Even though I’m a fee-only financial advisor who doesn’t benefit either directly or indirectly from my clients purchasing any type of insurance,
I’m a big advocate of purchasing life insurance on your children. I’m also disturbed about the amount of bias and inaccurate information floating around. The prudent, responsible thing is to always carry enough coverage for a child’s funeral expenses. Also, if you’re in a good place financially by not having consumer debt and being on track for your retirement,
it also makes sense to at least consider using a policy as an accumulation vehicle. In case you’re wondering, yes, I carry life
insurance on my children that is very similar to what I recommend here.
Let’s start by looking at some of the big reasons that you’d buy coverage.
At its most basic level, the purpose of life insurance is to indemnify you for the financial expenses of a child passing away. While there is another view that holds you should only buy life insurance to replace lost income, this ignores that there are economic losses incurred in addition to a loss of income. It has become standard practice to buy life insurance on non-working spouses when you have minor children, why should you not buy insurance on the children themselves? Consider the following:
- Final expenses can easily top $10,000 once factors such as casket, grave site, memorial, and funeral costs are factored in. Do you live in a place other than where you’d want your child buried? If so, have you factored in this additional cost to your planning. Are you in a position to write a check for this? If not, how would you come up with the money if the unthinkable were to happen?
- Time off of work. Speaking for myself, if I lost one of my sons, you wouldn’t see me back at work tomorrow. While I’m fortunate in that I have wonderful clients and love my job, it’s difficult to say how long it would take me to get back in the saddle. How much vacation time do you have? Does your employer allow other employees to donate sick or vacation time to you if tragedy should strike? While the hit TV show Breaking Bad adds a dramatic spin to what can happen at work if you are grieving, it also underlines the fact that there are better places to grieve than at work. Would you have the ability to come back to work on your terms or would you have to go back for financial reasons?
- Counseling. No two ways about it, you and your family will need counseling if a child dies. What sort of mental health benefits does your health insurance have? Are you positive that those benefits will be enough to cover the need? If not, are you in a position to pay out of pocket?
- Replace money spent on education. I’ve had clients get angry at me for bringing this topic up, but it still need to be discussed. College is an investment, but what happens if the student dies before the money that is spent on education is recouped through higher earnings? Yes, this is a very steely eyed way of looking at the world. Any federally-guaranteed student loans will be forgiven, but anything that you pay out of pocket or from a 529 plan will be ‘lost’.
- Charitable intent. I’m tearing up as I write this, but the biggest way that I would honor my child would be to use their memory to bring as much happiness into the world as I could. This is a luxury that might not be affordable without life insurance. We’ve had two friends who have lost children to rare medical conditions and the charitable works done in that child’s name make the world a better place and have helped friends and family with the grieving process.
A second big reason to buy a policy on a child is to lock in future insurability. Once a life insurance policy is underwritten and put in force, it will stay in force regardless of changes in the child’s medical condition. And as I’ve written before, the younger you are typically the better your health is. By buying life insurance on a child, you won’t have to worry about the following items:
- Developing an adverse medical condition that makes coverage more expensive, if it doesn’t render the child uninsurable. The classic example is juvenile diabetes – most insurers won’t ever insure you if you have juvenile diabetes and were diagnosed prior to age 10. Another common teenage medical issue that has a long standing impact on insurability is depression and the use of anti-depressants.
- Drug or tobacco use. Tobacco use won’t render you uninsurable in most cases, it will just double the rates that you’ll pay. The impact of drug usage will vary from carrier to carrier. Marijuana use will typically put you in a higher rate class and might render you uninsurable depending on frequency and recency of use, while using harder drugs can make you permanently uninsurable.
- Avocation factors such as being a private pilot or extreme sports. Both of these will affect rates and possibility insurability if a policy is purchased as an adult. Insurers will even consider scuba diving to have an increased mortality rate depending upon how deep you dive. If coverage is bought on a minor, these types of activities are immaterial.
