I have heard many life insurance horror stories that go something like this.
A couple, who just married or just had their first child, walks into an insurance agent’s office asking about life insurance. Riding the high of being newlyweds or new parents, they are ready to buy just about anything. After all, they want to prove that they care about each other.
Before you know it, the insurance agent is talking them into a life insurance policy, which is more complicated than quantum physics. A policy that this young couple doesn’t really understand the long term effects of.
The purpose of this post was to simplify life insurance. A wrong decision on life insurance at a young age can set your finances back for years. I don’t want this to happen to you.
Life Insurance 101 | Who Needs Life Insurance?
If someone depends on your ability to earn income,like a spouse or child, you need life insurance.
Life Insurance 101 | Types of Life Insurance
- Term Insurance – A policy that’s written for a specific period of time, generally ten, twenty, or thirty years. During the term period, the premiums stay the same. After the term is over, the premiums raise drastically.
- Whole Life Insurance – A life insurance policy with a savings component. When you pay the premium, a portion goes to the life insurance and a portion going to a savings vehicle. The benefit is that if you continue to pay the premiums each month, you have permanent protection for the rest of your life.
- Universal Life – Similar to a whole life policy. The main difference is that there is flexibility in the premium payments.
Life Insurance 101 | The Case for Term Insurance
There are very few instances where buying a whole life policy makes sense. I’ve sold millions of dollars of life insurance and all of it has been term. There hasn’t been one person I’ve met, where it makes sense to purchase anything but.
The problem with whole life insurance policy is the high fees and poor investment choices. For example, say you purchased a $1,000,000 whole life insurance policy with a monthly premium of $400. A portion of your monthly premium, say $100 for this example, goes to paying for the life insurance portion. The other $300 goes to the cash value. The only problem is that this $300 goes into an investment account with incredibly high fees, bad investment options, and lack of flexibility.
The alternative is just getting a term policy, for only $100 a month. With the $300 in savings, you can just invest it yourself with little fees and lots of flexibility.
Life Insurance 101 | How Much Life Insurance Should You Buy?
Now that you know a term policy is probably the right policy for you, the next question is how much should you buy.
Below is an example of how to calculate how much life insurance you do need. No calculation is perfect, but I find this spreadsheet I made using a formula from the Boglehead’s Forum is a very close estimate.
A couple of things to know:
- I used 4% rate of interest to calculate the amount of capital needed. I assumed a 7% rate of return and 3% inflation.
- Insurance bought through your employer, isn’t necessarily portable. Meaning, if you changed jobs, you no longer have life insurance. Therefore, you may not want to include employer coverage in the “current insurance” cell.
- This calculation assumes the surviving spouse continues to work.
Life Insurance 101 | Buying Life Insurance
The cheapest life insurance you can find, is through your employer.
Often, employer’s offer a small life insurance policy, the most common number I see is $50,000, free of charge. If the amount is over $50,000, the premium which accounts for the insurance exceeding $50,000 is taxable income.
Due to the small cost for a $50,000 policy, generally employers automatically enroll everyone into the plan. If you do need more, some employers have a voluntary program in addition. However, unless you’ve had health problems in the past or smoke, it’s usually a safer decision to forgo this coverage.
When you purchase life insurance through your employer, the coverage is guaranteed issued. Meaning, no matter your current health situation, you’re guaranteed to get coverage because there is no medical underwriting. Therefore, even if you had a terminal illness and your employer offers a guaranteed issued life insurance, you will be paid upon your death.
The medical underwriters, who make up the premiums understand the majority of people buying guaranteed coverage, have a higher chance of dying. Therefore, they charge higher premiums for it.
So, if you’re young and healthy, it makes sense to purchase life insurance on your own. This way, you’re not paying for the members of the group who are purchasing life insurance because they can’t get it anywhere else.
So how do you go about getting life insurance on your own?
There are options. As with everything today, you can use the Internet. It’s fast and you don’t talk to someone face to face.
The other option is using an insurance agent.
I’m a bit biased, knowing that I’m licensed to sell insurance in almost every state in the U.S., but life insurance is still one area where shopping with an independent insurance agent has many advantages over going through an online broker.
As a life insurance agent, I’ve gotten to know the reputations of the companies. One life insurance company is very different from another. Keep in mind, if you’re buying a term life insurance policy for 30 years, it’s important that the company still exists 30 years from now.
Also, going with an independent agent isn’t more expensive. Online brokers are just independent agents themselves. Either way, you’re paying a commission.
Is there a chance you get a bad agent? Of course! If an agent tries to talk you into a whole life policy, it’s a sign that you need to find another agent. There are some bad people in the insurance world.
Last, it’s a smart move to get to know an insurance agent you can trust and ask questions to. Right now, you just might be insuring a car. In the future, life gets more complicated, as does insurance. You want someone who can answer your tough questions, besides Google.
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If you have any additional questions, let me know in the comments.
{ 2 comments… read them below or add one }
Thanks for the informative post on term life insurance, but my study into life insurance has prompted an entirely different direction on whole life insurance that you might find valuable.
To begin, I do not look at whole life insurance as an “investment” (in the stock market meaning that people associate with investing). Maybe it is my brief stint of studying the actuarial science behind life insurance, or maybe it is just the academic in me that prefers to look at things differently, but whole life insurance, to me, is an asset, not an investment. In fact, I find it difficult to distinguish how anyone could even call it an investment. When priced by insurance companies whole life insurance is actually not priced like term insurance. Term insurance premiums are so inexpensive because, besides the commissions and expenses of the insurance company, the premium is only paying for the deaths projected to occur that year. And given that only 2% of term policies pay a claim, the premiums are very small. Whole life insurance, on the other hand, is federally regulated to ensure that certain reserve requirements are met for funding the future death benefit obligation of the insurance company. The guaranteed cash values must contractually be equal to the death benefit at the age of endowment. Accordingly, the whole life insurance policy does NOT have a “savings component” but rather it is merely building equity much like homeownership. You would never say that the difference between the mortgage payment of a home (say $600) and a rent payment ($100) goes to fund a side “savings component.” Where does the additional $500 go? It goes to pay for ownership of the home. Same with whole life insurance, the additional premium goes to fund the reserve requirements of the death benefit. This is why it is not an investment: it is not tied to the market and it is not your money. The equity in your home is not “your money” but is the value that your home is worth. The cash value is also not your money, but it is the value that your insurance policy (and the reserve requirements) are contractually worth.
Interestingly, this contractual valuation of whole life insurance can be extremely beneficial for financial planning if the policy is properly coordinated with a person’s other assets and investments. I find it strange that your CFP training or life insurance training has not lead you to see the strengths of the product and place it accordingly in a client’s portfolios for its strengths rather than its weaknesses.
However, I have written a very large book already, so I will stop writing, but thank you for your informative post!
Anonymous
I like what you said about making sure the insurance company you choose will be around in 30 years. I’ve often thought about that especially with the declining economy.