What Everyone Should Know about Life Insurance

Life insurance is an essential protection to have, especially for married people with children. When a primary wage earner is taken in death, serious decisions and consequences arise, such as whether to sell the house, whether a stay at home Mom should go to work, whether a grandparent should move in to take care of kids, and mourning the loss of the spouse/parent.  These issues, along with all the rest that go along with such a stressful time in life, are best made with the peace of mind that comes from knowing that money is not a problem or a factor in the decision.

Below you’ll find a “top ten” list of basics points to consider regarding life insurance.

1. All policies fall into one of two camps.

There are term policies, which are simply insurance coverage, with no investment component.  These policies are “rented”, in that they will expire at some point, and no equity is built up.  Unless you die, there will never be a benefit to a term policy.  There are also many variants of whole life, which combine an investment product with permanent insurance and build up cash savings which are owned for life.  This type of policy has a “cash value” that is separate from the death benefit.  Younger people usually buy term insurance, which can have a level premium for as long as 30 years.  Term insurance greatly reduces costs, but creates no ownership, and will expire.

2. Insurance is sold, not bought.

Agents sell the vast majority of life policies written in the U.S. because the life insurance industry has a vested interest in pushing high-commission (and high-profit) whole-life policies.

3. Whole life insurance is expensive.

Policies with an investment component cost many times more than term policies. As a result, many people who buy whole life often can’t afford an adequate amount of coverage, leaving themselves underinsured.  It is possible to buy a combination of a smaller whole-life policy with a larger term policy riding on top.  This combines an investment feature with adequate coverage.

4. Whole-life policies are built on assumptions.

The returns quoted by the agent are educated estimates, but they are not reality.  Your stock broker would not sell you shares of IBM and pretend to tell you what the price will be in 20 years.  Your insurance company has basic guaranteed rates—make sure you look at those, instead of assuming that the projected accumulation values and interest rates are guaranteed.

5.  You may want to keep your investing and your insurance separate.

There may be better places to invest, without paying the high commissions and expenses of whole-life policies.  On the other hand, life insurance cash has many favorable tax advantages, both in life and in death, and if you have a trusted life insurance agent in your family, it is worth meeting with him/her and discussing options and possibilities.  Nine Year Mortgage believes that where money is concerned, knowledge is power.

6. Buy enough term coverage to fill your needs.

Life insurance is no place to go easy, especially when the cost for coverage is at historic lows.  The rule of thumb is at least 10 times one’s average salary, but some experts say 20 times is better.  The old saying is that no widow ever said her husband owned too much insurance!

7. Match the term of the policy to your needs.

You want the policy to last as long as it takes for your dependents to leave the nest, for your retirement income to kick in, for the house to be paid in full, or until you are certain you will not have a large estate tax burden which is best paid through life insurance.

8. Buy when you’re healthy.

Older people and those who have health problems pay much higher rates for life insurance – so buy as early as you can, but don’t buy until you have dependents.  (spouse or children)  It is best to err on the side of buying early, since one never knows when a health problem will arise.

9. Tell the truth.

There’s no sense in shading the facts on your application to get a lower rate. Be assured that if a large claim is made, the insurance company will investigate before paying, and if they can prove that you were not honest in your application, they will not pay the claim.

10. Use the Web to shop.

Buying term life insurance has never been easier, thanks to the Internet. You can get tons of quotes on line, and avoid the pushy salespeople.  However, if you want to use your life insurance as an investment vehicle, which many people do, then an agent can be a valuable financial counseling partner for the features and benefits of a whole life policy.  Once you get a policy, make a note to shop every few years for a better rate, or even at the same rate to reset your term.  If you can get the same rate on a new 20 year policy after three years, it makes sense to take advantage and get the new term.  Be aware that most companies have a two year waiting period on certain types of events, like suicide

How much do I need and for what term?

There are six major issues that life insurance must provide for.  For the primary wage earner, these are:

1. Pay off the home mortgage
2. Pay off all other debts
3. Cover funeral expenses
4. Provide an income for surviving spouse so that work is optional
5. Provide for college education for dependents
6. Cover income taxes due on large estates

For example, a married 35 year old father with 3 children under the age of 10 who earns $60,000 per year might go through the following calculation:

1. Pay off mortgage = $200,000
2. Pay off other debts = $35,000
3. Funeral expenses = $15,000 (costs can vary substantially)
4. Provide $45,000 per year in income for surviving spouse so she won’t have to go to work.
5. College education for the kids $100,000 each.
6. No large estate (will leave less than $3 million, which is not subject to tax)

Since the mortgage is paid off, a nest egg of $1,000,000 earning 6% before taxes will generate $45,000 per year without dissipating principal, unless interest earnings are very bad over the years.

TOTAL LIFE INSURANCE NEEDED = $1,550,000.  (note this is about 25 times income)

How long a term should you choose?

How long should the coverage last?  Let’s move forward with the father above.  If he had purchased a 30 year level term policy at age 25, then by age 55 when this policy runs out, he would have provided for the kids college education and if he manages his finances properly, he could have his house paid off.  By this time his wife may have gone back to work since the kids are out of the house, so she won’t need such a generous income.  He might be able to drop his coverage down to $500,000.  But what about his health?  Who can guarantee it will still be good?

Even if his health is still good, since he is now age 55, and the cost of another 20 years worth of coverage for $500,000 will be nearly equal to what the $1,550,000 policy cost at age 25.

So, does he need any coverage at all?  Would he want to leave an estate and help provide for his grandchildren?  How about donating to a favorite charity at his death?  Will the wife have a pension, and if not, then will Social Security be sufficient for her needs?

These are issues for the family to discuss, in consultation with their children and grandchildren.  If he wants insurance but can’t get it, he will be sorry he didn’t purchase more, or set aside the money for whole (permanent) coverage when he was younger, even though it’s much more expensive.

EXAMPLE:  $1,550,000 of permanent coverage for a healthy male, age 25, will cost about $12,000 per year, or about $1000/month.  Even if the policy doesn’t pay out until age 80, a permanent policy means exactly that—someone, somewhere, will get $1,550,000 upon the death of the insured.

$12,000 per year for 55 years of coverage adds up to $660,000 in premiums, or about 42 cents on the dollar.  But the policy doesn’t strictly work that way—after about 25 years, it has built up cash value on which you can earn interest, and that interest can go towards paying the policy premium.  This means that the total paid into the policy is down to $300,000, or about 19 cents on the dollar.

There are other uses for that cash value as well—a qualified agent can show some very attractive investment options and tax-favored income streams that can be arranged from a whole life policy.

Life Insurance Summary

BOTTOM LINE:  The cost of life insurance will vary from family to family, but in most cases you should err on the side of more, rather than less coverage.  It is true that the costs of permanent insurance are far higher than simple term coverage, but if bad health rears its ugly head, and term coverage runs out before the need for insurance has disappeared, there will be disappointment.  Cash-value policies can never be canceled, and they also build up attractive cash accounts that have very favorable tax treatment.

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