- Family history. I hesitate to even include this as it doesn’t affect a minor’s insurability, but it will have an impact on an adult’s rate class. Different carriers view this differently – some only want to know if a parent died before a certain age of a certain cause such as cancer or heart disease. Other carriers are looking for any incidence, even if non-fatal, and at any age and in any immediate family member including siblings.
- Most people in their 20’s won’t buy life insurance no matter what. As I’ve mentioned in other postings, the best time to buy life insurance is long before you need it, typically as soon as you can. The problem is that most people in their twenties think that they are invincible and usually wait to buy a policy until their 30′s when they start having families and appreciate their own mortality a little more. The biggest impact to waiting is not that rates will go up based on age, but that you’ll be less likely to qualify for a preferred rate at age 35 as opposed to age 25.
The third reason to buy a policy is that it makes an attractive accumulation vehicle:
- Preferential tax treatment in that cash values grow inside of a policy tax free and death claims will be paid out tax free in most cases. There are limits to what how much you can pay in premiums into a policy and when you can pay in those premiums. Any policy that has too much paid into becomes a Modified Endowment Contract (MEC) and loses some of its tax advantages.
- A source of liquidity. You can borrow against a life insurance policy’s cash value without a credit check or paying taxes but be aware that the loan might affect the policy’s longevity. Also, you can withdraw what you’ve paid in premiums tax free and pay income tax only on gains if you choose to surrender the policy.
- Compound interest. Everything else being equal, the longer you have money working for you, the more you’ll ultimately have. The key to building wealth is to start saving early enough where your assets will have a chance to fully utilize compound interest. Unlike a college savings account or retirement plan that has a 20-30 year life span, a life insurance policy can stay in force 80 years or longer!
- Ability to get higher yields, and a vehicle that will behave well in a rising interest rate environment.Even though interest rates have come up from all-time lows in the early part of 2013, CD’s, money markets, and savings accounts are still paying miniscule amounts. A life insurance company invests its premium dollars in long term bonds to get better yield and then also places some guarantees on the cash values so they are not subject to market or interest rate fluctuations. As a result, rising interest rates work in your favor as the cash value of a policy earns a higher rate of return without losing like value like individual bonds or bond mutual funds do. Right now policies are earning around 4.5% and have done even better historically.
- Watch out for fees. The access to a higher earning vehicle doesn’t come without some costs however. You have to pay for the cost of insurance, various administrative fees, and possibly commissions. Some policies also have surrender charges which limits your ability to extract cash value if you decide the policy is not for you and want to surrender it. Before buying a policy work to understand what your policy charges and how this affects longevity and performance. Universal and Variable Universal Life policies do a much better job of breaking out policy costs where Whole Life products are a black box in that not much is disclosed about their internal cost structure.
- Possible preferential financial aid treatment. I’m aware that cash value has been sold as an alternative way of paying for college, but as mentioned above watch out for the fees. It will definitely be more expensive than a low-cost 529 plan. The other thing to keep in mind is that while the FAFSA doesn’t factor in life insurance cash values among other things, more and more private colleges and prestigious public schools are using the CSS PROFILE which does. If your child is under age five there is no telling what financial aid officers will look at by the time your son or daughter reaches college.
- Ability for the parent to control the policy past the child’s 18th birthday. There are three parties to a life insurance policy: the policy owner, the named insured, and the beneficiary. What typically happens is that the parent will buy the policy and be the owner and beneficiary and the child will always be the named insured. The policy owner always has the right to change the beneficiary at any time for any reason and the policy owner can also be the owner indefinitely – it’s not like a UTMA/UGMA custodial account that technically becomes the child’s property at the age of majority. What I advocate doing is not giving your child ownership of the policy at age 18 as they will probably surrender the policy and take the cash value and do something stupid with it. Instead, I advocate not even telling your children about the policy and then giving it to them as a wedding gift or when they have their first child and are more likely to appreciate what they have been given.
