Life Insurance: Outsourcing of Risk

By: Steven Weintraub

If there was ever a poster child for self-insuring, it would be Warren Buffett. He is worth roughly $82 billion, has no dependent relatives, has total liquidity in his largest asset, and will likely avoid paying estate taxes – because everything is being left to charity. Not everyone has all those bases covered.

Because insurance tends to be “sold,” many creative applications have been proposed. We see only a few legitimate uses for life insurance, including:

1. To protect a stream of income. This would certainly apply to a young family with a mortgage that depends on a single breadwinner. What would the family do financially without that income?
2. Estate liquidity might be necessary to pay estate taxes when it is either desirable to retain key assets (family farm or business) or not conducive for a quick sale (real estate). With reasonable planning, taxes only apply to estates that exceed approximately $23 million in today’s world.
3. Buy-sell agreements in a privately held business where the death of a partner requires liquidation of their interest from remaining partners.

How much life insurance do you need?

Estimating estate taxes and business valuations entails straight-forward math. On the other hand, the calculations to protect a lifetime of wages can get complex and are potentially subjective. Precision requires a comprehensive view of expenses and existing resources.

What type of life insurance is best for you?

A temporary need is satisfied with “term” insurance. The risk of death increases each year, so the cost of pure insurance should rise accordingly. Insurance companies came under some pressure because too many individuals were dropping their policies as they became elderly, ironically, when the benefits were needed the most.

The industry “solved” this by creating permanent insurance, sometimes referred to as whole life or universal life. Annual premiums are elevated in the early years to build a savings fund within the policy. Insurance lobbyists had enough political clout to persuade Congress to let those savings build tax-free. That aspect of a policy has facilitated some conflation on whether life insurance is “an investment.”

How should you approach life insurance upon retirement?

Individuals with permanent insurance have typically built up some cash value over the life of the policy. If the insurance is not being used for business or estate tax purposes, it might not be necessary to retain. Specifically, insurance that was put in place to protect a stream of income loses usefulness when the income goes away. This makes sense because the ability to stop working is a function of having sufficient savings and/or sources of cash flow to support your lifestyle.

If the protection is no longer needed, the owner can convert the cash value into a lump-sum distribution, a stream of income, or a policy that requires no further premium payments. Beware that the income tax consequences of letting an insurance policy lapse can be complicated. One potential creative solution is to exchange the cash value into a long-term care policy.

If you have a mature policy, it might be worth getting a second set of eyes to look at your options.