I, like many, have a love-hate relationship when it comes to life insurance. As a whole it is oversold, and many have a bad taste in their mouth because of a past bad experience.
On the other hand, in the world of farm transition and estate planning I have also seen life insurance serve an important role in saving many family farms. This typically comes with careful planning and choosing the right product for the right situation.
The first question we ask is what is your need for life insurance? Perhaps you don’t need it or you’re self-insured from other income sources. For some, it may be wiser to use insurance dollars towards other means such as paying down debt, investing toward retirement, or buying a farm.
Identify the need
Start by identifying the purpose. Life insurance is often considered if there are debts or other obligations your estate may incur, such as from land or equipment debt, estate and inheritance tax, or long-term care and nursing home costs. It can also be a source of liquidity to fund buy-sell agreements or equalize inheritance between farming and non-farming heirs. The last fit may simply be to fix or improve existing policies to better complement your estate plan.
Make a business decision
So, when does life insurance make sense? I encourage you to treat the choice as a business decision. Is the liquidity from the life insurance needed to support the successful transfer of your family farm? What is your opportunity cost for securing the same amount of death benefit with other sources such as financing, investing, etc? How many years do you have to pay premiums before you exceed your death benefit? Does the cost fit into your budget just like any other cost of production?
Life insurance is not always the best business decision, but here are a few recent examples to illustrate where it may:
Family 1 – Is faced with an estimated $500,000 estate tax liability in the state of Illinois. Unfortunately like many farm families they don’t have a lot of cash in their estate to cover taxes or other debts (“land rich, cash poor”). Their annual premium to purchase $500,000 of life insurance is $9,500. This adds a $5/acre expense to their overall cost of production. The premium to death benefit ratio is 1.9% when comparing it to the cost of borrowing from traditional financing. They will pay premiums for 52 years before they pay more premium than death benefit. They could invest $9,500 per year at 7% up to their life expectancy and it will grow to $600,000. However, they’re not comfortable with the stock market and investment funds will still be subject to federal and state income tax, whereas life insurance is income tax free.
Family 2 – One farming and two non-farming heirs. They want to transfer the “home farm” with the building site to their farming heir. They determine the three children’s family value of the home farm to be $500,000 each. They gift the farm to their farming heir now and purchase two $500,000 life insurance policies for each of the two non-farming children. In this case, the farming heir pays the premium and views them as his “farm payment” now to buy out his two siblings. The total premium cost for both polices is $25,000 per year for a total of $1M of insurance. His lender estimated the annual loan cost to borrow $1M today is $75,000 on a 20-year note, or a $375 per acre farm payment on the 200-acre farm. Alternatively, the life insurance offers a $125 per acre insurance cost which will position him to own the home farm free and clear after the insurance pays out. He still plans to work with his lender to secure a 20-year note at that time, but to instead purchase additional land to expand the operation.
Family 3 – Spouse owns a nursing home policy with a $7,100 annual premium and an increasing cost of $500 every year. The policy has no return of premium benefit but a maximum benefit of $300,000. Alternatively, $7,100 per year purchases $200,000 in guaranteed life insurance. The difference is the insurance premium is a fixed cost, and if it turns out she does not go to the nursing home the policy still provides a death benefit to her children.
As always, please consult with your trusted advisors who are more familiar with your specific situation before making important financial decisions as illustrated above.