Life Insurance: How Much and What Kind To Buy
How much life insurance do you need? What type is appropriate? You should review your life insurance needs each time you have a major life event. Here is what you need to know to properly plan for your life insurance needs to buy enough and to get the most for your money.
The prospect of planning for your family's life insurance needs may seem daunting. The array of confusing products available, coupled with the calculations needed to find the right amount of insurance, would put anyone off.
Yet the hard fact is that life insurance is an essential part of your family's financial well-being.
The more you know about it before you go to your agent, the better your coverage will be. If you don't plan for your life insurance needs, the result could be a waste of thousands of dollars on inappropriate or ineffective life insurance or, worse, financial hardship due to not having enough insurance.
This Financial Guide gives you some basic guidelines about whether and when you should purchase life insurance, and provides you with a system for determining how much you need. It also discusses the types of insurance available, their suitability for various situations, and how to comparison shop for a policy.
Do You Need Life Insurance?
The purpose of life insurance is to provide a source of income, in the case of your death, for your children, dependents, or other beneficiaries. Life insurance can also serve other estate planning purposes, such as giving money to charity on your death, paying for estate taxes, or providing for a buy-out of a business interest. These will not be discussed in this guide, however.
Whether you need to buy life insurance depends on whether anyone is depending on your income. If you have a spouse, child, parent, or some other individual who depends on your income, you probably need life insurance. You might also need life insurance for estate planning or business succession planning purposes.
Here are some typical insurance situations along with typical insurance needs:
Situation 1: Families or single parents with young children or other dependents
The younger your children, the more insurance you need. If both spouses earn income, then both spouses should be insured, with insurance amounts proportionate to salary amounts.
If the family cannot afford to insure both wage earners, the primary wage earner should be insured first, and the secondary wage earner should be insured later on. A less expensive term policy might be used to fill an insurance gap. If one spouse does not work outside the home, insurance should be purchased to cover the absence of the services being provided by that spouse such as child care, housekeeping, and bookkeeping. However, if funds are limited, insurance on the non-wage earner should be secondary to insurance on the life of the wage earner.
Situation 2: Adults with no children or other dependents
If your spouse could live comfortably without your income, then you will need less insurance than the people in Situation (1). However, you will still need some life insurance. At a minimum, you will want to provide for burial expenses, for paying off whatever debts you have incurred, and for providing an orderly transition for the surviving spouse.
If your spouse would undergo financial hardship without your income, or if you do not have adequate savings, you may need to purchase more insurance. The amount will depend on your salary level and that of your spouse, on the amount of savings you have, and on the amount of debt you both have.
Situation 3: Single adults with no dependents
You will need only enough insurance to cover burial expenses and debts unless you want to use insurance for estate planning purposes.
Situation 4: Children
Children generally need only enough life insurance to pay burial expenses and medical debts. In some cases, a life insurance policy might be used as a long-term savings vehicle.
Situation 5: Retirees
Types Of Insurance
Although the array of insurance products may seem confusing, there are really just two types of insurance: term and cash value, which is more commonly referred to as whole life, universal life, or permanent life insurance.
With term insurance, you pay for coverage for a specified amount of time, and if you die during that time the insurer pays your survivors the death benefit specified. Cash value on the other hand provides you with some other redeemable value in addition to paying a death benefit.
For individuals age 40 or less, a term policy will almost always be less costly than a whole life policy. Although term policies do not build cash values, many are convertible to whole life policies without a physical exam. Thus, a term convertible policy may be a good option for someone who is under 40.
Term Insurance
There are various types of term insurance including:
Renewable. A renewable term policy is the most common type of life insurance where the policy renews automatically on a renewable term, e.g. every year, every 5 years, every 10 years, or every 20 years, which is the most popular renewal term. You do not need to take a physical or verify the fact that you are employed. The premium goes up at the beginning of each new term to reflect the fact that you are older. Most renewable term policies can be renewable until you reach age 70 or so. Re-entry. With this type of policy, you must undergo a physical exam after a certain period, or pay an extra premium.
Level. With level term policies, the premium is guaranteed to stay the same over a certain period. This period may be shorter than the term of the policy. Nearly all life insurance bought today is level term insurance.
Decreasing. With a decreasing term policy, a good option for insuring mortgage payments the face amount of the policy decreases over time while the premium payments remain the same.
Return of Premium. Some insurers offer term life with "return of premium." Typically, premiums are significantly higher and they require keeping the policy in force to its term.
Cash Value Life Insurance
There are four types of cash value life insurance: (1) whole life, (2) universal life, (3) variable universal life, and (4) variable whole life.
The first two types are the most common and have a guaranteed cash surrender value; in the last two types, the cash surrender value is not guaranteed.
