Navigating the world of life insurance can feel overwhelming, especially after a major life event like divorce. With a plethora of policy types and complex terms, it's easy to lose sight of the fundamental purpose: providing financial security for those who depend on you. This post aims to demystify life insurance, offering a clear overview of common policy types and, more importantly, guiding divorcees through the essential steps of evaluating their insurance needs. We'll explore how to align your coverage with court orders, calculate necessary amounts, and thoughtfully review existing policies, ensuring you make informed decisions that safeguard your financial future.
Why is life insurance such an important tool? The answer to this question has been clouded over many years with the flood of new insurance types and complex insurance products. In the most general sense, though, a core function of life insurance is to provide money upon one’s death that helps cover the risk of losing an income resulting from a premature death. Life insurance provides a safety net for those who are dependent upon that income, such as children or a surviving spouse. It could also be used to pay final expenses and to satisfy debts, particularly in cases where one’s goal is to leave certain assets collateralized by that debt to their beneficiaries.
Many types of life policies exist. Here is a brief description of some of the most common:
Given the complex nature of the various types of insurance products available, much can be said about the nuances, pros, and cons that apply to each. The intent of this writing is to review in a general sense how your need for insurance should be considered. However, specific decisions on whether you should maintain, drop, or replace an existing policy should always be carefully considered with a financial or life insurance professional.
Once more, there are several purposes in having life insurance coverage. The most common, and what applies most to divorcees, is for replacement of income. We have three recommendations for divorcees when it comes to life insurance:
The starting points for reviewing your need for insurance are any orders from the court and your divorce agreement. If you are the recipient of alimony, the best practice is for you to own a life insurance policy on your ex-spouse and pay the premiums. This allows you to maintain control of the policy and ensure that you are assigned as the correct beneficiary of the policy. Note that it is also best if the life insurance is obtained before the divorce is finalized to ensure that your soon to be ex-spouse cooperates with any medical underwriting requirements.
If you are already divorced and wish to own a policy with your ex-spouse as the insured, however, you still can. You will just need to provide evidence to the insurance company that you have an “insurable interest”. Insurable interest means that you are reliant on your ex-spouse’s income to provide alimony.
If you are the payor spouse of alimony or child support, you may be also ordered by the court or obligated under your divorce agreement to maintain life insurance with your ex-spouse as the beneficiary. The orders or agreement will usually stipulate how much the death benefit should be as well as how long the policy must remain in force.
If you have minor children or other dependents that rely on your income, you may still have a need for life insurance. The first step in assessing the right amount of insurance coverage to buy is reviewing the expenses that would need to be covered in the event your income stops.
For example, let’s say that you have two children: age 8 and age 10. If you were to pass away prematurely, you would like to provide $4,000 per month to help cover your children’s living expenses until your youngest turns 21. Also, you want to provide four years of in-state education at an assumed cost of $30,000 per year for both of your children starting when they are 18. Let’s also assume that a reasonable rate of return that could be earned on your investments is 6% per year, and inflation (increase in prices over time) is expected to be 3% per year.
Using a financial calculator, spreadsheet software, or with the help of your financial professional you discover that it would require approximately $520,000 today to provide for your monthly goal of $4,000 in income for your children for the next 13 years. Note that this amount assumes that $520,000 is invested at a 6% growth rate, and the $4,000 per month expense need increases at a rate of 3% per year.
Additionally, using the same growth rate and inflation assumptions, you or your financial professional also find that it would require approximately $180,000 today to fully fund your college goal. In total, therefore, you need about $700,000 in after-tax dollars available to provide for your children’s expenses and education goals.
Once you calculate the total amount of dollars needed, next you measure that against the balance of investments or financial resources you already have available today. For example, if you have $300,000 in after-tax dollars available, you may need to cover the $400,000 difference with life insurance. One good option in this case could be to purchase a $400,000 15-year term life insurance policy. This fully covers your expected needs today and the term extends until your children are expected to graduate college and no longer need any support.
