Need Life Insurance? Set Requirements For Different Life Stages

by Kosmo on 2011-07-145

Who should have life insurance? Lots of people. We cover a few scenarios that explain why we would need life insurance. Let’s follow a couple through various stages of their lives to see how they set their insurance requirements through the years. Let’s look at different situations where this type of insurance could be advantageous.

Why Life Insurance? Let Us Count The Reasons

1. Insurance to cover future health issues or burial costs.
Charles and Michelle Convali happily welcome baby girl Sally into their lives. They weren’t sure whether they should buy life insurance for their child. They could buy a whole life policy and hand it over to her when she is old enough to begin paying premiums — and avoid the possibility of later-occurring health conditions causing the cost of insurance to spike. Or they could swing the opposite way on the term/whole life debate and buy a term policy.

A term policy would be incredibly cheap and would allow them to be financially prepared for the worst moment of any parent’s life — the early death of a child. Nobody likes to think about this possibility, but the financial stress of paying for burial costs adds to the tremendous emotional burden. For a couple of dollars per month, Charles and Michelle purchased a term policy. The payment was withdrawn from Michelle’s pay check each month — a financial safety net was in place, although the young family rarely thought about it again — it was a classic case of “set it and forget it”.

Tip: Use life insurance on a child if you want to address a difficult possibility, which is to be able to afford burial costs if the unthinkable ever happens. Life insurance is often taken to cover “final expenses”.

2. Life insurance to cover a mortgage or large debts.
Fast forward a couple of decades. Sally graduates from college and marries her sweetheart, Billy Blougher. They buy a house — and attached to the structure is a healthy mortgage. Sally and her husband realize that neither of them could afford the house on their own if their spouse were to die, and want to ensure that the surviving spouse has the flexibility to stay in the house as long as they wish. They each purchase insurance policies that cover the balance of the mortgage.

3. Insurance to replace lost income.
Three years later, Sally gives birth to a little girl. Their new bundle of joy keeps them awake at night — sometimes with late night feedings; other times with the stress of wondering if they’ll be able to provide for their baby. She’ll definitely need to go to college — and their baby girl will be smart enough to get into a top school. So add four years of tuition (plus a Masters … or an M.D.) to the equation.

Sally and Billy wonder if there is a “magic number” for the amount of life insurance they will need. A million dollars? Two million? After several discussions with family, friends, and co-workers, they decide that there is no magic number — more of a thought process. They determine that they want income replacement until their daughter is out of her undergraduate years — 22 years in the future. They use this to determine a starting value. Since Sally earns more than Billy, the amount of insurance on her life is higher.

4. Insurance to cover everyday expenses.
Sally and Billy realize that life insurance proceeds are generally tax free, so they adjust the numbers down a bit. Then they realize that in a one parent situation, the surviving parent is going to have a lot less free time. This might mean hiring someone to watch their child from time to time. It may also mean less time for cooking and more meals from restaurants. In short, the parent will be paying a premium for convenience. After taking this into account, Sally and Billy bump the numbers back to the starting point. This seems to be a bit on the high side, but they’ll err on the side of caution at this point.

Sally and Billy stop for a moment and realize that while each of them brings income into the family budget, each of them also drains money for their expenses. In addition to basics such as food, clothing, transportation, and medical costs, each of the spouses likes to splurge every once in a while. Billy likes to drink Dom Perignon and collect vintage baseball cards, while Sally enjoys Native American artifacts and upgrades her high end MacBook every two years. If Billy were to die, the budget for Dom and baseball cards could definitely drop to zero; the same applies for artifacts and computers if Sally kicks the bucket. In the end, the “cost of living” for Billy and Sally are deducted from the insurance that will be taken out on their own lives. Now they have an idea how much insurance to take out. They answer some questions, have some blood drawn, and start making payments.

5. Insurance for a business buyout.
How does Sally earn a living? She runs a business with Diane, an old friend from college. Each of them love the business, much to the chagrin of their disinterested spouses. Sally knows that Diane’s husband Jack would have no interest in owning half of the business if Diane were to die – and she knows that she and Billy couldn’t come up with the money to buy him out.

