Life insurance is meant to protect a person’s family from the financial consequences of the insured person’s premature death. The traditional purpose of life insurance is to provide beneficiaries with a lump-sum cash payment, known as a death benefit, upon the policyholder’s death. These days, however, life insurance is also often used to create a tax-advantaged estate for the policyholder’s survivors, regardless of whether his or her death occurs unexpectedly or prematurely.
Types of Life Insurance
There are two main types of life insurance: term and permanent (also known as cash value insurance).
Term Life Insurance
Term life insurance provides a death benefit, but only for a specific term, or period of time. If you die within the term, the policy pays out the death benefit to your beneficiaries. If you survive the term, you must reapply to continue coverage. Term life insurance is based upon the presumption that you’ll die before you have significant assets to pass on to your beneficiaries: it gives you the security of knowing that your beneficiaries will have money to live on if you die prematurely, before you’ve built up significant wealth. There are three types of term life insurance:
- Annual renewable term: Annual renewable term policies have premiums that rise as you age (and the likelihood that you’ll die increases). The monthly premium amount typically resets to a higher number at the end of each calendar year, though most policies include a maximum premium amount. Most provide coverage until the policyholder turns 70.
- Fixed-rate level term: These policies allow you to lock in a premium price for a set term, such as 10 or 20 years. At the end of the term, you typically don’t need to be reevaluated in order to renew your policy, but your premiums will increase based on your age.
- Decreasing term: These policies have premiums that stay the same throughout the life of the policy but coverage amounts that decrease annually. This pattern fits well with the decreasing need for insurance coverage as your wealth builds as you age.
Permanent Life Insurance
Permanent life insurance is the only type of life insurance that has no specified term and provides guaranteed coverage until death. Permanent policies also differ from term policies by adding an investing component—some policies allow the policyholder to receive annual cash dividends or invest the death benefit in order to grow its value. There are three main types of permanent life insurance:
- Whole: Whole life policies require the policyholder to pay a fixed monthly premium throughout the life of the policy. The policies’ return rates (the amount of annual dividend payments) are also fixed—usually at just 3–4%. Whole life insurance is the safest, most predictable type of life insurance: policyholders always know how much they’ll pay in premiums and how much their loved ones will receive when the policyholder dies. These policies have one main drawback: the death benefit amount cannot be changed.
- Universal: Universal life insurance policyholders can change the death benefit amount at any time, lower or suspend premiums during hard times, or pay more toward premiums when return rates are high (as determined by overall trends in interest rates).
- Variable: Variable life insurance policies invest the death benefit amount in investments, such as stocks and bonds. If the investments increase in value, the value of the death benefit rises. If the investments perform poorly, the value of the policy drops, and the premiums you pay rise to make up the difference.
Which Type of Policy Should You Buy?
Permanent life insurance costs significantly more than term life insurance, but that doesn’t mean that permanent life insurance is always the better choice. One strategy many policyholders use is “buy term and invest the difference.” Under this strategy, you set aside the money you save by buying term life insurance instead of permanent insurance, then invest that money diligently in the stock market. Because the average annual return of the stock market has historically been 8–10%, chances are you can build more wealth than you would with a permanent policy, whose average annual return is just 3–4%. If you’re not comfortable investing in stocks, however, a permanent life insurance policy may be a better choice for you.
How Much Coverage Do You Need?
The amount of life insurance coverage you need depends on your health, age, financial situation, family obligations, and other personal factors. For a rough estimate of the amount of money your family should need in order to maintain its lifestyle should you die, add together:
- Expenses you might cause to incur while you’re still alive: Include hospital expenses, long-term care, and so on.
- Expenses you might cause to incur after you die: Include your debts, such as credit card balances and mortgages, plus whatever expenses will be required to liquidate your estate, including your funeral arrangements.
- Expenses your beneficiaries will incur in their own lives: Unless your beneficiaries have their own savings or another income stream, you’ll want to leave them a lump sum equal to the amount of money they need to sustain their lifestyle each year, multiplied by the number of years you expect them to live.
Life Insurance Costs
The cost for life insurance varies widely depending on the type of policy you buy and your specific situation. The older you are when you apply for a policy, the more expensive the premiums will be. Expect permanent life insurance premiums to be three to five times greater than those for term life insurance.
How to Buy Life Insurance
Given the multitude of options involved, it’s best to purchase life insurance through a captive or independent agent. The agent should be able to explain all the options involved and help you make the best choice for your individual circumstances. Some of the most popular providers include: