Life Insurance Protects Your Family - and You

Life insurance. Did your eyes start to glaze as soon as you read those words? Although talking about life insurance is not one of the more fun things that I get to do as a financial professional, I do believe that in most cases it is part of a comprehensive financial foundation. So while life insurance may not be as "sexy" as some of the other topics I've discussed in this column, I do think it's a topic that should be covered.

Who needs it?

You buy homeowners' and auto insurance policies hoping that you'll never have to use them. And it's true that most people's houses don't burn down, and many people go through life without ever having an automobile accident. Life insurance, however, is a different matter: everybody is going to die. The question you need to ask yourself is if you need to be insured when the inevitable happens.

There's no obvious answer. The vast majority of people need to have life insurance in case they die prematurely. You should have life insurance if you're still in the middle of your career, or if you still have significant obligations -- a spouse and/or children who are financially dependent on you, and future or ongoing expenses such as the cost of your children's education, mortgages, and business loans.

Life insurance is really nothing more than income replacement. If you're not getting out of bed, going to work, and practicing every day, where is the check going to come from to cover your family's expenses?

On the other hand, if you have already retired, are debt-free, and have sufficient investments to cover the expenses of your spouse or other dependents as long as they live, perhaps you don't need life insurance (except maybe for tax purposes, which I will address later).

Less than you think

How much life insurance should you buy? That's a difficult and deceiving question.

We live in a consumer society. No matter where we are financially, or what we have in the bank or in stocks or at home, it seems that there's always more that we would like to have. Against this backdrop, it can be difficult to decide exactly how much life insurance is sufficient.

I've been blessed with 31 years as a financial practitioner. I also have the advantage of being the third generation in my family to be in the financial business, so I've learned not only through my own experiences but also through my father's and grandfather's.

When I think back, I'm struck by how often people who have bought what seems to be a very large amount of life insurance discover, as time goes on, that the amount wasn't nearly as significant as they thought. In my first year of practice, my father had a physician client who went on a sailing vacation with his wife. They went missing in the Bermuda Triangle and were never heard from again. They left five very small children.

I recall going out and paying that claim, thinking it was a lot of money -- hundreds of thousands of dollars. But that was in 1972, and as those five children grew, it turned out not to be so much money, after all.

In my own career, I've had a 30-year-old physician client who died of cancer, leaving three young kids. His wife was also a physician, but it was impossible for her to maintain a private practice while raising her children alone. She had to go into a hospital-based practice where she could better define her hours, but she lost earnings by doing that. There was a significant amount of insurance paid out, but now it's 20 years later, and what I thought was a lot wasn't so much -- not when they had very bright kids who went to private school and then to Ivy League colleges.

In every one of these cases, the amount of life insurance that the physician had purchased wasn't an arbitrary decision. We had gone through a process to try to determine just how much they would need. What we came up with seemed like a lot of death benefit at the moment, but time has proved that the amount was not as big a cushion as we thought.

How much is enough?

There are two ways that you can decide on what is an appropriate death benefit for life insurance. The first method uses the premise of capital consumption. You project what lump sum your survivors would need to fulfill your obligations and take them to zero. (Your obligations would include taking care of your spouse and your children for X number of years and paying off any debts such as the mortgage.) You'd include in your calculations the principal your survivors would receive as a death benefit plus the earnings on that principal (when invested) over the years. Eventually, you use up all the money, and in a perfect world, your obligations are over by the time it runs out.

This is a crude mathematical projection, and it is easier to do in some cases than in others. I consider this the "best guess" method of deciding on a death benefit. You can't be sure that the assumptions you make today will be valid 10 years from now. You might base your projections on the assumption that your death benefit will run out at the same time your spouse starts collecting Social Security, but who's to say the government won't raise the retirement age five years from now or reduce benefits? Unfortunately, when you make an invalid assumption, the capital consumption method of calculation is not forgiving; there is little room for error.

The more conservative method -- and the one that's easier to calculate - is capital preservation. At your death, you create a pool of capital with a very large death benefit. That pool of capital is then invested, and the return on the investment (interest, dividends, appreciation) is used to care for your spouse and children and to handle the other obligations. Your survivors live not off the money itself, but off the return on the money.

The younger you are, the more likely it is that the capital preservation method will be attractive to you.

For one thing, it's more difficult for younger people to make an accurate capital consumption calculation, because they are projecting farther into the future. It's also easier for younger people to create that pool of capital needed for the capital preservation method. When you are young, the statistical chance of your dying is very low, so the cost of insurance is also low. You can buy a lot more death benefit for only a little more in premiums.

