Life Insurance Planning: What Type and How Much?

A life insurance policy is a contract with an insurance company that will pay your beneficiary a sum of money in the event of your death. Because of its potential to rapidly appreciate in value, along with its tax-favored status (the proceeds your beneficiary receives are generally income tax–free), it can be used to solve even the most complex financial planning challenges.

General Purposes of Life Insurance

Create an estate
In the event that a lack of time or other circumstances prevent one from accumulating sufficient assets to care for his or her spouse and/or children, life insurance can create an instant estate.

Pay estate taxes
The Federal Estate Tax is an excise tax on the right to transfer property at death beyond a certain amount. Life insurance can be used to pay these taxes using “discounted dollars.”

Protect a medical practice
Medical practices face special insurance funding needs to provide a business continuation plan that will protect the shareholders (practice owners) in the event of death. Life insurance is ideally suited to provide the capital needed to adequately buy the interest of a deceased owner and indemnify the practice against the loss of the services, expertise, and skill of a key employee.

Pay off a mortgage
Life insurance proceeds can be used to pay off personal or business mortgages or other loans. These proceeds may also allow the survivor to continue to make monthly payments and use the cash for other purposes.

Provide collateral for a loan
A life insurance policy may be used as collateral to obtain a loan at favorable interest rates. This includes Small Business Administration loans.

Equalize inheritances
Very often, a child may enter the family business—in this case, a medical practice. Life insurance death benefits are often used to “equalize” the inheritance of the other children who decide not to practice medicine.

Replace a charitable gift
Gifts of appreciated assets to a charitable remainder trust can provide income and estate tax benefits. Life insurance can be used to replace the value of the donated assets. Proceeds from life insurance can also be paid directly to a charity.

Distribute like a will
Life insurance is distributed like a will, in that you specify who and how much of the benefit will be payable to each beneficiary. Unlike a will, however, life insurance has the added benefit of privacy. Wills, once probated, become public documents.

Types of Life Insurance

There are many types of life insurance policies available today. However, most policies fall into 1 of 4 categories—term life, whole life, universal life, and variable universal life.

Term Life

Term life allows you to purchase the largest death benefit while minimizing your (initial) premium outlay. Term insurance offers pure protection and does not build cash value.

You should purchase a substantial amount of term insurance when you are young to protect your future insurability (your ability to purchase coverage as your health can change). You can always convert your policy to permanent insurance at a later date, regardless of your health, if your policy contains a conversion option.

When you purchase a term policy, you are buying coverage for a specified period of time. If you die within the term of the policy, the insurance company will pay the death benefit to your beneficiary. The majority of term policies available today offer fixed premium rates for 10, 15, 20, or even 30 years.

Return of premium term life
Return of premium term life insurance works the same way as level premium term life insurance. However, if you keep your policy for the entire guarantee period and do not die, all your money is returned to you in a lump sum on an income tax–free basis. However, you must pay substantially more for this feature compared with a traditional level premium term life insurance policy. It is therefore best that you do an analysis to determine if the potential return justifies the additional premium outlay for the return of premium feature.

Whole Life

In addition to providing a death benefit, whole life policies build cash value. When you purchase a whole life policy, you traditionally pay a fixed premium for the life of the policy. Part of your premium payment goes to the insurance company to cover the cost of the death benefit element of the policy, and the balance is invested in the insurance company’s general account.

The cash value of a life insurance policy grows on a tax-deferred basis and can be accessed through policy loans or by surrendering the contract. The level premium structure, guaranteed rate of return, and guaranteed death benefit make whole life an attractive choice for some buyers. Unlike the following policies, the only “moving part” in a whole life insurance policy is its dividend.

Whole life insurance provides value in excess of its guarantees through dividends. Dividends are paid to the policyholders if declared by the Board of Directors. When dividends are declared, they have the following 3 components:

  1. The insurance company’s investment rate of return in excess of the guaranteed return promised in the policy
  2. Mortality experience, which is better than what is guaranteed in the policy
  3. Expenses of policy administration, which are less than the cost guaranteed in the policy.

In addition, whole life insurance is considered an “exempt asset” in many states, and is specifically protected from the claims of creditors, including malpractice. However, state laws vary widely when it comes to protecting life insurance. As a result, it is important to know whether your state exempts some, all, or none of the cash value in your policy.

Universal Life

Universal life insurance was developed in the late 1970s to overcome some of the “disadvantages” of term and whole life insurance. When your premiums are paid, expense, insurance, and maintenance charges are deducted; the remainder is invested in the insurance company’s general account.

Most universal life policies contain a guaranteed minimum interest rate that will be applied to the cash value. Any returns above the guaranteed minimum will vary with the performance of the insurance company’s portfolio, but will not go below the guaranteed interest rate. Universal life does not allow you to decide how your premiums are invested. However, as the policy owner, you can vary the amount and frequency of your premium payments. This type of policy is best suited for those looking for the flexibility to change their premium payments if their financial situation changes.

