Life insurance can be a confusing topic to most people. Who needs it? How much do you need? What’s the difference between whole life and term life? Who is this guy knocking on my door trying to sell me a policy? Today, I’d like to help shed a little light on this topic so you feel more confident in understanding what coverage you currently have and if it fits your financial needs or not.
In this article, I will address the three most important aspects of the life insurance process - understanding the different types of life insurance, determining how much you need, and where to purchase your life insurance.
Four Types of Life Insurance
Understanding which type of life insurance you should purchase is a critical part of the process, as the coverage terms and cost of coverage will vary greatly (possibly by thousands of dollars per year).
Level-Term: The most basic and straightforward type of policy, level-term provides the greatest amount of coverage for the cheapest premium. The policy will look something like this: $500,000 of death benefit coverage, $200 annual premium, 20-year term. This means as long as you pay the $200 annual premium, your beneficiaries will receive the $500,000 death benefit if you pass away within the 20-year term period. After the 20-year term, you will have the option to convert this policy to a permanent (more below) policy without going through underwriting again, or simply let the policy lapse and no longer have coverage. Level-term policies are available in a range of timeframes - most commonly 10, 15, 20, or 30 years.
Level-term is my preferred type of policy for most individuals, as you can obtain a large amount of coverage at a cheap price. Level-term coverage is great for covering debts like a mortgage, that you know you will have for a set period of time. If you pass away, your beneficiaries will be able to pay off the debt and stay in the home.
Annual Renewable Term (ART): Similar to a level-term policy, annual renewable term provides a large amount of death benefit coverage at a low premium price. However, with ART, your premium will increase ever so slightly each year of the policy. For example, your first year premium may be $150, but in year two it will increase to $160, then $175 in year three, and so on. The policy is guaranteed-renewable, which means as long as you are willing to pay the increased premium each year, you will maintain coverage.
Often times, ART insurance is good for covering a debt that you will only have for a few years, like a promissory note for purchasing a business. If you want the coverage passed 3 or 4 years, it is most likely cheaper to purchase a level-term policy.
Whole-Life: Whole-Life insurance is known as a type of “permanent” insurance, which is intended to last your lifetime. With a whole-life policy, the premiums will be much higher than a term policy, as you are building up a “cash-value” account which will help pay your cost of insurance later in life. A whole-life policy will have a fixed premium, which you will pay each year for the life of the policy. The policy will look something like this: $500,000 death benefit, $2,000 annual premium, policy lasts until age 120. This means as long as you pay the annual premium each year, you will be guaranteed to have coverage until the day you pass away.
Why is the premium so much higher than term-life? In the early years of the policy, a small portion of your premium goes to pay your current costs of insurance. The remaining portion goes into a “cash-value” account, which will accumulate interest over time. This cash value account will also assist in paying the extremely high costs of insurance in your later years. Even though your premiums remain level for the life of the policy, your internal cost of insurance will rise each year you get older, which is why the cash-value account needs to help pay those higher costs.
Permanent policies like whole-life or universal-life are great to use for estate planning purposes. Since the policies will be around for your entire lifetime, the death benefits can be used either to pay estate taxes due at your death, or used in legacy planning and go towards a charitable cause you care about.
Universal-Life: Similar to a whole-life policy, the universal-life (UL) policy is permanent and intended to last your lifetime. The policy works in a similar fashion, with a higher premium and cash-value account to help fund future insurance costs. With UL policies, the cash-value grows based on current interest rates, which will fluctuate over time, but the insurance company will guarantee a minimum interest rate (generally around 2-3%).
The main added benefit of a universal-life policy over a whole-life policy is the flexibility of premium payments. With a whole-life policy, the fixed premium must be paid each and every year. With a UL policy, you can structure the premiums to pay higher premiums for the first 10-20 years and discontinue premiums after that. The flexible premiums also allow you to not pay the premium for a few years and restart premiums later if you are going through a tight budget period.
Another form of universal-life is the variable universal life policy. The variable UL policy also has a flexible premium, but differs from the traditional UL in that the cash-value is invested in mutual fund-like “sub-accounts”. This allows you to participate in various investment classes for potentially greater growth instead of having your cash-value grow based on current interest rates.
Determining How Much Life Insurance You Need
To determine how much life insurance you should purchase, you need to know three main things:
How much money your family will need as an immediate lump-sum
This includes final expenses upon your death plus paying off any outstanding debt you will leave behind (mortgage, credit card, auto, etc.)
How much money your family will need to fund future expenses
This is based on your family’s current monthly expenses (I will reduce joint monthly expenses by 15%, as there unfortunately will be one less family member around).
How much money you will leave behind for your family
This includes your personal savings and retirement accounts.
To calculate how much you will need available for lump-sum payments, you will need to estimate your final expenses (average around $10,000-20,000 depending on geographical location and complexity of your estate for accountant and attorney fees). Once you have this number, you can then add in your current debt that will need to paid off when you pass away.
For the amount of insurance needed to fund future expenses, I recommend using the 4% safe withdrawal rate as your go-to assumption. This means that you can withdraw 4% of your invested assets on an annual basis, without drawing down the principal. If your family’s current monthly expenses are $5,000, you will reduce this amount by 15% as I mentioned above, to get a monthly replacement need of $4,250 (5,000 x .85). Now, take $4,250 x 12-months x 25 and you will get a total of $1,275,000. To double check your answer, you can take $1,275,000 x 4%, which equals $51,000, divided by 12-months = $4,250.
Finally, you will want to factor in the assets that you will be leaving behind for your family. With the above calculations, say your current insurance need is $1,500,000 ($1,275,000 for future expenses, plus $225,000 to pay final expenses and outstanding debts). You now will subtract out the assets you will leave behind for your family. If you have saved up $250,000 in your retirement accounts, plus $50,000 in a taxable investment account, you can subtract off $300,000 from your need.
This brings your final life insurance need to $1,200,000.
Your personal situation will obviously be different from this example, but this gives you a good idea of how to walk through the process with your own finances in mind.
Where To Purchase Life Insurance
Life insurance policies can be purchased two main ways - either through an insurance agent or an online brokerage. The most important aspect of purchasing a policy is to work with someone that can help you shop around to different insurance companies to find the most competitive quotes, and someone who can help you through the underwriting process. Everyone’s medical history is different and every insurance company looks at medical histories differently. The rating you get on your insurance policy can save you a large sum of money by the time you finish paying premiums. This is why it is important to shop around to different insurance carriers to receive multiple quotes!
If you work with an insurance agent, make sure they are able to work with a number of different insurance companies so they can shop around to find you the best possible policy for your needs. Insurance agents that only represent one company are not serving your best interests, because you may not be receiving the best policy you are eligible for.
Working with an online brokerage can make the life insurance purchase process a little less stressful. Often times, the online brokerages will allow you to complete your application online in a matter of minutes, without any underwriting for certain levels of term insurance. This can be appealing to some, but you may be at risk of not receiving the best policy if you don’t shop around for multiple quotes from different insurance carriers.
I recommend contacting a fee-only financial planner to help you through this process. Not only does a fee-only financial planner not work on commission, they will connect you with the insurance agents or online brokerages that will serve your needs the best.
The life insurance purchasing process can be daunting, but if you take the time to understand the different types of policies, calculating how much insurance you need, and finding the right place to purchase your policy, you will be much more prepared to make an informed purchase.
Life insurance is an integral part of your financial plan - hopefully you never need to use it, but it will make life much easier for your loved ones to get through a tough time if it is needed.