Whole Life. This is the traditional life insurance policy. It provides a death benefit, has a cash value build-up, and sometimes pays dividends. You do not need to renew a whole life policy. As long as you pay your premiums, you will have coverage, usually until your death. The premium for a whole life policy remains the same for the amount of time you own the policy; the premium is "level" in insurance parlance. Thus, when you are younger, the premium you pay for your whole life will be greater than what you would pay for term insurance but when you are older, the premium will be much less than a term premium.
Part of each premium goes into the cash value of your policy. Your cash value, which is actually an investment, is guaranteed to grow at a fixed rate. You do not have to pay current income taxes on the growth in the cash value-it is tax-deferred.
You can borrow against your cash value at a rate that is usually better than the prevailing consumer lending rates. If you die with an outstanding loan amount, the loan amount, plus interest, will be subtracted from your death benefit.
Dividend-paying whole life policies-termed "participating" policies are usually offered by mutual life insurance companies. Mutual life insurance companies are generally owned by policyholders while other insurance companies are owned by shareholders. The dividends are refunds of insurance premiums that exceed a certain level. They are paid when the insurance company does well during a quarter or a year. Of course, premiums for participating policies are usually higher than those paid for non-participating policies.
Term policies can also be participating, but the dividends paid are usually minimal.
Universal Life. Universal life, also known as "flexible premium adjustable life," is similar to whole life, but offers more flexibility in terms of payment of premiums and cash value growth. With a universal life policy, your monthly premium amount is first credited to your cash value. The company then deducts the cost of your death benefit and the expenses of the policy. These costs are about equal to what it would cost to buy term coverage. As with whole life, your cash value grows at a fixed minimum rate of interest. The growth of the cash value is tax-deferred, and you can borrow against it or make partial withdrawals.
A special feature of universal life is that you can vary the premium paid from month to month. You can pay more or less-within certain limits-without jeopardizing your coverage. You can even let the cash value absorb the premium. However, the danger here is that if the premium payments fall too low, your policy may lapse. While some states require the insurer to tell you when your cash value is at a dangerously low point, you will, if you live in another state, have to maintain a careful watch on the amount of cash value if premiums are skipped.
Variable Universal Life. Variable universal life allows you to choose the investment for your cash value. You have a potentially greater cash value growth, but you also have added risk, depending on the type of investment you choose.
Variable Whole Life. With variable whole life, the death benefit and cash value will depend on the performance of an investment fund that you choose. Again, you have potentially greater reward, with its accompanying risks.
How To Shop For Insurance
In order to be able to shop for the best premiums, it's a good idea to know how premiums are calculated by insurers. Bear in mind that premiums vary among insurance companies, and it is a good idea to ask several insurers for their rates.
Insurance companies place individuals into four risk groups: preferred, standard, substandard, or uninsurable. The premiums charged will be commensurate with the category you are placed in. Thus, a standard risk will pay an average premium for similarly situated insurers.
If you have a high-risk job or hobby, you will be considered substandard, a high risk. A terminal illness at the time you apply for insurance will render you uninsurable.
Having some type of chronic illness will place you in the substandard category. People with conditions such as diabetes or heart disease can be insured, but will pay higher premiums.
One company's category for you may not hold with another company. Thus, it still pays to shop for insurance with other companies even though one may have labeled you "substandard."
Once an insurance company approves you for coverage, you cannot be dropped unless you stop paying your premium.
Shopping For A Policy
In most states, there are rules, set by a group of state insurance regulators, requiring the agent to calculate two types of cost indexes that can help you to shop for a policy. You can use the indexes to compare policy costs.
One type of index, the net payment index, gauges the cost of carrying your policy for the next ten or twenty years. The lower the number is the less expensive the policy will be.
This index is useful if you are most interested in the death benefit aspect of a policy, as opposed to the investment aspect. The other type of index, the surrender cost index, is useful to those who have a high level of concern about the cash value. This index may be a negative number. The lower the number, the less expensive the policy.
These two indexes apply to term and whole life policies. With universal life policies, focus on the cash value growth and the cash surrender value to make comparisons. Cash surrender value is the amount you receive if you cancel the policy. It is not the same as cash accumulation value. If you are shown two universal life policies, and they have the same premium, death benefit, and interest rate, then the one with the higher cash surrender value is generally the better policy.
Here are some questions to ask about policies:
- How do cash values accumulate? An early, rapid build-up is generally preferable.
- How has the policy's cash value performed in the past? You can get this information from a publication called Best's Review, Life and Health Insurance edition. Determine how the policy performed in comparison with the company's projection and with other insurers.
- Are any special features merely bells and whistles, or do they add value for you?
- What is the company's rating with Best, Standard & Poor's, and Moody's? You can find these publications in public libraries. The rankings should be in the top three to ensure that a company has financial stability.
