Why Do I Need Life Insurance?

The Takeaways:

1. You don’t have to buy life insurance, but the first reason to consider it is when you have a big and long term financial responsibilities for you or your loved ones, it is to your great advantage to own life insurance.
2. Everyone talks about “death benefits” from life insurance because that is often the largest payment from your life insurer, who paid $100 billion to the beneficiaries of policyholders who died in 2021, the highest amount in a single year.
3. You don’t have to have a child to buy a life insurance. Living benefits of a life policy give anyone reasons to have a life policy for unpredictable future events for oneself, like accelerated death benefits & secured mortgage payments when one lost job.
4. Life insurance involves very personal choices, where a long term oriented mindset matters more than demographics and liabilities. Cultures play a big role especially between American parents and Chinese parents.
5. Next to the long term mindset is the long term financial responsibilities one faces, like raising children, saving money for college education of the youth, leaving a legacy in personal cause, mortgage payments, owning a business, and senior long term cares.

Do I must Have Life insurance?

I have heard that question many times in my life. I myself also wondered about that. But the short answer is “No” because, let’s face it, life insurance is not for everyone, or in a flip side, not everyone needs a life policy.

To avoid sounding negative, the safe and sound answer should be “It depends.”

Unlike auto liability insurance that is required by the law, no one will force you to buy life insurance. The urge to own life insurance may come from inside more than outside.

That said, let’s change the question to this: “Why would anyone want to buy a life insurance policy?”

Reasons for Owning a Life Insurance

With the new question we will have a more constructive, more positive answer. We are not talking about why anyone must have life insurance. Instead, we ask for reasons why someone would choose to have it.

Let’s begin from ChatGPT and see what the chatbot would have to say (with my edit).

Here are some reasons why you might need a life insurance policy:

1. Demographic Reasons to Protect Your Loved Ones: If you have anyone financially depending on you (spouse, children, or aging parents), life insurance can ensure that they are financially protected in the future when your pass away, allowing your loved ones to maintain their standard of living.
2. Business Continuity Reasons to Protect Your Brand or Endeavor: If you are a business owner, life insurance can ensure that your business continues and that your family is protected in case of an untimely passing. Both whole life and term life insurance options should be considered for the reason of protecting your business.
3. Funding for Future Expenses: Life insurance can be seen as an investment for future expenses, such as college tuition for your children.
4. Peace of Mind: Having life insurance can give you peace of mind, knowing that your loved ones will be financially protected in the event of your passing. It can also provide a sense of security and stability during uncertain times.

The above is just a start, and I’d say it missed at least two things: It does not cover the particulars or specifics of why you should have life insurance and it essentially skips the “living benefits” for policyholders. Let’s get into details below.

Life Insurance Is Very Personal

The first thing ChatGPT missed is your personal choice for life insurance. To be sure, all insurance decisions are based on personal choices, even for auto insurance. The law says every driver must have a liability auto insurance to protect other drivers involved in an accident that is your fault. At the minimum, all California drivers must have:

• $15,000 for injury/death to one person.
• $30,000 for injury/death to more than one person.
• $5,000 for damage to property.

However, you don’t have to have a comprehensive and/or collision coverages that are designed to protect yourself and your autos. Whether you choose to buy those coverages is totally up to you or is your personal choice.  

Personal choice matters especially for life insurance because no law says one must buy life insurance. Just because you have a demographic need (a wife, children and/or grandchildren) does not necessarily mean you will buy life insurance. Let me illustrate with real life examples.

Americans Do Not Always Pass Wealth to Heirs

According to an article published in New York Times, “Two-thirds of Americans who have at least $3 million in investable assets have not talked to their children about their wealth or never will.”

Another article by the Atlantic discusses how many grandparents offer some sort of financial support to their grandchildren. Some may choose to keep their wealth private from their own children. This could be due to a variety of reasons, such as not wanting to create conflicts among siblings or not wanting their children to become complacent with the idea of inheriting wealth.

