Just in Case

Our daughter, Karla, and husband, Grant, are expecting their first child. They’ve already started making changes. She’s snacking on crackers and raisins throughout the day to combat a queasy stomach. Last night she went to bed earlier than on my last visit.

Last night we also talked about what they’re doing to tidy up their financial house as they anticipate the birth. When they purchased their house, they did so with two mortgages. At the time, they developed a strategy to pay off the second mortgage in 37 months (since paying it off in less than three years included a prepayment penalty). Grant told me he has one student loan which he’ll pay in full this year.

When I awoke this morning, I realized there is one financial matter we didn’t talk about last night—life insurance! What are the financial ramifications if one of them should die prematurely? Here’s what I’ll discuss with them after breakfast.

Insurance is a form of risk management. For some risks, the best financial decision is to keep the risk. My father had a term life insurance policy that he renewed each year. In his mind, the purpose of this policy was to pay for funeral expenses. Since he had enough financial resources to do that on his own, he eventually did not renew the policy and “kept” the risk.

At other times, the best financial decision is to reduce the risk. That’s what Karla is doing by watching her sugar consumption given the risk of gestational diabetes during pregnancy. Church insurance providers will sometimes inspect a church facility and make recommendations on ways to decrease the likelihood of injuries and claims.

The purchase of insurance allows a person to transfer risk. For example, with a life insurance policy, a person and an insurance company create a contractual agreement that, for a specified premium from the person, the insurance company will assume the risk and pay a death benefit if the person dies while the policy is in force. The insured person has transferred the financial risk to the insurance company.

Insurance makes the most sense from a financial perspective when the risk is relatively high and the premium is relatively low. The financial ramifications of a premature death would be very costly for Karla and Grant at this point in their lives, and the cost of life insurance is relatively low. They need to take appropriate steps to transfer the risk.

Some people claim the “rule of thumb” for determining the amount of life insurance you should carry is between five and ten times your annual gross income. The problem with counting on a thumb is that it can lead to purchasing more insurance than is actually needed. This approach doesn’t take into account other resources available to cover the expenses. Furthermore, gross income is subject to income tax while the typical life insurance settlement is tax free.

Instead of using a multiple of income, Karla and Grant would do better to calculate using anticipated expenses. Grant needs life insurance to cover known expenses should he die prematurely. Karla should go through the same process because her contribution to the family’s finances is different than Grant’s. Each would then purchase a life insurance policy and name the other as the primary beneficiary.

What kinds of financial risks do they face? Well, there would be funeral expenses and other immediate costs at death. Then there are one-time expenses to settle things like a mortgage and other debts. Part of a life insurance settlement could start a college fund. Consideration might be given to ongoing living expenses. Childcare would be a factor if the surviving parent had to work. Each might want to provide the other a supplemental income stream through the child-rearing years when expenses are higher.

Making these calculations can become quite complex. Inflation should be factored in. The present value of a future need could be computed. To help with this process, I’ll suggest that Karla and Grant use an Internet search engine to find several examples of a “life insurance calculator.” The ones that ask for the most detailed information will be the most helpful. They should use several before settling on an amount. If the online calculator doesn’t already do so, they should subtract other assets and life insurance death benefits from the amount needed and then purchase term life insurance for the difference.

Okay. I’m ready for breakfast and an important conversation.

Originally published by Pensions & Benefits USA.