It’s a common question for people considering life insurance – I’ve heard I need it, but how much do I really need and how much is it going to cost? To get to the right answer, you first have to understand some of the basics about the different kinds of life insurance, how they work and who is the best fit for each type.
Life insurance is concerned with the economic value of human life, which, in simple terms, means everyone has financial value. From an insurance perspective, a person’s life value considers their capacity to earn an income during their lifetime and then to bring that value into a current amount (known as the present value of future earnings). Also, policies may consider how those earnings are used. The purpose of life insurance is to provide a replacement of the economic value a person provides to dependents, family, creditors, charitable causes and business functions (to name a few). A major advantage of life insurance is the potential tax-free nature of the benefit.
How Life Insurance Works
There are two types of life insurance: term and permanent (also known as “whole life”). There are many variations of each. Term life insurance is normally used to have coverage for a specific period of time (i.e. 1, 5, 10, 20, 30 years). It is usually less expensive, particularly in your younger years, since you are buying a pure cost of coverage. Pure cost means there is no cash value built up inside the policy so you are paying just to be covered. The cost of the underlying coverage increases each year, since you get older. Term costs in later years can become very expensive.
Permanent life insurance is a combination of a term policy with a cash value component. Generally, the cash value component that builds within the policy helps offset the higher cost of insurance in later years. Once you are approved for a permanent policy and pay the required premiums, the insurance company can never cancel the policy — even if your health changes. However, the insurance company can cancel the policy if premiums are not paid when due.
When initially applying for life insurance, there are usually two requirements: a medical exam by an independent examiner, which usually includes records from your physicians, and a completed application.
What Kind of Life Insurance Should You Choose?
There are many forms of term or permanent coverage from the simplest to the complex. Policies can be plain coverage with no options or have many options that add significant costs. For full explanations and guidance on which one is right for your situation, ask a financial adviser that has a leading industry certification, like a Certified Financial Planner (CFP), Chartered Life Underwriter (CLU) or other recognized insurance designation.
The Cost of Term Life Insurance
Term insurance is for a specific, temporary period of time. The most common term insurance is called level term. For example, if you apply for a 20-year term policy, the company figures out the premiums for each of the 20 years and divides the number by 20, so your premiums stay the same (level) over the 20-year period.
Another type of term Insurance is called a renewable term policy, which provides you protection during a certain period of time and permits you to renew the policy prior to its expiration date. A new medical exam or evidence of insurability is not usually required during the term coverage.
Most companies have a term insurance age limit, which means you can usually renew the policy up until the age of 70 (though this depends on your state and there are certain exceptions that may allow a longer time period). The policy offers a death benefit, a face amount usually in the form of a dollar value.
Term policies are generally less expensive than purchasing whole life insurance since they do not have the cash value component. However, these become more expensive with advancing age. Most term policies allow you to convert to a permanent life policy during the term. Premiums (the amount of money you pay for the insurance) may be “level” — you pay the same amount each pay period for the same amount of coverage during the term of the policy — or “non-level” — the premium can increase in increments due to age or price stays the same with coverage decreasing as you age (think of a mortgage) where the increasing cost attributed to age is offset by the decrease in coverage.
The Cost of Whole Life Insurance
Whole life Insurance (permanent insurance) provides policyholders two benefits: a cash value and a death benefit — a dollar value paid out when you pass away.
How are premiums determined for whole life (or term) coverage? A premium is based on your age, health status, risk classification, company expenses and company profit. Also, the activities you participate in are considered. A person that hang-glides, races cars, scuba dives or flies a private plane is a higher risk and charged accordingly, for example. The premium starts with the mortality tables, based on your current age and referenced in the Commissioners Standard Ordinary Mortality Table. Your health status at the time of application is a major factor: a healthy person gets a more favorable rate than a person that smokes, has high blood pressure, diabetes or other riskier conditions, habits or hobbies. Premiums are usually “level,” which means you pay the same amount each premium due date (either monthly, quarterly, semi-annually or yearly) or they may increase each year.
How Much Life Insurance Do I Need?
The amount of life insurance is dependent on each individual, business or charitable need. Some people use a multiple of current income. I think this method is very imprecise and doesn’t reflect the uniqueness of each person. A better way is to estimate the costs of paying off expenses, such as your mortgage, student loans and car loans and add in replacement income for the remaining dependents, family, etc. The most precise way is a process called “Human Life Value.” The process is a complex calculation that is performed by skilled advisors and considers each individual’s future earning capacity and other unique individual factors.
There are many types of policies and companies that provide products. It is important to disclose your real needs, health history and situation, since policy costs can vary company to company depending on their willingness to accept your risk. Insurance is about matching an individual’s profile at the time of application to a company’s underwriting guidelines.
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