Questions and Answers on Life Insurance: The Life Insurance Toolbook (Fifth Edition)

PRAISE FOR

QUESTIONS AND ANSWERS ON LIFE INSURANCE

Tony’s book is my comprehensive life insurance reference. He takes complex topics and breaks them down into plain English. I relied heavily on this book when studying for the CFP exam and continue to use it when I have life insurance questions in my role as a wealth manager.

—Janet Hoffman, CFA, CFP

Principal, Integral Financial Solutions, Inc.

I am using your book again this summer and plan to use it in the fall as well. The students love the simple straightforward nature of your writing. It is easily understood for anyone who knows very little or nothing about life insurance. Your book demystifies what some would considers a very difficult topic to understand.

—John Gilliam, PhD, CFP, ChFC, CLU

Assistant Professor

Master’s Program Advisor

Texas Tech University

I found this book to be very thorough, covering many important topics regarding life insurance. This book is very consumer friendly, as well as informative to a seasoned professional. There does not seem to be very much on the topic of life insurance in the marketplace and it is refreshing to see Mr. Steuer tackle these issues in a consumer-friendly manner. I would be more than happy to recommend this book to anyone interested in learning about the life insurance industry. Many books are written on how to accumulate assets/wealth. More books, like this one, should tackle the issues of protecting financial assets.

—Jacob Zollett

Vice President, Cohen Insurance Agency

"Questions and Answers on Life Insurance is a great primer for anyone with life insurance questions. This is a particularly valuable resource since consumers never know who to believe when they are contemplating buying a policy. After reading this book, you’ll increase your chances of obtaining a better policy or you may very well decide you don’t need cash value life insurance at all. I share Steuer’s belief that most people only need term insurance. If you want a rare unbiased look at insurance, this is your guide."

—Lynn O’Shaughnessy

College Solutions Blogger

& Financial Columnist

I have had this book on my reference shelf for a while now, and find myself picking it up more often all the time. When looking at life insurance there are many pieces and topics to cover, and that can lead to not only confusion on the part of the consumer, but also to those in the industry to different extents. There is no ‘best’ policy—only the best policy for the financial objective of the buyer. Getting to that objective and then finding the policy type that fits that need is briefly mentioned specifically in the book under policy suitability. However, the underlying tone of the book throughout—its educational tone—provides information that will allow the reader to see what makes a particular type of policy applicable to the needs at hand—whether they be maximum cash values, specific business applications, etc. Mr. Steuer also touches on some more advanced upper market tools, such as premium financing, that may be of interest to those involved in sophisticated sales. As someone who has been involved with life insurance analysis for twenty-two years, I can say that overall this is a very useful and readable book.

—Roger Blease

Owner, Blease Research

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher and author are not engaged in rendering legal, accounting, insurance, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional should be sought.

Published by Life Insurance Sage Press

Alameda, CA

Updated Edition 2022

Copyright ©2010 Tony Steuer

All rights reserved.

No part of this book may be reproduced, stored in a retrieval system, or transmitted by any means, electronic, mechanical, photocopying, recording, or otherwise, without written permission from the publisher.

Previously published by iUniverse Star (an iUniverse imprint) in 2004.

Distributed by River Grove Books

For ordering information or special discounts for bulk purchases, please contact River Grove Books at PO Box 91869, Austin, TX 78709, 512.891.6100.

Design and composition by Greenleaf Book Group and Alex Head

Cover design by Greenleaf Book Group

Publisher’s Cataloging-in-Publication data is available.

Print ISBN: 978-1-7342100-3-3

eBook ISBN: 978-1-7342100-4-0

Fifth Edition

TO MY WIFE, CHERYL, AND TO MY SON, AVERY

Families are what life insurance is about

and my family is what life is about.

Once in a while you get shown the light

in the strangest of places if you look at it right.

—Scarlet Begonias, Robert Hunter

CONTENTS

INTRODUCTION

CHAPTER 1: INTRODUCTION TO LIFE INSURANCE

Q1What Is Life Insurance, Where Did It Come From,

and Why Should I Care?

Q2Why Do I Need Life Insurance?

Q3How Much Life Insurance Do I Need?