How do I buy life insurance on my child?
There are three ways of getting life insurance on your children, I’ll list them here in increasing order of desirability.
You take it as employee benefit if offered by your employer. A lot of times, I’ll see employers offer between $10,000 to $15,000 for free or minimal cost and you will have the ability to buy a little more, typically no more than $25,000 in total coverage. Coverage of this amount will pay for final expenses but it won’t leave money for anything else that needs to be taken care of. There is little, if any, underwriting done on this type of coverage. Often, you have to proactively opt-in to this employer coverage, as it doesn’t automatically cover your children. Make sure that you have opted in!
You can add your children as a rider to an existing life insurance policy that you own. This will be a little more expensive than employer offered insurance although it can cover all children for one price so if you have more than four kids it can actually save you money. There will be some underwriting, but that underwriting usually consists of broad health questions. The advantage with any type of privately held policy is that it is portable, meaning that it stays with you regardless of what your employment status is. Child riders are typically in the same range as employee benefit coverage, $10,000 to $25,000 per child, but they frequently include the ability to buy coverage on the child over and above this amount at a later date regardless of medical condition.
Finally, you can purchase a stand-alone policy on the child. Broadly speaking, you can buy a policy with a face amount between $25,000 and $500,000, while most people opt for between $50,000-100,000 in coverage. Typical pricing for a $50,000 – 100,000 policy is between $50-100/month depending on the child’s sex, age, and if you intend to pay more for a shorter time period. You can get a policy for as little as $20/month for a smaller policy on a young child. Underwriting is a little more in depth than on a stand-alone policy but no blood work or urine sample is needed.
What types of policies are available on children?
Life insurance comes in two forms: term insurance and permanent insurance. Term insurance does not build any cash value and only lasts for a fixed number of years, usually no more than 30, before it disappears. Term insurance is not sold on children as it would run out in their peak earnings years and also due to company pricing constraints – it costs more to underwrite and service a policy than a company could collect in premium.
The other type of life insurance policy is a permanent, or cash value policy. These types of policies come in different shapes and sizes which I’ll get to shortly, but the big differentiator is that they can accumulate a cash value and can also last a lot longer. Currently, for new policies, every insurer that I know of is using the 2001 mortality table that projects life expectancy out to age 120 and it is possible to structure a cash value policy to provide coverage up to that age as well.
One type of permanent policy is a whole life policy. A whole life policy is a fixed-premium policy, meaning that the premium you are committed to pay has little, if any, flexibility. When premiums are paid into a whole life insurance policy, part of the premiums pay for the death protection (technically known as cost of insurance) and the other part of the premium is added to the policy’s cash value and invested on your behalf by the insurance company. The thought behind a whole life policy is that over time, there is more and more cash value in the policy so there is less pure insurance to buy as the insured becomes older and the cost of that insurance is more expensive. For instance, if I buy a $100,000 whole life policy on my one year old son there will be no cash value to start with but at age 30 it might have $30,000 in cash value, and at age 50 it might have $50,000 in cash value.
Whole life policies can either be participating or non-participating. A participating policy means that if the company makes more money on their investments than they predict or fewer insureds die in a given year, some of those excess earnings are returned to policy owners in the form of dividends. A non-participating policy means that the company’s earnings are immaterial – the policy’s premium is cast in stone at the time the policy is taken out. Typically mutual companies are the only companies who sell participating policies.
There are two things to keep in mind with participating polices. The first is on participating policies, the policy is illustrated with and funding levels (called target premiums) are determined based on an assumed interest rate, not a guaranteed interest rate. For instance, a policy might guarantee three percent earnings on cash values, but it can be illustrated at earning five or six percent. If the policy earns less than is assumed in the illustration your cash value won’t be as high as in the illustration and you might have to pay more in premiums down the road.
