Nobody likes thinking about life insurance. It is complex. It makes you think about your own death and mortality. And it adds an expense to your budget. However, life insurance is crucial if you have people that depend on you. It is the main asset in the protection bucket of the 5 pillars of personal finance and you likely need more. In this beginners guide to life insurance we will lay out all the basic fundamentals you need to know.
- What is life insurance?
- What are the different types of life insurance?
- How much insurance do you need?
- What is the preferred life insurance strategy? and
- What is underwriting?
After reading this life insurance for beginners guide you will be well prepared for starting this important journey to protecting your family.
Key Takeaways:
- Life Insurance is an important part of your personal financial portfolio, but it can be complex and confusing.
- There are many types of life insurance products, but life insurance for a beginner can be as simple as getting adequate coverage with low-cost term.
- From tax-advantaged savings for retirement to replacing lost income, there are many uses for life insurance.
A Beginners Guide to Life Insurance’s Purpose
Life insurance is a contract you enter with an insurance company. You pay premiums to the insurer and if you die while the policy is active, your named beneficiary gets the death benefit. For instance, if you purchase a policy with $50 monthly premium payments and a $250,000 face amount, you pay $50 every month. If you die, the person(s) you name in the contract will receive the $250,000 death benefit.
There are some nuances. For example, depending on the product type that the death benefit may be different than the face amount, but that is the basic way life insurance works.
Your beneficiaries can use the life insurance money to pay off debt and your mortgage, replace your income, or help fund future expenses like retirement and children’s college.
Different Types of Life Insurance for Beginners
Life insurance is simple at its core, but there are many types of life insurance and each company has their own version of the product. The main 2 types of life insurance are term insurance and permanent insurance.
Term insurance is the most affordable as it covers you for a period of time and then has an end date. When you buy term insurance, you pay a flat premium for the level-term period. (IE- 20 year term life policy has 20 years of level premiums). There are some ways to extend your coverage with term, through either the post-level term period or a term conversion rider. However, most people purchase a term policy because they want the death benefit coverage for a set period of time.
Permanent life insurance is a wide label that covers many types of products. At their core, all permanent life insurance will have:
- Coverage that lasts until you die (if you pay enough premiums.
- A cash value account within the policy that a portion of your premium funds.
- Investments that can earn a return in your cash value account.
The main classes of permanent life insurance are whole life insurance and universal life (UL) insurance. Within UL, there are further subcategories of guaranteed UL (GUL), index UL (IUL), Variable UL (VUL), and most recently Index Variable UL (IVUL) or hybrid UL. The main differences between the UL products is what you can invest your cash value account in.
Additionally, UL insurance often has a no-lapse guarantee (NGL) rider which sets a premium level you can pay to guarantee your coverage regardless how the cash value account performs.
Permanent life insurance has many positives over term, but the increased flexibility and guaranteed coverage comes at a cost. A typical permanent life insurance product will cost 5 to 15 times as much for a similar amount of term life coverage.
How Much Life Insurance Do You Need As A Beginner?
There are many different ways to calculate how much life insurance coverage you need. The 4 primary ways to calculate life insurance coverage needs are:
- A multiplier on your income (usually 10-15 times your annual income)
- Human Life Value
- DIME Method
- DEEM MethodTM
The correct answer will be highly individualized, but you want to ensure you have enough coverage to protect your loved ones if you were to pass away unexpectedly.
Our preferred method is the DEEM calculation which says your life insurance coverage should be enough to pay off:
- Debt – All your outstanding debts
- Expenses – Cover your families cost of living expense
- Education – Pay for any college or private school education costs you want to cover for your children
- Mortgage – Pay off your mortgage so your family doesn’t have to leave their home
Overtime, your life insurance coverage needs will change, so you need to review your coverage annually to make sure it is the correct amount for you situation.
What Is Underwriting?
Underwriting is the process where the insurance company calculates a health/risk rating for you. The healthier they determine you are, the lower your premiums will be on your policy.
Since the insurance company is on the hook to pay out a death benefit when you die, and the less healthy you are means the sooner you are likely to die, they want to charge less healthy lives more. Actuaries use a mix of company specific data and data from large mortality studies to develop mortality tables. These tables give a probability of death for each age based on the different risk classes.
When you purchase an insurance policy, you will go through some sort of underwriting process.
The most stringent process is ‘full underwriting’ where you need to answer a health questionnaire and undergo a medical examination with blood test. This process can sometimes take 90 days from when you apply to when your policy gets issued.
There are simplified underwriting and guaranteed underwriting individual life policies as well. These typically forgo the medical exam and base your rating on just the health questionnaire. Depending on the product, there could be as few as 4 questions to dozens.
If you are healthy, you generally will receive a lower price by going through the full underwriting route. (Also, the insurance company pays the cost of the exam so you get a ‘free’ check-up out of it).
How Much Does Life Insurance Cost?
The price of life insurance is highly dependent on many factors.
Term life insurance is the most affordable product. A 40-year old getting a $500,000 policy can pay under $1 a day for a term product.
Permanent products can vary greatly in price depending on the richness of the guarantees and benefits plus any flexibility you have. In general, a permanent product will cost 5 to 15 times as much as a similar amount of term coverage. Therefore, if it cost $30 a month for a term product, it can cost $150 to $450 a month for a permanent product with the same coverage.