CHAPTER 2: TYPES OF LIFE INSURANCE

Q4What Are the Basic Types of Life Insurance Products Out There?

Q5How Do I Tell the Basic Differences Between Term and Permanent Life Insurance?

Q6The $64,000 Question—Should I Buy Term Life Insurance or Permanent Life Insurance and Invest the Difference?

Q7What Are the Different Types of Term Life Insurance?

Q8How Do I Recognize the Advantages and Disadvantages of Term Life Insurance?

Q9What Are Some of the Characteristics of Permanent (Cash Value) Life Insurance?

Q10What Are the Types

of Permanent (Cash Value) Life Insurance?

Q11What Are Endowment Life Insurance Policies?

Q12How Can I Tell the Difference Between the Many Types of Whole Life Insurance?

Q13What Is Universal Life Insurance?

Q14What Are Variable Life and Variable Universal Life and Why Are They Different?

Q15What Are No-Load/Low-Load Life Insurance Products?

Q16What Are Some Advantages and Disadvantages of Permanent (Cash Value) Life Insurance?

Q17What Is a Policy Rider?

Q18Are There Any Other Types of Life Insurance?

Q19How Do I Make a Cost Comparison Between Life Insurance Policies?

CHAPTER 3: CHOOSING AND EVALUATING A LIFE INSURANCE POLICY

Q20How Do I Choose a Term Life Insurance Policy?

Q21What Are Life Insurance Illustrations and How Can They Help?

Q22How Do I Read a Typical Term Life Insurance Illustration?

Q23What Should I Look for in a Term Life Insurance Illustration?

Q24What Should I Consider in Choosing and Evaluating a Permanent (Cash Value) Life Insurance Illustration and Prospective Policy?

Q25What Are the Four Basic Components That Compose and Dictate the Performance of a Life Insurance Policy?

Q26What Is Really Important in an Illustration/ Product Analysis?

Q27What Type of Earnings Are There on a Life Insurance Policy?

Q28What Are Dividends?

Q29What Are Interest Rates and How Are Interest Earnings Credited?

Q30What Is the Difference Between Gross and Net Interest Rates?

Q31On What Are the Interest Rate Assumptions in an Illustration Typically Based?

Q32What Other Questions Should I Consider Regarding Interest Rates and Dividends?

Q33How Is a Mortality Charge Determined?

Q34What Are Overhead and Administrative Expense Charges, Premium Loads, and Cash-Value Based Wrap Fees?

Q35What Are Persistency and Lapses?

Q36What Is Lapse Support?

Q37Why Should I Watch out for Lapse-Supported Products?

Q38How Do These Factors Affect the Performance of a Permanent Life Insurance Policy?

Q39What Are Some Other Considerations and Situations?

Q40What Is a Universal Life Insurance Policy Illustration?

Q41Is There Any Way to Guarantee the Death Benefit on My Cash Value Life Insurance Policy?

Q42Is There Any Oversight of Policy Illustrations?

CHAPTER 4: HOW TO CHOOSE A LIFE INSURANCE COMPANY

Q43Where Do I Start in Choosing a Life Insurance Company?

Q44What Are the Differences Between a Mutual Insurance Company and a Stock Insurance Company?

Q45What Is a Rating?

Q46Who Are the Rating Agencies?

Q47How Do I Compare the Ratings from Each of the Five Major Rating Services on a Relative Basis?

Q48What Are the Definitions for Each Rating?

Q49What Would Be of Assistance in a Financial Analysis?

Q50Who is IRIS (Insurance Regulatory Information Reports)?

Q51What Is the Risk Based Capital System?

Q52Are the Carriers Held to any Ethical Standard?

Q53How Do I Find Out About Any Complaints Filed Against My Insurance Company or File My Own Complaint?

Q54So, What is the Best Way to Select An Insurance Company?

CHAPTER 5: FINDING A LIFE INSURANCE AGENT

Q55How Do I Find a Life Insurance Advisor?

Q56What Are the Regulatory Resources for Researching a Life Insurance Advisor?

Q57What Else Do I Need to Know About My Insurance Advisor?

Q58How Is the Agent Compensated and How Will That Affect the Advice You’re Given?

Q59How Is the Current Compensation System Harmful to Agents and Consumers?

