There are many types of life insurance, and researching them can make your head spin. This is an industry with lots of choices, and lots of salespeople. Let’s dig a little deeper and check out all the choices.
Why Life Insurance?
In my opinion, life insurance should not be used to make your family inordinately wealthy in the case of your death. It should also not be used as an investment vehicle while you’re alive. Life insurance should be used to:
- finish paying your home mortgage or car loan.
- pay funeral costs or medical bills that might have incurred if you were sick.
- pay for child care so your spouse can continue to work.
- pay for your child’s education.
In a nutshell, Life Insurance should be used to protect your family in the event that you, your spouse, or both of you, pass on. It’s as simple as that. Again, just my opinion.
Types of Life Insurance
I did a lot of research before settling on a term life insurance policy. I asked a lot of questions, and met with a few financial advisers, to make sure I was doing the right thing for my family. There are a number of different types of life insurance you can purchase: Term, Whole, Variable, Universal, and Universal Variable… the choices can actually drive you insane.
To make it easier to understand, I divided them into three groups:
Term life is pure life insurance with no cash value account. It is also the simplest and least expensive type because your premiums are the same for the life of the policy. This type of policy only has one function: to pay a specific lump sum, to whomever you’ve designated, upon your death. The policy limit and death benefit are the same; a 20 year $500,000 policy pays a $500,000 death benefit for the next 20 years. If the insured passes away one day after the policy is activated, or anytime within the length of that policy (eg 20 years for a 20 year policy), the death benefit is the same.
The book “Bogleheads Guide to Investing” recommends the following:
Buy the longest period that you can afford and need. Make sure the policy is guaranteed renewable, meaning that you will be able to purchase future coverage regardless of your health.
Similar to Term life is Whole life insurance. Instead of purchasing for a set period of time (a “term”), you purchase the policy to cover your “whole life” and your premiums also remain the same throughout the life of the policy. However, unlike Term, this is not pure life insurance; the company will invest a portion of your premiums. Some of them share investment proceeds with you in the form of a dividend or will offer you a relatively low guaranteed rate of return.
A portion of your payments go to a policy’s “cash value”, and that is the main selling point of Whole Life. This is different than the policy’s death benefit. The cash value of your policy can be withdrawn, borrowed or you can cancel your policy and collect the cash value. Remember that canceling a policy usually includes a surrender fee.
Variable, Universal, and Universal Variable
Variable, Universal, and Universal Variable provide both a death benefit and a cash value account; that’s why they are sometimes called “cash value policies”. They are more expensive than Term Life because they fund a savings account in addition to buying insurance. This savings account is similar to a mutual fund and includes various investments. As the investments grow, so does. your cash value. If the investments drop, well, so does your cash value.
Which should I choose?
I think there are three main factors to buying life insurance:
If cost is an issue, then Term Life is the easy choice. It’s by far the cheapest option.
Whole, Variable, Universal, and Universal Variable life insurance are expensive. They can be over 6x the cost of Term Life. While you’re young that might not be a problem, but as you get older it can be more difficult to afford if you’re living on a fixed income.
Length of Coverage
Depending on the reason you’re buying life insurance will determine the length of coverage you will need. Most people purchase life insurance to protect their family financially in case of death, not to make them rich. If you have children, you’ll want coverage until they are at least financially dependent. Your mortgage is a big expense, so make sure you have enough coverage to last the length of your loan and have enough to pay it off. This would also apply to any other loans you’ve taken out or cosigned.
Mixing Insurance With Investments
Do you want to mix your insurance with your investments? With the exception of Term, the other types of insurance all have an investment portion to the policy.
These investments are not as flexible as you might like. Expenses ratios can be high, which will eat away at your returns. [link: investment fees]. Investing the difference in an Index Fund[link: index funds] will probably be a better investment.
What Company Should I Choose?
There are a lot of insurance companies out there, so how do you choose? The most important part of choosing a company is making sure they are financially stable. The worst thing that can happen is the insurance company going out of business when you need to make a claim. There are three companies that provide ratings, A.M. Best, Fitch, Kroll Bond Rating Agency (KBRA), Moody’s and Standard & Poor’s. The tricky part is that each company uses it’s own ratings system, and they often disagree with each other. It might be best to research ratings from two or more companies before you commit to buying a policy. Many of these ratings agencies provide free reports, but you will need to create an account and log in.
Once you have loved ones that depend on you, life insurance is an important step for their financial security.