Life Insurance Lego®
If you have a child with a disability, you very probably need to consider permanent life insurance rather than just term insurance. This is because people with disabilities generally have more expenses and, regrettably, less opportunities to earn a living wage. As a result, your child with a disability may always need some financial assistance from family to supplement her/his government benefits and earned income. I discussed this in more detail in my previous blog.
Term insurance is like that plastic ring-stacking toy for very little children. All the rings are basically the same, except for size and color. Term policies are mostly the same, except for their term length and death benefits amount.
Permanent insurance policies, however, are more like Lego. They have many different features. Each feature is a like a different size and shape of Lego brick. There are many possible combinations of bricks (permanent policy features) that result in policies that look and act very differently. We will discuss some of the very basic bricks here, but please consult with a seasoned insurance professional to build the right product for your situation.
The first thing to understand is that pretty much all permanent policies have an insurance component and a savings/investment component. When you pay your premium, some of the premium pays to insure against the risk of you dying and the company having to pay out money to your beneficiaries. The rest is invested on your behalf by the insurance company and the growth, if any, is credited to your policy based on the insurance contract’s design. Some contracts promise a fixed rate of return. Some offer a rate of return based on the performance of one or more indices, like the S&P 500. And with some policies, the investment portion of your premiums is invested directly instruments very much like mutual funds. As with any investment, the structure that has the lowest risk, also has the lowest expected growth. The structure with the highest growth potential will carry the highest risk.
This investment portion, also called the “cash value” of the policy can do different things. Among them:
It can cover a portion of the premium. As you get older, the risk of you dying and the policy having to pay out gets higher. All else equal, your premiums would get larger and larger the older you got. If they remain flat, it is probably because your cash value is paying a portion.
It can increase the death benefit. Some permanent policies are structured to have a minimum death benefit regardless of how the investment portion performs but if the investments do well and the cash value grows, what the company eventually pays your beneficiaries will be higher than that minimum.
It can provide you additional savings. You can generally withdraw portions of the cash value or you can take out a loan from your policy.
If you have a child with a disability, though, you are buying the policy for a very specific reason that hinges on the death benefit rather than the opportunity to invest the money. Because permanent policies have both the insurance and investment components, it is possible to allocate the premium in many ratios. For example, if my premium is $2,000/year, it may be that as much as $1,900 is going to cover my insurance and only $100 is being invested. Conversely, it may be that only $500 is going towards insurance coverage and $1,500 is being invested. If you are buying the policy for the death benefit it is crucial that you understand the relationship between premium structure and death benefit.
The lower the amount going towards insurance, the lower the policy’s minimum death benefit. Two policies holders could be paying very similar premiums and have very similar costs of insurance but the one whose premiums were allocated primarily for insurance will have a much larger death benefit than the other. The one who is allocating more premium to investment will have a high cash value but a relatively low death benefit. If you want to maximize your insurance bang for your buck, you want to determine an affordable premium and then have as much as possible pay for insurance.
You also need to understand two additional things about cash value in a permanent insurance policy. First, depending on how it is invested, the cash value may stay flat or decrease. If your policy is a variable policy and your cash value is invested in those mutual fund look-alikes, then the cash value will go down when the market goes down. If your policy is at a state where the cash value is supposed to pay part of the actual insurance costs, a decline in cash value could lead to an increase in premiums. If you are not able to pay the increase in premiums, the policy could lapse. At the very least, you might have to accept a reduced death benefit in order to keep the premiums down.
Second, using the cash value for one purpose will reduce the amount left for another. So, if you withdraw a lot of the cash value or even borrow it as a loan and the cash value was also supposed to pay part of those premiums-that-increase-with-age, you may find yourself in that same situation of choosing between paying suddenly higher premiums, losing some of the death benefit or losing the policy altogether.
These days, Lego kits come with detailed step-by-step instructions. If you follow them, you will get a model that looks and acts like the intricate toy promised on the box. Similarly, if you need your permanent insurance policy to live up to your expectations, you need to pay close attention to its design and work with a professional to build the right policy for you.