Life insurance is a simple concept, as well as a simple product to buy. That of course assumes that you are in good health. I find life insurance in general to be one of the more intelligent ways to eliminate financial risk. If you have seen a surviving family become poor in less than a year after the death of an income earner, then you know what I am talking about. Life insurance provides the dollars needed to survive at exactly the time they are needed. And you will never pay more into a life insurance policy than your beneficiaries receive from the policy at their time of need. I really don’t like to talk about the different types of life insurance contracts unless I am speaking to someone in person. If you already know the type of insurance you want, then I am boring you. And if you know nothing about life insurance, you should talk with a financial planner or insurance agent about the different types and which is best for you.
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When buying Term Life Insurance, you buy a certain amount of life insurance for a specified period, or “term”, and at your death, a check is written out to your beneficiaries. Your premium payments are broken into two parts; most of the money you pay for your coverage goes toward the cost of the protection or the “death benefit”, while a small portion goes to pay policy fees. Most every policy has an ongoing policy fee to cover the cost of doing business, paying commissions, sending out bills, answering phones, etc. And by the way, you do not save any money by not using a live insurance agent when you purchase your policy. If anything, you will need that agent from time to time for service and questions. Good insurance agents can provide years of valuable advice.
So that’s how simple life insurance can be to understand...you pay now so that the insurance company pays at a future time of need. Term life insurance has never been less expensive, and you can lock in the rates for up to 30 years. That means that a young man of 45 years old could purchase a policy today and pay the same rate for the next 30 years...until age 74! For most of us, that would be a sufficient amount of time to be insured. After all, who will suffer a financial loss because of our death at that age?
If you have the good fortune of being worth millions of dollars at that age, you could justify the need for life insurance to help pay your estate taxes so your heirs won't have it taken out of their inheritances. But realistically, most of us will spend most of our money before that age, or set up trust to facilitate the efficient distribution of our wealth. Aside from the rare cases like our last example of the millionaire, I must honestly say this, my concern is that no husband, wife, or child(ren) suffer financially after the death of a loved one, because of poor financial planning. There is no way to know when a tragedy is going to happen in a family, but there is a way to plan for the financial struggles that could follow. I have seen families lose everything, including the lifestyle they were accustomed to, because a decision maker either decided not to buy life insurance, or purchased too little.
Don’t get stuck on the types of life insurance. Find out how much protection you need, then find out which type of policy will allow you to purchase that amount at a reasonable cost. The answer is almost always Term Insurance. That is the type my wife and I own.
Other Types of Life Insurance:
I will touch on the “other” types briefly, and the circumstances in which they may make sense. Term Insurance comes in “terms” or lengths of years of coverage. If you bought a 20 year plan, you would have possibly several choices after the 20 years were up. You could let the policy end, or lapse, and that would be the end of the policy. You could decide to reapply, if your health was still good, for another term. In some cases, the term plan will simply turn into an annual renewable term plan with premiums that increase each year thereafter. Or you could have conversion privileges that allow you to convert the term plan into a “cash value” policy by a certain age.
I believe that most people buy term for the period they feel they need the coverage. Lots of our clients that have children around 5 yrs. old, for example, will purchase a 20 year level term plan. The policy is specifically designed in their financial plans to protect the income that would provide for that child until he or she were out of college and on their own. Many people buy 30 year term plans to cover a 30 year mortgage. If you want life insurance to cover you until you die, even if that death doesn’t come until age 95 years old or so, then perhaps a portion of your life insurance plan should include a “cash value” policy. That cash value policy will cost much more than the term policy because they are covering a longer period. And because most people die after age 75 or so, the insurance company is more likely to pay a death claim if that policy stays in force.