Second is that the policy owner on a participating whole life policy has a choice on how to use the dividends paid by the policy. There are several options but two of the more typical are premium reduction and to buy paid-up additions. Premium reduction means that if your target annual premium is $1000/year and the policy pays a $300 dividend you only have to come up with $700 out of pocket to pay the premium, the other $300 is covered by the premium. Buying paid up additions means that you use the $300 in this example to buy additional coverage that requires no further premium payment. Neither option is inherently better than the other – paid up additions are better if you’re trying to grow the death benefit and cash value while reduction of premium is better for people who are trying to minimize out of pocket costs.
The second type of permanent life insurance policy is a Universal Life (UL) policy. In some states, UL is called “Flexible-Premium Adjustable Life Insurance”. The biggest thing with a UL policy is that it has flexible premiums, meaning that to a certain degree you can control how much goes into a policy and when. On a UL policy, any money paid in as premiums will have a little money deducted up front for things such as premium taxes and possibly sales commissions, the remainder will be added to the policy’s cash value and invested with ongoing expenses of the policy such as administrative charges and the cost of insurance deducted from the policy’s cash value.
There are some more moving parts with UL policies, however. A subset of UL policies are called Variable Universal Life (VUL) policies. Let me explain the difference as plainly as I can. In a standard UL policy, the cash value is invested for you by the company and you earn interest at varying rates. The cash value is guaranteed against investment loss (however the cash value can still go down if the ongoing expenses of the policy are greater than the interest earned) and there is also a minimum interest rate that the policy will earn. As I write this in August 2013, most UL policies are paying in the neighborhood of 4-5% with guaranteed minimums on new policies of 1-3%. The guaranteed minimum stays in force for the life of the policy and has been trending down with lower interest rates. There is no ceiling on what a UL policy will earn, but interest rates are closely tied to what long term bonds earn so don’t expect it to perform like the part of your portfolio that’s invested in stocks and stock mutual funds.
A VUL policy on the other hand has some choices about how the cash value is invested. In addition to a fixed sub-account which is invested by the life insurance company just like in a UL policy, there are also variable sub-accounts which carry investment risk and can invest in stocks, bonds or a combination of the two. Most sub-accounts are managed by differing mutual fund companies but have a life insurance ‘wrapper’ around them. Allocating part of your cash value to one or more variable sub-accounts can give your policy the potentially earn more, but it also means that the cash value can go down. Like all investing, the more risk you take, the higher your highs will be but also the lower your lows will be as well.
The big danger with having money in the variable sub-accounts is that when the markets are down, more shares of the variable sub-account has to be sold to pay the policies ongoing expenses which could affect the policy’s long term viability. Unlike investing for a far off goal like retirement where you can just let a losing investment sit and wait for it to recover, a VUL policy is always consuming money, either in the form of new premium being paid in, earnings on the cash value, or sale of sub-account shares. Stated another way, ongoing policy costs can force you to ‘sell low’ if there isn’t additional premium money being paid in.
The other big decision on any type of UL or VUL policy is choosing the death benefit. Most policies will give you two ways of structuring a policy: as an Option A or level death benefit; or as an Option B or increasing death benefit. Assume that you have a policy with $50,000 in cash value and a $1,000,000 face amount. Just like a whole life policy, the Option A policy will just pay out the face amount ($1,000,000), regardless of how big the cash value is while an Option B policy will pay out both the cash value ($50,000)in addition to the face amount ($1,000,000).
Since the amount of pure insurance on an Option A policy decreases as the cash value grows, it’s best for people who want to pay policy premiums in small amounts out of monthly cash flows. Option B coverage on the other hand will always have $1,000,000 in pure insurance coverage regardless of how big the cash value is, making it more expensive to own and a better choice for someone who wants to pay in policy premium in big chunks. An important point to note is that all insurers require evidence of insurability to move from an Option A to an Option B policy since the insurance company will be taking on more risk, while not every company requires evidence of insurability to move from an Option B to an Option A policy.
