Friday, September 11, 2015

Life Insurance

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One group of important financial decisions every person and/or family have to make deal with insurance--how much of what kind do we need, and what kind do little other than make the agent wealthy?  Too little insurance can leave your family finanically devastated if bad things happen; too much means you spend money to buy something  you do not need.  This begins a series of posts on types of insurance you should consider (and note that I said "consider", not "buy").  As with most other things in life, not everyone needs everything.  You need to look at your life and your needs to decide how much of what type of insurance to purchase.

Life Insurance:

The purpose of any insurance is to protect you from unexpected happenings that could financially devastate you or your family.  You are making a bet with an insurance company.  They bet that the bad thing doesn't happen; you bet that it does.  They know the odds and if they pay out more in claims than they collect in premiums, they go broke.  Most people pay far more in premiums than they will collect in benefits.  With that in mind, remember that death is not unexpected--all of us are going to die one day.  However, we generally expect to die when we are old and when people no longer depend on us financially.  The purpose of life insurance is not to leave money to your heirs; it is to protect your family against the loss of your income or services.  That is important to keep in mind when you consider the two basic types of life insurance.

Term Insurance:

Term life insurance is pure protection. If you have $1 million in term life insurance in force when you die, your benificiary  gets $1 million dollars.  Once the policy expires, when you die, no one gets anything.

Because of that, if the insurance company believes you have a 1% chance of dying this year, they need to charge you 1% of your policy value, plus a little extra for administration and profit in premium.  In other words, at that rate, $1 million in life insurance would cost you $10,000 plus profit and administration this year.

Term polices are generally quoted for a set number of years from the initial purchase date.  They can be level term which charge the same amount per year throughout the term of the policy or the premium can change at intervals throughout the life of the policy.  Most allow the policy to be extended past the end date but allow the company to set the rate after that date.

Put simply, most people's chance of dying in a given year increases each year.  A policy in which rates increase each year is generally cheaper on the front end; one in which rates remain stable over time is cheaper on the back end.  No term policies are affordable for those who are elderly or for those who have serious health problems at the time the policy is purchased or priced..

Whole Life Insurance

Whole life insurance is part protection, part investment.  While term insurance is designed to be dropped at some point in life (after the kids are grown, after the investments reach a certain point, after the house is paid for...), whole life is designed to be a permanent part of the insured's portfolio.

The insurance company agrees to pay the face value of the policy when the insured dies.  Since they know that date is coming, and since the plan is that the policy will be in effect at that time, the insurance company has to charge more.  Using the example above, not only does the insurance company have to charge $10,000 to cover the chance of you dying this year, they also need to put some money away to use to supplement the premiums when you get older--when you are 95 and have about a 50% chance of dying in the next year, they are only going to charge you the same $10,000 they charged when you took out the policy.

They do this by utilizing an approach known as "cash value".  Imagine your life insurance as two buckets.  Each year you pay the same premium.  The insurance company takes the amount needed to insure your life and puts that in the "insurance" bucket.  The rest they put in the "cash value" bucket and invest it.

Using the example above, $10,000 of the first year's premium would buy the protection and the additional money (which is a substantial amount) goes to "cash value". If you die that year, your benificiaries will receive $1 million, most of which is protection.  The next year, that premium does not buy as much protection because your chance of dying has increased.  The way the company is able to pay out $1 million if you die is because they have the cash value.  If you die in year two, the payout is still $1 million, but less of it is protection and more of it is cash value.  By the time you reach old age, your yearly premiums are buying very little protection but you have a large amount of cash value built up--cash value that isn't really insurance but rather is a savings account held by your insurance company.  

For some people the forced savings aspect of whole life insurance is worth the cost.  However, most young families need a lot of life insurance and most cannot afford a lot of whole life insurance.  Term allows them to get the protection they need at a more affordable cost.

How Much to Buy, What Kind and Why?

A good insurance agent should give you several options and be able to explain the advantages and disadvanates of each.  I'm not an insurance agent; I'm a consumer who has done some research.  What is right for me and my family may not be right for you.  However, I'm not earning a commission selling you insurance.

