What You Need to Know When Buying Life Insurance

/ September 15, 2016

There are two basic types of life insurance: term and permanent.

The fundamental difference is right there in the name: Term life insurance is only in force during a set period or “term,” while permanent life insurance is yours for your entire life. So why doesn’t everyone just get permanent? Because it’s much more expensive — 10 times more than term, on average. The higher cost makes sense, since the insurance company knows it will be paying out eventually (whereas with term, there’s a good chance you’ll outlive the policy and cost the company next to nothing). However, it also means that most people can’t afford permanent life.

For most people, term is the way to go.

Term life insurance is way simpler than permanent. You pay a (much lower) premium for a set period of protection, which typically coincides with your prime working years. You can think of it as insurance on the income you haven’t yet earned. The advantage is pretty obvious: You can guard against uncertainty by securing a large death benefit for relatively little money. And if you invest the money you save by not going with a permanent insurance policy, you can wind up with more cash at the end of your life than a permanent policy would’ve paid anyway (of course, the tricky thing is actually putting aside that difference rather than spending it).

But even if you don’t invest the balance of what you’d pay for a permanent policy, term life insurance still offers a ton of value by safeguarding your dependents when they’re most vulnerable. You can buy a 20- or 30-year term policy with the expectation that your kids will be able to provide for themselves by its end, and when you and your partner will also hopefully be reaping the rewards of prudent investing, not to mention Social Security and pensions. Sure, your term policy has no value once it expires, but that’s OK — you were paying for the protection.

But there are some cases when permanent makes sense.

Life insurance is all about covering need, and in some cases the need for it lasts your entire life. One example is for those with special-needs children who will always require care.

Permanent life insurance also makes sense if you’ve built up enough wealth that your heirs will need to pay an estate tax — this year, that bar is set at $5.45 million. Life insurance death benefits are not subject to income tax, so if you get a permanent policy, you’ll know that your heirs will have cash-on-hand to pay the estate tax. This may make even more sense if the majority of your wealth is in property or other non-liquid assets.

Your health and age at the start of the policy are the biggest factors in determining your premiums.
The formulas life insurance companies use to set premiums are incredibly sophisticated, but they’re all designed to gauge life expectancy, which means age and physical health are the primary factors. However, your physical health is only actually measured once, via that medical exam when you first apply for coverage. The insurance company then uses population data to project your average risk of dying over the course of the policy (and sets your premiums accordingly).

This means that the younger and healthier you are at the start of the policy, the lower your premiums will be. It’s also why guaranteed renewability and a guaranteed conversion option are so important, because they too rely on that initial health picture, which is most likely the healthiest you’ll be at any time during your coverage.

Think carefully about how much life insurance you really need.

Maybe you’ve heard that you should multiply your annual income by 10 to get your life insurance face value, but five seconds probably isn’t enough to spend calculating something so important.

First, consider your long-term debts. Do you have a mortgage that will require payments for the next 25 or 30 years? What about student loans, medical expenses, and credit card balances? If you have kids, are you planning to pay their college costs?

Then ask yourself how much it takes to sustain your household at your current spending habits.

Don’t assume you’re covered through work.

Most employer plans carry a death benefit of far less than you would want your dependents to have, and they’re also not portable if you switch jobs. It’s great if you have employer-sponsored life insurance, but you should probably supplement it with a policy of your own.

Do yourself a favor and work with a broker.

Insurance brokers (people who sell insurance for multiple carriers) sometimes get a bad rap because they work on commission, and if they’re slimeballs, they can push an expensive policy that you don’t need just to get a heftier cut of the action. But most brokers aren’t slimeballs, and they can be a huge help.

Brokers not only can quickly sift through hundreds of options to find the policies that best fit your needs, but also know which companies are likelier to offer you the lowest premium. How? They’ve reviewed insurance policies every day (probably for years), so they’re familiar with the specific underwriting criteria of various companies — which ones are more generous on height and weight tables, or which ones are particularly strict about driving records.

You also won’t save money by not working with a broker. Insurance companies assume a broker fee when they set their premiums, so even if you buy your policy through a website like Policygenius.com, your premiums will be the same as if you worked with a broker. The only difference is where that commission money goes.

Maybe you’ve heard that you should talk to a fee-only financial planner instead of a broker. While it’s true that fee-only advisers don’t receive commission from insurance companies, that doesn’t mean they don’t have some other arrangement that incentivizes them to suggest certain policies. Plus, a fee-only adviser only makes recommendations, leaving you to purchase the policy yourself (and pay the built-in commission).

Even though brokers are paid on commission, that doesn’t mean they won’t give you good advice. Just make sure they’re licensed to sell life insurance in your state, and they don’t have a disciplinary record. Both of these pieces of info are publicly available from your state’s Department of Insurance.

The Bottom Line

If you have dependents who rely on your income, you need life insurance. Term offers the best value for the money, but make sure your term policy is with a financially strong company, with enough coverage and flexibility to allow for changes in your situation. It pays to shop around, but ultimately your best bet is to use an agent or broker who knows the marketplace.

This post originally appeared on the Simple Dollar.

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