Stop Not Understanding Life Insurance: The Definitive Guide

Do I need life insurance?

Stop Not Understanding Life Insurance The Definitive Guide .png

Imagine a room full of people running the odds on how long a stranger will live or die and then making bets on those odds. It could sound like an interesting scene in a movie, where questionable characters indulge in some casual underground gambling, but what I’m actually describing is a room full of underwriters in the life insurance industry.

When you look at it that way, doesn’t the insurance industry sound fascinating? It’s one of the biggest industries in the world and it’s all based on risks and making bets. 

There are very few products you purchase that are like life insurance. When you try to purchase it, you have to fill out an application. You don’t know what the price will be. They might ask you for a medical exam where a company will analyze your bodily fluids; then someone sitting in an underwriting office determines whether or not the insurance company will even offer you insurance. What other shopping process is like this? It’s so weird.

Now that I’ve got you excited, let’s dig into the burning questions about life insurance that keep you up at night.

Who Needs Life Insurance?

A life insurance is policy is used to replace the salary of a loved one when they pass away. If you have anyone in your life depending on your support, like a spouse or a litter of children or adult parents, you probably need life insurance. Especially if you have a mortgage, privately held student loans or other kinds of debts that your loved ones will become responsible for in your stead. 

Even if you don’t earn any income, if you’re the main caretaker for your children, you still may consider a policy to cover childcare expenses in your absence.

Life insurance brings peace of mind knowing that your family will be cared for if you can’t be there. 

What Impacts the Cost of Life Insurance?

Age, gender, health, occupation, residence and the type of insurance all impact the cost. 

A younger person applying for life insurance will have a lower cost than an older applicant. Women have longer life expectancies, so the average cost for women tends to be lower than for men. Your overall health and family history will have a significant impact on how much your insurance policy will cost. If you’ve had cancer or have a family history of life-threating illnesses, your premiums will reflect that. Your job impacts your premiums. Someone who sits at a desk all day will pay lower premiums than a stunt person. Where you live impacts your costs, just like car insurance. And the type of life insurance policy has a drastic impact on the cost of your coverage.

There’s more than one type of life insurance, but let’s first talk about term insurance.

There are many types of life insurance and it can be confusing to navigate, but the good news is, for the majority of people, term life insurance is the way to go. This type of life insurance gets its name because of how it works.

The premium (the amount you pay to the insurance company for the policy) is fixed for a certain term. The typical flavors of term insurance are 5, 10, 20 and 30 years. So, for 20 years, you pay the same, fixed premium every year. You can pay it all in one fell swoop or you can set up monthly or quarterly payments. If you kick the bucket within the term period, the insurance company will pay a predetermined amount (you determine this amount when you apply) to your beneficiary. You name your beneficiary or beneficiaries during the application process, but you can still change it once the policy is placed.

If you’re still alive and kicking when the policy expires, you outlive the policy and the insurance company wins the bet and they keep your money. Simple, right?

Term is the most popular kid at school because it’s the simplest and cheapest way to meet your life insurance needs. It’s the bucket-of-chicken deal. It gets the job done and it’s the most bang for your buck. Really though, the most important thing it will give you is knowing that your loved ones will not become destitute if you prematurely bite the dust.

So what about the other types of life insurance?

Yes, there are other types of life insurance. One common type is our dude, whole life insurance. Other types include, but are not limited to universal, permanent and variable life insurance.

These policies are permanent. This means as long as you pay your premiums, you’ll have coverage. Unlike term, they never expire and you’re always covered. As long as you have coverage and you’re paying your premiums, your beneficiaries will have a benefit when you croak - even if you’re super old and wrinkly. You might feel better always having coverage, but naturally, it’s going to cost more.

These policies also have a cash value component. You can borrow or draw this money from the policy while you’re still alive. There may also be a retirement component to these insurance policies.

I know, I know. Whole life insurance is it tempting because it sounds like there are all these fancy things and term insurance is the basic bitch of the life insurance world. But here are a few things to consider.

  1. Most of the time insurance is a tool for preventing loss and not a tool for gain.

  2. Most people don’t need whole life insurance; you need to have the right circumstances in order for it to make sense. Whole life premiums are crazy-expensive compared to term and these policies usually come with high fees that take big chomps out of your returns. According to the Society of Actuaries (SOA), premiums for whole life insurance can be 5 to 10 times higher than the same amount of term life insurance.

  3. A lot of insurance salesmen (who sometimes call themselves financial advisors, wealth managers, etc.) get paid a higher commission for selling whole life insurance over term insurance. So I’m not saying your friend who used to be an actor who now works for Northwestern Mutual or TransAmerica Advisors is a bad guy, I’m just saying that when your only tool is a hammer, everything looks like a nail. Read: When all you have to sell are life insurance policies, surely everyone needs life insurance.

So is whole life worth it?

It depends on each person’s unique snowflake of circumstances. In general, financial advisors will recommend whole life insurance policies for resource-rich people who are already putting the maximum amount of money they can into tax-sheltered savings accounts (i.e. retirement savings accounts, kids college savings accounts, health savings accounts, etc.). So if you’re one of those people, flush with cash, but still maxing out contributions to those accounts, you may consider adding a permanent insurance policy to your strategy.

And for some folks, it makes sense to use whole life insurance for estate planning. So if you suspect you need this because of all the sacks of money you have crowding you and your minimalist lifestyle, it’s best to consult with a financial planner.

I did tell you that term life insurance is ultimately more bang for your buck. If you don’t believe me, we’re going to do some examples with math. Trigger warning. Math ahead.