What Impacts The Price Of Life Insurance?
Life insurance prices vary greatly depending on your age, health, and product you purchase. Some general rules of thumb around when the product costs more money:
- The older you are
- The longer your coverage period
- Less healthy people
- Those with dangerous jobs or hobbies
- Products with guarantees
- Life insurance riders add costs
- The more flexibility a product has
- Products with more complex investments in the cash value account
It is important to work with an advisor and understand what you are purchasing so you don’t over pay for features you don’t need or miss out on benefits you want.
Who Needs Life Insurance?
Life insurance is complex and adds an expense to your budget, however it is crucial to your finances. Life insurance is one of the main assets in the protection pillar of the 5 pillars of personal finance.
Almost everyone with a dependent should strongly consider life insurance. Life insurance can protect your loved ones if you were to pass unexpectedly. At a minimum, you should have enough coverage to replace your lost income. But if you have lots of debt or an outstanding mortgage, you may consider buying more coverage to cover those expenses.
Additionally, life insurance can be helpful for estate planning purposes and tax-efficient use of funds in retirement.
Life insurance death benefits are largely tax-free allowing you to pass an inheritance down to your heirs. Life insurance also avoids probate allowing for a low expense and quick transfer of assets after death.
If you have a lot of qualified retirement assets, you can avoid required minimum distributions (RMDs) and avoid a future ‘tax bomb’ when you draw down those assets. Many people buy life insurance with their IRA money for this purpose.
Lastly, if you have maxed out all your retirement accounts, you can use some permanent life insurance to get an additional source of tax-advantaged savings.
In short, there are many uses for life insurance and most adults could use it in their financial plans.
Pros & Cons of Life Insurance
Life insurance is a contentious topic. There are people who believe life insurance is a waste of money. While most financially savvy people know many reasons why you should buy life insurance. Other people try to avoid buying it by purchasing alternatives to life insurance for financial protection.
Here are the top pros and cons of life insurance.
Benefits of Life Insurance
There are many benefits to life insurance. Some of the top ones include:
- Replace an income and pay off debts upon your death
- Avoids probate
- Tax-advantaged savings
- Tax-free inheritance to your beneficiaries
- Affordable term insurance
- Liquidity in your permanent insurance cash account
- Forced savings
- Tax and investment diversification
- No required minimum distributions (RMDs)
- Many products that can fit different niche needs
Downsides of Life Insurance
Despite all the positives of life insurance, there is also some negatives, including:
- Complex and confusing
- Administratively time consuming
- Can be expensive
- High fees in permanent insurance
- High surrender charges for withdrawals
- Too many options to choose from
- Cheaper to self-insure
The Final Word on Life Insurance For Beginners
Life insurance is an important piece of your personal financial picture. Life insurance for beginners can be confusing and many find it complex and expensive. However, the value of knowing you have financially protected your loved ones is incalculable.
It is estimated nearly half of American households would use all their savings within 6 months of losing an income earner.
If you have dependents, are looking for another tax-efficient retirement vehicle, or want to leave a money to your heirs or for charitable causes after you die, life insurance is an important tool to consider.
If you are a life insurance beginner don’t have coverage yet and don’t know where to start, buying term and investing the difference (BTID) and setting up a term life insurance ladder will give you future flexibility and adequate coverage for cheap. Additionally, a term conversion rider allows you to lock-in your insurability now and have the option to convert to a permanent policy later.
Frequently Asked Questions (FAQs):
There are many different types of permanent life insurance and each company has its own flavor of the product. The main types of life insurance are whole life insurance and universal life (UL) insurance. Within UL there are guaranteed UL, variable UL, index UL, and index variable UL (also known as hybrid UL). Each permanent insurance product has lifetime coverage available and a cash value account that a portion of your premium funds. The different types of permanent insurance vary largely based on how that cash value account is invested.
There are 4 commonly recommended ways to calculate your life insurance coverage needs:
1) Multiplier on your annual income (usually 10 to 15 times your income)
2) Human life value calculation
3) DIME Formula
4) DEEM MethodTM
We think the best way to calculate your coverage needs is the DEEM MethodTM. This method uses the 3 major liabilities most people have (outstanding debt, mortgage, and future child education expenses) and adds to it the number of years of living expenses you want covered. For example if you have 2 kids and want to leave each $50,000 for college, you have $25,000 of your own student loans, a $200,000 mortgage and you want to provide 10 years of living expense coverage for your family that spends $50,000 a year you would have $825,000 of coverage needs based on:
1) $100,000 in education expenses ($50k x 2)
2) $25,000 in debt
3) $200,000 in mortgage
4) $500,000 in expense coverage ($50,000 x 10)
Yes. There are ways to extend your term life insurance coverage beyond the original term period you purchased. Most term products give you the option of ‘post-level term’ where you buy annual renewable term policies with increasing annual premiums. Additionally, if your policy has a term conversion rider, you are able to convert your term life insurance into a new permanent life insurance product with the same coverage and risk class, without re-undergoing the underwriting process. You will need to review your policy documents to see if either option is available on products you have.
Many factors go into the calculation for your premium amount. The main ones are:
1) Age
2) Coverage period
3) Health rating
4) If you have a dangerous jobs or hobbies
5) Products with guarantees
6) Any riders you elect
7) The flexibility a product offers
8) The investment options available