Life insurance is the foundation of your "financial house". Along with auto and property insurance, Life insurance should be your primary consideration. Life insurance, like all insurance, is based on a "pooling of risk". This simply means that within a large group of individuals, a certain number will die at a fairly young age, another certain number will die in mid-age while the remainder (usually the majority) will die at an advanced age. Those who die later in life pay more premiums and, in effect, subsidize the insurance costs of those who die younger thus pooling or spreading the risk over a larger group of people. If you knew you were going to die at age 80, you would be financially ahead to invest the value of the insurance premiums in a diversified portfolio. But what if you died tomorrow, or next year? Your investments would not have grown large enough to support your family. Thus some kind of life insurance is the financially responsible thing to have. But what type?
There are several types of insurance: permanent, term and a combination of both. Let's take a look at each one:
This type of insurance has been around the longest and is most familiar. There are two main types: pay for life, pay for a predetermined period of time. With pay for life, the premiums are lower but you continue to pay the same premium for the same amount of insurance until you die. With a predetermined period, you will pay a higher premium for the same amount of insurance but the payments will cease after 40 years or after the insured reaches age 65 or some other period of time. Again, the premiums and the amount of insurance remain constant. Once the policy is "paid up" (the predetermined period is completed) the insurance remains in force until it is paid out on the insured's death. Permanent insurance can be "participatory" or "non-participatory" - which simply means that the policyholder may - or may not - receive "dividends". A life insurance "dividend" is actually a rebate of part of the premiums paid. This occurs when the company determines that the amount of premiums received is greater than the projected funds required to pay off the policies. This may happen when a significant number of policyholders live longer than expected or when expenses are much less than anticipated (or when the company's investments earn more than expected). A "dividend" may be redeemed in many ways including as cash or as payment for more insurance. Permanent insurance builds up "cash value" over time. This cash value may be received by surrendering the policy (cancelling the insurance). In some plans, the cash value may reach a level where it can be used to sustain the policy (i.e. pay the premiums).
As the name implies, term insurance is in effect for a certain period of time and then ends. The term may be a certain number of years such as 1, 5, 10, 20, etc. or until the insured reaches a certain age. At the end of the term, the insurance coverage ends. Should the policyholder die at any time after this point, no benefits would be paid out. However, many term policies have "riders" that guarantee that the policy may be renewed, usually at a higher premium. Term insurance is intended to cover a "temporary" need. For example, most people (especially married couples [or singles] with responsibilities) are less financially secure when in their twenties or early thirties. They often have children to take care of and/or a large mortgage to handle. Since term insurance is much cheaper than permanent insurance (especially if the insured is young), it makes sense to buy term insurance to cover the necessary expenses of raising children and paying the mortgage. Once the children are grown and/or the mortgage has been paid off (or significantly paid down), the need for this insurance declines or disappears. However, term insurance does not provide any "savings" feature that is often promoted as a feature of permanent insurance. This "savings" feature is the cash value that builds up in the policy. However, on the insured's death, only the face value of the permanent insurance policy is paid out. Any cash value is retained by the company.
Term insurance when combined with an investment program is the most efficient means to provide protection when it is most needed and income when it is most needed (at retirement). For best results, the insurer should consider paying out the same amount of money as required for a permanent policy by buying an equivalent amount of term insurance and investing the difference in premiums.
Other Life Insurance
More recently, other insurance products have appeared which combine some of the features of term and permanent insurance. We will briefly look at two of them.
One of the attractions of term insurance is its much lower premiums. Universal Life is an attempt to provide lower cost protection while freeing up funds for investment. To do this, it separates the factors that go into the insurance premium: the real cost of pure insurance, the investment portion and the expenses portion that includes the company's overhead and operating expenses. The investment portion of Universal Life is controlled by the policyholder. Thus, it is really only suitable for someone who has both the investment knowledge and the time and inclination to manage the investment. The insurance portion is most often renewable 1 year term insurance. This insurance offers the lowest cost for insurance so that, in the beginning, more of the premium paid goes to the investment portfolio than is possible with permanent insurance. Still, a person who has the ability to manage his/her own portfolio would be financially ahead to buy the cheapest term insurance and set up and manage his/her own diversified investment account.
Term to 100
There is one area where permanent insurance still makes sense: estate planning. While the bulk of most estates will pass tax deferred to a spouse, the tax implications can be enormous when it is passed down to children. Permanent insurance can be purchased to cover the tax liabilities when the estate passes to anyone other than the spouse. Term to 100 can also be used for this purpose. Although essentially term insurance, many such policies either mature(or endow) at age 100 (meaning that the face value of the policy is payable at that time) or are considered "paid up" and no more premiums are required to keep tyhe policy in force. (Not to mention the fact that so few people live to be 100 or more that it can, in effect, be considered "permanent".) Since this insurance is cheaper than pure permanent insurance, it is a good alternative for estate planning.
Life insurance is a contract between the policyholder and the policy issuer (the company, or the insurer). In most cases, the policyholder is also the person insured, but this is not always the case. One can insure the life of anyone in whom he/she has a financial or emotional interest. When the policyholder is not the insured, the policyholder is still responsible for making sure that all relevant information about the insured is forwarded to the insurer as well as making the premium payments.
There is yet another interested party: the beneficiary. The beneficiary is the person(s) who will receive the value of the policy when the insured dies. When the policyholder is not the insured, he/she will likely be the beneficiary. Otherwise, the beneficiary is likely to be the spouse, children, or other members of the family. Since companies can also buy life insurance, they can also be the beneficiaries. It is important to note that as long as the beneficiary is NOT the "estate" of the insured, the face value is paid to the beneficiary tax free. This money is also free and clear of any debts or obligations the insured may have had (unless it can be proved that the policy was taken out for the purpose of evading these debts). The beneficiary can be changed at any time by the policyholder unless the beneficiary is designated as "irrevocable". In this case, it can only be changed with the signed approval of the current beneficiary. Finally, a policy may be assigned to a charitable organization (the organization becomes the irrevocable beneficiary). From the point the policy was assigned to the charity and on, all premiums become tax deductions for the policyholder. A policy may be temporarily assigned to a bank or other lender as collateral on a loan. Once the loan is repaid, the assignment should be removed.
So, how much life insurance do you need? One method to determine the required amount of insurance is the Capitalized Value approach.