To protect your home from fire, theft, or storm damage, you purchase homeowner’s insurance. To protect your car from careless drivers or hail, you purchase auto insurance. And for expensive medical procedures, you likely have a health insurance plan that you pay for yourself or through your employer.
But what about insurance that helps to protect your life?
Life insurance is important for anyone, especially someone who has dependents, debt, or owns a business. One of the simple, yet unfortunate, facts of life is that we all have an expiration date, and protecting our loved ones is one of the most important steps you can take in financial planning.
Unfortunately, only about half of Americans owned a life insurance policy in 2020, leaving 1 in 3 American families unprotected and vulnerable.1 If you have dependents – young children or a spouse who relies on your income or caregiving responsibilities – and are thinking about purchasing life insurance for the first time, here’s what you need to know.
What is life insurance?
Life insurance is a contract between an insurer and a policyholder. In exchange for premiums, the insurer promises to pay a sum of money to the policyholder’s named beneficiaries if they pass away. This sum of money is often referred to as a death benefit.
Life insurance is designed to protect the “economic value” a parent or family member provides to their dependents. Most people want to know that, if something were to happen to them, their family will be able to sustain their lifestyle from a financial point of view. Life insurance helps ensure that your spouse will be able to continue mortgage payments or that your children will be able to afford a college education in the future, even if you’re not there.
How much life insurance?
Just as an insurance company will not insure your Toyota for $1M or a home valued at $500k for $10M, you also cannot insure a person for more than the value they provide to a family or a business.
The insurance company allows you to insure your life up to a maximum amount. This amount is called your economic life value (ELV), which is determined by your life expectancy and income. The amount of life insurance someone has can be more important than the type of insurance, length of coverage, or the company it is with.
See below for a basic schedule of life insurance coverage based on the ELV model.
- In your 20s, consider 30x your income.
- In your 30s, consider 20x your income.
- In your 40s, consider 15x your income.
- In your 50s, consider 10x your income,
- Age 65+, consider 1x your net worth.
Different types of life insurance
There are many different types of life insurance to choose from, some of which may be better suited to your unique situation and goals for your lifetime. The most common types of life insurance include the following:
Term/temporary life insurance
- Convertible term insurance (can be converted to a permanent policy)
- Non-convertible term insurance
Permanent life insurance
- Whole life insurance
- Universal life insurance
- Variable Universal Life Insurance
- Indexed Universal Life Insurance
There are several variations on these different types of life insurance, which we’ll explain in a future article. For now, we cover the basics below.
Term Insurance and the True Cost
Term life insurance policies expire after a certain number of years (the term). You choose the term you’d like in increments of 5 or 10 years, with the most common terms being 10 years, 20 years, or 30 years. The longer the coverage, the more expensive the policy will typically be.
Term insurance guarantees2 the premium and the death benefit for the term period of the policy. This type of insurance can be considered when the individual cannot afford permanent life insurance but would like a death benefit to protect the person’s family or business.
If you pass away during the covered term period, your beneficiaries will be paid the death benefit. Statistically, more than 98% of people outlive their term life insurance.3 This is one reason why the premiums are generally more affordable; after the policy expires, there are no more benefits.
If you survive the policy term, your premiums are pure cost. You lose not only the premium, but you also lose what the premiums could have earned in another account, which is a lost opportunity. The biggest opportunity cost of term insurance is when the policy expires, and the death benefit is lost.
Permanent Life Insurance
Permanent whole life insurance (PWL) insures your life until death, regardless of your age. It will typically require a larger premium due to the living benefits and length of coverage that is provided by the policy. PWL not only provides a death benefit forever, but it also provides a separate cash value component that can be used by the insured for any reason at any time provided there is cash value in the policy.4, 5
Your premium is guaranteed for life and can never increase, but you may be able to change or reduce your premium in the future. In later years, the guaranteed cash value and dividends can exceed all premiums paid providing you with a way to recapture premium payments.6
Permanent life insurance has been popular for many years because it typically provides the following benefits that can be utilized while you are living:
- Immediate legacy for heirs or charities that does not expire
- Guaranteed Premium payments
- Guaranteed Cash Value
- Tax Advantages7
- Creditor Protection (varies by state)8
- Retirement income maximization
As the policyholder makes the scheduled premium payments, they build cash value. The cash value grows at a guaranteed rate and the policyholder can receive dividends. Many mutual insurance companies have paid dividends to their policyholders for more than 150 years, proving they have stood the test of time.
The cash values can be accessed through surrendering the dividends, withdrawals, loans through the policy, and cash value lines of credit with a participating bank. If a loan is not repaid when the policyholder passes away, the death benefits are reduced by the outstanding loan amount.
Term or Permanent – What’s Right for You?
If we all had a crystal ball and knew we would be alive in 30 years, we might not consider purchasing a term insurance policy that would expire prior to then. This knowledge could allow you to take the funds used to purchase term life insurance and put them towards other wealth-building methods such as savings, retirement plans, investment accounts, or cash value life insurance. Term life insurance is often considered to be more affordable than permanent life insurance, but perhaps only in the short term.
While you may not “need” life insurance later in life or during retirement, a permanent life insurance policy alleviates the risks of losing your coverage and provides quite a few benefits that can be used even while you are living. And, while many people may also believe they will not have a “need” for a permanent death benefit, it is important to coordinate your life insurance planning with all other aspects of wealth accumulation and retirement income planning.
The value of coordinating permanent life insurance into an overall financial plan could not only provide a lifetime worth of protection to your beneficiaries but simultaneously help increase your wealth and income during your lifetime.