Q60Can an Advisor Accept Both a Fee and a Commission?

Q61Is There a Code of Ethics for Life Insurance Agents?

Q62What Is the History, Purpose, and Structure of State InsuranceRegulation?

Q63Why Do States Currently Regulate Insurance?

CHAPTER 6: OTHER ISSUES BEFORE BUYING A POLICY

Q64Okay, I’m Ready to Buy Some Life Insurance. What ShouldI Expect?

Q65How Will I Know That This Is the Right Policy for Me; In Other Words, Is It Suitable?

Q66Is There a Difference in How Often I Pay My Premium?

Q67What Is Insurable Interest?

Q68What Should I Consider in Choosing a Beneficiary?

Q69Who Should I Name as the Policy Owner?

Q70What Are Life Insurance Survivor Options?

CHAPTER 7: UNDERSTANDING UNDERWRITING

Q71What Is Underwriting and Why Is it Important to Me?

Q72How Do I Begin to Understand the Underwriting Process?

Q73How Does the Underwriting Process Work?

Q74What Are Some Tips for My Life Insurance Examination?

Q75Who Is the Medical Information Bureau (MIB)?

Q76What Is a Rated Premium (and/or Do I Have a Known or Unknown Medical Condition)?

Q77How Will My Build Affect My Insurance Premium?

Q78What Are Some Sample Guidelines to Qualify for Preferred Rates?.

Q79How Will Tobacco Usage Affect My Premiums?

Q80How Do I Find Out Why My Life Insurance Application Was Not Approved or Modified?

Q81What Is Financial Underwriting?

Q82How Does the Conditional Receipt Work?

Q83Why is Honesty the Best Policy and/or Can What the Insurance Company Doesn’t Know Hurt You?

Q84Is There Anything Else That I Need to Know About Underwriting?

CHAPTER 8: MONITORING YOUR IN-FORCE LIFE INSURANCE POLICY

Q85How Do I Monitor and Evaluate an In-force Policy?

Q86What Areas Should I Review for Potential Changes?

Q87Is My Current Permanent Life Insurance Policy in Good Health?

Q88What Is an In-force Illustration?

Q89How Do I Order an In-force Illustration?

Q90What Will the In-force Illustration Tell Me?

Q91Are There Other Issues If I Purchased a Limited Premium- Payment Policy?

Q92How Do I Measure a Life Insurance Policy’s Internal Performance and Compare It with Another Policy?

CHAPTER 9: WHAT SHOULD I KNOW ABOUT LIFE INSURANCE REPLACEMENTS?

Q93Why Would I Consider a Life Insurance Replacement?

Q94How Is Replacement Defined?

Q95What Issues Favor Replacement?

Q96What Issues Favor Retention of an Old Policy?

Q97What Are Some Questions to Consider Before Replacing?

Q98What Type of Worksheet Can I Use With a Proposed Term Life Insurance Replacement?

Q99What Type of Worksheet Can I Use With a Proposed PermanentLife Insurance Replacement?

Q100Are There Any Special Situations to Consider?

Q101Are There Any Tax Issues to Consider with a Replacement, and What Is Internal Revenue Code Section 1035?

Q102What Are Some Myths About Replacement?

Q103What Are Some Reasons for Replacing?

Q104What are Some Areas to Use Caution in Making a Replacement?

Q105How Have the Replacement Regulations Evolved to Provide More Protections For Consumers?

CHAPTER 10: WHAT YOU NEED TO KNOW ABOUT POLICY LOANS

Q106What Is a Policy Loan, and Why Might I Not Want One?

Q107Are Policy Loans Tax-Free?

Q108How Does a Policy Loan Become Harmful?

Q109How Can a Policy Loan Be A Pitfall?

CHAPTER 11: LIFE INSURANCE AND QUALIFIED RETIREMENT PLANS

Q110Should I Have a Life Insurance Policy Inside of a Qualified Retirement Plan?

Q111Why Can It Be a Good Idea to Have Life Insurance Inside of aQualified Retirement Program?

Q112Why Is Having Life Insurance Inside a Qualified Retirement Program Not a Good Idea?

Q113What Else Do I Need to Know About Life Insurance Inside a Qualified Plan?