Okay, you’re still with me. You see the need to have some coverage on your child and the benefits to buying a stand-alone policy for that child. The question now becomes: what should you look for when buying a policy? Here are some things that you should keep in mind:
- Financial strength of the company matters. It the policy is held until the child’s death, it could be in force for 70-80 years or longer. While life insurance is a highly regulated industry and all companies have to meet minimum financial requirements, life insurance companies have been known to fail. You want to make sure that your insurer will be around for the long haul.
- Make the policy as big as you can. Even though the death benefit amount might seem excessive now, remember that inflation will reduce the purchasing power of that death benefit over time. The other reason to buy a big policy is that since mortality rates are so low for juveniles, a large proportion of premiums go to pay fixed administrative and overhead expenses. Buying a larger policy will spread these fixed expenses out more. Some policies do allow you to buy more coverage on a child down the road through a future insurability rider, but my opinion is that it’s better to buy a bigger policy off the bat as there are limitation as to when you can exercise the option to buy more insurance and it becomes more expensive to buy additional coverage the older the child becomes.
- If at all possible, overfund the policy. Overfunding means that you are paying more into the policy than is needed to keep it in force. That excess premium gets added directly to the cash value in the case of UL or buys paid-up additions in a Whole Life policy and, in turn, the cash value will then earn more. The Holy Grail with any permanent life insurance policy is to have the cash value become large enough where the earnings on the cash value are enough to pay for all of the policy’s costs, essentially making the death benefit free. The IRS does limit how much can go into a policy based on the insured’s age and sex so make sure that you check with your agent or the insurance company to know what this number is.
- Have your child go through full medical underwriting as soon as they turn age 18. As mentioned earlier, unlike adults who require a blood draw and a urine sample to get coverage, on children the underwriting is much simpler. As a result, companies often will put children in their own rate class. This rate class is better than the rates that a tobacco user or someone with medical issues will get but not as preferential as the rate structure for someone who is healthy and goes through full underwriting. There is no cost for you to do the underwriting and there is no risk that the policy gets up-rated, as once a policy has been in force for more than two years it becomes uncontestable on medical grounds.
- Make the policy as flexible as possible. It’s impossible to predict everything that will happen in your lives, the financial markets, and interest rates for the many years the policy will be in force. What might make sense now might not make sense twenty years from now. As an example of keeping a policy flexible, if you decide to go with a UL policy as opposed to Whole Life, I’d urge you to buy a VUL even if you have no intention to use the variable sub-accounts for the foreseeable future.
- Bring in a fee-only financial advisor or fee-only insurance consultant. Yes, I’m highly biased on this point, but hear me out. Life insurance is a very opaque topic to begin with and most knowledge is concentrated in the hands of people who sell it for a commission. Additionally, a lot of the best carriers only sell directly to the public or through captive agents so it’s difficult to get information on all the options that are available. A fee-only advisor can give you an objective opinion on how much coverage to buy as well as what type to buy. Additionally, they will have relationships with commissioned agents and direct to consumer companies to make sure that you’re working with someone who has your best interests at heart and you aren’t taken advantage of.
- Design your policy based on what you’re trying to accomplish and how you’re going to fund it. There are different ways of designing policies based on having the largest possible death benefit as opposed to maximizing cash value growth. The other factor to keep in mind is funding – how much are you planning to put in and for how long? Are you going to pay premium out of existing assets or monthly cash flow? All of these questions will help focus on designing a policy that’s right for you.
Where does child life insurance fit in big picture?
In summary, the prudent, responsible thing to do is to carry some sort of coverage on your children. Insurance is the perfect way to protect against events with a low probability of occurring but with a devastating impact if they do happen. If you are on track for your retirement goals and find cash building up in your bank account, I’d encourage you to look at using a policy as an accumulation vehicle as well. Be sure to keep an eye on the internal policy fees though!
