Life Insurance 101 Understanding the Basics
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Life insurance is likely a critical piece of your financial plan. It doesn't have to be complicated, but how it works and how much you need can be difficult questions to answer. Unfortunately, aggressive sales tactics surrounding the life insurance industry can also lead to confusion in the buying process. Let's take a few moments to discuss the basics of life insurance to help make you a more confident insurance buyer.
The basics of how Life Insurance Works
Life insurance is essential to protect financially anyone who depends on your income. This is most commonly a spouse or partner, kids, but it could also extend to other family members and business partners. Life insurance provides a single, substantial drop of cash in the event of your unexpected death that can go towards meeting the financial needs of your survivors.
A few key points of all life insurance policies are:
- Income tax-free death benefit - if and when life insurance does pay out, the payout is generally free of income tax. What you see is what you get.
- Length of Coverage - your policy will likely be one of two types here:
- Term Life - created to be inexpensive and cover you for a specific amount of time, such as 10 years, 20 years, or 30 years. You will decide how long the coverage will last when purchasing the policy.
- Permanent life insurance is designed to cover you for your full lifetime. It is much more expensive and carries a "cash value" component, which we'll discuss later. It is not appropriate for all circumstances. In fact, I would argue that use cases for this kind of coverage are fairly limited.
- Premium Costs - Life insurance isn't free, of course; you'll have to pay a premium as long as you want the coverage to be available or "in force." Premiums are affected by several factors, including
- Your personal health and other individual characteristics and habits
- The amount of insurance
- The length of insurance coverage (the length of a specific term or permanent life)
- Other riders or "features" that may be added to the policy.
Do you have an "Insurable interest?"
An "insurable interest" is insurance industry jargon for "do you have something to protect?" In the case of life insurance, the question is, do you have
- Income to protect if you are no longer earning it?
- People relying on that income that need support if the income goes away?
I will say something here that deserves emphasis: if you don't need a death benefit, you most likely do not need life insurance. There are many aggressive insurance salespersons out there who will try to convince you that an insurance policy makes a great investment vehicle. An insurance policy is a tool to manage your risk. It's a form of financial protection you hope never to use. It is typically lacking as an investment vehicle. I have had many clients come to me with a variety of insurance-as-an-investment products that were draining their cash flow with high premiums, under-insuring their family with too-small death benefits, and growing poorly (if at all) due to high fees and lackluster investments - proof that life insurance is not an all-in-one solution for personal finance.
How Much Coverage Do I Need?
The next question most people have is, "How much life insurance do I need?" The best way to answer this is to consider what you would need to cover in the event you weren't able to financially support your family.
If you search online, you'll find lots of rules of thumb, like buying 10 times your salary. Like most rules of thumb, they might be better than nothing, but they also don't account for our personal situations and could grossly overestimate or underestimate the actual insurance need.
For a more specific answer, a few questions to think about would be:
- How much mortgage and other debt do I want to cover?
- How much should be set aside for college expenses?
- What are the day-to-day expenses for your survivors?
- Are there new expenses that might come up, such as additional childcare costs?
- What is the earning power of my survivors? Keep in mind that the loss of a loved one is a catastrophic event, and even if your spouse or significant other works, don't assume they are just going to pick up at the same income level in a couple weeks.
Keep in mind your need for coverage will change over time. Just married and relying on each other's income? If something happens to you, you'll need some coverage to ease your partner's burden. Growing the family with children? Now you have a few more mouths to feed and get through to adulthood. Taking that vacation property? That's another mortgage and more significant expenses to cover.
Eventually, your need for coverage will wane. As you approach retirement, your assets should have grown to provide for your family in retirement. Social security income will kick in, covering some of your needed income. If you've completely retired, there will be far less, if any, need for life insurance coverage as fewer people should be counting on you for financial support, and hopefully, a majority of your debts will be paid down.
Notice I didn't say there would be no need for coverage in retirement. There certainly may be cases where continuing to carry coverage is warranted, but it will become increasingly expensive as you age.
Working with an independent financial planner (particularly a fee-only planner who does not make a living selling insurance) can be the key to objectively evaluating how much coverage you need and whether you need coverage at all.
That's just the tip of the iceberg.
So far, we have discussed the basics of Life Insurance: 101. There's much more to it, though, when it comes to selecting the right type of insurance (hint: the kind of insurance that gets the most hype and the biggest sales pitch is probably not the one you need) and more advanced insurance planning where permanent life insurance policies potentially are the solution. We will keep this series going and write more in upcoming blogs that will take you further through the process and help you provide your family with the protection they need.