Let me use a hypothetical example. Sam owns a small business with a net worth of $6 million. Sam was divorced with one son, Simon, and three daughters, Ashley, Dawn and Kelley. Sam has decided to pass his wealth not to the offspring but to an estate, which starts from a will, an executor who is in charge of the estate after Sam dies, a guardian for Kelley who is currently only 14 year old, an inventory or an account for distribution of heirs, among other things.

ChatGPT offers several reasons why a life insurance policyholder, like Sam, might name their estate as the beneficiary of their policy (with my edit):

• Simplicity: If you name your estate as the beneficiary, the distribution of the death benefit is determined by the terms of your will. This can simplify the process of distributing the funds to your heirs, as it’s all managed through the probate process, which is the legal process of administering a deceased person’s estate, including identifying, valuing, and distributing the assets, settling debts and taxes, and transferring the remaining assets to the beneficiaries.
• Flexibility: By naming your estate as the beneficiary, you retain control over how the death benefit is distributed. If your circumstances change, you (or the court in California) can update your will to reflect your wishes.
• Protection: If you have debts or liabilities that may not be covered by your assets, naming your estate as the beneficiary of your life insurance policy can provide additional protection for your loved ones. One way is to establish a trust, a legal arrangement where you transfer ownership of your assets to a trustee who manages them for the benefit of your beneficiaries. When you establish a trust, your assets are no longer considered your property, so they cannot be seized by your creditors or debtors.

However, naming your estate as the beneficiary may also delay the distribution of funds to your heirs. Additionally, if you have a large estate, naming your estate as the beneficiary could increase the overall size of your estate, potentially triggering estate taxes.

That said, Sam and his heirs do not need to worry about that because the IRS will charge estate tax only for estates with a value above certain tax exemption threshold. For individuals passed away in 2021, the exemption amount is $11.7 million, meaning any estates valued at or below $11.7 million are not subject to estate tax. Sam’s net worth was only $6 million, way below the tax threshold.

Chinese Want to Pass Every Penny to Heirs Top of Form

On the other end of the spectrum and unlike many American parents, many (mainlander) Chinese parents will treat their children as the most important people in the world, literally more so than their spouse. They will do everything in their power to make sure the children get all the wealth they created, which has been their life goal to begin with. For these parents, one of the favorite way to pass wealth to the next generation is to open an irrevocable life insurance trust (ILIT) account.

This is obviously the topic for another day but briefly, an irrevocable life insurance trust (ILIT) is a type of trust that is commonly used to manage life insurance proceeds. It is called “irrevocable” because, once the trust is established, the grantor (the person who creates the trust) cannot change or revoke it without the consent of the beneficiaries.

In other words, an ILIT is permanent and not meant to be changeable. You really must have made up your mind to pass the wealth down to the trust, otherwise you may get into a lengthy process to reverse it — if possible at all. Some states allow for modifications if all of the beneficiaries consent to the changes. In other cases, the court may have the authority to modify or terminate the trust based on certain circumstances, such as a change in circumstances that makes the trust’s purposes impractical or impossible to achieve.

But Chinese parents are unlikely to change their mind on their children, so this is not really a risk factor for them at all.

There are several benefits to using an ILIT, including:

• Estate tax savings: Since the life insurance policy is owned by the trust, it is not considered part of the grantor’s estate for tax purposes, which can reduce the amount of estate tax that must be paid. Say a Chinese businessman named Mr. Lin owns a net worth of $50 million. He can put $11 million into an ILIT for his 15 year old son, Ben, which is just below the lifetime gift tax exemption that allows individuals to make gifts up to $12.06 million as of 2023 over their lifetime without incurring a gift tax for Ben to pay.  
• Asset protection: Because the ILIT is irrevocable, the assets in the trust are protected from the grantor’s (e.g., Mr. Lin) creditors and from any legal claims against the grantor. In other words, even if Mr. Lin owed $2 million debt to the bank, bankers cannot take money from the $11 million in ILIT, which is off limit to all creditors.
• Control: The grantor like Mr. Lin can specify how the life insurance proceeds will be distributed, which can provide greater control over how their assets are used after their passing.