Q114Are There Any Government Regulation Issues and Concerns (Insurance Industry As Well) Regarding Life Insurance in a Qualified Plan?

CHAPTER 12: TAXES AND LIFE INSURANCE

Q115Does the Cash Value of My Permanent Life Insurance Policy Grow on a Tax-Deferred Basis?

Q116How Are Withdrawals from a Permanent Life Insurance Policy Typically Taxed?

Q117Are Policy Loans Income Tax Free?

Q118What Are the Income-Tax Consequences of the Inside Interest During the Policy’s Lifetime and at Surrender/Termination?

Q119Are There Any Taxes on a Life Insurance Death Benefit?

Q120How Could the Estate Tax Affect My Estate?

Q121How Is a Monetary Settlement Received from an Insurance Company Class Action Settlement Taxed?

CHAPTER 13: LIFE INSURANCE TRUSTS

Q122What Is an Irrevocable Life Insurance Trust, and Why Should I Consider It?

Q123How Does an Irrevocable Life Insurance Trust Work?

Q124What Is My Basic Role If I’m Named Trustee?

Q125What Are Some Tools to Assist Me as a Trustee and Fiduciary?

CHAPTER 14: MISCELLANEOUS ISSUES

Q126What Happens When It Is Time for a Claim to Be Paid?

Q127What Happens When You Need to Track down a Missing and/or Unknown Life Insurance Policy?

Q128What If a Life Insurance Company Goes Bankrupt?

Q129As a Business Owner, Are There Any Special Planning Concepts?

Q130Can I Donate My Life Insurance Policy to a Non-Profit/Charitable Organization?

Q131What Are Some Tips on Understanding Viatical and Life Settlements to Sell a Life Insurance Policy?

Q132What Is Stranger-Owned Life Insurance (STOLI)?

Q133What Is Premium Financing and How Does It Work?

Q134What Is Private Placement Life Insurance?

CONCLUSION

What Should I Make of All of This?

APPENDIX A

Contact Information for All State Insurance Departments

APPENDIX B

Additional Factors That May Impact Underwriting and What You Need to Know

GLOSSARY

Key Life Insurance Terms

TONY STEUER—BOOKSHELF SPECIAL OFFER

VERALYTIC SPECIAL OFFER

A NOTE FROM THE AUTHOR

ABOUT THE AUTHOR

INDEX

INTRODUCTION

Fools and their money are soon parted.

Many people go to casinos thinking they’ve got it figured out and that they can walk away winners. Yet there must be some reason why casinos are such big, fancy places with free entertainment, free drinks, and so many other temptations, right? (And there must be some way they can afford those utility bills!)

The Life insurance industry can to some degree be compared to casinos in the sense that odds are involved and that insurance companies did not get those big shiny buildings by paying out more than they take in. The U.S. life insurance industry is huge, and it did not get that way by being bargain oriented. Given that, it’s time for a type of guide that helps you make the most out of your life insurance dollar. Unlike gambling, life insurance is a critical part of most financial plans. But like gambling, fools and their money are soon parted indeed.

Life insurance is widely regarded as one of the least exciting things to think about. But chances are (especially if you’re reading this) that you have a life insurance policy, and with any product that you’re spending large sums of money on, you should know what you’re getting. I’ve worked with clients and advisors for thirty-five years, and I’ve discovered an astounding lack of knowledge about life insurance. That is why I’ve written this book.

Regardless of how much you know (or don’t know) about life insurance, this book will help you best utilize your life insurance dollar and help you get the best deal you can. Why pay more than you need to? Unless, of course, you feel that insurance companies need your financial support.

If you do believe that, let’s start off by looking at the size and scope of the life insurance industry. It is one of the biggest industries in the country, as these statistics from the 2007 ACLI Life Insurer Facts Book show:

•$12 trillion of individual life insurance in-force

•$83 billion of credit life

•Close to $7.4 trillion of group life insurance

That’s for a whopping total of just under $20 trillion of life insurance in-force. That’s a lot of dough, and anywhere there’s a lot of money, there’s a lot of different things going on. The phrase the rich get richer didn’t pop up out of nowhere.

