Life Insurance Basics
Life insurance is the most fundamental building block of personal finance. If you think about personal finance as a house, life insurance is the foundation that holds up the rest.
Why is life insurance important?
Life insurance is a pretty funky thing, it's the one financial product you never get to enjoy. Life Insurance is more than a wife taking out a $20,000,000 policy right before she hires a hit-man. Life Insurance is the most important foundation to financial security.
You cannot replace yourself or a loved one, but you can replace their financial impact on you and your family. For the sake of example say your household consists of one stay at home parent, one working parent and two kids. Think now about how much money is brought in over the entire career of the working parent. Say they make $35,000 a year after taxes and never get any bonuses over a 30 year career: that's a$1,050,000 financial contribution to the family. What will happen if the income earner dies? That's why you need life insurance. With out proper coverage, when one parent dies the kids loose both - the remaining parent needs to take on extra work to make ends meet. It's also important to cover the stay at home parent - how much would extra child and home care cost? It's important to cover kids, but they're a financial liability, they don't contribute to the household income, so you should only look for enough coverage to cover finial expenses and time away from work to deal with your grief.
Who should be insured?
Anyone in the household who has financial responsibilities. Children should be insured enough to cover final expenses & time away from work to allow a proper grieving period, but children are financial liabilities - they don't contribute to the household finances, at least not generally (child actors aside).
Life Insurance can also be important for businesses, e.g. "Key" Person Insurance or as part of a Buy - Sell Agreement.
How much coverage should I carry?
It is in the best interests of most consumers to follow The Theory of Decreasing Responsibility & purchase the coverage amount you need for the specific period of time you need it. Generally, you'll want to cover all debts, final expenses, and the amount of money required to finish raising your children. Other considerations when calculating how much life insurance coverage you carry include enough money to send your children to college, and enough to reach your retirement goal.
It's important to keep inflation in mind and calculate future needs adjusted for inflation, e.g. say you want to include your retirement goal of $3500 per month (debt free). If inflation is 3%, and your retirement is 30 years away, that $3500 per month in today's dollars equals $8495 per month in future dollars 30 years away.
What are the types of Life Insurance?
The three most popular types of life insurance are:
Term Insurance - this is pure insurance for a period of time. You pay a premium, there's a death, the company pays a death benefit. Very simple. This type of life insurance is most likely to be the best type for you.
Whole Life Insurance - this is "permanent" insurance that combines "cash value" with insurance. You have two items, insurance & cash value bundled into one product. You almost always end up paying more in premiums (and fees & commissions to the agent) for lower coverage than you can get with Term Life.
The cash value element is either guaranteed to grow at a set rate, or has a variable investment component (your agent must be securities licensed for the variable component), and you're allowed to borrow from your accumulated cash value. This does not make sense, it's your money, so why should you need to borrow it? Also, do you want to control your money, or do you want the insurance company to control it? If you want control, then buying Term & investing the difference in premiums (between what you'd pay for the same coverage in Term versus Whole Life), or paying the same premium for Term but getting better coverage, is the option for you.
It should also be noted that even though you are paying for both the cash value & insurance, you only ever get one or the other. Say you have a $100k death benefit & have accumulated $100k in cash value & then you die. The beneficiaries of your life insurance policy do not get $200k from the accumulated cash value & the insurance. They only receive the $100k of insurance.
Consumer Reports states: "Cash-value insurance can provide estate-planning and tax advantages for well-to-do people over 60. But for most people, Consumer Reports has long recommended term life as the simplest, least-expensive option." - www.consumerreports.org/cro/money/insurance/is-your-life-sufficiently-insured/overview/index.htm
In 1977 the Life Insurance industry was one of, if not the largest industry in the U.S. Because of consumer pressure resulting from companies like A. L. Williams & Associates's loud anti-Whole Life stance, and from long time agents from major companies speaking out, as well as consumer pressure resulting from books like "What's Wrong With Your Life Insurance," by Norman F. Dacey, the FTC conducted an analysis of Life Insurance Trade Policies and concluded that Whole Life isn't good for consumers: http://www.ftc.gov/be/econrpt/197907lifeinsurancecost.pdf.
An additional note: even though your premium payments for Whole Life Insurance are based on having both insurance and the accumulation of cash value, it often takes years for any of your premium to be applied to cash value.
Universal Life Insurance - Universal Live insurance is a complicated mess that fuses a type of Term Life with investments / cash value & should almost always be avoided. The problems with Universal Life include all those of Whole Life, but also include additional problems.
John E. Girouard, a former Life Insurance Agent & current Investment Advisor and contributor to Forbes has a great article "Retirement Disaster Looms For Universal Life Policyholders" that goes into greater depths on why Universal Life should be avoided.
Further thoughts & comments:
You don't have cash value in your car insurance policy, why should you have it in your life insurance policy? Cash value policies are frequently sold as an investment, even as college savings plans, but before you purchase a policy, make sure your agent runs all the number for you. Make sure you see the difference Term Insurance will cost versus the same coverage for Whole Life. You'll see for your self that if you purchase Term & invest for yourself the difference in premiums (between Term & Whole Life or Term & Universal Life), you'll save more in premiums & have control over your investments instead of the insurance company.
I. Almost 100% of the time, Term Life Insurance will be what's best for you. If your life insurance agent insists on selling you Whole Life or Universal Life insurance ask him or her to show you:
- What the premiums would be in a Term Life plan for the same coverage.
- How much coverage could you purchase with a Term Life plan for the premiums of the Whole Life or Universal Life plan they're trying to sell you.
- Whole and Universal plans often sound appealing because they accumulate “cash value.” Make your agent show you how much of your premium goes to insurance and how much goes to cash value.
- Ask your agent when will cash value begin to accumulate and how quickly will it grow.
- Ask your agent to show you the specific clause in the policy where it says upon your death your beneficiaries will receive both the cash value and the insurance death benefit. Say you have a Whole Life policy with $100,000 in life insurance coverage and you've accumulated $100,000 in “cash value.” Make your insurance agent show you the specific clause that guarantees your beneficiaries will receive $200,000 upon your death. What? He or she can't find it? Yeah, it's not there and it never was.
- Whole & Universal Life often sound appealing because you can borrow from the cash value. Ask yourself if it makes sense that you should have to repay your own money at interest. Ask your agent what the interest rate would be and how long it could take to access the cash in an emergency. Ask yourself again if you want the insurance company to control your cash or if you want control.
II. LIFE INSURANCE IS NOT AN INVESTMENT! They're also not college saving plans! They're frequently sold as an investment or a savings plan. Life insurance companies often offer a product suitable for investment purposes these are called annuities. Life insurance policies, however, are almost never suitable for investment purposes and if your agent insists otherwise, you may want to find another agent.
Did your agent ask you how much coverage you need, or how much you can afford? Life insurance agents are almost universally 100% commission and they make their highest commissions on Whole Life & Universal Life (or a version of them, e.g. Variable Life).
There are investment products offered by life insurance companies that should be considered in looking at an overall investment strategy: Annuities.
Final thought: there's an old saying by life insurance agents, "sell Term to sleep at night, sell Whole Life to put food on the table, so sell Whole Life & take a sleeping pill."
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