May 19, 2020

Coronavirus Pandemic – A Reality Check on Life and Disability Insurance

The Coronavirus outbreak is a difficult yet eye-opening experience, and a reality check for our financial health. It is a reminder that it does not matter how well life appears to be going, bad events might happen, and that is why risk management is always important. For personal wealth management purposes, good risk management in this time of crisis includes making sure that your life and disability insurance needs are being met with high quality and cost-efficient products.

  1. Life insurance

Life insurance is an income replacement tool, and your life insurance coverage should be enough to cover the financial needs of your dependents in case you are no longer here to provide for them. Popular guidance often focuses on calculating life insurance needs as a multiple of a person’s annual income. However, that is an over-simplified method that does not work for everyone since each person’s situation is unique. It is important to focus on what your dependents need instead of how much your income is. Following is one approach for calculating your unique amount of life insurance coverage:

Step 1: Calculate your financial obligation

Add the following items to find the amount of your financial obligation:

  • Outstanding debts (mortgage, credit cards, etc.)
  • Dependents’ expenses (for example: the portion of your spouse’s living expenses that you plan to support, your children’s living expenses until a certain age, your children’s education expenses, etc.)
  • Your final expenses (medical bills, funeral, etc.)
    • Calculate the present value of the above future expenses

Step 2: Calculate your resources

“Resources” include the following items:

  • Liquid assets
  • Discounted after-tax income stream (including your spouse’s income in most cases)

Step 3: Calculate your coverage gap

Subtract the amount of “resources” from step 2 from your total financial obligation from step 1 to find your coverage gap. This is the amount of life insurance that you should get.

You can also check out this online life insurance needs calculator from LLIS.

Once you have determined the necessary amount of coverage, the next step is determining the best type of life insurance to use.  There are various options to choose from, including term life, whole life, and universal life policies. In our experience, term life is the best choice in the overwhelming number of client scenarios.  As a pure risk management product, it provides by far the most coverage for the least cost.

  1. Disability insurance

Most people do not consider disability insurance an essential component of risk management but having adequate disability insurance coverage is as important as, if not more than, having adequate life insurance coverage.  In fact, the pool of individuals who should have disability insurance is even greater than those who require life insurance since, even for those without dependentsdisability insurance is still crucial. There is a common belief that most disabilities are results of physical accidents; however, there are, in fact, more long-term disability insurance claims because of illnesses than because of accidents. Among the most common reasons for long-term disability claims are cancer (15%), pregnancy (9.4%), and mental health issues including depression and anxiety (9.1%).

Below is a simple way to calculate your disability insurance needs:

Step 1: Calculate your monthly expenses, including:

  • Monthly mortgage or rent payment (plus real estate taxes if they are not escrowed)
  • Monthly loan payments, including student loans and auto loans
  • The amount of other daily expenses including food, clothing, entertainment, etc. that are consistent with your living standard.

Step 2: Calculate the amount you need to save for retirement per month:

  • Since most disability insurance policies only pay until age 65 or 67, saving enough money to provide for your living expenses post-retirement age is very important, especially when you have to use disability insurance proceeds to replace your income.

Step 3: Calculate the net amount of disability insurance benefits

  • Add up the results you get from step 1 and 2, and you will have the net amount of disability insurance payout that you need.

Step 4: Determine if the disability proceeds will be pre-tax or post-tax

  • If you plan to pay the premium with pre-tax money (which is most likely mandatory for employer-provided policies), use your expected post-retirement tax rate and the your required net payout as calculated in Step 3 to calculate your gross disability insurance needs using the following formula:

If you plan to pay the premium with post-tax money, your disability insurance proceeds will be tax-free, and the result you get from step 3 is the amount of monthly benefit that you should purchase.

Additionally, two issues specific to disability insurance are important to consider:

Disability definition: different companies and different products can apply very different meanings for the word “disability”. The two most common definitions are “Own Occupation” and “Any Occupation”. Policies with “Own Occupation” definition of disability will pay if the insured is no longer be able to perform the duties of their specific occupation, whereas policies with “Any Occupation” definition will only pay if the insured cannot work in any job.

Portability: Disability insurance policies that are purchased through an employer are often less expensive, but most likely not portable. This means leaving a job may also mean losing critical disability coverage.  That is why, in addition to the disability insurance often provided through employers, people should carry private disability insurance that goes with you.

You now have a good handle on the basics of life and disability insurance, the two most important components of a personal risk management plan. Unfortunate events do happen, and the best thing you can do about it is to carefully prepare for the worst by having sufficient insurance coverage in place. It is never too late to start building a personal plan and it is always helpful to re-evaluate your needs from time to time.