Life insurance can be confusing, and this book will help you better understand this valuable financial tool. But keep in mind that this book is not about investing—it’s about life insurance. It’s about using life insurance as life insurance and not as an investment tool. If you want to invest, and by all means you should, look elsewhere, because no matter what you read or hear, life insurance is not an investment tool. While life insurance policies may have an investment component, they are insurance contracts.

As mentioned, I have spent 35+ years in the life insurance industry. In California, the Department of Insurance offers a license that is held by less than thirty people, known as the Life and Disability Insurance Analyst License. I hold that license as well as the Chartered Life Underwriter (CLU) designation, discussed in Chapter 5. My leadership roles include serving on the California Department of Insurance Curriculum Board, serving as President of the San Francisco Chapter of the American Society of CLU & ChFC, serving as President of the Leading Life Insurance Producers of Northern California, and serving on the Board of the San Francisco Life Underwriters Association.

My goal is to use my experience to provide you with a useful reference tool. This book is designed with the question and answer format so that you can access the specific information you would like to review. You only have to use the information that is most relevant to your situation. It’s designed to be painless.

As a consumer, you can learn about life insurance from the ground up or by focusing on any particular topics that interest you. If you are an advisor, this book will assist you in finding answers that will allow you to better work with your clients. For both consumers and advisors, this book offers a go-to reference for verifying information that you gather from other sources.

This book is not a guide or advisory on buying term life insurance and investing the difference vs. buying whole life or universal life. I’m not here to sell you either way. No, what type of insurance you decide to buy is all up to you.

My biggest hope is that you find this book useful as a reference. The more informed you are, the better choices you can make.

CHAPTER 1

INTRODUCTION TO LIFE INSURANCE

Q1 What Is Life Insurance, Where Did It Come From, and Why Should I Care?

Life insurance is a type of insurance that pays money when someone passes away. That’s simple. However, to understand what life insurance is today you should look at how life insurance originated. Life insurance is one of the very oldest types of insurance/financial products in existence. It stems from the old principle that if a villager’s house burned down, the other villagers would help to rebuild the house.

The first life insurance came from this concept. Then a concept known as the tontine annuity system was founded in Paris by the 17th century Italian-born banker Lorenzo Tonti. Although essentially a form of gambling, this system has been regarded as an early attempt to use the law of averages and the principle of life expectancies in establishing annuities. Under the tontine system, associations of individuals were formed without any reference to age, and a fund was created by equal contributions from each member. The sum was invested, and, at the end of each year, the interest was divided among the survivors. The last remaining survivor received both the year’s interest and the entire amount of the principal.

However, as the amount of money that people wished to be insured for increased, and the risk potential for violent fluctuations for those involved increased as well. To minimize this effect, it was necessary that the law of large numbers be applied to this situation. This is where we see the first roots of the actuarial practice. An actuary is a mathematician employed by an insurance company to calculate premiums, reserves, dividends, and insurance, pension, and annuity rates, using risk factors obtained from experience tables. These tables are based on the company’s history of insurance claims as well as other industry and general statistical data.

This is an example of the principle known as the Law of Large Numbers. This principle states that the greater the number of similar exposures (in this case—lives insured) to a peril (e.g. death), the less the observed loss experience will deviate from the expected loss experience. Basically, the more people that the risk is spread out over, the more money (premiums) will be coming in. So, when a person does die, it will not be as big of a burden to the rest of the insureds. Of course, in certain circumstances, there will not be much that can be done.

The function of insurance is to safeguard against misfortunes by having the losses of the unfortunate few paid for by the contributions of the many that are exposed to the same peril. This is the essence of insurance—the sharing of losses and, in the process, the substitution of a certain small loss (the premium payment) for an uncertain large loss. (Reference—Black, H. and Skipper, K.; Life Insurance, Twelfth Edition, Prentice Hall (Englewood Cliffs, NJ), p. 18)

Life insurance, like any other financial product, is a tool to assist you in accomplishing a specific goal (or goals). As such, it will assist the beneficiary when there is an economic loss, due to the death of the insured that extends well beyond just funeral or final medical expenses. The loss of future income, due to the death of a breadwinner, can have a severe impact on the lifestyle of the surviving family members. Debt owed by the deceased may become due and payable as well as possible estate or inheritance taxes. Life insurance can create an immediate source of funds to enable the payment of these expenses and to provide a source of future income.