The American example of naming an estate as the beneficiary versus the Chinese example of using an ILIT to pass the wealth down help illustrate how different people choose to work with life insurance differently, which in turn is affected by different cultures and preferences.  

Why Death Benefits Matter

Like I pointed out earlier, the ChatGPT answer listed above also missed the living benefits of a life insurance policy. This is understandable as when it comes to life insurance, the thing called “death benefits” quickly come to our mind. This makes total sense as they are typically the biggest chunk of money from the insurer, and will only be sent out after the policyholder is no longer alive.

Not only are death benefits the primary payment from a life insurer but they are not generally taxable income for the beneficiaries.

For example, you have a daughter named Chloe who is the beneficiary of your life insurance policy and when you passed away, leaving a death benefit of $100,000, Chloe gets to keep that lump sum without paying income tax. In fact, Chloe does not even need to report that $100,000 on her income tax form for the year she received the money.

Only under unusual circumstances would Chloe have to pay taxes. One scenario is when she decides to let the life insurance company keep the money to generate interest, Chloe then needs to pay tax on the interest part. For example, say Chloe keeps the $100,000 on the account with the insurer and one year later it generates $500 interest, Chloe would have to report that $500 as income and pay tax on that.

Another scenario is when Chloe’s father bought the life insurance policy through a group life plan, which is typically paid by pre-tax dollars, then Chloe would have to pay taxes and her death benefits will not be $100,000 after paying taxes. Another (unusual) scenario is when Chloe decided to sell the policy (with $100,000 death benefits) to someone else.

Why Living Benefits Also Matter

When prompted, ChatGPT offers the following answer:

Life insurance provides financial protection through death benefits for your loved ones, but it can also offer living benefits while you’re still alive. Here are some listed by ChatGPT (with my edit):

• Cash value accumulation: Many whole life insurance and universal life insurance build cash value over time, which policyholders can use the money anyway they see fit, with the following uses or advantages:
• Tax-deferred growth: The cash value of certain life insurance policies grows tax-deferred, meaning you don’t have to pay taxes on the growth until you withdraw the money. Being able to pay taxes later rather than now saves you money because money has more value today than tomorrow.
• Supplemental retirement income: You can use the cash value of certain life insurance policies to supplement your retirement income. This can be especially useful if you’ve maxed out other retirement savings options, such as 401(k)s or IRAs. This means in addition to the money saved though 401(k) and IRA, plus social security, you have an extra source of income when you retire.
• Collateral for loans: The cash value of a life insurance policy can be used as collateral for loans, such as a home equity loan or business loan. When you need money today, banks can look at your cash value from the life insurance policy and say “Okay, we see you have $100,000 cash value from your life policy and we can loan you $150,000 using that $100,000 as the backup.” Banks won’t say that to someone with no life policy, or with a term life policy that carries no cash value.
• Estate planning: Life insurance can be used as part of an estate planning strategy to transfer wealth to your heirs. Life insurance proceeds are generally tax-free to your beneficiaries. We say “generally” but more specifically the death benefits will be tax free, while the beneficiaries do pay taxes on the cash value that is more than the paid premium. Say Sam has paid a total of $250,000 in premium and the cash value comes out at $400,000 at Sam’s death, due to insurance company investing the $250,000 in the financial market, that extra $150,000 (=$400,000 – $250,000) will be taxable income for any beneficiaries of Sam’s life policy.
• Long-term care benefits: Some life insurance policies offer long-term care benefits, which can help cover the costs of long-term care if you become unable to care for yourself due to an illness or disability.

The above list misses one thing: accelerated death benefits, which allow policyholders to receive a portion of their life insurance payout in advance if they are diagnosed with a terminal illness or critical condition.

