A Life Insurance Primer
Life insurance is something that nearly everyone buys at some point in their life. It’s also, I’ve found, one of the most misunderstood financial products around (with the possible exception of annuities). So I hope this will be a useful though brief primer on the world of life insurance.
The first question to ask is why you need life insurance. The most common reasons are: to replace lost income today, to replace lost future earnings/savings that would have come from the deceased’s income, or for estate tax purposes. Some might say as an investment, but that shouldn’t be the driving force.
There’s really only one type of insurance- term. You pay a premium and if you die during that time the policy pays. It’s that simple. Every other type of insurance is a variation on this. That said, there are two main categories of life insurance- term and whole life (WL) (sometimes called permanent). WL is term with an investment account added to it. Universal and Variable life policies are variations of traditional WL.
For term insurance, there are two main types- annually renewable and level premium. Annually renewable typically has premiums that increase each year as you age. It’s cheap when you’re young, not so cheap later on. Level Term has premiums that don’t change for a set period of time. It may be 10, 15, 20, or even 30 years. The premiums may or may not be guaranteed to stay the same during that time period. After the time period has passed, you can often keep the policy but at a much higher premium. For both types of term policies, they usually can’t be kept past age 75 or so.
Whole life is a complicated creature. Its cousins Universal and Variable are too. The main difference between them is who is taking the risk in the investment account. In traditional WL, the insurance company takes most of it. In a Variable policy the owner (you) take most of it. Universal is somewhere in the middle. The upside to WL (and the others) is that you can usually keep the policy to age 100 or longer and premiums stay level the whole time. That makes these policies more useful for estate planning than term insurance.
You may have access to group life insurance through your employer. It’s simple to get and no health questions. That’s great for folks with significant health problems. It’s not so great for healthy people since their rates will likely be higher than if they bought private coverage. That’s right- it’s usually cheaper to buy your own term policy than buy your employer’s coverage- if you’re fairly healthy.
I often see folks who own multiple policies from different companies. Sometimes it’s just a matter of having bought them at different times. Sometime they felt they were spreading the risk around. Assuming the companies were all financially sound (say “A” rated or better), what they’ve really done is just cost themselves money. It’s usually cheaper to buy (1) $600,000 policy than (2) $300,000 ones. Why? In the latter you’re paying twice the underwriting costs, administrative costs and perhaps even commissions. Coverage per $1,000 of death benefit usually gets cheaper the more you buy in a policy. Consolidation of policies can often save you money.
Finally, let’s talk about sales commissions or loads. If you buy a policy from an insurance agent, he/she is usually being paid a commission by the insurance company. Commissions are much lower for term policies than any version of a WL policy. There are now coming on the market some WL policies that are termed “Low Load”. They carry lower commissions than traditional WL policies. This doesn’t apply to term policies however. We’re waiting, but I’m not aware of any yet, for the arrival of no-load WL policies. It’ll take one of the very large companies introducing this to break the log-jam. But this causes problems with their sales force. So why is a low-load WL policy desirable? The effect of loads manifests itself in how fast the cash value (investment) account grows. In the early years it often stays pretty close to zero. That's because so many costs/expenses are still being recouped by the insurance company. In the low-load policies these expenses are less so the cash value account grows much faster early on, and that carries on through-out the policy’s life.
So there- the briefest of brief explanations of the world of life insurance. It’s complicated. But don’t let that be your excuse for not looking into and buying it if you have a legitimate need. If you have dependent children, a non-working spouse, or you’re very far behind on retirement savings, you may very well have a need. A large estate tax problem counts too. But that need should be determined as part of your overall financial picture, not just through a quick rule-of-thumb “guesstimate”. Contact a professional for help. Fee-only planners like myself don’t sell the insurance or receive commissions, but we can help advise and guide you. Give me a call if I can help.
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