Note that you should include the value of assets you have today in this analysis only if you are comfortable that they be used for these goals. For example, if you have $250,000 in home equity but you desire your children to continue living in the home until they graduate college, you may not wish to assume your home equity is available as a resource to help cover their needs. Moreover, you would want to be sure the mortgage payment and cost to maintain the home are included in your calculations for monthly expenses.
Finally, the same analysis process can be applied for determining how much insurance to purchase on an ex-spouse to replace alimony that would end immediately upon their passing. For example, assuming a growth rate of 6% on any insurance proceeds, it would require approximately $382,000 in an account today to replace $5,000 per month of alimony that you otherwise expect would continue for the next eight years. In this case, however, you would not assume any other resources are available to offset this need. The only exception is any death benefit associated with a life insurance policy already in place and you are mandated by the court to be the beneficiary. As such, it would be a good idea to purchase a $400,000 life insurance policy with a 10-year term with your ex-spouse as the insured and you as the named beneficiary.
One final note: The purpose of this section is to simply illustrate and educate one common method of measuring how much life insurance a divorcee may need. However, the examples used are in many ways overly simplified, and the calculations are too complex for most to attempt on their own. As such, we highly recommend working with a financial or life insurance professional to help you determine the most appropriate amount of coverage for your specific goals and circumstances.
Our third and final recommendation, once the first two have been complete, is to take inventory and review all your existing policies. Divorce is a major change in your financial situation. For example, you may have previously purchased life insurance with the assumption that your spouse would be reliant on your income to help cover marital expenses for the next twenty years. Of course, this is no longer the case.
That said, a word of caution when evaluating your existing insurance: very careful consideration should always be given before you cancel any existing policy. For one, your need for insurance could change again in the future. For instance, if you get remarried, your next spouse may become dependent on your income should you choose to combine your household income and expenses. Also, insurance premiums only increase with age, and if you develop a chronic illness or health condition you may become uninsurable in the future. Quite often the most inexpensive insurance option is the one you already own.
As the decision to keep, cancel, or replace your existing policies is unique to your circumstances and the characteristics of each policy, any guidance that we can provide will be too general to make any final decisions. However, as a starting point, here are some of the most helpful questions you should ask when making this decision:
One final recommendation is necessary when it comes to replacing an existing life insurance policy. You should never cancel an existing life insurance policy until the replacement policy is active and your first premium is paid. You never know what may come up when going through medical exams and underwriting to buy a replacement policy, and it may take several months to finalize the process.
Life insurance, while complex, is a vital tool for securing your financial legacy, particularly during and after a divorce. By understanding the core functions of different policies and meticulously evaluating your specific needs, you can make informed decisions that protect your loved ones. Remember, court orders and divorce agreements often dictate insurance requirements, so these should be your starting point. Diligently calculating the necessary coverage, considering factors like dependent expenses and educational goals, is crucial. Finally, a thorough review of existing policies, keeping in mind potential future changes and health considerations, will ensure your coverage remains relevant and cost-effective. While this guide provides a solid foundation, professional guidance from a financial or insurance advisor is invaluable in tailoring a plan that perfectly fits your unique circumstances. Ultimately, life insurance offers peace of mind, knowing that your financial obligations will be met, even in your absence.
Investment advice, financial planning, and retirement plan services are provided by Prosperity Planning, Inc., an SEC registered investment advisor. The information contained herein, including but not limited to research, market valuations, calculations, estimates and other material obtained from these sources are believed to be reliable. However, Prosperity Planning, Inc. does not warrant its accuracy or completeness. The information contained herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or to participate in any trading strategy. If an offer of securities is made, it will be under a definitive investment management agreement prepared on behalf of Prosperity which contains material information not contained herein and which supersedes this information in its entirety. Any investment involves significant risk, including a complete loss of capital and conflicts of interest. The applicable definitive investment management agreement and Form ADV Part 2A will contain a more thorough discussion of risk and conflict, which should be carefully reviewed before making any investment decision.