The Purpose of Life Insurance
Life insurance is designed to provide for the loss of financial resources that occur when someone in a family dies prematurely. Now the key word here is prematurely and this speaks to a lot of the misconception that people have about this type of insurance.
There are several things that need to be present in order for life insurance to be a good investment. Like all insurance, life insurance involves paying a premium over the expected value of a revenue stream. In other words, if you saved this money up yourself, and invested wisely, like the insurance companies do with your money, you would end up with more money in the end, because there are additional costs involved in having the insurance company do it for you.
This is always the case with insurance, so you pay more for the service they deliver, but in exchange for this, they handle the risk. So while you get less in the end with life insurance policies, the value of the policy can be obtained whether the event occurs at any point in the process.
So if one did save up on their own to provide the desired level of financial security in the event of their death, they may end up dying sooner than expected, and at a point where they may not have saved up enough to prepare for this properly.
Insurance addresses this risk, for a price. So we need to make sure that the insurance is needed, and for instance if one is wealthy enough that one can already provide for one’s family in the desired manner when they die, then paying this premium may not be wise. Plenty of wealthy people do have life insurance though, so not everyone properly understands this, and they may not get the proper advice from their advisors either, especially if one of the roles of the advisors is to sell insurance.
Life insurance salesman often are seen in not the most positive light, although at least some of this is misplaced, but on the other hand they do tend to at least convey the impression that their goal is to generate as much in sales as they can, with that being their primary motivation. Sometimes this can be over construed though and people may be too hesitant to purchase enough, and as a matter of fact most people are under insured when it comes to live insurance.
Getting An Idea of How Much Life Insurance You Need
So they may tell you that you can’t have too much life insurance, you can though, although this is very often not the case. It can be quite expensive to replace someone’s income over a period of many years, especially if they die quite young. If someone dies at 45 for instance, we would expect them to have 20 years left in the workplace, and if they made $50,000 a year, that adds up to a million dollars.
Now it’s true that there would be some savings involved in their not being around, but most of this income is going to be needed if the family wants to maintain their current standard of living. Let’s say that in this case this is going to be three quarters of a million.
Now they may have saved a certain amount and we could deduct that from the total, but younger families don’t generally have a lot of liquid assets, and what they do have is usually earmarked for retirement, so even including this is dubious unless it’s a very large amount.
Families may be willing to settle for a reduced standard of living in the event of the death of one of their breadwinners though, and they also may see themselves as not being able to afford spending enough on a life insurance policy to fully replace the lost income stream. It’s important to look at what the extent of the coverage one does select and see if that is going to be at least minimally sufficient, and this is where a lot of people fall short.
Something like a $100,000 policy does sound like a lot, but if this only ends up providing an extra $5,000 a year in the model we are using, from age 45 to 65, then that might end up falling well short of expectations. In cases where the sole earner in a family dies, this may not be enough to keep their family from living in squalor.
So what can happen is that they may be able to get by for a few years on the amount they receive, but even being thrifty may have them running out of money far too soon, and be placed in the very predicament that this insurance was supposed to prevent.
It’s not even enough to account for the working income that the insured would generate, as we need to look at replacing one’s entire income for one’s expected lifetime, so that’s going to take us to age 80 or beyond and also include pension income. If one expects a generous amount of that, then this can make a real difference.
So this can add up to quite a bit of money, and although replacing all of this income may be too much to shoot for, we always want to make sure that what we do shoot for is going to be enough to get by with what we consider a minimally acceptable standard of life for the survivors.
Term Life Insurance
There are many types of life insurance policies that one can purchase, and people generally don’t look into the options too much and usually rely on insurance agents to provide advice. It’s always preferable to be knowledgeable yourself though as you can’t always count on agents to provide you with the best advice.
Term life insurance is the most popular variation, and provides a defined benefit if the insured dies in a way in accordance with the policy. All insurance policies have terms and conditions, for instance if one takes one’s own life, dies in a military conflict, or engages in behavior deemed reckless or too risky, benefits aren’t paid.
It is always a good idea to read the conditions of any insurance policy, as these are provided with the goal to inform, and one must always be aware of what sort of coverage one is entitled to, and this is the only real way to plan properly to manage the risks that one seeks to.
Term life provides a benefit upon death for a specific term, generally from 1 to 30 years, after which one may renew the term or not. This is not unlike other insurance policies of specified terms, like home and auto, although the terms with life insurance are generally a lot longer in duration.
One may choose a set benefit over the term, or one may instead select a policy with a decreasing payout, which in some cases can be more efficient. If one’s insurance needs decline, for instance as a family pays off their mortgage and other debts, and accumulates assets, then the need for a death benefit may decrease.
Since the total payout exposure to the insurance company is less with declining term life, the costs of it are less as well, making it more economical. It’s important to only select this if your needs do decrease though, but if they do, then this makes more sense whether or not you are looking to save money, as the goal with insurance is to protect enough but not over protect.
Permanent Life Insurance Policies
As one ages, the cost of life insurance goes up, in accordance with the risk involved, and insurance companies use all sorts of calculations to define their risk. One may select permanent life insurance though, which is more expensive but isn’t subject to being renewed.
There are two main types of permanent life insurance, whole life and universal life. Both types provide both an insurance component, a death benefit in other words, with an investment component, which may be borrowed against or withdrawn while the policyholder is still living.
Since the goal here is to place yourself in a comfortable position to take care of your family upon your death, as well as provide for yourself and your family comfortably while you are still alive, permanent life insurance takes care of both needs, and this is why many people find it so attractive.
Of course the premiums for this type of life insurance are going to be considerably higher, but since this provides a savings component as well, provided that one can afford this, it can be a great way to take care of both needs at once.
Both whole and universal life are very similar, with universal life offering the additional flexibility of using the accumulated interest to help pay for the premiums later on, as well as having the potential to earn more than the stated interest on the policy should the insurance company’s investments outperform expectations.
With all insurance policies though, they are priced in terms of the benefits, and this has to do with both the payouts and the features, and as always, if you want more you pay more.
The important thing is to make sure that you have enough protection as far as the death benefit is concerned, and insurance companies offer an array of investment products beyond that, such as annuities for instance, and they are well positioned to take care of your income replacement needs as well as helping build wealth for later in life.