If interest rates decline or the insurance company’s mortality or expenses increase, the crediting rate on the cash portion of the policy could decrease (but not below the guaranteed interest rate). This can lead to premium payments that are larger than expected to maintain the policy’s death benefit, cause you to reduce the policy’s death benefit to allow you to make the same premium payments, or force you to borrow from your cash value to subsidize the premium payments you are making versus the premium payments you should be making. Note that with increasing insurance costs combined with a declining interest rate environment, policies can “blow up” or implode.

Universal life with a secondary no-lapse guarantee
This policy is very similar to a traditional universal life policy, but the insurance company guarantees that the death benefit on the policy will remain in effect even if the cash value is zero. This is known as a secondary guarantee. If the policy owner makes timely premium payments, the policy’s death benefit is guaranteed to the age of ?100 years. Generally, the greater your premium payments, the longer the guarantee will last.

All guarantees are based on the issuing company’s ability to pay claims, and do not apply to any underlying investment options.

The advent of this policy can be attributed to the number of policies that did not perform as illustrated or imploded. Suddenly, what is old is new again.

Equity indexed universal life
Equity indexed universal life is very similar to variable universal life insurance. However, it is designed to minimize the downside potential normally associated with the stock market while allowing policy owners to participate in the upward movement of a stock, normally the S&P 500. This is because the insurance company contractually agrees to credit the policy’s cash value with the same return that the index realizes, calculated without dividends over the same period, subject to a certain maximum or “cap.” In years when the underlying equity index is flat or loses value, the cash value is subject to a floor.

The potential to realize higher upside returns without the downside risk normally associated with the stock market is why some insurance agents and financial planners tout the benefits of an equity indexed life insurance policy.

However, most insurance companies will only allow you to participate in 50% to 75% of the gains realized by the index. Therefore, if you are purchasing insurance as an investment, why would you want to limit your potential returns? Generally, if you are a good investor, you would most likely want to purchase individual securities and not have your returns limited by an index, especially when your rate of return is capped.

Finally, these contracts, as well as other universal life policies, often contain substantial surrender charges if a policy is terminated. These surrender charges are generally highest in the early years of a policy and decline over time, usually between 7 and 15 years.

Variable Universal Life

Although whole life insurance provides the policy owner with guaranteed premiums, guaranteed cash values, and a guaranteed death benefit, this is not the case with a variable universal life insurance policy. Generally, premiums for a variable universal life insurance policy are only guaranteed for a limited period, and there is no guaranteed death benefit and no guaranteed cash value (the policy owner decides how the cash value will be invested, retaining all investment risk).

The concept of variable universal life insurance is relatively easy to understand. When you pay your premium, part of it covers the cost of insurance, part of it covers administrative expenses, and the balance is invested in mutual fund–type subaccounts you choose.

During the extended bull market and low interest rates of the 1990s, this type of policy gained popularity. Although most of these policies were purchased to provide death benefits, physicians also purchased this type of policy to build cash values to provide emergency funds, to provide funds for their child(ren)’s education, or to provide supplemental retirement income.

Unfortunately, the majority of these purchasers were unaware of the effect that stock market volatility has on the performance of a variable universal life insurance policy. The variable life policy is sold by a prospectus, which includes a description of how the policy works. Be sure to request a prospectus, which contains more complete information—including charges and expenses associated with the policy—and read it carefully before investing or sending money. The Securities and Exchange Commission also requires individuals who are selling variable life policies to be licensed to sell securities.

Other Features to Look for in a Policy

Term Conversion Option

Many term policies allow you to convert some or all of the death benefit of your term policy to other forms of permanent insurance, regardless of your future health. Ideally, if your goal is to convert to a form of permanent insurance, you should purchase your term policy from a company that has a reputation for offering a broad array of competitive permanent life insurance policies.

Waiver of Premium Rider

Another important aspect of a life insurance policy is the waiver of premium rider. This rider enables you to have the premiums of your life insurance policy paid for by the insurance company in the event of your disability. If your goal is to convert your term life insurance policy to a permanent life insurance policy, it must be included in your term life insurance policy. However, if this is not your goal, you may want to think twice about adding this rider, because it can cost 15% or more of the entire policy’s annual premium.

How Much Life Insurance Do You Need?

Before you attempt to finalize the death benefit amount and choose a specific type of life insurance policy, you may want to have some idea of the size of the policy you should consider. The simplified worksheet (Table) will give you a starting point for discussion of your life insurance needs with your insurance agent or financial planner.

Table

Conclusion

Purchasing adequate life insurance protection is a fundamental component of a physician’s financial plan. It can be used to protect against risks that would be financially devastating to you, your family, and your medical practice. Some basic preparation will help to ensure that your loved ones will have the financial resources needed in the event of your death.

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