When working with clients, one of the planning items we review is insurance, including disability, homeowners, auto, umbrella and life. Each of these policies are very important in the event that something terrible happened, but a consistent theme is doctors not knowing how much is enough, what type of policies they should consider and what features their policy should have.
Over the next 5 weeks, I will be covering the basics of each of these policy types, starting with life insurance. I encourage you to use this information to review your existing policies to make sure they still fit your needs and life.
What is life insurance?
Life insurance is quite simply an amount of money your named beneficiaries will receive if you die. Insurance companies underwrite individuals based on their medical records and history, family history and lifestyle (things like smoking and sky diving) to determine the risk category of any given individual. From there, the insured is grouped into a category ranging from Super Preferred to Substandard (also called rated), which will determine the annual premium of the policy.
Life insurance is considered "outside of your estate", and unless it’s specified otherwise, the pay out is not directed by your will, rather by who you named as the beneficiary. Its really important to review beneficiaries regularly- deceased family members and ex spouses may not be who you want insurance proceeds to pay to.
Another unique feature of life insurance is that the pay out is tax free. This is one of the reasons permanent (such as whole life) policies are often marketed as an investment. So long as premiums are paid for with after-tax dollars the benefit is not taxable to the beneficiary.
Term or Permanent?
Term insurance covers individuals for a set period of time, such as 20 years. It’s the simplest, most economical form of life insurance and a good fit for most individuals. You have may heard the phrase “buy term and invest the difference” as an alternative to a permanent policy.
Permanent insurance is a broader category that includes whole life, universal and variable universal policies. Each of these policy types is unique, but the goal of the policy is to last until the insured dies, regardless of age.
When you think about a typical life cycle, people start working, have a family, build for retirement then life off of their accumulation. Life insurance is meant to replace a loss, so for most people, it’s no longer needed when they reach retirement.
In general, my bias is to buy term (and invest the difference). In planning with clients, and especially practice owners who have most of their wealth tied up in their practice, I believe flexibility and liquidity is a priority. Although there are provisions for accessing the value of permanent policies, they are much more rigid than building savings on top of a term policy.
There are some situations where permanent insurance can make sense: if a taxable estate is involved (insurance can serve as a replacement to beneficiaries for estate taxes owed), the concept of forced savings for those who have a hard time setting aside funds for investment, and personal preference—I have never met a beneficiary who was unhappy they received the benefit when a loved one passed away.
How much is enough?
Planning wise, there are two ways to approach the need for insurance:
1. How much does your family need?
2. How much would it take to replace your earnings until retirement?
Insurance companies consider #2 when determining how much a person can get in insurance—they’re not going to let someone making $50,000 per year get a $20 million policy. I generally believe this is the best approach as well even if the amount is technically more than a family needs.
Because insurance is a lump sum figure, there's sometimes sticker shock associated with a multi-million dollar policy, which is appropriate for most practice owners. I’ve heard “my wife can go back to work” or “what if my spouse gets remarried” as reasons to have less insurance than income replacement… these are all possibilities, but a harsh message to send from the grave to a family grieving the loss of a loved one. Term insurance especially is inexpensive enough that I encourage doctors to take care of their families.
Practice owners have a second consideration with insurance, which is insuring the value of a practice. The amount needed to replace the value of a practice
For example, if a solo doc passed away, the value of their practice would likely be dramatically lower (and possibly nothing) than if they sold it while alive. If a family was counting on the value of the practice for retirement, not insuring for an amount similar to the net value in a potential sale could be devastating financially.
Alternatively if a practice owner has multiple associates who account for a large share of production, the value would most likely decline only a little if the owner passed away since the practice would still be operational. There's the added bonus that one of the associates could be the potential buyer. In this case, it may be appropriate to insure against some loss in value and some working capital to cover the owner's contribution to the practice until it's able to be sold.
For practices owned by multiple doctors, it is best practice to have a funded buy/sell agreement in place, something that’s typically done with insurance. I suggest doing this with a formula based on EBITDA and funding up in anticipation of practice growth. Typically the practice would own the policy, and the practice would buy the shares of the deceased with insurance proceeds. Any excess funding could be used toward working capital as the loss of a doctor is likely to negatively impact financials for a period of time.
The topic of life insurance can be complex but is extremely important. Take the time to look at policies, amounts, beneficiaries and structure annually to make sure your evolving life circumstances are still covered for your loved ones.