Ideally, with a " Cash Value" policy, your premiums will include not only the cost of the insurance protection and the policy fee, but also a contribution to a “cash value” fund. Interest is applied to that “extra” premium that you sent in to the company and a cash account builds. Basically, it works like this. You send in $1,000 with your annual bill. The life insurance company places that money into your cash value (savings) account portion of the policy. The insurance company then takes $200 out of your cash account for the cost of the life insurance (COI), $60 for the policy fee, and any other fees they may charge to manage your policy. What is left stays in the interest bearing account to grow.. Each year, as the cost for your life insurance increases due to your age, a greater amount of money is taken out of your cash value account and directed towards the cost of insurance (COI). But because you are paying a premium amount that is much greater than actual cost of the COI, the “cash value” of your account grows in greater increments than does the increases in the COI. So, while the premiums that you send the company never increase, and your cash account continues to grow, it might appear that your direct cost for being insured never increases. In fact, after years of paying in to a cash value policy, you may actually be able to surrender your policy for the cash value account and receive back more than you even paid in.
Is This a Deal or What?
What one needs to realize is that the cost of insurance (COI) continues to increase each year that you age. There is the illusion that you never pay more as you get older because they started out charging you so much more than they needed to. The reality is, you could buy term life insurance for much less premium and invest the difference in an alternative investment vehicle that would most likely give you a greater return than the interest rate than the insurance company will give you on your cash value account in your policy. Then at the time of your death (lovely thought hey?) your beneficiaries would receive both the proceeds from your life insurance policy (income tax-free), and the value of your alternative investment (at a stepped up basis).
There is another point I like to make to bring a client’s planning into perspective when buying “cash value” or what is also called “permanent” life insurance. How does someone in their thirties decide to buy life insurance that will make sense when they are in their nineties? Due to the time value of money, or put another way, due to inflation and the value of the dollar, this practice only promotes an improper allocation of valuable investment dollars. Let me explain what I mean. I’m 30 years old and want to buy life insurance that will be there whenever I die, even if that is in my 90’s. I figure that $100,000 will pay my mortgage off so that’s a good number. But what is that $100,000 going to be worth in “purchasing power” when I’m 95? If we assume a reasonable rate of inflation to be the standard long-term 4%, then that $100,000 will be worth the equivalent of $7,813 in today’s dollars. That is because with 4% inflation over a period of 65 years, what you could buy for $100,000 today, will cost around $1,279,873 by then.
So what a brilliant financial move. You paid into a life insurance policy for 65 years so that when you died someone could just about pay for your funeral. But if you had planned for the unlikely event of you dying at a younger age, and put the rest into a decent investment, you would leave your beneficiaries hundreds of thousand of dollars. And the best part is this. Once your kids are old enough where they’re not relying on you to put food on their table, you could spend some of that money you invested into stocks and mutual funds on yourself...you won't have to die to get it.
I haven’t discussed the surrender fees that the insurance company takes out of your cash value account if you want out to the contract in the first 15 years or so. And I haven’t questioned how you would feel making 4% on your money while the stock market made people millionaires in the last ten years. Believe me, I don’t have an ax to grind with the insurance companies. But I have learned some things about buying life insurance in the last 20 years. So I only buy and sell Term Life Insurance, except for some very special and rare situations.
Like life itself, life insurance can be quite complex at times. Not every situation will be addressed easily. And you are not going to learn everything there is to be known about life insurance and the insurance industry over the Internet. There is a lot to take into account here, but the general concept is simple. Everyone is out for themselves to make a buck. Don’t jump in feet first because a nice person told you that they want to help you. And remember...it’s life insurance. It’s an important part of most people’s financial plan, but it's primary function is to provide liquidity at death. I have heard all the arguments about different types of cash value plans making you rich. And I have been around for the last twenty years watching the results.
Get what you need or want for the lowest cost, while taking into account the quality of the company insuring you. If you need help in making your decision you may want to work with a Certified Financial Planner, a Chartered Financial Consultant, or someone that has been formally educated in financial planning. I also suggest that you work with an insurance agent that has been licensed to sell life insurance for at least three years. It may seem like the right thing to do to let your cousin, who has been in the business for a couple of months, sell you insurance. But the odds are, you are cheating yourself from letting some extremely skilled professionals help you in a very important matter. Put knowledge over friendship when it comes to financial planning...trust me. And if you don’t have reason to believe otherwise, you may want to contact your state insurance department to ask if there have been any substantiated complaints filed against a particular agent. They will tell immediately in most cases. If you need more information or have questions you may call us at 1-800-BUY-TERM