Life insurance is one of the best ways to make sure your family is taken care of after you are gone. The purpose of life insurance is to cover expenses or replace lost income after the passing of a relative.
From basic necessities such as funeral expenses to outstanding debts, estate taxes, regular bills, and children’s education, life insurance plans can cover a whole range of your family’s needs even after your death.
The unfortunate reality, however, is that a large number of people do not buy insurance on their own. Rather, they are talked into buying it by someone in their social circle or an insurance agent.
So, they do not pay attention to the details and buy the policy recommended by the salesperson without even knowing if it is the right choice for them. This is a flawed approach, as you have no way of knowing if the policy you buy will sufficiently cover the needs of your family after your death.
Choosing the Best Life Insurance Policy
One mistake that many people tend to make when it comes to life insurance is that they look for the ‘best’ life insurance policy. The truth is that there is no such thing as the best life insurance policy for the simple reason that people are different. Just watch the OK comedy Along Came Polly and focus on Reuben Feffer and Leland Van Lew!
They have different income capacities and different needs, which means there could never be a single best policy that covers the needs of people at different ends of the socioeconomic spectrum.
The right approach is to look for the ‘right’ life insurance policy, which meets your individual needs. The most important question you need to ask is – will this plan cover the needs of my family in my absence?
Also, you need to realistically assess your financial situation and determine if you can continue to pay the premium over a long period of time – anywhere from 10 to 30 years – irrespective of whatever temporary setbacks you might face (losing your job, switching to a different job, health problems, and so on).
What is the Best Life Insurance?
Life insurance can be broadly classified into two categories – Term and Whole Life. The best life insurance plan for you will be the policy that best meets your needs. We break it down below so you can make the right choice.
Term Life Insurance Policies
Term life insurance is also referred to as pure life insurance. The purpose of it is to take care of your family’s financial needs in the event of your untimely death. The premium you pay goes towards the death benefit, which will be paid out to your family after your death. It could be paid out as a lump sum, an annuity, or on a monthly basis, depending on the policy you choose.
How does term life insurance work?
A typical term life insurance policy is designed to provide financial protection for the beneficiaries of the insured (the person who buys the policy) for a particular period of time. It could be anywhere from 10 to 30 years.
You have to pay the premium, which remains the same throughout the term, either as monthly installments or as annual payments. If you die while the policy is still in effect, your family will get the death benefit. If you are alive at the end of the policy’s term, at which point it expires, you will not receive any payout.
The biggest advantage of term life insurance is that it is extremely affordable. If you are a non-smoker in your late 20’s or early 30’s, with no pre-existing health problems, you could buy a $500,000 policy for as little as $25 a month. The cost, however, could go up depending on a number of factors. See more life insurance rates here.
Health Condition – This is the single most important factor which determines the premium for your insurance policy. If you are young and healthy, your premium amount is likely to be very low. If you, on the other hand, are older, suffering from ailments, or have a family history of diseases like diabetes, heart disease, or cancer, your premium amount is likely to be high.
In some cases, you might be asked to pay a higher premium amount by your insurance company even if you are young and healthy. It depends on your line of work and your pastimes and hobbies. If you are a firefighter, policeman, miner, oil rig worker, or work in any other sector which is generally considered ‘high risk’, your insurance premiums are likely to be high.
Similarly, if you have dangerous hobbies like rock climbing, paragliding, bungee jumping, or race car driving, you can expect to pay a lot more towards insurance premiums compared to others.
Death Benefit – This is quite straightforward – if you need a large payout for your family, you need to pay higher premiums.
Term Length – The longer the term, the more expensive the policy is likely to be.
There are several types of term life insurance policies, which differ from each other in terms of the coverage offered, the premium amount, and a number of other factors.
- Level Term Life Insurance – This is a policy where, as the name indicates, the premium remains consistent throughout the term.
- Annual Renewable Term Life Insurance – The policy is set only for 12 months and needs to be renewed every year. The premiums are extremely low at the start, but keep increasing as you get older.
- Return of Premium Term Life Insurance – In this type of policy, the premium amount that you pay throughout the term will be returned to you at the end. The amount is also tax-free. The premiums, however, are very high compared to a normal term life insurance policy.
- Decreasing Term Life Insurance – In this policy, you pay a fixed amount as premium throughout the term, but the payout keeps decreasing year after year. The most common type of decreasing term insurance is mortgage protection insurance, which is linked to your mortgage and the payout typically covers the outstanding balance. The premiums are very low for this type of policy, but the payout usually goes directly to your lender.
- No Medical Exam Term Life Insurance – As the name indicates, you do not have to undergo a series of medical exams in order to qualify, which is usually the case with regular policies. However, you have to pay a higher premium to offset the risk to the insurance company. Your options in terms of coverage are also very limited in these types of policies.
The downside of term life insurance is that it lasts only for a set period of time. If you happen to outlive the policy, you do not get any payout.
If, at that point, you still need insurance, you might have to convert it into a whole life policy (which lasts your entire life) or buy a new policy – both of which could cost you a lot of money due to your age and health condition at the time.