Benjamin Franklin helped found the insurance industry in the United States, in 1752, with the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire. The current state insurance regulatory framework has its roots in the 19th century, with New Hampshire appointing the first insurance commissioner in 1851. Insurance regulators’ responsibilities grew in scope and complexity as the industry evolved. Congress adopted the McCarran-Ferguson Act in 1945 to declare that states should regulate the business of insurance, and to affirm that the continued regulation of the insurance industry by the states was in the public’s best interest.

The purchasing of life insurance is an uncomfortable task for many people, and the image of most life insurance advisors leave something to be desired with examples such as Bill Murray in Groundhog Day and Mel Brooks in High Anxiety. Typically, there is recognition of an obligation to protect one’s dependents from the financial hardship of an untimely death, but no one likes to think about the fact that they will die someday. This is another reason—aside from the potential discomfort of dealing with a life insurance advisor—that can make it easy to delay and put off the decision to purchase life insurance.

Keep in mind as you go through this process that life insurance is not for you, it is for your survivors. Therefore, you typically will only have a need for life insurance when you are leaving behind someone or some entity that is dependent on your income.

"Any road will get you there as long as you don’t know where you’re going."

—Socrates

Q2 Why Do I Need Life Insurance?

Times have changed, and the reasons people buy life insurance have grown from the original purpose. The following is a list of some of the more common reasons:

Income Replacement—Protect the premature death of a spouse or parent so that the loss of income is not devastating to the family.

Payment of Outstanding Debts—Such as mortgages, car payments, and credit cards.

Final Expenses—Funeral and other administrative expenses.

Education Funding—The death of a parent may mean that the quality of education, intended for a child, may be out of reach.

Emergency Fund—Any adjustment expenses, such as time off work and medical and counseling expenses.

Special Needs Child—Life insurance provides a guarantee that the funds will be there to care for those special needs.

Business Continuation—To provide funding to assist in orderly transfer of business ownership in the case of an owner’s death—life insurance guarantees that the business is transferred as intended.

Business Insurance—Key Person, Executive Bonus, Split Dollar, and Deferred Compensation funded with life insurance.

Estate Taxes—Under current tax law, life insurance can provide liquidity at death to pre-fund the estate tax liability. This may not be necessary if the Estate Tax is permanently repealed.

Charitable Giving—A charitable-minded client may leave a gift to a favorite organization, without significantly reducing the size of the estate, by using the death benefit to replace the value of the property gifted to heirs.

Equalizing Inheritance—Provides additional liquidity to assist in providing each child with equal shares of their parents’ assets.

Income In Respect of a Decedent—People die owning assets that have not yet been taxed; these taxes then become the obligation of the beneficiary. Life insurance provides liquidity to assist in the payment of these taxes.

Second Marriages—There can be conflict when a parent with children remarries. Life insurance on the parent provides the new spouse financial security from the insurance coverage. At the same time it allows the children to receive the parent’s estate immediately. This can avoid unwanted animosity between the children and the new spouse and allow them to live in harmony.

Please note that that life insurance is commonly used for business reasons. Further information is in Question 129.

Is proper planning for everyone?

As the famous saying goes, only two things in life are certain: death and taxes. This table looks at the fact that no matter how rich and famous you are, you should always expect the unexpected.

Q3 How Much Life Insurance Do I Need?

This is an excellent question to which there are as many answers as there are people to ask. Every advisor, financial columnist, and relative has a formula that they consider the best. This section is designed to present the various methods used, as well as the pros and cons of each method ranging from the simple to the extremely complex. As these issues deal with how to value a life, it is indeed a very complex proposition.

The method that makes the most sense to you is probably the one that may work the best for you. No method is perfect, as you are trying to hit a moving target. Life brings many changes and your needs will change with them. The more assumptions you make, the more complex you’ll make your planning, and the more chances there are that something will not work as planned. This does not mean that you should only use the simplest methods—it is to give you a concept of why it is important to actively participate in all of your planning, fully understand it, and constantly monitor it. After all, it is your money. Remarkably, the simplest formulas can often be the best.

