A nationwide study on life insurance recently completed by Forbes Learnvest revealed that 57% of respondents owned life insurance. Good news right, however only 28% were “extremely confident” about their understanding of their coverage or how life insurance works. 66% of study respondents had a poor understanding of how they would access their money when their loved ones die. A little side note, the insurance company would probably appreciate you not knowing how to access the money as well.
So let’s get down to the basics here. Life insurance is a policy that will pay money to a named beneficiary (most likely spouse or children) upon your death. This is a vehicle to help protect your loved ones if you were to die before you got old. In most cases it provides cash to pay for your family to maintain their lifestyle and education expectations if one or both of the parents die while they are still raising children. It could also be good to have if you are going to protect your loved ones from your financial obligations When you purchase the policy, you determine the amount of coverage you need. There are many types of life insurance available, let’s explore a few of them here.
FIRST: DO YOU EVEN NEED THIS?
If you ask a nail maker if you need nails, they’ll give you a hundred reasons why you need nails. The same thing goes for life insurance salespeople! In my opinion there is really one reason you are going to need life insurance, family. If you have a family that is dependent on your resources for their well being and survival, you need life insurance. Your children are going to be dependent upon you financially for at least 18 years (most likely more) and you want to hedge against them not being financially OK if something happens to you.
How Much Do I Need?
An easy rule of thumb is you get enough to cover a large portion of your annual expenses and cover debts that are outstanding. For example, you could add your mortgage, annual expenses and tuition costs for a 4 year institution and base you amount of coverage on this. Of course, you may do more or less based on your budget or ability to self insure (the latter meaning you’ve done well, congratulations!).
TERM AND WHOLE AND UNIVERSAL LIFE
Universal life sounds like a church you may want to warn your friends about if they are going to join (I say this as a licensed internet minister of the Universal Life Church)! In all seriousness, there are a few different types of life insurance policies in the market and the easiest way to distinguish b/w them is temporary vs permanent. Let’s get into those differences now.
Term insurance is the least expensive plan you will find on the open market. There are typically 2 ways you can buy term insurance. One is through your employer through your benefits package. This will typically not be a large policy, but often the employer will allow 2-5 times your annual income and it’s very inexpensive. If you have a need, this will get you part of the way there, very cheap! The other way is to buy a 10, 20 or 30 year policy on the open market. These policies, while not as cheap as your employers, are the least expensive manner in which to protect your family for financial loss if you die. Let’s give a scenario to explain how this works.
First, an understanding of how Life Insurance companies decide how much they collect from you each month in exchange for how much your family gets if you die. Remember, this could mess with your head a bit, but this is money you will NEVER see, but you are buying so those around you don’t suffer. Now to the meat and potatoes. Your monthly premiums are what you pay to insure the company pays if you die. These rates with life insurance are typically based on your present age today, your health, your family history, whether or not you smoke or work in a dangerous industry or spend your spare time jumping out of airplanes and shooting off fireworks. Those last 2 activities could get you denied coverage!
The gist here, the younger and healthier you are, the lower your risk is to the insurance company that you are going to die within the term of the policy and thus the less money you have to pay in insurance premiums. The opposite is also a factor. Let’s say Sarah is a 26 year old girl who works out, doesn’t smoke and eats food from Whole Foods everyday. She’s a much lower risk than John who is 45, hasn’t exercised in 5 years and lives on a steady diet of Cheetos and Bud Light. Who do you think is going to have more healthy years ahead. Just don’t ask my dad because he’d swear that John will outlive Sarah!
When you buy term insurance, you are buying a set amount of time to insure yourself, at a specific amount of money, say $300,000 to $2,000,000 and it’s typically 10-30 years. This is the most basic type of life insurance and the easiest to understand. It’s very straightforward and unless you are working with a financial professional who has a deep understanding of overfunding insurance products for cash value pull outs, this is really the only type of life insurance you’ll need over time. You die, family gets paid, you live, family keeps you!
Whole life is a policy that does what it says, it’s going to protect you for your whole life. The insurance company set’s a premium knowing that as long as you pay, they are going to have to pay out sometime. It could be today, it could be in 50 years. That said, they know they will have to pay and they set your premiums to reflect that. That’s why whole life is so much more expensive than term. The insurance company is placing a bet they only imagine they will lose, so they need to find a way to profit!
These policies are also unique in that they carry a cash value and allow you to borrow, tax-free, against the policy’s cash value during your lifetime. Of course, the policy’s cash value changes over time and is lower than the total sum of the death benefit it provides.
I know your going to ask, so, how exactly does cash value accumulate in your permanent life insurance policy?
According to our friends at investopedia “When you make premium payments on a cash-value life insurance policy, one portion of the payment is allotted to the policy’s death benefit (based on your age, your health, and other underwriting factors). The second portion covers the insurance company’s operating costs and profits. The rest of the premium payment will go toward your policy’s cash value. The life insurance company generally invests this money in a conservative-yield investment. As you continue to pay premiums on the policy and earn more interest, the cash value grows over the years.”
They also go on to explain that in the early years, the cost of insuring you is lower so more of your cash value goes into the permanent cash feature. Then as you get older, more of the premium is going to pay for the insurance.
There’s all types of things you could do with the cash, but I recommend a professional to help you out there! I just remind you that Whole Life is designed to do just that. A policy that can last your whole life.
Universal Life is the final type of policy we’ll address here. Universal policies are similar to Whole Life policies in that they are permanent protection, however they’re a bit different. They tend to run a little less expensive than Whole Life, but there’s a bit more complexity. It’s not a set it and forget purchase, but if you put the work in, you could save over whole life insurance over time.
There are multiple types of Universal policies on the market today and most of them are relatively complex. If you are interested in a Universal policy, I’d recommend working with an advisor that yoy trust.
Life Insurance plans also offer a series of optional add ons known as riders. Here are a few of them to consider when looking at your policy. Critical Illness and Chronic Illness riders are there to pay money if you get a critical illness or a chronic illness. The critical illness rider is typically set amount of money for cancer, heart disease etc… The chronic illness rider allows you to access your policy amount if a physician says you have 12 months to live or less. Other riders include Accidental Death or Double indemnity if you die in an accident. This basically means if you die with a certain accident or an accident period, your family gets much more money. There are riders for spouses (insure your spouse), waiver of premium (if you are disabled and can’t work, the premiums are waived), Child term rider (insure your child) and Long Term Care riders. LTC rider states that if you cannot do 2 activities of daily living, such as cleaning, using the restroom, moving yourself around, cooking for yourself etc., the policy will allow you to use your benefit amount to pay for someone to do these things for you. It’s an expensive rider and a type of policy we’ll dig into in a later article, but it’s a great way to protect yourself against a long term care need.
Life insurance is complicated! I recommend speaking to a broker or advisor to discuss your needs. The good news, you can throw a rock in a crowded space and hit a licensed life insurance rep! I hope this primer provided you the guidance to help make the process a bit less confusing!
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