The purchase of life insurance is one of the most important protections that you can put in place to protect your family and the life you are building in the event that you pass away unexpectedly.
It’s one of those things that people generally know they need, but don’t know when to purchase, or how much coverage to opt for. But with just a little guidance and planning you can assess your family’s needs to make sure you make the right decision for you.
Unfortunately, the industry can be confusing and far from transparent in terms of fees, expenses, and provisions. Life insurance is very important coverage, but the product needs to match the goals and needs.
Additionally, insurance agents are typically not held to the fiduciary standard and may have conflicts of interest in that they are compensated based on which product you purchase rather than what you might need.
I’ve written this post to help outline some of the basic information about types of life insurance, who it might be a good fit for, what it protects, and what are the pros and cons of each one. My hope is that you can arrive at the table with your life insurance agent with more knowledge than before.
How Life Insurance Works
Insurance, at its most basic level, is the pooling of risk of a group of people by a company. These are risks that an individual could not afford to take on by themselves. A company takes on the defined risk, like having a shorter lifespan than expected and a family losing a lifetime of earnings. For pooling the risk, the company accepts premiums from policyholders in return for bearing the risk and possibly paying a death benefit.
Life insurance is a legally binding contract. The insured person must disclose past and current health conditions and high-risk activities (any skydivers out there?!) and often undergo some type of medical exam so that an insurance company can assess the risk.
Terms to Know
- Insurer: The company that is pooling the risk and is responsible for paying the death benefit
- Insured: The person whose life is being insured by the insurance company. If this person passes away while the policy is in force, a death benefit will be paid
- Owner/Policyholder: This person may or may not be the insured and makes decisions about the contract and pays premiums to the insurer. For example, a company may pay the premiums for and own a policy on a key employee, who is the insured
- Beneficiary: Who receives the death benefit payment
- Death Benefit: How much is paid upon the death of the insured
- Premium: Amount paid, often annually, by the policyholder to the insurer for protection
- Cash Value: An “investment” that you are building inside a policy that, depending on the terms of the contract, can be withdrawn or used as collateral for a loan from the policy
How much Life Insurance Do You Need?
This question is the “million dollar question,” or often millions of dollars. The first question to consider is, “What is this insurance for?” Some common reasons include the following:
- Replace a spouse’s salary and future retirement savings during peak earning years
- Pay off debt, like mortgage and students loans
- Ensure that funds will be available to pay for a child’s college expenses later in life
- Cover potentially high medical bills and debt
- Fund a special needs trust
- Provide liquidity, or cash flow, for estate taxes
- Ensure that heirs receive a specific dollar amount in inheritance
A financial advisor can help you determine your needs, goals, and calculate an appropriate amount that considers inflation and a possible assumed investment return.
Types of Life Insurance
There are multiple types of life insurance contracts that fulfill different purposes, and it is important to understand the types and risks that each insures to make the best decision for your family.
Term Life Insurance
Term insurance offers coverage for a specified death benefit for a specified amount of time. For example, a couple might buy $1 million in death benefit coverage for 20 years. The idea is to provide protection until large expenses are gone (i.e. children are grown) and you have saved a large amount toward your financial goals. Most policies have an annual premium that does not increase each year.
Pros:
- Often cheapest premiums (less likely that an insurer will have to pay a death benefit)
- Meets a specific need for a specific amount of time
Cons:
- You have to make an educated guess about how long you’ll need coverage
- Coverage ends at the specified time, and it is often difficult and expensive to buy coverage later in life.
- Does not build cash value
Potentially Appropriate Clients:
- Young family with one working spouse
- Young family with two working spouses that could not sustain standard of living on a single income
- A divorced parent with a specific liability, like alimony or child support
Term life insurance is often one of the most efficient ways to insure your life. Be aware of an “annually renewable term” that provides a cheaper premium in earlier years that increases each year. It is a good deal early on, but if your income is unlikely to rise enough to keep up with higher premiums, you could lose coverage at an inopportune time.
Universal Life Insurance
Universal life insurance policies are a type of permanent life insurance policy that can build cash value that earns interest. These policies are sometimes called “flexible premium” or “flexible benefit” policies because you can adjust premium payments or death benefit as needs change.
Alternatively – and importantly – the company can adjust the premium due if the policy does not perform as expected (read: your premium can go up unexpectedly or coverage will lapse).
There are multiple types of Universal Life, including Guaranteed Universal, Variable Universal, and Indexed Universal, which will not be discussed in detail here.
Pros:
- Premiums are cheaper than whole life but often more expensive than term life
- Can build cash value that earns interest
- Is a permanent policy as long as premiums are paid
Cons:
- Premium adjustments can leave you with less coverage or too expensive coverage when you need it
- Illustrations may use very rosy return expectations.
- A low interest rate environment makes it difficult to grow the cash value
Potentially Appropriate Clients:
- Someone who wants or needs coverage beyond typical term issuance ages
- Someone who wants access to cash value
Be aware of projections in an illustration. If the guaranteed scenario would not give you the coverage you need, it might not be a good fit. Do not be lured in by the flexible premiums if it compromises the coverage you need.
Whole Life Insurance
Whole life insurance is a permanent life insurance policy that builds cash value and earns interest. As long as the premiums are paid, a death benefit will be paid to the beneficiary regardless of the age at which they pass away.
Pros:
- Is a permanent policy as long as premiums are paid
- Builds cash value that earns interest
- Can take a loan against the cash value or withdraw the cash value
Cons:
- Generally the most expensive coverage
- May be more insurance than you need
Potentially Appropriate Clients:
- Someone who wants to leave a specific amount to heirs
- When a trust needs to be funded, like a special needs trust
- A family with an estate tax liability
Be aware of discussions of a whole life policy as an “investment.” Especially in the current low interest rate environment, insurers are not able to offer much in terms of interest. Additionally, high commissions and fees can diminish any returns you might see.
Making the Right Insurance Decisions
The amount of life insurance you need will vary greatly at different stages of your life. What you need at 25 will look very different when you are 45 or 65.
As with every financial analysis, it’s not a one time only assessment, but rather an ongoing process that will need to be reviewed regularly. Be sure to review things roughly every 5 years, or when a life-changing event such as a marriage, or the birth of a child occurs.
Insurance decisions are typically best made when a fiduciary financial advisor collaborates with an agent with a deep industry and product knowledge to provide the best fit for your needs. If you would like any guidance on how to begin this process, we would welcome the opportunity to speak with you, so please do get in touch.