue working, there would be extra costs involved to hire someone to help with taking care of the children and doing many of the tasks the stay at home spouse is responsible for in the home.

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In providing for adequate living expenses for the surviving spouse, typically you will want to provide a portfolio that allows for a withdrawal rate of around 4%.  So, if you save $1,000,000, the surviving spouse could take out $40,000 a year.  As you age, your savings help decrease the amount of life insurance you need as you move closer to retirement.

Until you are financially independent, meaning you have adequate investment income and assets to meet your living expenses for the remainder of your lifetime, you need some life insurance.  Buying inexpensive term insurance to cover a vast majority of your insurance need until you reach financial independence works well for most physicians.  Term insurance can come in many forms - 10-year level, 20-year level, 30-year level, and increasing premium term. 

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When buying term, you need to think through any situation that might cause you to consider converting the term insurance to permanent or whole life insurance.  Several examples include a permanent need given a future estate tax liability or a specific need or goal to have life insurance beyond the typical term expiration.  If this is a goal, make sure you understand the conversion options in your term insurance to a permanent policy.  This can be a valuable benefit especially in a situation when insurability issues crop up in later years. 

Next: What is the rule-of-thumb?

One of the areas where we see clients overspending on life insurance is in poor policy design.  For example, take a 40 year old with a $1,000,000 insurance need.  Assume over the next 10 years, he will save $500,000, and the following 10 years $500,000.  Assuming good health, a 20 year term policy for $1,000,000 would cost somewhere around $730, while a 10 year term policy would cost somewhere around $400 or about 45% less.  While this is a simplistic example, you can see the benefit of buying some 10 year coverage and some 20 year coverage.  There is no need to overpay for coverage by buying all 20 year coverage.  A laddered approach of having some 10-year level, some 20-year level, and some 30-year term or permanent coverage may allow you to purchase more insurance at a lower cost and match your needs.

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There are a lot of factors to consider here, but none of these ideas are considered as part of a rule-of-thumb approach.  There is a lot of value in this area to having a good fee-only advisor and insurance agent working with you to help you decide not only the amount, but also the term structure and best companies to consider. 

Bill Cleveland, MBA, CPA, CFP, is a partner and senior adviser for Preston & Cleveland Wealth Management, LLC, with offices in the Southern U.S. Cleveland is a fee-only CFP and a member of the National Association of Personal Financial Advisors (NAPFA), providing comprehensive financial planning and investment management services to individuals and retirement plans across the country. He can be contacted at bwc@preston-cleveland.com.