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Should You Carry Life Insurance on Your Kids?

There are a few reasons why carrying life insurance on your kids can make sense.  Among these are (1) inability to afford a proper funeral should they pre-decease you, (2) desire to preserve your child's insurability, or (3) desire to 'set them up for life'.  In this post, we'll answer the question and as you will see, much depends on your financial circumstances.

Funeral Expenses

It is a terrible, terrible thing when a child dies at a young age.  Beyond the emotional toll that lasts a lifetime, there is also a financial ingredient as very few of us have a plan to pay for the funeral of a child.  Often, memorial funds are setup at banks so family, friends, and the community can help pay for these expenses, but there is no guarantee that these contributions will match the high costs of a funeral.

For this reason, it is a good idea to purchase some form of life insurance on your children.  The chances of this kind of tragedy striking are incredibly low, and consequently, insurance premiums are very inexpensive.  Generally speaking, a policy can be had for only a couple of dollars per month through group life insurance from an employer or as a rider (add-on) to an individual life insurance policy.  Either way, it's worth investing a few dollars a month to make sure you're covered if you don't have the money availble to pay these expenses.

Preserving Insurability

Many of us have family medical histories that will make it difficult for our children to obtain life insurance when they need it.  To remedy this problem, a permanent life insurance policy can be purchased for a child that will (1) guarantee coverage, (2) lock in premium rates, and (3) increase the death benefit to keep pace with inflation.  In short, even with a poor family medical history, insurance can be procured to assure them of coverage later in life.

'Setting Them Up for Life'

If you are wealthy and want to help your kids become wealthy too, a max-funded permanent life insurance policy can be used to accomplish your goals.  With a permanent life insurance policy, you'll give your kids a great deal of financial flexibility that will allow them to take out a loan at favorable interest rates, preserve their insurability, and provide an asset that could be used in starting a business, going to college, or even retiring comfortably.

NOTE: We typically do not find this last reason attractive as it often backfires with children living 'soft' lives and squandering these funds more often than not.  Research suggests money given is far less valuable than money earned.

Wrapping Up

Of the three main reasons why you should buy life insurance on your child, the first is the most common.  The simple fact is that most of us don't have sufficient money set aside to cover the cost of a child's funeral.  Beyond that, special cases such as preserving insurability or setting up a child for life can be valid reasons, but are much less common.  The bottom line is you should always carry insurance for large losses that you otherwise cannot afford.  In this instance, it's a few dollars each month to offset a risk that can be upwards of $10,000.

Critical Thinking

• Having a child pre-decease you is one of the worst things that can ever happen to a person.  What are the indirect costs associated with this type of event?
• Strictly from a financial perspective, what does a funeral cost?  What about any final medical bills?
• Is it worth a few dollars each month to insurance against the financial costs of this type of tragedy?
• What is the opportunity cost of buying this kind of insurance?  How many hamburgers, fries, or soft drinks does it equate to?

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When to Buy Permanent Life Insurance - Whole, Universal, Variable, or Variable Universal

Many advisors almost exclusively advocate purchasing term life insurance while many insurance agents continue to recommend permanent life insurance (sometimes forcibly).  Who's right?  It depends.  Term life insurance is likely the best option for most due to its temporary nature and significantly lower costs, but permanent life insurance has an important role as well.  As we'll point out in this post, whole, universal, variable, and variable universal life insurance can all be suitable policies depending on circumstances.

The Basic Rule

At the heart of all of these situations where permanent life insurance makes sense it the basic principle that if you have a permanent insurable interest (say, taking care of a special needs child), then you should purchase a permanent insurance policy.  It seems rather simple, but often, unwary individuals and families will buy a permanent policy to insure a temporary need.  This is unfortunate because permanent policies are very expensive and the added costs are not easily recouped.

I'm Rich

There is a small percentage of folks who are very wealthy and require life insurance to offset the effects of estate and inheritance taxes.  Life insurance is income tax free, and if setup properly can also escape death taxes.  Most commonly, wealthy individuals will purchase permanent life insurance of some form or another and own it within an Irrevocable Life Insurance Trust (ILIT).  With the insurance owned by an entity exempt from estate taxes, the proceeds from the policy can be paid to the beneficiaries without taking a haircut from Uncle Sam.

I Own a Successful Small Business

Most businesses don't reach higher levels of success with only one owner; they usually have two or more.  As a small business, there are two major life insurance needs that may arise in the form of insuring against the death of an owner or that of a key person whose loss would make a material impact on the business.  These issues are nearly always best handled with permanent life insurance.

In the case of an owner's death, the surviving owner(s) typically will not want to be in business with the deceased's beneficiaries so a buy-sell agreement will be used to facilitate the sale of the deceased's interest in the company.  This arrangement keeps the business functioning well because there is no interference from those unfamiliar with the company and it frees up equity to bring on a replacement in the company, if needed.  The beneficiaries receive a cash payment and can then walk away from the business altogether.

With a key man that isn't an owner, life insurance may be important to insure against the possible loss in business should the key person die unexpectedly.  These are usually executives or general managers of small businesses who have a great deal of responsibility and influence on the success or failure of the firm.  By insuring this potential for loss, the business owners are better able to provide for a stable transition from the deceased to a new key person.

I Have a Special Needs Dependent

Another important use for permanent life insurance is for the provision of funds for a special needs dependent that will need money long after the provider dies.  These are typically owned in a trust that has specific provisions associated with it, but having permanent life insurance in place ensures that money will be available to a dependent beyond the provider's lifetime.

I Am a M-I-S-E-R-A-B-L-E Saver

This last one is debatable, but we'll take a more behavioral approach to personal finance on this.  For those that simply cannot save a nickel without being forced to do so, permanent life insurance may be a way to force savings into one's life.  Make no mistake, insurance is an extremely expensive savings vehicle that will produce returns that are far below other alternatives and may even trail inflation.  However, some folks seem to be able to commit to and stay with an insurance policy better than a 401k, IRA, or savings account.  While we can only speculate, the highly inflexible provisions of permanent life contracts (like not being able to take out a dime for 15 years) and regular payment of premiums required appear to be a good combination for those that cannot save on their own.

Wrapping Up

We are major proponents of term life insurance, but permanent policies do have a place.  We've pointed out four common issues that make permanent life insurance a suitable option.  However, you should always remember the rule that permanent policies should only be used to insure permanent needs.  By the way, if you're a miserable saver and generally can't hold onto money for any length of time, the odds are good that you have a more permanent problem on your hands, thus, permanent insurance could make sense.