What Is It?
If you're like most people, you have various types of insurance to guard against financial losses that you couldn't cover on your own if certain unforeseen occurrences--life-threatening illnesses, car accidents, damage to your home, and so on--took place. Life insurance, in particular, offers a valuable form of protection because it ensures that your spouse and other surviving dependents will have adequate resources if you die an untimely death. For this reason, many people view life insurance as an absolute necessity. They are willing to shoulder its cost in exchange for the peace of mind that comes with knowing their families will be provided for after they die. But you may be reluctant to pay out of pocket for life insurance premiums year after year and receive nothing tangible in return. If so, perhaps you should forgo life insurance. This does not mean, however, that you should leave your dependents totally exposed to the risk of your premature death. Rather, you'll want to take other steps to minimize that risk. This is where self-insuring comes into play.
The term "self-insurance" is a misnomer, since the whole idea behind insurance is to transfer your risk to someone or something else. Nevertheless, it can work under the right conditions. In terms of life insurance, self-insuring involves earmarking certain assets or saving money so that your dependents will have money to draw on when you're gone. In effect, if you die unexpectedly, the designated or saved assets serve as a substitute for the death benefits that a life insurance policy would have triggered. If followed properly, a good self-insurance plan can save you the expense of life insurance without sacrificing the protection you're looking for. Ideally, your surviving spouse can meet your funeral costs and carry on as before, while your children will have enough money for college and perhaps even an inheritance.
Caution: Depending on your age, health, and other factors, you may be uninsurable altogether or at least uninsurable at standard rates you can afford. If so, self-insurance may be your only option if you want to provide for the future of your dependents.
Caution: Self-insuring is not very common, simply because most people don't have sufficient resources to do it. That's why most of us need traditional life insurance if we want to protect against premature death. Depending on your financial and other circumstances, total self-insurance may be a viable option for you. As a middle-ground strategy, it may also be appropriate to combine a self-insurance plan with a relatively inexpensive term life insurance policy. Whatever you decide, you should consult additional resources before proceeding.
One Way to Do It
Set Aside a Lump Sum
This is probably the safest and wisest self-insurance strategy, at least from a life insurance standpoint. You simply take a portion of your existing assets and set it aside as a separate fund that your dependents will have access to when you're gone. Since the temptation can be strong to draw on this fund for emergencies and expenses while you're alive, you must make a conscious decision not to touch it under any circumstances. Pretend the money isn't even there, and keep reminding yourself how much your family members will need it to reach their goals if you die prematurely.
Set Aside the Right Amount
If you choose this option, the amount that you should reserve for self-insurance purposes will hinge on several factors. First, while you want to provide as much money as possible for your dependents' future, you are limited by how much you can realistically afford. If the value of your assets is only $125,000, it may not be feasible to set aside $100,000, which is over 80 percent of that total. If you follow the general rule that life insurance coverage should be a multiple of your income, another consideration will be your yearly salary and other sources of income. Since your level of income allows your family to enjoy a certain standard of living, an amount directly based on your income will enable them to continue to maintain that standard after you're gone. You should also take into account how much money your family will need, particularly any large expenses that you anticipate they will have in the future. For example, if you have an 8-year-old daughter who will be heading off to college in 10 years, you'll want to project what the cost of college will be and include the appropriate amount(s) in your fund.
These are only a few of the factors that should go into your decision about how much to set aside. Keep in mind that the amount of self-insurance you need is usually the same amount as if you bought a life insurance policy. With the aid of a qualified professional, you can use the same criteria and mathematical method you might use to determine an appropriate level of life insurance death benefit coverage.
Keep the Value of the Assets Growing?
If you decide that self-insurance makes sense for you, remember that setting up a personal fund with earmarked assets does not mean that you should stash some money under a mattress or in a savings account. The first strategy would prevent your money from growing at all, while the second would offer very minimal growth. Since the money you earmark is to provide death benefits for the people you love, you have a vested interest in seeing that this money works for you. Thus, if you reserve $100,000 and die 10 years later, you will count on the money increasing to far more than $100,000. With this in mind, approach self-insurance as an investment for the future, and select specific investment vehicles that seem likely to give you an acceptable rate of return.
