Insurance is the financial product you don’t need until you do. Unfortunately all insurance companies know this, so they go to great lengths to properly protect themselves. Well, so should we! Let’s be honest, nobody likes to discuss the possibility (or probability) of bad things happening but we all know they do. We also know that nobody likes to deal with insurance companies. Whatever the case may be, there always seems to be a “loophole” where they get off the hook. However, they are legally and contractually bound to the provisions outlined in the contract as long as you (the policy holder) hold up your end of the bargain…which generally just entails paying your premiums on time.
In the most basic of terms, we buy insurance to protect things of great value.
It’s important to be educated on the topic and knowledgeable of what your policy stipulates. You can buy insurance for just about anything…cars, homes, income, TVs, the Vegas dealer drawing Blackjack…the list goes on and on.
Let’s start with some insurance basics. To simplify as much as possible, there are a few key items and definitions to be familiar with:
Premium – What you pay for the insurance coverage.
Deductible – What you are on the hook for should loss occur (before the insurance company will step in and pay). Sometimes this will be in the form of an elimination period.
Coverage Amounts – What the insurance company is on the hook for after your deductible has been satisfied.
In general their relationship to one another is as follows:
The higher the deductible, the lower the premium and vice versa.
The higher the coverage amount, the higher the premium and vice versa.
In the event of a covered loss (car accident, tree falling on your house, disability preventing you from earning income, etc.) you will be on the hook for the deductible amount and the insurance company will pay the difference up to the limit specified in the policy.
Okay, so now that you know the basic principles of insurance, where do we go from here?
Let’s look at some of your most valuable possessions; car, house, baseball cards, grandfather’s watch, golf clubs, Mac Book? All of these are valuable and can be insured, but arguably the most valuable possession you have is your ability to generate an income, which can be insured in a couple of ways. So how do we prioritize where we devote our protection dollars?
Of course we all know that cash flow is king. From bills to savings to vacation money, it all hinges on generating cash flow. Undoubtedly, the most devastating loss to a household is the loss of income, either due to death or disability of the primary wage earner. Consider this:
70% of U.S. households with children under 18 would have trouble meeting everyday living expenses within a few months if a primary wage earner were to die today.
40% of U.S. households with children under 18 say they would immediately have trouble meeting everyday living expenses.
With those startling figures one would assume that, given its significance, income would be protected with insurance. However, less than 45% of individuals owned life insurance, and less than 40% owned disability insurance. On top of this, there’s a good chance that even the ones who are insuring their income, are most likely under-insuring.
Now, how do we go about putting this protection in place?
Well, the keys here are to understand what we need to protect, and that requires us to know what we’re spending. For a household making $100,000, saving 20%, paying taxes with 30% and spending 50%, they would need to replace about $50,000 annually if they were to have their primary bread-winner be disabled and unable to work for a significant period of time. To simplify this process, most individual disability policies will replace 60% of your income. If it’s an individually owned policy and you are paying the premiums with after-tax dollars, then the monthly benefit comes to you tax-free, so the monthly budget is now protected.
That is a simple example and the reality is disability policies can be very complex. It’s important to consult an independent insurance advisor who is licensed with different insurance carriers, and is able to present and explain the many different intricacies of each contract.
Life insurance is not too different. The goal is to provide financial means in the event of loss of a wage earner. There are two common ways to decide how much insurance to put in place; one is income replacement, and the other is liability pay down. While there is no right or wrong way to go about putting coverage in place, we’re going to focus on income replacement. In a similar exercise as discussed before, it’s important to decide how much monthly cash flow needs to be replaced.
Using the example above, let’s say we want to replace $50,000 per year. What amount of insurance would we need to be in-force to safely generate the cash flow back into the household? Using a 5% rate of return, which over a long period of time is reasonable for a balanced portfolio, we would need to put $1 million dollars of insurance in place. Similar to the tax treatment of disability insurance, life insurance proceeds are generally paid to the beneficiaries free of federal and state tax.
The reality is simple. Insurance, when used properly, is a very powerful financial tool.
The issue is, the way insurance is bought and sold. Insurance companies pay their agents’ commissions for selling their policies. Inherently there is nothing wrong with this, however this compensation structure can often drive an agent to be “pushy” and “over sell” the consumer which creates a frustrating and negative experience. Remember, though, not all agents are created equal, and it’s important to develop a relationship with someone you trust. Someone who will shoot you straight, explain the pros and cons of various policies and present you with several options from which you as the consumer can choose between.