Whole Life Insurance
Whole life insurance is also called permanent life insurance due to the fact that it lasts throughout your life. Unlike term life insurance, it does not expire after a predetermined period of time. Instead, it stays in effect as long as you keep paying the premiums and provides a payout for your family in the event of your death.
Yet another advantage of whole life insurance is that it has what they call a cash value. The premiums you pay are generally divided into three categories – insurance costs, overhead and fees, and cash value.
- Insurance cost is the amount that goes towards the death benefit, which will be paid out to your family in the event of your death.
- A portion of the premium goes towards the insurance company’s overhead and fees.
- The remaining portion goes towards the cash value.
Initially, a large portion of the premium goes towards the death benefit and only a miniscule portion goes towards the cash value component. As the years go by, the proportion changes considerably – the death benefit portion decreases and the cash value portion increases significantly.
At one point, several years into the term of the policy, the cash value portion accounts for 100% of the premium you pay. The cash value portion of your policy also grows at a fixed rate, which is predetermined by your insurance company. The interest amount that you earn is usually not taxable.
One of the biggest advantages of having a cash value component in your insurance policy is that you can borrow against it or withdraw a portion of it in case of an emergency. If you decide to borrow against the accumulated cash value in the form of a policy loan, you have to repay it with interest.
The rate of interest, however, is much lower compared to regular loans. If you decide to make a partial withdrawal, the amount is usually deducted from your policy’s death benefit portion.
It should be noted, however, that the cash value portion of your policy is usually not included in the death benefit. The death benefit is paid out to your family while the cash portion is usually absorbed by the insurance company itself. In other words, the cash value component is useful to you only as long as you are alive. You can borrow against it or withdraw a part of it for your other investments or to pay for any emergencies.
Some whole life policies pay out both the death benefit as well as the accumulated cash value to the beneficiaries. Some policies also pay you dividends on an annual basis. These policies, however, are generally very expensive.
Riders for Whole Life Policies
Whole life policies can offer you additional protection in exchange for higher premiums. The additional component is called a rider, which serves many different purposes. For example, if you have someone in your family who needs long term medical care – typically in a nursing home setting – you could select a rider on your policy to make sure the nursing home expenses are taken care of even after you are gone.
Similarly, if you want to provide your family with an additional source of income apart from the death benefit, you could flip the switch for such a rider on your policy as well. You could choose the disability rider, which covers your premium payments if you are temporarily disabled and not able to work.
You could also choose the accelerated death benefit rider, which allows you to use the money in your death benefit to pay for your treatment and care, in the unfortunate event that you are diagnosed with a terminal disease.
The biggest downside of whole life insurance is that it is more expensive than term life insurance. The premiums are significantly higher and the interest you earn on the cash value portion is very low compared to what you could earn from other types of investments.
This is why whole life policy is generally considered ideal for high net worth individuals who want provide their heirs with money (death benefit payout) to pay off the federal and state estate taxes.
Apart from whole life, there are other types of permanent life insurance policies as well.
Universal Life Insurance
Universal life insurance is similar to whole life insurance, except the fact that it is more flexible. Your premiums go towards insurance costs, overhead and fees, and cash value. The most notable feature of this type of insurance is that once you have accumulated enough cash value, you can use it to pay your premiums.
If, at any point during the term of your policy, you are not able to pay the premium due to unforeseen circumstances (job loss, moving to a different city, medical expenses, and so on), you can use the money in the cash value to pay a few months of premium. You can also make a lump sum payment instead paying premiums on a monthly basis.
Just like whole life policy, the cash value in a universal life policy also earns you interest. The rate of interest, however, varies from time to time, depending on market conditions.
Universal life insurance also allows you to increase or decrease your death benefit, although there are charges associated with doing this. Also, you might have to undergo a medical exam to obtain increased coverage.
You can purchase riders on your universal life policy for additional protection. The common choices include long-term care (covers the nursing home expenses of someone in your family or your own), family income (provides an additional payout apart from the death benefit), and spousal insurance (your spouse can be covered under the same policy for an additional cost).
The downside of universal life insurance is that it is more expensive than regular life insurance policies. The interest rate offered for the cash value portion is not fixed and fluctuates from time to time, depending on the market.
Variable Life Insurance
Variable life insurance has a cash value component that is ‘variable’ or ‘appreciable’, based on market conditions.
Unlike whole life insurance, the cash value part of your premium does not earn a stable interest rate. Instead, it is invested in a number of securities including bonds, equity funds, and money market funds. You have the option of choosing where your money gets invested.
Since your cash value is directly linked to the market, it might increase or decrease in value depending on the conditions. Over the course of 10 or 20 years, however, it will outperform the cash value components in whole life or universal life policies, both of which usually offer a modest rate of return.
The long term gains from the cash value are also non-taxable. So, if you let your cash value accumulate for the entire term of your policy, your family might receive a large payout, on which they do not have to pay taxes.
On the downside, variable life insurance is likely to cost you much more than a regular term life policy or even a whole life policy for that matter. If your investments do not garner sufficient returns, your insurance company might increase your premium to contribute to the cash value component.
