Finding the middle ground between being “insurance poor” and unprotected requires assessing real needs and choosing products that are affordable. This article introduces different types of insurance products and the role that they can play in a personal financial plan.
Death is one of things that no one likes to talk about. Yet, protecting loved ones from the financial consequences of death is one step you can take to gain peace of mind for you and your loved ones. And this is where life insurance enters the picture.
If you have a family or spouse who depend on you for financial support, or if you work at home providing your family with such services as child care, cooking, and cleaning, then you need life insurance. Older couples also may need life insurance to protect a surviving spouse against the possibility of the couple’s retirement savings being depleted by unexpected medical expenses. And individuals with substantial assets may need life insurance to help reduce the effects of estate taxes or to transfer wealth to future generations.
Determining what type of insurance depends on your goals, while deciding on an appropriate amount of coverage requires an assessment of your needs. Some approaches use a formula based on your income, while others factor in future liabilities, such as mortgage debt, college expenses, and estate taxes. The bottom line is quite simple: Don’t go it alone. Enlist the services of a qualified life insurance professional to help you determine the type and scope of coverage that best suits your financial objectives.
Conventional wisdom says that life insurance is sold, not purchased. In other words, some people are reluctant to discuss the importance of owning life insurance, and others are simply unaware of the need to have life insurance. Although many large companies provide life insurance as part of their benefits package, this coverage may be insufficient.
Who needs life insurance? If there are individuals who depend on you for financial support, or if you work at home providing your family with such services as child care, cooking, and cleaning, you need life insurance. Older couples also may need life insurance to protect a surviving spouse against the possibility of the couple’s retirement savings being depleted by unexpected medical expenses. And individuals with substantial assets may need life insurance to help reduce the effects of estate taxes or to transfer wealth to future generations.
Types of Insurance
Term insurance is the most basic, and generally least expensive, form of life insurance for people under age 50. A term policy is written for a specific period of time, typically 1 to 10 years, and may be renewable at the end of each term. Also, the premiums increase at the end of each term and can become prohibitively expensive for older individuals. A level term policy locks in the annual premium for periods of up to 30 years.
Declining Balance Term insurance, a variation on this theme, is often used as mortgage insurance since it can be written to match the amortization of your mortgage principal. While the premium stays constant over the term, the face value steadily declines. Once the mortgage is paid off, the insurance is no longer needed and the policy expires. Unlike many other policies, term insurance has no cash value. In this sense, it is “pure” insurance without any investment options. Benefits are paid only if you die during the policy’s term. After the term ends, your coverage expires unless you choose to renew the policy. When buying term insurance, you might look for a policy that is renewable up to age 70 and convertible to permanent insurance without a medical exam.
Whole Life combines permanent protection with a savings component. As long as you continue to pay the premiums, you are able to lock in coverage at a level premium rate. Part of that premium accrues as cash value. As the policy gains value, you may be able to borrow up to 90% of your policy’s cash value tax-free, although loans reduce the policy’s death benefit and cash value, and may trigger a taxable event if the policy lapses.
Universal Life is similar to whole life with the added benefit of potentially higher earnings on the savings component. Universal life policies are also highly flexible in regard to premiums and face value. Premiums can be increased, decreased or deferred, and cash values can be withdrawn. You may also have the option to change face values. Universal life policies typically offer a guaranteed return on cash value. You’ll receive an annual statement that details cash value, total protection, earnings, and fees.
Drawbacks to this type of insurance include higher fees and interest rate sensitivity. Universal policies include up-front fees as well as ongoing administrative fees totaling as high as 5% to 7% of your premiums. You may also find your premiums increasing when interest rates decline.
Variable Life generally offers fixed premiums and control over your policy’s cash value. Your cash value is invested in your choice of stock, bond, or money market funding options.1 Cash values and death benefits can rise and fall based on the performance of your investment choices. Although death benefits usually have a floor, there is no guarantee on cash values. Fees for these policies may be higher than for universal life, and investment options can be volatile. On the plus side, capital gains and other investment earnings accrue tax deferred as long as the funds remain invested in the insurance contract.
