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Life Insurance - The Basics

Life Insurance - The Basics

July 12, 2021

Are you considering life insurance for the first time?  Then it’s good to start with the basics.  I’m going to take a quick dive into the fundamentals of life insurance and some of the common questions I’m asked. 

In this article, I will address:

  1.       Do you actually need life insurance?
  2.       How much life insurance do you need?
  3.       What is Term Life vs Permanent Life?
  4.       What is most important when choosing a policy?
  5.       Why should you talk to a professional?

Do you need life insurance? 

Here are a few questions to ask yourself:

  • Does anyone depend on my income to survive?
  • Would my death create a financial hardship for anyone?
  • Do I have enough liquid assets to cover my final expenses (funeral)?
  • Do I need to improve the liquidity of my estate?
  • Do you own a business?

If you answered yes to any of these, then you probably need life insurance.

How much life insurance do you need?

This will depend on which of the above questions you answered ‘yes’ to.  If someone depends on your income, or there would be a financial hardship if you passed, or even considering your final expenses, then there is a simple acronym that will help: D.I.M.E.S 

  • Debt – Add up your debt, including credit cards, car loans, student loans, but not your mortgage, since that is included as a separate item on this list
  • Income – A good rule of thumb is to calculate 10 years of your current annual income
  • Mortgage – Your current mortgage balance
  • Education – Any expected education expenses for your children or dependents
  • Services- According to your final wishes, how much would your funeral arrangements cost?

The total of these numbers should be the Face Amount of the policy. The Face Amount is the total dollar amount that would be paid to your beneficiaries if you were to pass. 

If you are looking for liquidity in your estate, or you are a business owner, then you should consult an Advisor. Many factors go into these calculations, and life insurance may or may not be the best fit for what you are hoping to achieve.

What is Term Life vs Permanent Life? 

Term life insurance guarantees the coverage and the premium for a set period of years, usually between 10 to 30 years. This means you will have the same payment every month (or year depending on your payment plan) until the term ends. The longer the term, the higher the premium. Once the term ends, the rate will increase based on your age and initial underwriting classification. 

The low cost of shorter-term policies makes them very popular. However, if you choose a policy with a shorter term, there are a few risks you should be aware of. If you still need life insurance after the term ends, you will only have a few options. First, you can apply for a new policy but will be subject to new underwriting and run the possibility of being denied.  Second, you could keep paying on your current policy but at dramatically increased rates that will increase every year. Third, you may be able to convert the term policy to a permanent policy, but this too will have a large premium increase. 

Term insurance is most commonly used when insurance is needed for a specific time (to cover your 30-year mortgage, for example), and/or when a large amount of insurance is needed on a limited budget.

Permanent Life insurance is designed to last until you die. Your premium payments are split into two buckets. One bucket purchases life insurance at a predetermined rate based on your age. The second bucket builds a cash value for the policy based on which type of permanent policy you chose. The cost of insurance is usually low to start, so more money will go into the cash value.  As you age, the cost of insurance will increase. Eventually, the cost of insurance may even be more than the monthly premium, and money will be taken from the cash value of the policy to fund the difference. If at any point you do not have enough to pay the cost of insurance, either from new premium payments or from the cash value already accrued, the policy will lapse. There are many different types of permanent life insurance policies that all offer different payment structures and different returns on the cash value in the policy. Permanent insurance is most commonly used for needs that will last until you die. These policies also have several advantages that may include tax-deferred growth of the cash value, and the ability to borrow against the value of the policy.

What is most important when choosing a policy?

Now that you know your Face Amount need, it is time to compare different policies and policy types. Your budget will be the biggest factor in determining which policy makes the most sense for you.  Here is how I rank policy choices and considerations from most important to least:

Face Amount – This should be at least as high as your D.I.M.E.S total.  This is the most important factor in determining life insurance. You should alter all other policy          factors before you reduce the face amount.

 Policy Term – How long will you have the need?  You can safely assume that increasing the term will increase your premium. If there are budget constraints, you should choose a shorter-term before reducing the face amount. Also, as you think through your D.I.M.E.S numbers, you will see that you probably won’t have the same needs forever.  A family with young children that just purchased a new home may have needs that will extend at least 20 years for education expenses and 30 years for a mortgage.  A couple that no longer has children in the home and a small balance on their mortgage may only need insurance for another 10 years. It is ok to consider a combination of policies to cover your needs and stay within your budget.

Multiple policies and Breakpoints -  As you consider going with one large policy, or multiple smaller policies to cover specific terms, you should ask if there are pricing breakpoints for the policies you are considering.  For example, a policy that is over $1,000,000, may have a lower premium than 2 policies for $500,000 each. It is also very common for families to consider policies of various terms. For example, a family may choose to purchase a 30-year policy to pay off debt and replace income; and also purchase a 10-year policy to cover education expenses.

Investment and Tax-Deferred Growth - Warning: This should be the last item that is considered. You should know that there are large commissions that are paid with life insurance purchases, and those commissions are based on the premium of the policy. If you are considering using life insurance as an investment vehicle, you should make sure that ALL other options for you to invest on a tax-deferred basis are considered and presented to you. I also recommend you receive a second opinion if someone is (what?)

Why should you talk to a professional?

There are a lot of options that go along with life insurance.  As you look into purchasing a policy, you will be confronted with various additional options, called ‘riders’. These can range from having the policy pay its face amount early in the event you are diagnosed with a terminal illness, to making the premium payments for you in the event of a disability or injury. These may or may not be coverages you want or need, and they all come at an extra charge. When you consider that life insurance is most likely going to be a 10 year plus commitment, it is a good idea to have a professional who will help you compare policies and benefits.