Very
few people enjoy thinking about the inevitability of death. Fewer yet take
pleasure in the possibility of an accidental death. If there are people who
depend on you and your income, however, it is one of those unpleasant things
that you have to consider. In this article, we'll approach the topic of life
insurance in two ways: first, we will point out some of the misconceptions
about life insurance and
then we'll look at how to evaluate how much and what type of life insurance you
need.
Does
Everyone Need Life Insurance?
Buying life insurance doesn't make sense for everyone. If you have no dependents and enough assets to cover your debts and the cost of dying (funeral, estate lawyer's fees, etc.), then insurance is an unnecessary cost for you. If you do have dependents and you have enough assets to provide for them after your death (investments, trusts, etc.), then you do not need life insurance.
However,
if you have dependents (especially if you are the primary provider) or
significant debts that outweigh your assets, then you likely will need
insurance to ensure that your dependents are looked after if something happens
to you.
Insurance
and Age
One of the biggest myths that aggressive life insurance agents perpetuate is that, "insurance is harder to qualify for as you age, so you better get it while you are young." To put it bluntly, insurance companies make money by betting on how long you will live. When you are young, your premiums will be relatively cheap. If you die suddenly and the company has to pay out, you were a bad bet. Fortunately, many young people survive to old age, paying higher and higher premiums as they age (the increased risk of them dying makes the odds less attractive).
Insurance
is cheaper when you are young, but it is no easier to qualify for. The simple
fact is that insurance companies will want higher premiums to cover the odds on
older people - it is a very rare that an insurance company will refuse coverage
to someone who is willing to pay the premiums for their risk category. That
said, get insurance if you need it and when you need it. Do not get insurance
because you are scared of not qualifying later in life.
Is
Life Insurance an Investment?
Many people see life insurance as an investment, but when compared to other investment vehicles, referring to insurance as an investment simply doesn't make sense. Certain types of life insurance are touted as vehicles for saving or investing money for retirement, commonly called cash-value policies. These are insurance policies in which you build up a pool of capital that gains interest. This interest accrues because the insurance companies is investing that money for their benefit, much like banks and are paying you a percentage for the use of your money.
However,
if you were to take the money from the forced savings program and invest it in
an index fund, you would
likely see much better returns. For people who lack the discipline to invest
regularly, a cash-value insurance policy may be beneficial. A disciplined
investor, on the other hand, has no need for scraps from an insurance company's
table.
Cash
Value vs. Term
Insurance companies love cash-value policies and promote them heavily by giving commissions to agents who sell these policies. If you try to surrender the policy (demand your savings portion back and cancel the insurance), an insurance company will often suggest that you take a loan from your own savings to continue paying the premiums. Although this may seem like a simple solution, this loan will cost you, as you will have to pay interest to the insurance company for borrowing your own money.
Term insurance is insurance pure and simple. You buy
a policy that pays out a set amount if you die during the period to which the
policy applies. If you don't die, you get nothing (don't be disappointed, you
are alive after all). The purpose of this insurance is to hold you over until
you can become self-insured by your assets. Unfortunately, not all term
insurance is equally desirable. Regardless of the specifics of a person's
situation (lifestyle, income, debts), most people are best served by renewable
and convertible term insurance policies. They offer just as much coverage and
are cheaper than cash-value, and, with the advent of internet comparisons
driving down premiums for comparable policies, you can purchase them at
competitive rates.
The
renewable clause in a term life insurance policy means that the insuring
company will allow you to renew your policy at a set rate without undergoing a
medical. This means that if an insured person is diagnosed with a fatal disease
just as the term runs out, he or she will be able to renew the policy at a
competitive rate despite the fact that the insurance company is certain to have
to pay out.
The
convertible insurance policy provides the option to change the face value of the policy into a
cash-value policy offered by the insurer in case you reach 65 years of age and
are not financially secure enough to go without insurance. Even though you will
be planning in the hope of not having to use this option, it is better to be
safe and the premium is usually quite inexpensive.
Evaluating
Your Insurance Needs
A large part of choosing a life insurance policy is determining how much money your dependents will need. Choosing the face value (the amount your policy pays if you die) depends on:
- How much debt you have: All of your debts must be paid off in full, including car loans, mortgages, credit cards, loans, etc. If you have a $200,000 mortgage and a $4,000 car loan, you need at least $204,000 in your policy to cover you debts (and possibly a little more to take care of the interest as well).
- Income Replacement: One of the biggest factors for life insurance is for income replacement, which will be a major determinant of the size of your policy. If you are the only provider for your dependents and you bring in $40,000 a year, you will need a policy payout that is large enough to replace your income plus a little extra to guard against inflation. To err on the safe side, assume that the lump sum payout of your policy is invested at 8% (if you do not trust your dependents to invest, you can appoint trustees or chose a financial planner and calculate his or her cost as part of the payout). Just to replace your income, you will need a $500,000 policy. This is not a set rule, but adding your yearly income back into the policy (500,000 + 40,000 = 540,000 in this case) is a fairly good guard against inflation. Remember, you have to add this $540,000 to whatever your total debts add up to.
- Future Obligations: If you want to pay for your child's college tuition or have your spouse move to Hawaii when you are gone, you will have to estimate the costs of those obligations and add them to the amount of coverage you want. So, if a person has a yearly income of $40,000, a mortgage of $200,000, and wants to send his or her child to university (let's say this will cost $80,000), this person would probably want an $820,000 policy ($540,000 to replace yearly income + $200,000 for the mortgage expense + $80,000 university expense). Once you determine the required face value of your insurance company, you can start shopping around for the right policy (and a good deal). There are many online insurance estimators that can help you determine how much insurance you will need.
- Insuring Others: Obviously there are other people in your life who are important to you and you may wonder if you should insure them. As a rule, you should only insure people whose death would mean a financial loss to you. The death of a child, while emotionally devastating, does not constitute a financial loss because children cost money to raise. The death of an income-earning spouse, however, does create a situation with both emotional and financial losses. In that case, follow the income replacement trick we went through earlier (your spouse's income/8% + inflation = how much you'll need to insure your spouse for). This also goes for any business partners with which you have a financial relationship (for example, shared responsibility for mortgage payments on a co-owned property).
Alternatives
to Life Insurance
If you are getting life insurance purely to cover debts and have no dependents, there is another way to go about it. Lending institutions have seen the profits of insurance companies and are getting in to the act. Credit card companies and banks offer insurance deductibles on your outstanding balances. Often this amounts to a few dollars a month and in the case of your death, the policy will pay that particular debt in full. If you opt for this coverage from a lending institution, make sure to subtract that debt from any calculations you are making for life insurance - being doubly insured is a needless cost.
Summary
If you need life insurance, it is important to know how much and what kind you need. Although generally renewable term insurance is sufficient for most people, you have to look at your own situation. If you choose to buy insurance through an agent, decide on what you'll need beforehand to avoid getting stuck with inadequate coverage or expensive coverage that you don't need. As with investing, educating yourself is essential to making the right choice.
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