Caution: As always with investments, you have to find a balance between risk and desired return. You want to realize a profit so that your dependents will have even greater resources to draw on down the road. Conversely, you certainly don't want to suffer a long-term loss on an investment that you made specifically to substitute for life insurance.
The Advantage of Setting Aside a Lump Sum
In any case, the advantage of reserving a lump sum for protection purposes is clear. This way, barring financial disaster, you can take comfort in knowing that the money will be there for your dependents if you die tomorrow or 10 years from now.
The Tradeoffs of Setting Aside a Lump Sum
The problem, of course, is that most of us have assets of modest value and not the luxury of being able to set aside huge sums of money as protection against premature death. The decision about whether to earmark some of your existing assets for the purpose of self-insuring will depend on your financial situation, particularly your net worth, and will generally be appropriate only for those with relatively substantial assets.
Tip: Just because you can't afford to self-insure yourself right now doesn't necessarily mean that you will never be able to. At some point, you might win the lottery or inherit money from a relative. Perhaps your assets have simply grown in value over the years as a result of your shrewd investment strategies. Any of these scenarios, or any other event that produces a significant change in the value of your asset holdings, might warrant a reevaluation of your situation, including your life insurance strategy. Where 10 years ago you never dreamed that self-insurance would be possible, you might now be in a financial position to do it. If the total value of your assets is considerably higher than it was when you took out your life insurance policy, you may want to give some thought to earmarking some of those existing assets.
Caution: If you choose self-insurance over your existing life insurance policy, don't forget there may be surrender charges and other costs associated with terminating a life insurance policy.
Another Way to Do It
Set Up a Plan to Accumulate Funds
This is probably how most of us would have to go about insuring ourselves if we opted for self-insurance. Instead of setting aside a huge amount of money that you probably don't have, you can create a fund into which you deposit money for this purpose on a regular basis. The obvious advantage is that you don't have to be rich to do it this way. In fact, you don't need to have any preexisting asset holdings at all. As long as you have some form of steady income, you can probably establish a fund and make periodic contributions that you figure into your monthly budget. You may even be able to set it up as an automatic investment plan through which you arrange to have regular payroll deductions of a fixed amount go into specific investments of your choice. You only spend a little money at a time, and as you keep contributing to the fund, it builds in value. With the aid of a qualified professional, you can use a mathematical system to hammer out the details of your savings plan (e.g., how much to set aside, how often) based on such factors as your income/finances, how much money your dependents will ultimately need, and when you anticipate they might need it.
Invest Your Accumulated Savings Wisely
As with earmarking a lump sum of your existing assets for self-insurance, you should carefully select the investment vehicles for your savings plan. Keep in mind that the goal of the plan is to guarantee sufficient resources for your dependents, and so you'll want to choose investments that offer minimal risk and the possibility of greater returns than possible from cash equivalents.
In general, a savings plan works better with other forms of insurance than with life insurance. One reason is that such savings plans are well-designed to protect you from the various kinds of high-frequency, low-severity losses that often come into play with health insurance, homeowners insurance, and automobile insurance.
With life insurance, there is one and only one type of loss to protect against: death. If you save in lieu of having life insurance, your dependents will still be exposed to the kinds of financial losses that might result from your premature death unless the value of your fund is considerable. You might start up a savings fund thinking that in 20 years, there will be $100,000 available for your dependents' future. But you can't predict when you're going to die. Your well-laid plan will be all for naught if you unexpectedly die within a month after initiating it. Instead of the $100,000 or so you figured they would need, your dependents will be left with only the small amount you have contributed up to that point. So, in terms of eliminating or reducing risk, savings plans are generally not as effective a self-insurance strategy as is earmarking existing assets.
Potential Tax Consequences of Self-Insurance
Generally, if you die, the assets that you invested so wisely and carefully for the future of your dependents will have to pass through your estate, potentially subjecting them to federal estate taxes. Estate taxes may result in a substantial reduction to the amount(s) that your heirs receive after taxes. Depending on the projected size of your estate and other factors, the potential tax ramifications may be severe enough to make you think twice about self-insuring.
Tip: You may be able to minimize potential estate taxes through trusts and other strategies.
Caution: If the estate tax issues cause you to choose traditional life insurance instead, be aware that life insurance death benefits are also generally subject to estate taxes. However, you may be able to minimize those estate tax consequences by transferring ownership of your policy to another party more than three years before your death.
This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.
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