Last Updated: May 9, 2011
Insurance planning and risk management is one of the core components of the financial planning process. Insurance is a financial tool that transfers the risk of financial loss from one party, the insured, to another party, the insurance carrier. When there is an insurance claim, the insurer restores the economic loss, in whole or in part. A solid plan oftentimes includes insurance to cover property (personal property, real estate, automobile, etc.), liability (negligence, torts, etc.), and personal risk (death, disability, poor health, etc.).
For many, life insurance is among the more important types of coverage for individuals and families to have. There are three key questions when considering life insurance as part of your financial plan — how much do you need, how long should the coverage be in place, and what is doable from a cash-flow perspective.
How Much Coverage
The right amount of coverage is directly related to the goals which you want accomplished at or after your death and the assets available to fund these goals. Post mortem financial goals fall in to four categories: cleanup fund, readjustment income, life income and special needs. Most individuals have a need for a cleanup fund. The cleanup fund addresses items like medical bills incurred, but not covered by insurance, burial and funeral expenses, taxes, personal obligations, and unpaid pledges.
Many people also find it useful to have readjustment income for the first few years after the death of a spouse. This income lasts for a year or two and is designed to provide a financial cushion for the surviving family members. Done correctly, it provides surviving family members with income approximately equal to the family income before the death of a loved one.
In some situations, the surviving spouse needs life income. Life income differs from readjustment income as the life income is provided for a long duration whereas readjustment income is short-term in nature.
Finally, there are special needs which require attention after the death of a loved one. This would include things like paying off the mortgage, an educational fund, an emergency reserve fund and retirement needs.
The sum total of these four items, cleanup fund, readjustment income, life income, and special needs should be compared to assets available at death. There may be a need for insurance if the needs are in excess of assets available at death.
Duration of Coverage
After the needs are identified, the financial goals should be subdivided in to short-term and long-term needs. Term insurance works very well when the need for coverage is for 15 or fewer years. Permanent insurance should be considered when the need for coverage is long-term in duration.
After identifying the amount of coverage needed, and whether the need is short-term or long-term, you should consider your cash flow. If cash-flow is tight, make sure you have the right amount of coverage in place. Having the right amount of coverage in place must take precedence over the type of coverage (term vs. permanent). The right quantity should trump duration.