Life insurance: because we’re not fortune-tellers

(originally posted March 25, 2012 on my former blog)

Sometimes life is unpredictable.  (whomp, whomp… I know that makes me sound like a depressed person)  My grandma passed away at 91, my aunt passed away unexpectedly at 49 and a friend from graduate school was killed by a drunk driver at age 33.  No one likes to think they won’t be living to 91, but sometimes you need a contingency plan to protect the loved ones you leave behind.  By a strange coincidence, I purchased life insurance earlier this month.  So, this post is intended to give you a quick reference guide on life insurance options.

There are two basic types of life insurance: term and permanent.  A good analogy is that term insurance is like renting and permanent insurance is like owning.  With term life insurance, there is no cash value accrued and coverage is only guaranteed for a set period of time.  With permanent life insurance, cash value is accrued and coverage is guaranteed for your entire life at the same monthly premium.

Term insurance is the least expensive and the premium is usually about $10/month per $100,000 if you’re a young, healthy adult (but gets more expensive as you get older and/or less healthy).  You pay the premium for a set time period that you want coverage.  This is usually good for younger people with limited financial responsibilities/means and parents who want to insure their minor kids are taken care of if something happens to them.  The idea is that you may only temporarily want life insurance because you’ll eventually hit a point in life when the equity in your house or your other savings and assets will eliminate the need for life insurance.

Permanent life insurance is more expensive and premiums vary based on the plan. The most basic benefit is it provides insurance protection and builds up a cash value (savings).  This is a little more detail about the benefits:

  • You can access the cash value by taking a loan against the policy, it can be used as supplemental retirement income, and it can be used as collateral for loans
  • You may get paid dividends if and when the insurance company declares them or you can have the dividends rolled into your cash value.
  • You are guaranteed the benefit for life at your initial premium, whereas term insurance expires and renewing may not be at the same premium rate.  With term insurance, you might not re-qualify for a renewal or it might become very expensive because of age or health.

So, there are a lot of benefits!  That is probably why premiums can be 8-10x more expensive than term insurance when you are a young, healthy adult.

How does permanent life insurance build up cash value?   Part of your premium pays for the insurance and the rest is invested by your insurance company (or, in my case, Northwestern Mutual).  The benefit of this versus saving or investing it yourself is there is usually a guaranteed rate of return.  You can also choose how quickly you want the cash value to accrue, which will be factored into your premiums (the faster you want it to build up, the higher your premium).

There are three basic types of permanent life insurance: whole life insurance, universal life insurance and variable life insurance.  I stole the descriptions of these from the National Association of Insurance Commissioners ‘Life Insurance Buyer’s Guide’:

  • Whole Life Insurance covers you for as long as you live if your premiums are paid. This is the most common form of permanent insurance.  You generally pay the same amount in premiums for as long as you live. When you first take out the policy, premiums can be several times higher than you would pay initially for the same amount of term insurance. But they are smaller than the premiums you would eventually pay if you were to keep renewing a term policy until your later years.  Some whole life policies let you pay premiums for a shorter period such as 20 years, or until age 65. Premiums for these policies are higher since the premium payments are made during a shorter period.
  • Universal Life Insurance is a kind of flexible policy that lets you vary your premium payments. You can also adjust the face amount of your coverage. Increases may require proof that you qualify for the new death benefit. The premiums you pay (less expense charges) go into a policy account that earns interest. Charges are deducted from the account. If your yearly premium payment plus the interest your account earns is less than the charges, your account value will become lower. If it keeps dropping, eventually your coverage will end. To prevent that, you may need to start making premium payments, or increase your premium payments, or lower your death benefits. Even if there is enough in your account to pay the premiums, continuing to pay premiums yourself means that you build up more cash value.
  • Variable Life Insurance is a kind of insurance where the death benefits and cash values n the investment performance of one or more separate accounts, which may be invested in mutual funds or other investments allowed under the policy. Be sure to get the prospectus from the company when buying this kind of policy and STUDY IT CAREFULLY. You will have higher death benefits and cash value if the underlying investments do well. Your benefits and cash value will be lower or may disappear if the investments you chose didn’t do as well as you expected. You may pay an extra premium for a guaranteed death benefit.

Which one is better?  If you don’t have a good retirement savings or already feel financially strapped, term insurance is probably the best option right now so you can focus on increasing (or starting) your 401k and building up a savings.  If you are looking to make more long-term investments in your life, a mix of term and permanent is probably the best.  I have both because I want a little extra protection for when I have kids (and you usually get a discount when you buy them together) and I want to diversify my retirement and savings.  If you’re young, now is definitely the time to investigate your options because you will get a better rate.  Even if it is a small term policy, it is better to have some coverage.  No one likes to think they would need it, but sometimes life can be unpredictable.

Who can you talk to if you want to investigate options further?

  • I know everyone dreads going to them, but talk to a Financial Planner.  They will be able to recommend if it is something you should consider or if you should focus your financial efforts somewhere else.
  • Your car insurance company probably offers term life insurance.  I know State Farm offers it.
  • When I was doing my research for this post, I discovered the Consumer Federation of America will evaluate your permanent policy (if you already have one) to determine if it is worth keeping.

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