Life Insurance 101
Life insurance is an important component of a healthy financial life. Lacking sufficient coverage can be disastrous for those who depend on you financially. This article is meant to introduce you to the basic concepts and types of life insurance so that you can make a more informed decision before purchasing a policy.
- Why do you need life insurance?
- How does life insurance work?
- Types of life insurance.
- Group life insurance.
- Determining your life insurance need.
Why do you need life insurance?
The purpose of life insurance is to alleviate the financial burden your untimely passing would place on those who depend on you financially.
For example, if you have a family and children, life insurance is used to help meet their living expenses currently funded with your income. Similarly, couples who have joint debt, such as a mortgage, may carry life insurance so that they’re still able to make payments if one were to pass. If you have cosigned student loans (without a death discharge clause) life insurance is an effective way to make sure your cosigner doesn’t get stuck will the bill after you get hit by a bus on the way to work.
Coverage rules-of-thumb are not an effective way to judge your life insurance need. This is because individuals earning the same income may have drastically different coverage needs. For instance, a single individual with no debt may only require a small amount of insurance as compared to the primary breadwinner for a family of four.
How does Life Insurance work?
As the name suggests, life insurance is a financial product used to shift the financial risk posed by an individual’s mortality to an insurance agency. In exchange for a set premium, the insurer agrees to pay a defined sum, called the death benefit, to a named beneficiary if the insured person dies.
For life insurance to be issued, insurable interest must exist, which is to say the beneficiary must have a financial interest in the continued survival of the insured party. A business, for instance, can have an insurable interest in the life of a principal partner, whose untimely death would place a financial burden on the business. I, however, have no insurable interest in the next Evel Knievel and am unable to purchase a policy on their life simply because I favor the odds of their mortality.
Although life insurance cost varies by the type and terms of a contract, all rely on the same cost-determination principals. Actuaries employed by insurance companies perform complex calculations to predict mortality rates within populations, using variables such as age, gender, and health factors. These projections then enable insurance companies to estimate the premiums needed to adequately compensate for the risk posed by the contracts. This is why premiums are higher for older individuals, smokers, and contracts with longer terms or larger death benefits.
Types of Life Insurance
There are four major categories of life insurance: term, whole, universal, and variable life. Although all offer death benefits in consideration of premiums, each type works in slightly different ways. Because of this, it is important you understand the intended use and associated cost of each prior purchasing a policy.
The most vanilla variety of life insurance, term policies provide a predefined death benefit for a set period, ranging from 5 to 30 years. The most popular term policy is level-premium, which charges a fixed premium for the duration of the policy. A common add-on provision to term life insurance is the guaranteed renewable clause, which allows the policy owner to renew the policy at a predetermined rate after the current term ends, regardless of the insured party’s health at the time of the renewal. Although this increases the policy premiums, many find the peace of mind offered by this provision worth the extra coin.
Term policies are the simplest and most cost-efficient type of life insurance and are generally the most appropriate for the majority of individuals.
Whole life insurance is commonly referred to as “permanent life insurance” because it guarantees a death benefit for as long as you continue to pay the fixed premiums. A rider (optional policy addition) exists allowing the owner to spread premium payments over 10, 15, or 20 years so that they’re not required to make lifetime payments.
Unlike term policies, whole life insurance includes a “cash value” which accumulates and grows based on the terms of the contract. Paid with policy premiums, the cash value does not begin accumulating until after the first several years because initial payments are absorbed by agent commissions and administrative fees. Cash values can be withdrawn for any reason and are not taxable up to your basis (amount of money spent) in the policy. It is important to note that beneficiaries only receive the policy death benefit if the insured dies; any remaining cash value at the time of death is forfeited to the insurance company.
Due to the inclusion of cash values, whole life is much costlier than term life insurance. It is important to understand that whole life policies are not investment vehicles. Because of this, it is important to make sure what your goals for the policy are prior to purchasing, as term life may be a more appropriate product.
Universal life is a flexible form of whole life insurance. The primary characteristic of universal policies is the ability to increase (contingent upon medical examination) or decrease policy death benefits and premiums. By granting payment of larger premiums, policyholders can quickly accumulate cash values, which can be used to pay subsequent premiums.
For an additional cost, policy owners have the option to add the cash value to the death benefit, unlike whole life insurance which forfeits cash value upon death.
Universal life contracts can be surrendered in exchange for the accumulated cash value – through a surrender charge is normally applied.
Variable life is an investment-based insurance product. Contract premiums are divided into two accounts, a general account which pays for policy expenses, and a separate account, which is invested in securities such as stocks and bonds. Variable life death benefits are directly impacted by the value of the separate account, with the benefit value fluctuating with investment performance. Policies contain a guaranteed minimum value that will be provided, regardless of the separate account performance. **
Generally, up to 90% of the policy’s cash value may be withdrawn in the form of a loan, although it will need to be repaid as long as the policy is not surrendered.
I generally do not recommend purchasing variable life insurance, unless you have a clearly defined objective for the policy, as it tends to be an expensive product and poor investment vehicle.
Group Life Insurance
Offered by large entities, such as employers or professional associations, group life insurance provides coverage on a wholesale basis. Where individual policies require underwriting (the process of evaluating insurability) for each contract, insurers issue group insurance based on the projected insurability of the entire group. This, along with administrative cost economies, helps lower the price of group life insurance, making it less expensive than comparable products.
Group life insurance is commonly offered by employers in benefit packages. Employees are given coverage based on a predetermined methodology, such as a multiple of salary or position in the company. Although some employers offer permanent group insurance, group term life insurance is far more common. Premiums for group term insurance may be paid entirely by the employer, which is the case with “non-contributory” plans or shared between employer and employee. It is common for group policies to offer optional additional insurance for spouses, which can be purchased at group rates.
A drawback to group life insurance is that it is not portable, meaning that your coverage ends once you leave the company. Some policies, however, allow for you to convert group life insurance coverage to permanent life insurance once you end service with the employer. Although this may be expensive when compared to term policies, it can be an effective way to continue insurance coverage without having to supply individual evidence of insurability.
How much life insurance do I need?
As previously discussed, the amount of life insurance an individual requires is based on their specific life circumstances. Financial planners conduct needs analyses to determine the total amount of debt, income, and special needs not covered by current assets. This total need represents the appropriate coverage for the individual. For a typical family, insurance coverage needs are comprised of:
- Child-rearing period income.
- Spouse retirement income.
- Mortgage redemption fund.
- Education fund.
- Readjustment period income.
- Estate settlement fund.
- Special needs and emergency (extra-expense) fund.
If you’re unsure how much life insurance you require, or which products best fit your personal goals, you may want to consider engaging the services of an expert. Feel free to request a free consultation on our website, and get the process started today.
**When considering using variable life insurance policies for supplemental retirement income, it’s important to note that underperformance of the policy’s subaccounts may require increased premium payments to prevent a policy lapse. In the event of a policy lapse or termination, outstanding loans will be deemed a taxable payment to you as the investor. Guarantees are based on the claims-paying ability of the issuer.