Life Insurance
What You Should Know Before You Buy Life Insurance
DO YOU NEED LIFE INSURANCE?
The purpose of life insurance is to provide a source of income, in case of your death, for your children, dependents, or other beneficiaries. Life insurance can also serve other estate planning purposes, such as giving money to charity on your death, paying for estate taxes, or providing for a buy-out of a business interest.
Whether you need to buy life insurance depends on whether anyone is depending on your income. If you have a spouse, child, parent, or some other individual who depends on your income, you probably need life insurance. (You might also need life insurance for estate planning or business succession planning purposes.) Here are some typical insurance situations along with typical insurance needs:
Situation 1. Families or single parents with young children or other dependents. The younger your children, the more insurance you need. If both spouses earn income, then both spouses should be insured, with insurance amounts proportionate to salary amounts. If the family cannot afford to insure both wage earners, the primary wage earner should be insured first, and the secondary wage earner should be insured later on. A less expensive term policy might be used to fill an insurance gap. If one spouse does not work outside the home, insurance should be purchased to cover the absence of the services being provided by that spouse (child care, housekeeping, bookkeeping). However, if funds are limited, insurance on the non-wage earner should be secondary to insurance on the life of the wage earner.
Situation 2. Adults with no children or other dependents. If your spouse could live comfortably without your income, then you will need less insurance than the people in situation (1). However, you will still need some life insurance. At a minimum, you will want to provide for burial expenses, for paying off whatever debts you have incurred, and for providing an orderly transition for the surviving spouse. If your spouse would undergo financial hardship without your income, or if you do not have adequate savings, you may need to purchase more insurance. The amount will depend on your salary level and that of your spouse, on the amount of savings you have, and on the amount of debt you both have.
Situation 3. Single adults with no dependents. You will need only enough insurance to cover burial expenses and debts, unless you want to use insurance for estate planning purposes.
Situation 4. Children. Children generally need only enough life insurance to pay burial expenses and medical debts. In some cases, a life insurance policy might be used as a long-term savings vehicle.
Situation 5. Retirees. There is less of a need for life insurance after retirement, unless it is to be used for other estate planning purposes. You may need to provided an income for the second spouse to die if your retirement assets are not large enough. Further, you will need some insurance to pay burial expenses, final medical costs, and debts.
TYPES OF INSURANCE
After deciding on the amount of coverage you need, you can decide on the type of insurance product to best fill those needs. Although the array of insurance products may seem confusing, there are really just two types of insurance:
- Term, whereby you pay for coverage for a specified amount of time, and if you die during that time the insurer pays your survivors the death benefit specified; and
- Cash value — whole life or universal life — which, in addition to paying a death benefit, also provides you with some other redeemable value.
TERM INSURANCE
For individuals age 40 or less, a term policy will almost always be less costly than a whole life policy. Although term policies do not build cash values, many are convertible to whole life policies without a physical exam. Thus, a term convertible policy may be a good option for someone who is under 40. There are various types of term insurance, which we will discuss briefly here.
- Renewable. With the typical renewable term policy—the most common type—the policy renews automatically every year. You do not need to take a physical or verify the fact that you are employed. The premium goes up at the beginning of each new term to reflect the fact that you are older. Most renewable term policies can be renewable until you reach age 70 or so.
- Re-entry. With this type of policy, you must undergo a physical exam after a certain period, or pay an extra premium.
- Level. With level term policies, the premium is guaranteed to stay the same over a certain period. This period may be shorter than the term of the policy.
- Decreasing. With a decreasing term policy—a good option for insuring mortgage payments—the face amount of the policy decreases over time while the premium payments remain the same.
There are four types of cash value life insurance: (1) whole life, (2) universal life, (3) variable universal life and (4) variable whole life. The first two types are the most common and have a guaranteed cash surrender value; in the last two types, the cash surrender value is not guaranteed.
Whole Life. This is the traditional life insurance policy. It provides a death benefit, has a cash value build-up, and sometimes pays dividends. You do not need to renew a whole life policy. As long as you pay your premiums, you will have coverage, usually until your death. The premium for a whole life policy remains the same for the amount of time you own the policy; the premium is "level" in insurance parlance. Thus, when you are younger, the premium you pay for whole life will be greater than what you would pay for term, but when you are older, the premium will be much less than a term premium. Part of each premium goes into the cash value of your policy. Your cash value, which is actually an investment, is guaranteed to grow at a fixed rate. You do not have to pay current income taxes on the growth in the cash value—it is tax-deferred.
| TIP: You can borrow against your cash value at a rate that is usually better than the prevailing consumer lending rates. If you die with an outstanding loan amount, the loan amount, plus interest, will be subtracted from your death benefit. |
Dividend-paying whole life policies—termed "participating" policies—are usually offered by mutual life insurance companies. Mutual life insurance companies are generally owned by policyholders, while other insurance companies are owned by shareholders. The dividends are refunds of insurance premiums that exceed a certain level. They are paid when the insurance company does well during a quarter or a year. Of course, premiums for participating policies are usually higher than those paid for non-participating policies.
| Note: Term policies can also be participating, but the dividends paid are usually minimal. |
Universal Life. Universal life, also known as "flexible premium adjustable life," is similar to whole life, but offers more flexibility in terms of payment of premiums and cash value growth. With a universal life policy, your monthly premium amount is first credited to your cash value. The company then deducts the cost of your death benefit and the expenses of the policy. These costs are about equal to what it would cost to buy term coverage. As with whole life, your cash value grows at a fixed minimum rate of interest. The growth of the cash value is tax-deferred, and you can borrow against it or make partial withdrawals.
| CAUTION: A special feature of universal life is that you can vary the premium paid from month to month. You can pay more or less—within certain limits—without jeopardizing your coverage. You can even let the cash value absorb the premium. However, the danger here is that if the premium payments fall too low, your policy may lapse. While some states require the insurer to tell you when your cash value is at a dangerously low point, you will, if you live in another state, have to maintain a careful watch on the amount of cash value if premiums are skipped. |
Variable Universal Life. Variable universal life allows you to choose the investment for your cash value. You have a potentially greater cash value growth, but you also have added risk, depending on the type of investment you choose.
Variable Whole Life. With variable whole life, the death benefit and cash value will depend on the performance of an investment fund that you choose. Again, you have potentially greater reward, with its accompanying risks.