FA Playbook

When was the last time you thought about life insurance?

Anna Robaton, special to CNBC.com

If you are like many other people, you'll spend plenty of time worrying about whether you are saving enough for retirement and give relatively little thought to the issue of life insurance.

Life insurance often gets short shrift, partly because many people come at it with preconceived ideas, and that, according to advisors, results in some fairly common mistakes. Very often, people buy life insurance right after they get married or have their first child and don't give it another thought until their policies are set to expire.

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"One of the most common mistakes people make with regard to life insurance is assuming that their lives aren't going to change, and so they plan for a short time horizon on the insurance front," said Thomas Henske, a certified financial planner and partner at Lenox Advisors.

By midlife, many people are in the throes of raising children and paying off mortgages and may want higher levels of coverage but have difficulty getting it. "Sometimes as we get older, we lose our insurability because we are no longer as healthy or we can only get the coverage we want at an exorbitant price," said Henske, who is also a chartered life underwriter.

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The first issue to consider when it comes to life insurance is whether you need it at all. According to financial advisors, the answer to that question hinges in large part on whether your death would create a financial hardship for a surviving spouse and any children in terms of lost income.

"If someone else depends on your stream of income, then it makes sense to consider life insurance," said Charles Sachs, a CFP and principal at Private Wealth Counsel.

One of the biggest mistakes some married couples make is insuring one partner, the primary breadwinner, and not the spouse who has stepped back from his or her career to take care of children. That can be a costly mistake if the stay-at-home parent dies, advisors say. Among other issues, the surviving parent may face much higher child-care expenses.

Insurance how-tos

So you've decided to buy life insurance. What now? The next step, advisors say, is to determine how much of a death benefit you really need. The death benefit is the amount that an insurer pays out to the designated beneficiaries of a policy if the owner of the policy dies.

Some people give very little thought to that question and come up with an estimate that may or may not reflect their actual needs, said Edward Lebold, a financial advisor and chartered life underwriter with Portland Financial Group.

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"I see a fair amount of people [who] already have an amount of insurance that is a convenient round number, like $1 million," Lebold said. "What that typically tells me is they have licked their finger and put it up in the sky and said, 'That sounds like a nice number.'"

Some advisors undertake an exhaustive needs-based analysis that takes a number of factors into account, such as how much it would take to pay off mortgages, send kids to college and replace lost income.

Who needs life insurance the most now?
Who needs life insurance the most now?

Because life doesn't always go as planned, Henske prefers a simpler method, depressingly known as determining "human-life value." The end result is a figure that reflects the present value of an individual's future earnings on a tax-adjusted basis. Most insurance companies limit the death benefit of policies, or the payout, to 20 times future earnings, he said.

Those in the market for life insurance should also consider how long they'll need coverage, which will help them determine what type of policy to buy. Life insurance comes in two forms, term or permanent, although some policies are a combination of the two.

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Term insurance provides coverage for a specific period of time, and the premiums are typically fixed during that period. Many experts say term insurance is the right choice for most people because you buy coverage for only as long as you need it, although that involves some guesswork.

"Change in health status is one of the more common reasons why someone would come to us and say, 'I think I need to change my short-term coverage to long-term coverage,'" Lebold said. "We are going to look at what they have right now in terms of life insurance and what options their policies offers them in terms of conversion" to different types of policies or longer-term policies, he explained.

If you can retire financially, your life insurance needs are zero, since you as an engine of wealth creation are now worthless.
David Demming
president of Demming Financial Services

Permanent insurance includes universal and whole life. As the name implies, permanent insurance provides lifetime coverage. Often such policies build a cash value that their owners can access before death through loans or withdraws, much like tapping the equity in your home.

Not surprisingly, permanent insurance will typically end up costing you more than term insurance. It can also be complex and thus confusing to many consumers. What's more, some critics of permanent insurance argue that even policies that accumulate a cash value may represent mediocre long-term investments as compared to other options, such as mutual funds.

Some older Americans who no longer need life insurance to protect their families financially use it as an estate-planning or a charitable-giving tool. Life insurance trusts, for instance, may allow wealthy individuals to pass money to their survivors free from estate taxes.

"The first question with life insurance is: What is the purpose? What problem is the client trying to solve?" Lebold said.

"Another consideration is: What is the alternative to life insurance? Some clients may have other liquid assets that are sufficient to pay all or part of the estate tax," he added.

Some advisors say their goal is to get their clients to a point where they no longer need life insurance, having accumulated sufficient retirement savings, paid off their major debts and sent kids to college.

"If you can retire financially, your life insurance needs are zero, since you as an engine of wealth creation are now worthless," said David Demming, a CFP and president of Demming Financial Services.

—By Anna Robaton, special to CNBC.com

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