The younger you are, the more I believe that the best choice for you is capital preservation. It is the easiest method to calculate and the most conservative because it allows for inflation and provides the most protection for the family. Using this method generates such a gigantic number in death benefits that some people react negatively to it. But remember, it is an arithmetic calculation. You can play around with numbers, assuming anywhere from a low of a 5 percent return on capital to a high of 10 percent over the lifetime of the surviving spouse and during the lives of children through the age of independence. Every time you move that bar up -- when you decide, for example, that you want to pay for your children's graduate schools and the down payments on their first houses -- you increase the amount of the necessary death benefit.

The older you get, the more I swing away from the capital preservation method. Calculating capital consumption gets easier when you're in your late 40s or 50s, your children have grown, and you've built up assets and reduced debt.

Term or permanent life?

I'm now going to don my flak jacket to protect myself from all the insurance agents of the world -- I'm probably not going to be very popular with them.

That's because I am a real believer in term life insurance. You can buy some unbelievably low-cost term life insurance products with rates that are guaranteed for 10, 20, or 30 years. If you're like most physicians, your need for life insurance will diminish over time. That means you can buy, during the period that you need it, very large amounts of death benefits for very small rates per $1,000.

Having said that, however, I will also say that there are times when there is a real need for permanent, or whole life, insurance. This happens when someone is involved in sophisticated business circumstances and needs sophisticated estate planning.

Most people buy life insurance because they don't have enough other assets to take care of their dependents when they die. Life insurance replaces those assets and replaces their income. But some people -- statistically just 2 percent to 5 percent of the population -- are blessed to have accumulated a significant amount of assets or are involved in significant business ventures. They often have very high net worth but low liquidity. They need the life insurance to provide liquidity to pay for obligations such as federal estate taxes and state inheritance taxes.

Some years ago I had a physician client who had acquired apartments and built a very significant cash flow from that business. He thought that his family would be in great shape because he had this multimillion-dollar portfolio. He did, however, have one projected liability: when he died, his family would owe a few million dollars in estate taxes. His wealth was in real estate; to pay those taxes, his family would have to liquidate his portfolio, which would decrease their income.

He had a few options. He could figure out what his taxes would be and start escrowing the necessary money (being careful not to add to the value of his estate, which would increase his tax liability), hoping he didn't die before he finished saving. His family could refinance the apartments at his death, but they would be left with less income because they would be repaying those mortgages. Or he could buy permanent life insurance so that the death benefits would cover the taxes when he died.

Why permanent life and not term? Term, by its nature, is limited. Unless that physician knew that he was going to die before that term insurance ran out, he needed to have the protection of permanent life, which would be in place no matter when he died. That's difficult for many people to accept, because premiums for permanent life insurance are significantly more expensive than they are for a comparable amount of term life insurance. One of my clients, who pays several hundred thousand dollars a year just in premiums, says that he thinks of those premiums as a "silent partner" in the business, ready to step in when needed. I think that's a good way to look at it.

For businesses on a smaller scale -- group practices or solo practices -- you may still have some obligations that need to be met after your death, such as an office lease or payments for equipment. If you're part of a group, and that group would lose patients and corresponding revenue if you died, a term life insurance policy would reduce your partners' financial burden. Term insurance is appropriate in this case because most physicians have at least an idea of how long they will work, and term insurance can cover them during that time.

Make time to choose

The most important issue is not which method you choose to determine how much life insurance you need, or which type of insurance you buy. What is important is that you don't play ostrich, sticking your head in the sand and thinking that a premature death will never happen to you. It's also important for you to choose a methodology -- that you go through a process, and make a choice based on a formula rather than making a wild guess about the amount of insurance that you need. Finally, it's imperative that you put the insurance -- whatever amount you decide that you need -- in place in your financial foundation.

Trevor 'Chip' Lewis, Jr., CFP is Managing Director of PSA Financial Center, Inc. in Lutherville, Md. He was designated one of the Top 250 Financial Planners in Worth Magazine in 2001, and the Top 150 Best Financial Advisers for Physicians in Medical Economics in 2002. Among other professional organizations, Mr. Lewis has been active in the leadership of the National Financial Planning Association and the National Association of Planned Giving. He can be reached at chip@psafinancial.com or via editor@physicianspractice.com.

This article originally appeared in the January 2004 issue of Physicians Practice.