Let’s take Sally. She’s a 30-year old woman living in sunny California. She’s recently married so she’s applying for a $250,000, 30-year term policy. Her health is pretty good. She gets approved for the following policies: 

  • A 30-year term policy for $250,000 that will cost her $21/month (or $252 a year) , and 

  • A $250,000 whole life policy for will cost her roughly $287/month (or $3,440 per year).

The price difference is pretty considerable. Whole life costs $3,188 per year more than term. So while the whole life policy will costs more, after having the policy for 20 years, Sally can expect the cash value in the whole life policy to have an average rate of return of 4.6%. But that’s only after the first 19 years of less-than-average returns. According to James Hunt of the Consumer Federation of America, in the first 5 years, your return is negative at -10.7%. Then in years 6-10, it bumps up to 2%. And then up to 3.7% for 11 - 15 years. It’s very much a long-term strategy.

Here’s an alternative: You buy the term policy and you could invest the difference that you would pay for your whole life premium. If your return on that investment is greater than 4.6% after taxes, then you can, in effect, generate the “same” or better returns than buying a whole life policy. 

Obviously, you’d have to set up your investment account, separately, fund it separately and choose your investment allocation separately. Don’t be afraid of this though, technology is amazing and companies like Betterment, Wealth Front and Personal Capital make it crazy easy.

Permanent policies are more complicated in general. If and when you pull cash out of the policy, you may be subjected to paying taxes. It depends on the cash value, how much you’re withdrawing and how much you’ve paid in. Loans you take against the cash value could be taxed if you lapse or surrender the policy before you finish paying back the loan. 

Ultimately, your decision depends on what you’re trying to accomplish and what your financial goals are. If you just need term for a set number of years, like until your kid graduates from college, then pure, term insurance offers excellent protection. If you’re creating an estate or you want to make sure that your beneficiaries will receive a benefit regardless of when you die, you may consider adding whole life insurance to your financial plan.

Take the time to understand your options. Bank Rate has this niffty little questionnaire to help you determine if term or permanent is right for you.

How do you find a broker?

Insurance is a commodity and a heavily regulated industry. Brokers are going to have access the insurance products that are relatively the same and for identical products, and everyone has to charge the same amount. So you can buy a policy from your grandfather’s broker or shop online with Ladder Life or Policy Genius, and the prices and offers are not going to vary by much; if at all.

I would recommend doing your research first, so you don’t get bamboozled by someone trying to sell you something you don’t understand. Also, a good rule to live by is “Don’t buy anything you don’t understand.” If someone is trying to sell you a financial product, like life insurance or a mutual fund, they should know the product so well that they can explain it to you clearly enough that you understand what your’e buying. If not, don’t buy it from them because maybe they don’t fully understand the product. And if they don’t fully understand the product, there might be some crap in fine print that you could miss.

How much insurance do you need? 

Many roads lead to the same destination. In other words, there are different ways to calculate how much insurance you need. One simple rule of thumb is seven to 10 times your annual salary.

In my financial planning days, we used a different calculation. We would recommend $1 million in term coverage for every $50,000 of income being replaced. So, if you make $100,000, you’d need a $2 million policy. This is a bit of a maximalist approach and it has a major assumption. The major assumption is that you can and will invest the insurance benefit and you can and will generate a 5% return on the investment. The returns are what you’ll use to replace your loved ones income. A $2 million benefit, will be invested in the market and will generate a 5% return of $100,000. It’s a maximalist approach because you leave the principal benefit (the $2 million) untouched, in theory. And you can figure out how you’ll spend or save or invest or pass on that principal balance to your heirs.

If all of that sounds confusing, there’s no shortage of calculators to help you figure this out. Here are a few:

How long will the application process take? What’s it like? Is there really a medical exam?

It can be as short as less than an hour to a couple of months.

When my wife and I applied using Ladder Life, we were insured in 15 minutes. Maybe less. It was simple to do online. As mind-numbing as any form is.

It would take months if you use a more traditional application process, there were lots of underwriting requirements, like ordering your medical records and having you take a medical exam. 

What if I can’t afford a policy for the amount that the calculator told me I need?

Get some insurance. Get what you can afford. It’s better than not having any coverage at all or over extending yourself with a policy you can’t afford, then lapsing on it and losing coverage. 

A few other pro tips

Don’t miss a payment! If you miss a payment, you coverage will lapse. That means you’ll lose coverage and you’ll have to reapply to get it back. And since you’re getting older everyday, your premiums might go up when you re-apply.

There are a few loopholes to know about. There is something called the Contestability period and a suicide clause. The contestability period is the two years after you get the policy. If you die within that period, the insurance company can investigate the claim and deny coverage. The suicide clause states that if you commit suicide within the first two years of the policy, the insurance company will not pay the claim. After the two years, the policy will pay out, even if the cause of death is suicide. 

Don’t lie on your application. Smoking one cigarette in the last-twelve months and not reporting it in your application is a little different than omitting your half-a-pack-a-day habit. Either way, please don’t lie on your application so that your premiums will be lower. It’s fraud, yo. The insurance company could investigate your claim and if they can prove you lied, that can impact whether or not your family receives the death benefit. Be honest so you don’t make things difficult for your family. 

You need a policy for as long as you have dependents. This can be hard to predict because you could have adult children or aging parents who you help support. 

Consider a life insurance trust if you have minor children or you’re wealthy. Insurance companies may not pay out the death benefit to minor children. But you can set up a life insurance trust and the appointed trustee can disburse the money to the children right away. 

A life insurance trust is also a great tool for those folks who are wealthy, like their estate is worth $10 million or more. Talk to an estate planning attorney who can explain the benefits of keeping a life insurance benefit in a trust and out of your taxable state.