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May 3, 2011

Life Insurance 101: America’s Most Underused Risk Management Tool

Summary:

Almost four out of five U.S. households own some form of life insurance, meaning that to some degree, there is national consensus regarding the importance and usefulness of life insurance. However, the average household only owns enough coverage to replace 3.6 years of income, creating a significant gap between the amount of coverage families have versus the amount of coverage they actually need. Forty-four percent of U.S. households would agree that they do not have sufficient coverage to meet their potential needs. The question then arises of why so many Americans are underinsured.

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Almost four out of five U.S. households own some form of life insurance, meaning that to some degree, there is national consensus regarding the importance and usefulness of life insurance. However, the average household only owns enough coverage to replace 3.6 years of income, creating a significant gap between the amount of coverage families have versus the amount of coverage they actually need. Forty-four percent of U.S. households would agree that they do not have sufficient coverage to meet their potential needs. The question then arises of why so many Americans are underinsured.One of the primary reasons why we suspect that many Americans are not sufficiently covered is that they are not sure about what type of coverage they need or how much. They have concerns about affordability as well, especially in light of the nation’s current economic struggles. Most families are tightening their budgets in an effort to weather the storm, and unfortunately, life insurance is often one of the first expenses to go. With these issues in mind, we have come up with some basic answers to some of the most common questions that develop as families consider the purchase of life insurance.

Why do I need life insurance?
Traditionally, life insurance has been viewed as a way to cover burial costs and replace income. However, there are many additional ways that life insurance can serve as a valuable investment and risk management tool. For example, it can be used to pay estate taxes, pay off a mortgage, equalize an estate among multiple heirs, diversify investment and retirement plans, donate a substantial gift to charity, or purchase a partner’s share of a business if he or she passes away. If you do your homework, you will likely be surprised at the variety of life insurance plans that exist as well as their creative uses and how they can benefit you and your family when you pass away and while you are still alive.

What type of coverage should I purchase?
There are two main types of life insurance. Term life is temporary insurance that is offered for a specified term only; usually 10 years, 15 years, 20 years, or 30 years. Policies expire at the end of the term, much like health insurance, car insurance, or property insurance. In most cases, term policies can be converted to permanent coverage for a period specified in the life insurance contract.

Permanent life is just that — it’s permanent! Such policies can last for life if designed and monitored properly. Universal Life, Indexed Universal Life, Whole Life, and Variable Life products would all fall into the category of permanent life. They accumulate a cash value or internal cash reserve that can be used for a variety purposes. The cash value grows based on an interest rate determined by the insurance carrier. Permanent insurance can be flexible and transferable via a transaction called a 1035 Exchange, which is much like a 1031 Exchange in real estate. Typically, permanent life has a variety of uses beyond providing a tax-free death benefit, such as supplying a retirement income, serving as a cash reserve while you’re alive, offering long term care components, and giving you the opportunity to tap into the death benefit while you are alive to pay medical expenses if you become terminally ill.

Can I afford life insurance and how much do I need?
The cost of life insurance depends on your age, your health, the type of policy you’re applying for and how the policy is designed. Typically, permanent insurance, with its flexibility and multitude of uses, is much more expensive than term insurance. As you get older and/or your health diminishes, insurance carriers identify you as being a higher risk and therefore charge you higher premiums. It is best to lock in coverage while you are young and in good health.

How much coverage you need can be calculated based on your income, your projected future income, your net worth, and your age. In the case of key-person business insurance, the potential loss of profitability that would result from you passing would be a key component in the calculation. Insurance carriers consider each of these factors when determining how much coverage you can qualify for.

I’ve had some health issues. Will I even qualify for life insurance?
Underwriting is the process during which a life insurance company reviews the prospective insured’s medical records and life insurance physical exam to determine which underwriting class should be assigned to the insured. For example, ratings span from Preferred Plus, which means that the insured is as healthy as possible for someone that age, to Substandard, which means that the insured has below average health for someone in that age category. The more health issues you have, the more expensive your coverage will be. One very important fact to consider, however, is that underwriting is subjective. One carrier’s assessment of your health can be completely different from another carrier’s assessment. If you have health issues, there is value in shopping around because you never know which carrier might give you just the offer you were looking for.

What if I already have life insurance?
Active life insurance policies should be reviewed at a minimum of every two to three years. Changes in interest rates, the market, mortality tables, and product efficiency make it critical for policy owners to have their contracts evaluated periodically to ensure that their policies are still competitive. If you have a life insurance policy currently, it should be your goal to determine the following as part of your periodic reviews: Am I paying the lowest possible premium for the amount of coverage I have? How strong and stable is my insurance carrier? Is my current death benefit amount still sufficient to meet my needs? Is my policy guaranteed? Am I taking advantage of all of the living benefits my policy has to offer? Should my policy be owned by a trust? As your life changes, your policy should change to meet your evolving needs.

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About the Author

Scott Hinkle is a Shareholder of Grant, Hinkle & Jacobs, Inc., located in Solana Beach, California. Mr. Hinkle has over fifteen years of experience in the financial services arena. He specializes in the development and implementation of advanced business succession and estate planning strategies for business owners and high net worth individuals.

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