Life Insurance 101

Buying life insurance can be daunting.  After determining how much coverage your family needs, the next step is to decide on a policy that will best fit that need.  You might even need a couple different policies to get the job done.

How much is enough?

Life insurance is a gift of love to the ones you leave behind.  There is a minimum and maximum approach to how much coverage you should get.  The minimum is what your family would NEED for final expenses (roughly $10,000 in most cases).  The maximum is how you WANT for your family.  What kind of life would you want them to have if you are no longer there to make it happen?  Also, there is a limit to how much life insurance companies will allow you to purchase (roughly 20x your annual income).  This is considered your “Human Life Value”.  If you want to know what your Human Life Value is, use this calculator – Calculate your HLV.

Making sure you have enough death benefit is the most important part of buying life insurance.  Your family won’t care what type of policy you have if you die prematurely.  They will only care if it’s enough.

What’s the best policy?

If you ask 10 different advisors, you will likely get 10 different opinions.  Is your need for life insurance temporary or permanent?  It’s likely that you have some temporary needs, and also some permanent.  I usually tell clients that their need for coverage will change throughout their life, but it will likely not go away.  So a mix of temporary coverage and permanent coverage is likely what you need.

Term Life Insurance

Term insurance is temporary coverage with guaranteed premiums for a number of years.  By far the cheapest way to get covered.  As long as you pay the premium you will have a guaranteed death benefit for a certain number of years.  Most insurance companies offer policies with a guaranteed premium for 1 – 30 years.  The longer the guarantee, the higher the premium.  However once the guaranteed premium runs out, so does your life insurance.

Term life insurance is cheap because the insurance company knows there is a very small chance that you will die in the timeframe of your policy.  Less than 2% of term life insurance policies actually pay out to the beneficiaries.  Not because they are bad policies, or because insurance companies try to get out of paying claims.  The reason is most people will outlive their policy.

Should I just buy the cheapest term policy I can find?

Term insurance is cheap.  But if you just buy the cheapest policy you find, you may be leaving valuable benefits behind.  Consider paying a little bit more to get a policy from a good company with conversion options.  Some term policies include a conversion option that will allow you to convert your term policy to a permanent life insurance policy without medical underwriting.  If you qualified for preferred rates on your term policy, you would be guaranteed to get preferred rates on a permanent policy without medical underwriting.

The conversion option could be limited to the first 10 years of your policy.  Or it could be convertible for the entire benefit period.  There also may be limits to what type of policy you can convert to.  If you are interested in converting your term insurance at some point in your life, you will want to pay attention to what your options are.  You might also want to buy your term insurance with a company that offers good permanent life insurance policies (not all companies do).

Why would you want conversion options for your policy?  What if you are getting near the end of your 20 year term and come down with an illness that would prevent you from buying a new policy?  What if you put on a few pounds, or your health has changed, and you would no longer qualify for preferred rates on a new policy?  There are many reasons why you would want the ability to convert your policy even if you have no immediate intentions to do so.

Permanent Life Insurance

Your need for life insurance will change over the years, but it will likely not go away entirely.  If your need for life insurance is not limited to the next 10, 20, or 30 years, then chances are you could benefit from buying a permanent life insurance policy.  One that will be around whenever you die, and not just IF you die prematurely.  Some permanent life insurance policies also build cash value that you have access to along the way.

Whole Life Insurance

Also known as Participating Whole Life is the oldest type of permanent life insurance.  The premium for whole life insurance is fixed and guaranteed for life.  You also have a guaranteed death benefit, and guaranteed cash value in addition to an annual dividend.  This type of policy is typically offered by mutual companies (not publicly traded).   As a policy holder from a mutual company you become part owner of that company, and your policy is credited with annual dividends based on profitability.  You “participate” in the profits.  The long-term internal rate of return on whole life insurance cash value has been between 3-6% (tax-free).

Whole life is initially more expensive than term insurance.  However it does offer benefits beyond what term insurance can provide.  It’s a lot like renting versus owning your home.  Renting costs much less up front, and makes sense if you need a home for a set period of time.  If you want a home that provides security and builds value over time (i.e. equity), you buy it.  You’ll have more expenses up front, but you gain it back in long-term value.

Universal Life Insurance

In the 1980’s when interest rates were in the double digits, a 3-6% return on your whole life insurance was not very attractive.  You could get a 15% CD at the bank.  As a result, insurance companies created a permanent life insurance policy that ties your cash value to interest rates.

When rates are high, your cash value grows and as long as you have enough cash in your policy to pay the cost of insurance, you could lower your out-of-pocket premium.  However in a low-interest rate environment like we have been in the past 10+ years, there is little to no cash value in most UL policies.

Many life insurance companies now offer a death benefit guarantee feature on their UL policies.  Meaning as long as premiums are paid, you are guaranteed not to lose your death benefit.  Even if rates stay low and there is no cash value, your policy will not lapse.

Variable Universal Life Insurance

In the 1990’s the stock market took off, and you couldn’t pick a bad investment.  A 20% rate of return on your investment portfolio became expected.  Life insurance companies saw the trend, and they created a life insurance policy where you could invest the cash value.  This policy works similar to UL, however you take on all of the risk.  You get to decide where your cash value is invested, and as the market goes up and down, so does the cash value in your policy.

Summary

There are many options to choose from, and depending on your needs you may want a combination of different policies to adequately protect your family’s future.

“A man who dies without adequate life insurance should have to come back and see the mess he created.” – Will Rogers