Life Insurance in your Wealth Odyssey

Note: Life insurance is one, of many, "risk management" issues discussed in Wealth Odyssey (Primarily in Chapters 7 and 10). From a wealth-centric (wealth management) point of view, the issue can be summarized with this question: "What puts these resources, and therefore my plans, at risk?" Read Wealth Odyssey for a discussion on risk management issues.

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How does life insurance work in view of everything? Simply put, because you're still saving and investing, this means you don't have sufficient assets for all the obligations that you still do have. If you did, then you could retire and fund all your other concerns as well. In view of "Wealth Odyssey," life insurance fits in the center of the Wealth Odyssey Road Map (WORM) in a supporting role to your assets. If you lose the ability to accumulate assets due to death of the income provider (either or both of the life partners), then how is(are) the survivor(s) able to maintain their Standard of Individual Living (SOIL) without this income?

A premature interruption in the ability to accumulate the assets necessary to sustain your SOIL is obviously a problem and a risk. The discussion here concerns life insurance in case of death. However, the issue is also relevant to disability income insurance (DII) in case of disability. The primary difference is that DII provides the income lost for the time frame of the purchased benefit, while life insurance provides a lump sum benefit. This lump sum benefit could be used to purchase an annuity that provides income for a specified period up to including a life benefit, or it could be invested in a broadly diversified portfolio to do this. This article discusses the later scenario.

How do you calculate the total amount of life insurance you need? The basic amount considers the sum total of all the debt that you want to have paid off. Credit cards, car loans, education loans, mortgages, etc., comprise this starting amount. However, having these debts paid does not provide any income for the main standard of living expenses such as food, shelter, clothing, and possibly the retirement of your life partner. You need additional assets to offset the loss of the income that used to pay these expenses. Had there not been an interruption in income, these additional assets could have been saved and invested to ultimately retire and pay these living expenses. Life insurance provides these additional assets instantaneously. How do you calculate this additional amount?

Through the use of the "Wealth Rule." First, what is the amount of the annual lost income? Let's say for example that it is $40,000. Note, for couples the other life partner or spouse still has their earnings. We are calculating the loss of the deceased contributions to supporting the family's expenses. The other life partners (spouse) would need to do this same calculation on their income. Using the "Wealth Rule" with 5%, this means that an initial total value of assets would be $800,000. To continue with the example, let's say this individual has $150,000 already set aside in various retirement plans. Therefore, the net life insurance income need is $650,000 for this individual. This income amount would be added to the debt amount to get the total life insurance needed for the two needs. After knowing this, the individual can then determine what kind of life insurance product best fits their budget, needs and other priorities.

"Wealth Odyssey" discusses how to adjust the above basic calculation for Social Security or Pension considerations as well. Both of these have survivor benefits for spouses.

Speaking of Social Security or Pension - what is the asset amount required to replace the lost Social Security or Pension due to the recipient's death? You can calculate this using the "wealth rule." That resource amount either needs to be assets held in reserve for this replacement need, or in life insurance (assets you don't have for the obligation you do have).

Money doesn't know what your reason for having it is. A sum of money you've saved for retirement, or a sum of money as the result of a life insurance claim, an inheritance, or the lottery, can all be treated with the same "Wealth Rule" to determine what it can do for you. Under the "Wealth Rule" money can last a long time. The common factor is the money is meant to be used over a long, unknown, length of time. Without the "Wealth Rule" money is often spent faster than can be realistically sustained.

In the case of life insurance, most people are underinsured because they are not aware of what they are really trying to do; accumulate the assets to support a given SOIL.

Example:

Social Security - retiree receives $1000 per month; spouse of retiree received $500 per month. When either pass away, the $500 per month goes away. If the couple is in their 70's - the wealth rule applied is 5% - therefore replacement assets, and/or insurance, combined total required to replace this lost $500 per month is:

500 X 12 = $6,000 per year.   6000 divided by .05 = $120,000

of reserve assets (assets not used in currently living calculation) and/or insurance.