All of the issues discussed in this question will have an impact on the amount of life insurance and other assets needed. Often the desired goals may not be financially feasible. These issues are not only financially based; they can also be extremely emotional.

Another thought to keep in mind is that as your other assets grow, such as retirement plans and investments, your need for life insurance will decrease.

These are some of the more commonly used approaches.

BASIC APPROACHES

Multiple of Income

This method (also known as the human capitalization value) uses the approach of a multiple of your annual income—typically ranging from five to eight times your annual income. This is one of the oldest and best known methods to determine how much life insurance you need, as well as one of the easiest to use. It’s also the most frequently mentioned by financial columnists in consumer publications.

While simple, this earnings-multiple method misses a range of important factors. For example, it ignores household demographics, past savings, Social Security offsets, housing expenses, taxes, etc. It also ignores expected life changes and individual preferences about sustaining the living standards of survivors. It is simply a best guess.

Cover Your Debts

This entails buying only enough life insurance to cover debts such as your mortgage, student loan bills, or outstanding car notes. The issues are similar to the issues for the multiple of income approach discussed above in that it misses a whole range of factors, such as not considering any future debts or needs like child care or college education costs. This method is also too simplistic to provide any real value.

Human Life Value Concept

The human life value concept deals with human capital. Human capital is a person’s income potential. We all have a human life value. In wrongful death litigation, human life value is measured daily in court (however, the litigation value tends to be significantly different). Insuring human life value is the primary purpose of life insurance. The human life value concept goes beyond numbers and considers the entire impact caused by the loss of a human life and the value to a person’s loved ones. Here are some questions to give you a start:

If you had been killed in a car accident last week, and someone else had been responsible for your death, how much money would your family sue the responsible party for?

If you had been killed in a car accident last week, and you had been responsible, how much money would you want your family to receive?

If you died of cancer last week, how much money would you have wanted your family to receive?

How much are your tomorrows worth? What is your Potential Earning Power (PEP)?

Here are the steps to use the human value approach. The future expected earnings of the insured needs to be capitalized and the present value of income flow to the family (for the time frame needed) determined. This generally involves a multistep process:

How to Calculate

Estimate the insured’s earnings for the period of time replacement would be needed. When estimating earnings, future increases in salary may be considered and an average annual salary used. Whether or not to include growth of earnings has a significant impact on the amount of coverage that will be needed.

Subtract from earnings a reasonable estimate of annual taxes and living expenses spent on the insured, in order to arrive at the actual salary needed to provide for family needs. Commonly, this is a percentage of salary. Rather than calculating a composite of each separate need, it is often suggested that the survivors will need about 70% of the pre-death income to carry on after the insured’s death. A higher or lower percentage may be needed depending on a particular family’s circumstances. The percentage of salary needed can be more accurately determined through a detailed examination of the family budget.

Determine the length of time the net earnings need to be replaced. This could be until the insured’s dependents are assumed to be grown and no longer need the financial support of the insured, or until the assumed retirement age of the insured.

Select a rate of return with which to discount the future earnings. A conservative estimate on rate of return would be the return on U.S. Treasury bills or notes, or the rate of return paid for death proceeds left on deposit with the insurance company. A life insurance company will leave a death benefit in an interest bearing account. The rate paid on this type of account is the rate that should be used. A safe assumption would be the rate on a money market or certificate of deposit (CD) account.

Multiply the net salary needed by the length of time needed to determine the future earnings. Then calculate the present value of the future earnings using the assumed rate of return. This calculation can be performed using a spreadsheet, specialized software, a financial function calculator, or by using discount interest tables.

Example:

Let’s assume you are age 40 and make $65,000 per year. By examining your family budget, it is determined that $48,500 per year is needed for family support. It is also determined that this income would need to be replaced until retirement at age 65 (25 years). If we assume a 5% discount rate, the present value of your future net salary would be $683,556. Stated another way, it would take this amount to pay $48,500 per year for 25 years based on a 5% rate of return. This assumes that the insurance proceeds will be liquidated over the needed period of income (the capital liquidation method). A more conservative approach would be to keep the principal intact and live off the income generated (the capital preservation method). See discussion under life needs analysis below.

The human value method is useful in situations where replacing the