Happily, there is a solution to this. Sally and Diane have the business appraised. Each takes out a life insurance policy for half the value, payable upon the death of their partner. At the same time, they draw up a contract allowing either of them to buy out the partner’s spouse upon the death of the partner. If Diane dies, Sally will collect the proceeds from a policy on Diane’s life and use it to buy out Jack’s half of the business (which he inherits upon Diane’s death). Periodically, they have the business re-appraised, and adjust the insurance and contract accordingly.

6. Insurance coverage on key employees.
Sally and Diane have a key employee in their business. If Bob were to get hit by a bus, they would need to spend considerable resources finding a suitable replacement — and the business would suffer in his absence. Sally and Diane decide to purchase what is referred to as “key employee insurance”. Since Bob’s death would have a detrimental impact on the business, they have an “insurable interest” in Bob’s life. While some companies have abused the (usually) tax-free nature of these policies to take out insurance on low level employees (in some cases, janitors), Sally and Diane are using the policy in exactly the way it was intended — to ensure the viability of their business in case Bob dies.

Case Studies Are Just Thought Starters

These aren’t the only reasons to have life insurance, but these scenarios should serve as thought-starters. One thing to note is that you must have an insurable interest in the insured person at the time the policy is issued. In lay terms, this means that their death would have a negative financial impact on you. You can’t take out a life insurance policy on Oprah, in other words. However, the insurable interest does not need to exist at the time of death. For example, if Sally and Diane sell the business and go their separate ways, Sally is still allowed to collect life insurance proceeds upon Diane’s death (assuming that she continues to pay the premiums).

Kosmo has been employed in the insurance industry since 1997. In his spare time, he runs The Soap Boxers.

Copyright © 2011 The Digerati Life. All Rights Reserved.

{ 5 comments… read them below or add one }

krantcents July 15, 2011 at 7:23 pm

Insurance can cover a lot of things. Some people use life insurance to cover taxes that the estate may have to pay after death. Most insurance is used to replace income lost by the death of a spouse.

Petra July 16, 2011 at 5:35 am

Life insurance on a “stranger”?

What if the business is suffering, and Sally decides that she wants to cash in on Bob’s death to have the business survive (or to stop it but reduce the amount of debt they’ll end up with) and manages to kill him without anyone suspecting his illness wasn’t a natural one?

In the Netherlands, we had a case of “Good Mina” who took life insurance on her neighbors and friends and then nursed them to death whenever they caught a cold or something. Turned out she poisoned them. This was around 1860-1880.

I can’t understand from the article whether Bob needs to agree with this, and has to sign that he knows Sally and Diane are paying an insurance to cover their costs when he dies?

Silicon Valley Blogger July 16, 2011 at 9:33 am

I would expect that any individuals involved in buying life insurance on each other have an ongoing agreement. The idea is that people are business partners so they enter into it together. Key employee insurance should work the same way. Any relationship can turn out good or bad — even married people here enter into criminal schemes over life insurance. So I would consider this application of insurance to work similarly, whether it’s a spouse or close business partner. Of course, if something unexpected happens, the spouse or partner is typically first in line to be investigated as they could have motive. In criminal cases, the life insurance angle is quite a typical motive, though, between people who know each other.

I’m glad you raised this flag, Petra, since I do think that taking life insurance on people you work with is an intriguing thought.

Kosmo July 16, 2011 at 11:08 am

Yes, the key employee must agree to have the policy taken out. Take a look around the business world and you can probably spot some companies that have key employee insurance. Apple probably has a policy on Steve Jobs.

There was a case not long ago in the US involving two women who would take out insurance policies on homeless men (paying them a token amount to agree to it) and then killing them.

Insurance companies do have fraud departments. Death by unnatural causes is definitely a red flag that would raise the possibility of fraud.

Mike August 3, 2011 at 4:32 am

Great article! For Key Person insurance, they definitely need the consent of the insured. These are pretty common in larger companies or even in smaller ones where they have a star performer.

People tend to have strong feelings one way or another on buying insurance on minors but you can usually add them onto your policy as a rider for just a few dollars a month. May take some of the stigma out of purchasing a standalone policy.

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