First, you need to figure out why you need life insurance.  If you are single with no dependants, you probably don't need life insurance.  Hopefully lots of people would be sad if you died, but who would be financially hurt?  If you can't name anyone, then the only reason to buy life insurance at that time is to protect your ability to buy a low-cost product, in case something happens to you health-wise to make that impossible at such time as you acquire dependents.  In essence what you are doing in that case is insuring your ability to have life insurance, and in my opinion, there are few instances where that makes financial sense.  

Secondly you need to determine how much life insurance you need.  There are all sorts of calculators, rules of thumb and other guides that you can find online.  The bottom line is that this money will be there to provide for your family if you die.  It comes at the cost of money you could be spending or investing today.  What is the right balance?  It is hard to say and depends on the ages of the children, the current employment status of your spouse, and the amount your spouse could earn if necessary.  What other sources of money are available?  For example, if you die young, will your family inherit from  your parents?  Do you want the kids in private school?  Are you deeply in debt, or do you have a high net worth compared to your lifestyle?  Price policies at several different levels and figure out what will meet the goals you have for your family.  

Third, decide whether to buy term insurance, whole life or some combination thereof.  Most people who are not life insurance agents will tell you to "Buy term and invest the difference".  Term insurance, as noted above, is pure protection and is the least expensive way to get the coverage you need.  Life insurance agents offer a variety of products which offer characteristics of insurance and investments and there may be times when using whole life insurance is to somone's advantage.  Listen to the agent, remember that he gets more commission on whole life products and research the other alternatives.  However, you have to remember the "invest the difference" part of the equation if you expect there to be money available in your old age.  

Fourth, you need to research the financial viability of the insurance company you are considering.  You are entering into a contract that you hope will be long-lasting.  Saving a few dollars in premiums will not do you any good if the company is not able to pay your claim.  

Finally, do not consider this decision cast in stone.  Re-evaluate your insurance needs every year or two to determine if you have enough insurance, whether you need more, or whether you can lower the amount you have.

Also, especially if you are in good health, shop around for new coverage every year or two.  Policies are priced when you buy them; if your health is better than average years later you may be able to save a substantial amount by changing policies.

We were able to double our coverage recently without increasing premiums.  The old policies had been purchased when our older children were young, and they began with low premiums.  We knew the premiums would go up in later years, but also figured that the kids would be on their own soon.

Having our youngest increased the lenghth of time for which we would need life insurance and since our health was good shopping for a new policy allowed us to save money.  Had we had health problems, we would have been able to maintain the original policies at the prices originally quoted.  The main thing to remember in this type of circumstance is to find out if there is any reduced payout on the new policy while it is new, and if so, how much and for how long.  If it is worth carrying life insurance it is worth making sure it will be there if needed.  

*Part of Financially Savvy Saturdays on brokeGIRLrich, A Disease Called Debt and Femme Frugality*


  1. Thanks for sharing, my fiancee and I are looking into getting life insurance at the moment as we are planning on buying our first home within the next 18 months. We are finally starting to wrap our heads around the different options we have and what they mean for us.

    Rebecca Elizabeth

  2. My husband and I have life insurance which is set to cover the amount of mortgage we have. I'm sure it does increase year on year but to be honest, I've not looked at this properly for a few years! Your post has reminded me to look into it so thank you!

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  4. Thank you for posting this information. It is unbelievable how many websites there are out there about insurance and retirement; it can really be confusing unless you have somewhere to start. Having all the basics laid out like this made it easy for me to understand what I did know and what I needed to research. These are great stepping stones.

    Lachelle Muse @ Ernstam

  5. This post is really informative, thank you for sharing! I know when my wife and I had kids, we had a hard time shopping around for a policy that met our needs. We ended up getting a mixture of term and life insurance, but we never considered changing policies later on to reduce our premiums or increase our coverage.

    Henry Hansen @ Ethica Private Wealth Specialists

  6. Thank you for sharing such great information. It is informative, can you help me in finding out more detail on a Retirement Insurance Policy,i am very new to this field and wanted to understand the basics of investment insurance .