Life insurance is possibly one of the most misunderstood topics in financial planning. Because much of the education on this topic is produced by agents who have a vested interest in selling, it can be difficult to feel empowered and informed on the subject. It is important to understand the basics of life insurance prior to considering a policy to ensure what you are offered is truly the best fit for you. The below Q&A will better prepare you for your next conversation with an agent or help you re-evaluate your existing coverage.
How does life insurance work?
Simply put, a life insurance policy is a promise to pay a cash benefit at death. You pay a scheduled premium predicated on your age and perceived health risk, and your beneficiaries receive an agreed upon lump-sum benefit when you perish. Fundamentally, the purpose of life insurance is to provide for a financial burden if you are not here tomorrow. Most commonly, this includes funds for paying off debt or replacing the income you provide to your dependents.
Over time, this basic concept has evolved. Now some insurance policies include an investment component where your premiums are invested to benefit both you and the insurance provider. Confusion often stems from this kind of policy due to its complicated set up.
What are the different types of life insurance?
There are two broad categories of life insurance: term and whole life. Term life insurance offers coverage for a period certain – 10, 15, 30 years for example. Whole life insurance coverage is in place for – you guessed it - your whole life. Of course, there are sub-types within these two broad categories with different features and benefits.
Term insurance is normally cost-effective, flexible, and straight-forward. For these reasons, it is almost always the most suitable option. There are a couple of variations to term insurance that impact the premiums paid, such as level term (fixed premium rate for the entire policy period), annual renewable term (premiums increase every year) or decreasing term (good for mortgage protection as the benefit and premium decrease annually).
Whole life insurance on the other hand incorporates the investment component mentioned above. Different from term insurance, a portion of your premiums paid are invested and your investment returns accumulate as a policy’s “cash value.” This cash value can be used to pay future premiums or deferred for access after death. These policies offer a death benefit combined with an investment vehicle and for this reason they are more expensive to maintain. Variations on whole life insurance include flexible premiums vs. fixed premiums and investment selection options.
How much and what type do I need?
Many professionals will tell you that you should buy an amount equal to 10x your annual income. The correct answer, of course, is that it depends. Do you need life insurance? Will someone else be financially burdened by your death? If so, what does that burden look like? Is it a mortgage to repay or student loans to settle? Do you have a family who depends on your income for living expenses? The appropriate amount of insurance will depend on your answer to the above and will vary according to your unique situation. If you are ready for or already in retirement, your need for life insurance has likely ended.
With this, you can now consider the type of coverage best for you. Term insurance often makes the most sense due to its low cost, temporary time frame (since things change and one day you likely will not need life insurance), and straight-forward death benefit. Additionally, there is value in diversifying your insurance needs apart from your investment goals for the greatest chance of success. Many people recommend “Buy term and invest the difference.” You can spend less money on term insurance and use the difference in premium from a whole life policy to invest in the stock or bond market for a comparable or greater rate of return. Doing so gives you the life insurance coverage you need and independence to make your own investment choices.
Simplicity and flexibility are good guidelines to consider when making any financial decision and are especially applicable when considering life insurance. Making an ill-informed decision can be a costly mistake. Do your research prior to your next life insurance conversation and ask questions along the way to ensure you are making the right choice for your future.