How to plan for the unknown – Intro to Life Insurance
In my first post about financial planning I have discussed some of the benefits and framework I would use to help people plan for their financial needs. I have also listed several common goals which I will be delving into in separate posts going forward. Today I will introduce the idea of life insurance and how to plan for emergencies.
Using the framework from the “Financial Planning an Introduction” I will go through the steps in the financial planning framework and illustrate how to plan for emergencies.
- Define your goal – the objective is to make sure that if unexpected events occur my family is going to be financially secured and no dramatic changes in their lifestyle will be needed. Now it is important to say that whatever planning we do, a loss of a family member in an accident is going to be devastating and whatever we do the emotional loss will be real and overwhelming. Coping with it emotionally will be one of the hardest tasks in the world. In addition to it though, there will be many financial challenges to think about and my goal today is to make sure that my family is at least going to have food on the table, shelter and clothes for the family and be able to pay the bills.
- Quantify your goal – I would approach this step by really understanding what is important for my family and make sure that all of the priorities are quantified and taken care of in case of emergency.
- Cash needs for immediate expenses – these are expenses for medical costs, attorney fees, hospital expenses, funeral expenses and any taxes. These will be different for every family and a more comprehensive analysis can be done to be estimated accurately but a reasonable amount to be set aside can be either 50% of annual income or about 20,000.
- Outstanding debts – It is worthwhile thinking about how much debt your family can handle if there is a loss of substantial income. Some might even want to eliminate any outstanding liabilities such as credit card debts, school loans, auto loans and other.
- Emergency fund – some families are better than other in saving for emergencies. These are costs for unexpected medical expenses or major car or home repairs. Usually 6 months’ worth of income will be sufficient to create a cushion. If savings are not as adequate it is a good idea to add them to the analysis.
- Mortgage – one of the biggest concern of the survival family is the mortgage payments or rent payments. It might be a good idea to be eliminated as family income might become much more volatile and risky. If the family is renting a good estimate can be 10 years of rent expenses.
- Child or home care fund – these are funds that will support the family for the day to day care of a house and daycare for the children.
- College fund – tuition for the children can be paid in different ways – savings, loans, or current income. If the current sources of cash are scarce savings for college will ensure the needed resources are available.
- Assess current resources and close the gap to what is needed in order the goal to be achieved.
- Readjust the plan if the plan requires cash flows that will disturb the family current standard of living.
- Execute the plan – following the regular savings or payments will ensure the plan will provide what was intended for.
- Monitor and control – we cannot forget that additional adjustments can take place even when we are already executing the plan. Children might have grown up, the family can inherit large sums of money or win the lottery.
Now after we have looked at the financial planning framework from an emergency planning point of view let’s take a look at a regular family with real goals.
The J’s family lives in the suburbs of a large city. John the father and Jane the mother are both 35 years of age. As young professionals they are lucky to earn 100K each per year. They have twins Jack and Jill that are 8 years of age. The family lives in a house with an outstanding mortgage of 500K. Both parents commute to work by car and are still paying off their auto loans – currently outstanding at 20K.
One day John and Jane start thinking about what will happen if either of them gets into an accident during their daily commute and passes away. They decide to make a financial plan to protect the family in case of such emergency. Together they identify several priorities:
- Take care of immediate expenses – 20K
- Pay off the auto loans – 20K
- Create an emergency fund for the family – 100K
- Pay off the mortgage – 500K
- Maintain the family standard of living for at least 15 years (or until both children are out of college)
- Pay for college – 200K
- Leave at least 1 million as a bequest to their children
The family decides that if one of the parents is not with them anymore the family will be able to sustain its standard of living even with one of the salaries. However, all of the other goals will need to be satisfied. The family does not have savings so they decide to purchase life insurance to close the gap of resources needed and make sure no accidents will turn the financial well-being of the family around. The sum of all goals totals 1.84M (20K+20K+100K+500K+200K+1M).
Deciding to purchase life insurance with a death benefit of 1.84M will ensure the J’s family has a protection for emergencies. They realize from their insurance agent though that there are different types of insurance like whole life and term life. In my next post I will take a closer look at what each general type of insurance can provide and how to decide on one.