Universal Variable Life insurance is the most aggressive type of policy. Like variable life, you can choose from a variety of investment options. However, there are no guarantees on universal variable policies beyond the original face value death benefit. These policies are probably best suited to affluent buyers who can afford the risks involved.
|Key Terms and Definitions|
|Face Value — The original death benefit amount.
Convertibility — Option to convert from one type of policy (term) to another (whole life), usually without a physical examination.
Cash Value — The savings portion of a policy that can be borrowed against or cashed in.
Premiums — Monthly, quarterly, or yearly payments required to maintain coverage.
Beneficiary — The individual(s) or entity (e.g., trust) that is designated as benefit recipient.
Paid Up — A policy requiring no further premium payments due to prepayment or earnings.
How Much Insurance Do I Need?
A popular approach to buying insurance is based on income replacement. In this approach, a formula of between five and ten times your annual salary is often used to calculate how much coverage you need. Another approach is to purchase insurance based on your individual needs and preferences. The first step is to determine your unique income replacement needs.
Currently, a large portion of your income goes to taxes (insurance benefits are generally income tax free) and to support your own lifestyle. Start off by determining your net earnings after taxes. Then add up all your personal expenses such as housing, health care, food, clothing, transportation expenses, etc. This represents the amount that your insurance will need to replace. You’ll want a death benefit amount which, when invested, will provide income annually to cover this amount. Then, you should add to that the amounts needed to fund one-time expenses such as college tuition for your children or paying down mortgage or debt.
Income replacement for nonworking spouses is an important and often overlooked insurance need. Coverage should provide for your costs for day care, housekeeping, or nursing care. Add to this any net earnings from part-time employment.
Finally, estimate your own “final expenses” such as estate taxes, uninsured medical costs, and funeral costs.
Other Types of Life Insurance
Survivorship life insurance (also referred to as last-to-die or second-to-die) is a unique type of contract that insures the lives of two people. It pays a death benefit upon the death of the second insured. Therefore, it is typically less expensive than two individual policies. Survivorship life is often used for estate planning, where it may be possible to potentially leverage today’s dollars — via insurance premiums — into a potentially significant death benefit that can be used to fund estate taxes, create wealth for future generations, or benefit a charity. These policies may be available if one insured is medically “uninsurable.”
First-to-die life insurance insures the life of at least two people and pays a benefit upon the death of the first insured. This policy is useful for covering a mortgage or other large debt obligation where there is more than one debtor. In addition, it can be an ideal tool for funding a buy-sell agreement within a closely held business.
Life insurance is an important component of a sound financial plan. Buying insurance involves asking a variety of personal lifestyle and financial questions. If you are not already working with an insurance professional, you may want to consider the advice of a fee-for-service financial planner who can offer you an objective review of your insurance options. When you decide on what you want, there are many insurance companies to choose from. Consult your library or an independent insurance professional for companies with the highest ratings from the four ratings agencies: AM Best, Duff Phelps, Standard & Poor’s, and Moody’s.
Points to Remember
- Term insurance is basic, inexpensive coverage that does not accumulate cash value. Policies with very long terms offer stable premiums, but policies that require periodic renewal feature premiums that may increase over time to maintain coverage.
- Consider a term policy that is renewable and convertible to whole life should your needs change.
- Whole life provides level coverage with level premiums. A portion of those premiums goes into tax-deferred savings.
- Variable life offers control over your investments.
- Premiums on variable policies are fixed, but face value and the value of your investments can fluctuate.
- Universal life is highly flexible, but is sensitive to interest rate changes. Universal variable life offers more investment options but fewer guarantees.
- Insurance needs are based on income replacement and personal preferences.
1An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.
© 2012 McGraw-Hill Financial Communications. All rights reserved.
February 2012 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by D3 Financial Counselors, a local member of FPA.