Say John has a life policy with a death benefit of $250,000. At the age of 55 John was diagnosed with Lewkemia and will be treated by chemotherapy, radiation therapy, and/or bone marrow transplantation. John is never married and has no kid, but he can talk to his life insurer about getting a portion of the $250,000 death benefits out for his terminal illness.

Accelerated death benefits are typically included as a standard feature in many (whole) life insurance policies so you don’t need any special rider or add-on terms. That said, you do need to meet a few requirements, such as medical documentation of your condition, and other requirements such as minimum age and time since the policy was issued.

Only whole or permanent life but not term life insurance, which covers typically from 10 to 30 years, will offer accelerated death benefit. That said, some term life insurance policies may offer other riders, such as accidental death and dismemberment riders or waiver of premium riders.

Life Policies Are for People with a Long Term Orientation

In my view, life insurance is ultimately for people with a long time orientation. It is one of those things where mindset matters more than demography, liabilities or specific life circumstances.

What do I mean by long time orientation? It means one must think in longer terms like decades rather than years, months or days. The longest term we can think of is cross- or inter-generations like many if not most Chinese parents do.

Sometimes long time orientation comes to us or forces itself upon us. Mortgage protection insurance is a perfect example. It is a type of insurance that pays off your mortgage in the event of your death, disability, or job loss. The most typical term of mortgage is 30 years, which means even if you don’t want to think long term, mortgage payment will force you to act in a long term manner.

Here are some reasons why someone might consider getting mortgage protection insurance:

• Peace of mind: Knowing that your mortgage will be paid off in the event of your death or disability can provide peace of mind for you and your loved ones.
• Protection for your family: If you pass away, mortgage protection insurance can help ensure that your family is not left with the burden of paying off the mortgage on their own.
• Job loss protection: Some mortgage protection policies also include coverage for job loss, which can help cover mortgage payments if you lose your job.
• Simplified underwriting: Compared to traditional life insurance policies, mortgage protection insurance typically has a simplified underwriting process, which means you may be able to get coverage without undergoing a medical exam or providing extensive medical information.
• Affordable premiums: Mortgage protection insurance premiums are often more affordable than traditional life insurance policies, which can make it a good option for people who want protection but may not be able to afford higher premiums.

Final expense insurance is another long-term consideration, where life insurance payment can provide funds to cover your own funeral and burial expenses, which can be quite costly.

Leaving a legacy is another long term concern, where you can leave a charitable donation or other legacy to a cause or organization that is important to you.

Locking in insurability and low insurance cost, this requires a long term mindset to look into the future. If you are young and healthy, purchasing life insurance now can help you lock in a lower premium rate while you are still insurable.

The final scenario that a long term mindset provides motive for life insurance is a business owner, who can pass the business to their heir or heirs through a variety of methods, such as a will or a trust. This is known as succession planning and is an important consideration for any business owner, especially those who want to ensure that their business continues to thrive after their death.

The question is if business owners can pass the businesses to heirs, why would they have life insurance? ChatGPT offers the following answers (with my edit):

• To cover estate taxes: When a business owner passes away, their estate may be subject to federal or state estate taxes, which can be significant, up to 40%. Life insurance can help cover these taxes, so that the heirs don’t have to sell the business or other assets to pay them.
• To provide liquidity: Even if the business owner plans to pass the business to their heirs, there may still be expenses that need to be paid upon their death, such as funeral expenses or outstanding debts. Life insurance can provide the necessary cash flow to cover these expenses without requiring the heirs to liquidate assets.
• To equalize inheritances: If a business owner has multiple children who will inherit the business, life insurance can be used to provide an equal inheritance to children who are not involved in the business. For example, if one child is going to take over the business, the business owner may choose to purchase life insurance to provide an inheritance of equal value to their other children.
• To provide a buy-sell agreement: If a business has multiple owners, life insurance can be used to fund a buy-sell agreement. This agreement ensures that if one owner passes away, their share of the business will be sold to the remaining owners at a predetermined price. The life insurance provides the necessary funds for the remaining owners to buy out the deceased owner’s share.