Life insurance can be an important tool in your overall financial planning. But what you need and what you need it for can change over the different stages of your life.
Let’s talk about why you may need life insurance, different kinds of life insurance policies, how to figure out how much coverage you may want, and some additional considerations as you look at your options.
Why do I need life insurance?
The most basic part of any life insurance policy is the death benefit. When the policy owner dies, a death benefit is paid to the named beneficiaries of the policy. This could be a spouse, children, grandchildren or others.
You may want to carry a life insurance policy (or multiple policies) to accomplish one or more of the following:
- Protecting your family’s income in the event of your death
- Ensuring that your mortgage, your children’s educational expenses, and other debts are paid off upon your death
- Providing for a special needs child upon your death
- Providing liquidity for your estate upon your death
- Leaving a legacy for a spouse, children or grandchildren
- Leaving money to a charity upon the policy owner’s death
In addition to the death benefit, some types of policies also have a cash value component that can be tapped while the policy owner is alive for a variety of purposes, including withdrawing the cash, reducing policy premiums, or taking a loan against the policy’s cash value.
What type of life insurance policy should I buy?
Life insurance comes in many forms, and you want to make sure you’re carrying the best kind of policy for your needs.
Term policy
A term policy is sometimes referred to as pure life insurance. A term policy offers coverage for a specified length of time, such as 10 years, 20 years, or 30 years. As long as the premiums are paid, the coverage and the death benefit stay intact. When the term ends with the policy holder still living, however, the policy expires with no payout.
Term policies usually offer a larger death benefit than many permanent policies for a lower premium, so they may be a good choice if you only need the payout in a specified time period. When a term policy expires, you may have the option to renew the policy for an additional term, to purchase a new term policy, or to convert the term policy to a permanent life insurance policy.
You can also have multiple term policies, and some people ladder them so that they overlap and expire at different times. One risk of buying a term policy is that your health situation will likely deteriorate while owning the policy. If you need to purchase an additional policy once the term policy expires, the insurance company might charge a much higher-than-normal premium, or possibly deny coverage altogether.
Permanent life insurance
Unlike term policies, permanent life insurance policies have no expiration date; so long as the premiums are paid, the policy stays in effect. They do, however, come in two related but distinct flavors.
In a whole life insurance policy, the death benefit and the premium will remain the same over time, and the policy will remain in force as long as the premiums are paid. The policy builds cash value each year at a guaranteed interest rate, and this cash can be used to pay some or all of the future premiums, or can be borrowed by the policy owner. In that case, the death benefit will be reduced by any outstanding loan amount, and the loan will incur interest.
Universal life insurance policies allow more flexibility on premium payments, but the cash value growth is based on market movements, making them less predictable. For example, indexed universal life insurance generally ties the interest rate on the cash value to an index like the S&P 500, or another type of index. Similarly, variable universal life insurance allows the policy owner to invest the cash value in a separate account. These policies can be designed with a flexible premium, and a level or increasing death benefit.
How large of a death benefit do I need?
Determining what kind of a death benefit you need will depend on factors like your stage of life and the kinds of financial goals life insurance is fulfilling for you.
Start with this question: What happens to your family from a financial standpoint in the event of your death? If you’re still working, your family might need the death benefit to cover ongoing expenses that were previously covered by your salary. If you’re older or experiencing a long illness, the death benefit might be needed to cover unreimbursed medical expenses. What amount would cover your family’s needs?
The death benefit can also be used to ensure that you pass on funds to your heirs. In addition to covering your family’s needs, what extra amount would you want available to distribute to your loved ones?
It’s important to note that you can’t necessarily buy any amount of life insurance you want, especially not at a price you want. Insurance companies use underwriting to determine how much coverage they’ll offer, based on your specific circumstances. But it’s also not unheard-of for brokers to offer more than you need, so knowing what amount would be ideal for your needs can help you find the best available solution.
Buying life insurance
As you’re investigating buying life insurance, you’ll want to think through the cost, the stability of the issuing company, and how the policy is owned.
Balancing cost and benefit
The cost or premium of a life insurance policy is determined by a number of factors. These include:
- Age of the policy owner. The younger you are, the longer you’re likely to live. The longer you live, the longer the insurance company has to collect premiums before they have to pay out a death benefit. In the case of a term policy, a younger policy owner could conceivably outlive the term of the policy.
- Health of the policy owner. In most cases, the prospective buyer will be subject to a medical exam before they can purchase the policy. The results of the exam will be considered in setting the premium price. The better the applicant’s health, the better the price will be when considered among other factors. In some cases, the results of the medical exam may cause the insurance company to reject the applicant altogether, or to limit the amount of the death benefit they can purchase.
- Gender of the applicant. Women on average live several years longer than men and, all else being equal, women will pay a lower premium than men for the same policy type and death benefit amount.
- Does the applicant smoke? If the insurance company classifies you as a smoker, your premiums will be considerably higher than for a non-smoker. The difference could be twice as much.
- Lifestyle or occupation. Those who engage in relatively risky behaviors such as rock climbing, scuba diving, auto racing, and others will generally pay a higher premium, as will people in dangerous professions such as law enforcement, firefighting, mining, or many others. The insurance company may also issue a rider or exclusion depending on the activity or avocation.
- Family medical history. If your family medical history is filled with relatives who have suffered strokes, heart attacks, cancer and others, this will generally drive up the cost of coverage.
- Size of the death benefit. The higher the eventual payout, the higher the premiums will be.
As you’re considering policies, you’ll want to balance the cost of the premiums with the overall benefit to you and to your family.
The financial health of the insurance company
Ideally, you’ll hold your life insurance policy for decades. That means you need the company you purchase the policy from to be around decades from now to pay out the death benefit.
That’s why it’s important to check out the financial health and financial health ratings of the life insurance company before you purchase a policy. While the state insurance commissioner may offer some protection against an insurer who goes bankrupt, chances are the death benefits won’t be paid in full.
Owning the policy
There are (at least) three people involved in a life insurance policy besides the life insurance company: the person insured, the person who owns the policy, and the beneficiary or beneficiaries of the policy.
Often, the insured will also be the owner of the policy, and thus responsible for the premiums.
The policy may also be owned by someone other than the insured. For example, a spouse may take out a life insurance policy on their partner, paying the premiums and receiving the benefits when that spouse dies.
A policy may also be owned by a trust. This might be part of an overall estate planning arrangement designed to ensure that assets are passed properly to beneficiaries and that taxes are minimized.
A good tool for your toolbox
Life insurance can be a versatile and important tool for your financial and estate planning. But that doesn’t mean you need to purchase the maximum available policy, despite what a broker might tell you. Focus instead of figuring out what benefit you and your family need, what you can afford, and what kind of policy will best serve your needs.
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