There are administrative and management fees involved with your cash value investments as well. In some cases, life insurance companies tend to have caps on cash value investments. So, even under favorable market conditions (which is the case now because of tax cuts and regulations being curtailed), you might not be able to get higher returns beyond a point.
More importantly, the death benefit in many variable life insurance policies is a projected value, not a guaranteed one. The clause is that if your cash value investments perform well and meet the rate of return set by the company, your family will receive a particular amount as a death benefit.
If your investments do not perform well, the death benefit could get reduced. So, it is very important to check with the insurance company beforehand and make sure your policy has a guaranteed death benefit.
Guaranteed Universal Life Insurance
This is a basically combination of term and whole life insurance. It is ideal for older individuals whose term policy is about to expire and for those who have outlived their policy and are in need of insurance again.
If you belong to either one of these categories, you will find it hard to qualify for a traditional term or whole life policy. Even if you do, you might be asked to pay a higher premium, owing to your old age and health condition. In this kind of scenario, a guaranteed universal life policy could be the best option for you.
A guaranteed universal life policy does not have any cash value and the premiums are typically low. Unlike a regular policy, it does not have any set term. Instead, it is set to a particular age – from 90 to 121.
The premium remains consistent until the set age and the payout typically allows you to leave a sizable inheritance, which will cover your funeral expenses and allow your family to pay off the outstanding debts and estate taxes.
The only downside is that you have to undergo a medical exam in order to qualify for a guaranteed universal life policy. Since the cost of your policy is directly linked to your health condition, you are likely to pay a higher premium if you have any health problems.
Simplified Issue Life Insurance
This type of insurance, as the name indicates, simplifies the process of qualifying for the policy. You do not have to undergo a medical exam to qualify for the policy. You only need to fill out a form in which you have to answer a number of questions related to your health condition.
Simplified issue life insurance is ideal for older people and those with ailments, who are not likely to qualify for a term or whole life insurance policy.
The coverage offered in these kinds of policies is typically up to $500,000, which will be paid out to your family after your death. The premium remains the same throughout the term and there is no cash value component involved.
The policy basically allows you to leave an inheritance to your family, which they can use to pay for your funeral expenses and to pay off any outstanding debts. As with other policies, simplified whole life insurance also offers you the option of riders for various purposes like long-term care, terminal illness treatment costs, and waiver of premium in case of temporary disability.
On the downside, if you have significant health issues, you might be asked to undergo a medical exam or you might not qualify for the policy at all. Even if you qualify, some of the riders might not be available to you, depending on your age and health condition.
Guaranteed Issue Life Insurance
This is a type of insurance that you can qualify for irrespective of your age or health condition. If you can afford to pay the premium, you will get qualified. There is no need for you to undergo a medical exam, so there is no risk of getting turned down, even if you have significant health issues.
All the insurance company needs to know is your age, sex, and your place of residence. There is no specified term for these policies. They last as long as you live and your family gets the payout after your death.
The downside of guaranteed issue life insurance is that the premium can be significantly higher compared to term life or whole life policies. Also, the death benefit is also very low and in most cases is only sufficient to cover your funeral expenses.
This is the reason why this type of insurance is generally not recommended for anyone. If all you need is a policy that covers your funeral expenses, you are better off buying a final expense insurance policy.
Final Expense Insurance
This is, as you can guess, a policy that covers your funeral expenses. It is typically meant for old people, people with terminal illness, and people who are on hospice care. There are no medical exams or questionnaires and the qualification process is basically simple. If you can pay the premium, you can get qualified.
There are no term limits and the policy goes in force within 48 hours of your approval in most cases. The payout could range anywhere from $5,000 to $25,000, depending on the insurance company.
The only downside of final expense insurance policies is that the payout is typically low. It, however, makes sense since it is only meant to cover the funeral expenses of the policyholder.
Other types of insurance policies include mortgage life insurance (covers your mortgage payments and is paid out directly to the lender), credit life insurance (covers your loan payments and is paid out directly to the lender), accidental death and dismemberment insurance (you get paid if you lose a limb or sight or hearing ability in an accident and your family gets paid if you die in an accident), and joint life insurance [you and your spouse are insured under the same policy and the death benefit is paid out after one of you dies (to the survivor) or after both of you die (to your heirs), depending on your choice].
Choosing the Right Life Insurance Policy
Given below are the factors you need to consider while choosing an insurance policy.
Income – Will you be able to afford the premium? This is the first question you need to ask, as there is no point in choosing a policy with a high payout if you cannot afford to pay the premium for the entire term.
Coverage – The payout should be sufficient to cover your funeral expenses, replace your income, cover your children’s education, and pay off any debts that you might have. If you choose a policy just because the premiums are low, the death benefit might not be sufficient to cover your family’s needs in most cases.
Guaranteed Death Benefit – Some policies tend to have a clause wherein your death benefit payout depends on the performance of your cash value investments. While there is certainly an upside to policies that fall under this category, since the payout could be significantly higher under favorable market conditions, the inverse is also true.
Under unfavorable market conditions, the payout could get reduced, in which case your beneficiaries might find it hard to take care of all their needs. So, it is generally prudent to choose a policy with a guaranteed death benefit.
Choosing the Right Life Insurance Policy by Jonathan Holloway