Saturday, July 26, 2008

Purchasing life insurance

Now that you have given some thought to why you need life insurance, you are ready to figure out exactly how much you need and comparison shop for the best price.

There are three components to calculating the dollar amount of insurance that you need.
  1. Any lump sum amount.  For example, $150,000 to pay off the remaining balance on your mortgage.
  2. Any income that you will need for a specific period of time.  For example, $12,000 annually  for a period of five years to pay for childcare.
  3. Any income that you will need indefinitely.  For example, $20,000 annually to replace lost income.
It's not hard to turn these numbers into a specific dollar amount. The first category is by definition a dollar amount.  In order to calculate the dollar amount of insurance needed for the second category, simply multiply the dollar amount needed annually by the number of years needed.  In our above example, that would be $60,000.  For the third category, multiple the annual need by 20.  If you have 20 times the amount of annual income you need, you should be able to invest it so that it will produce the income you need indefinitely.  I will tell you how to do this in a later post.  In this example, $400,000 of life insurance would meet the needs in category three.  Therefore, the person in the example would need a total of $610,000 of life insurance to meet her family's needs.

The next step is to figure out what kind of insurance to get.  There are two basic categories: term insurance, which is temporary, and permanent insurance such as whole life or variable universal life.  This is an easy decision.  Buy term.  Here's why:

Whole life and variable universal life insurance policies never expire.  As long as you keep paying the premiums, the policy will stay in force, and when you die, your beneficiary will receive the proceeds.  In addition, these policies have a complicated investment component wrapped up inside the life insurance policy.  This means that some of the money you pay as premiums is invested on your behalf as a part of the life insurance policy.  Should you choose to cancel that policy, you will be able to turn the money in that investment into a stream of income if you choose.

Term life insurance is much more straight forward.  A term policy will cover you for a specific period of time, or term -- usually, 10, 20, or 30 years.  The premiums are much cheaper than premiums for a permanent policy.  If you die while the policy is in force, your beneficiaries will receive the proceeds.  If you live past the end of the term (which is a good thing - you're still alive, after all) or stop paying the premiums, the policy ends with no payout.

Term is almost always the best option because it is cheaper and it is simpler.  Once of my rules of thumb for financial planning is that simpler is almost always better.  If you need insurance, buy insurance.  If you need to invest, invest.  For most people, there is no real benefit to the added investment component of a permanent policy.  Most people would be better off buying the cheaper term policy and investing the difference in a dedicated investment account.

When financial products are complicated, the seller of the product usually comes out ahead.  When I was a financial advisor, I knew of some permanent life insurance policies that paid 50% of the first year's premiums to the salesperson as a commission.  If the commissions are that generous, do you really think that the product is always a good deal for the client?  I don't.

If you buy term insurance you will need to decide how long of a term you need.  If there is a specific event in your future that you think will reduce your need for life insurance - retirement, a spouse returning to work, or kids moving out of the house for example - choose a term long enough to last through that transition.

The internet is a great place to shop for life insurance.  For the most part, term insurance is term insurance.  All you need to do is price shop.  Sites like www.intelliquote.com are a great place to start.

Insurance policies are technical and can be complicated.  This post only covers the basics.  If you want to learn more, there are plenty of great resources out there, including this one from CNN Money: Money 101 - Life Insurance

1 comment:

Rachel said...

"Once of my rules of thumb for financial planning is that simpler is almost always better."
I couldn't agree more! Especially regarding having multiple accounts or choosing life insurance. Excellent points.