While most of us are aware of life insurance, many of us haven’t considered purchasing a policy or understand how life insurance works. We’re not sure if it’s something we need. The underlying goal of life insurance is to provide financial security for your family. Think of it as income replacement for your dependents. If you were to pass away, what would your family need? How many children do you have? Funeral expenses? Mortgage payments? College tuition? Fortunately, there are various types of life insurance policies that are flexible enough to meet your specific needs and budget. Below is a brief overview of how life insurance works.
What Are the Types of Life Insurance?
Some financial planners recommend enough insurance to cover five to seven years in case you die to allow for your dependents to maintain their current lifestyle. While there are exceptions, generally, you’ll want your life insurance policy to cover you until your retirement years. Life insurance isn’t considered a substitute for a retirement plan, and you’ll want to have enough savings to live on by the time you reach retirement and no longer pay for life insurance premiums.
Life insurance can be broken down into two distinct types: Term and Permanent. Each has its own distinct benefits and advantages, so consider your circumstance.
Term life insurance is the most basic type. The policy covers a set number of years, anywhere from 1 to 30. For younger people, this is often the least expensive option as it features relatively low rates for a fixed number of years. You’ll want to consider the length of the policy you purchase. If it expires and you want to renew, you’ll be older, and the rates will be higher. Term life insurance doesn’t have a cash value component (more on that below) or lifetime coverage. Essentially, your dependents don’t collect on the policy unless you die within the term period.
Permanent life insurance policies cover you until the day you die, no matter when it happens. The premiums can be fixed or flexible. The biggest benefit is the cash value component. The insurance company invests your premiums to build up cash reserves in your account. You aren’t taxed on the investment earnings until you cash in the policy, and you can borrow from the reserves. The drawback to permanent life insurance policies are higher premiums compared to term policies. Consumer Reports shows that a 40-year-old man in perfect health who wants a $500,000 policy would pay $6,670 in annual premiums for a “Whole life” insurance policy versus $660 for a term policy.
Permanent life insurance policies can be further broken down into sub-categories, each type allowing for various degrees of control where the money is invested.
This is the most basic type of permanent life insurance. Whole life features a fixed premium, meaning the rate you pay for your policy will never increase. However, the consumer has no control over where the money is invested. Whole life offers a certain amount of certainty, as your policy builds a cash value and the death benefit amount is guaranteed to your dependents.
This policy has a cash value that’s determined by short-term interest rates rather than the stated long-term rate of a whole life policy. The interest rates can fluctuate, but cannot fall below the policy’s guaranteed interest rate. The policyholder can shift funds between insurance and the savings components of the policy and can use savings to make premium payments. The premiums are flexible, meaning you can adjust your premiums and coverages as your needs change over time.
This type of policy gives the consumer control over where their savings are invested. The rate of return on investments not only impacts the cash value of the policy, but also will increase or decrease the amount of the final death benefit. The premiums in this model are fixed.
Universal Variable Life
This is a hybrid of the two. It allows for flexible premiums and for your cash value and final death benefits to be affected by the performance of your investments.
If you’re considering a life insurance policy, understand that the carrier is going to determine the amount of risk you represent in setting your rates. If they determine you pose too much risk, they may decline to offer you a policy. When you apply for a life insurance policy, you can expect to provide a medical history, including urine and blood samples, and possibly an EKG. Your family medical history, credit score, driving records, travels to riskier parts of the world, lifestyle, and hobbies may also be factored in. If you’re a smoker who enjoys base jumping on the weekends, you can expect a much higher premium than a non-smoker who jogs on a treadmill. It’s estimated that those who are smokers, obese, and have risky occupations pay more than 50% of the preferred rate. You’ll want to be forthcoming, though. Failure to list certain risk factors at the time of policy application could result in a denial of a claim.
A life insurance policy can be a part of your financial plan. There’s a lot of flexibility and options that will best meet your needs. You’ll want to research the nuances of each type of policy and consider your health and lifestyle, investment acumen, aversion to risk, and your current financial standing to choose a policy that works for you. While it’s uncertain what might happen in 10, 20, 30 years or more, you can remain confident that there’s a type of policy that will best serve your family’s needs. Compare quotes from several different carriers here.