Friday, October 23, 2015

The Definitive Guide to Life Insurance

RESOURCE: This guide is a part of my larger guide called The Definitive Guide to Workplace Benefits. Be sure to check it out.

This is my definitive guide to life insurance. I wrote this guide because a lot of people tell me they don't understand how life insurance works.

I've done my best to cover everything related to life insurance that I could think of below. Over time, I'll do my best to revise and add to it. If there's something that you think I should include, be sure and let me know in the comments.

My goal is to make the best guide to life insurance available online.

With that, let's get started.

What is Life Insurance?

Life insurance is pretty simple.

Life insurance is a contract with an insurance company. An insurance company agrees to pay an amount of money to a beneficiary when the person insured dies. In exchange, you pay an agreed upon premium to the insurance company.

That's a simple definition of life insurance.

What makes it complicated is the contract that lays out the agreement with the owner. This contract is usually called the policy.

I'll go through the different types of life insurance a little farther into the guide.

For now, the main thing that is important is that a life insurance policy is unilateral contract.

This means the insurance company has to abide by the contract as long as you pay your required premium.

You can decide to end your life insurance policy at any time. The insurance company can't do that unless the contract say they can.

That's why it's important to know what your life insurance policy says it does.

The First Type of Life Insurance - Employer Sponsored Group Term Life Insurance

Many people have some life insurance that they get through their employer and haven't purchased any coverage outside of what they get at work.

There are four types of employer sponsored group term life insurance. Those are:

The employer sponsored group term life insurance is owned and controlled by the employer. Because they control it, they can take it away or change it at any time. And if you leave employment or lose your job, you may lose that coverage.

Individually life insurance that you pay for is different in that you own it and control it. It's not dependent on where you work.

And that's the next kind of life insurance you need to know about.

The Two Primary Types of Individual Life Insurance Available - Term Life Insurance and Permanent Life Insurance

There are two primary types of life insurance that people usually have an option to choose from. The first type of life insurance is term life insurance and the second type is permanent life insurance.

Let’s talk about each of these two types:

  • Term life insurance The first type of life insurance is term life insurance. Term life insurance is good for a specific term or time period. Examples of term life insurance are basic group term life provided by your employer and 20 year level term life insurance.
  • Permanent life insurance The second type of life insurance is permanent life insurance. Permanent life insurance is designed to last your whole life. Examples of permanent life insurance are whole life, universal life and variations of universal life like variable universal life and indexed universal life insurance.

    Both types of life insurance have their place as long as you understand what they are and how they work. This is what makes a good life insurance agent a valuable resource. They can help you make sense of it all.

    What is the Best Type of Life Insurance to Buy?

    The best life insurance to buy is the life insurance that is in force when you die. Since we don't know when we might die, then we just have to do the best we can to match up the type of life insurance to the need that we are covering.

    Everyone feels differently, but I always suggest that people buy at least two types of life insurance policies instead of only one type.

    • A fully guaranteed whole life policy for final expenses (plus a little more) The amount of this policy will depend on how old you are. If you are near retirement, an amount closer to what a funeral might cost will make sense. But you never know, you might live another 30 years. And if you are younger, you might live for quite a long time. So I'd take the cost of funeral and multiply it a few times so that when you get to that point, you'll have a enough to pay for your funeral.
    • As much 20 to 30 year term life insurance as you can afford to pay for everything else This would be earmarked for debt or any other obligation that will reduce as you get older like the need to pay for college tuition for your children you might have had in younger years. I probably wouldn't keep that policy for the full term. Instead, while you are healthy, I'd opt to rewrite your term insurance every five years or so to extend that term out to as far as you can get it. 

    One thing I'd never recommend people do is buy a universal life policy unless they truly understand it and are going to watch it closely each year to make sure it's not underfunded. In the end, a lot of people lose their universal life policy because it's underfunded. This is exactly what the life insurance companies want to have happen so they don't have to pay a death benefit.

    In the end, most life insurance (especially your group term life insurance) won't pay because you'll just out live the coverage.

    That's why I suggest people buy some guaranteed whole life to supplement any term insurance through work or that they buy individually because everyone lives such a long time.

    Why Do People Buy Life Insurance?

    I always say that people buy life insurance because they "love" someone and want to care for them if they die too soon. The bottom line is that when people die, money is unfortunately needed and if you didn't have any money to leave behind, it could put a significant burden on the people you would have provided for had you lived.

    Some examples of how you might use life insurance proceeds are:

    • Pay for funeral costs Funerals do cost money and while the pine box in your back yard seems like a viable option (I think it's against the law anyway) that's not usually how your family decides to bury you. Most people try to buy at least some burial insurance and it's a pretty common kind of life insurance for seniors to look into purchasing if they didn't get buy any life insurance when they were younger. Older people either do that or they prepay for their funeral instead.
    • Pay off debts The most common debt you might want to make sure is paid off is your mortgage. Sometimes people buy mortgage insurance just for that purpose. But it could be used to pay off other types of debt like auto loans, credit cards and student loans.
    • Pay for future expenses You might want to provide money for college tuition or other costs for your children if you die to soon.
    • Lost income and survivor benefits When you add it all up, you make a significant amount of money during your lifetime. If you die too young, it does make sense to insure that income you would have made. You can also privately insure a pension plan's survivor benefit instead of taking the survivorship option.
    • Pay for business expenses and succession planning Closely held businesses have debts too that rely on an owner top pay off. Lenders might even require the owners to purchase life insurance to pay off business debts they have personally guaranteed. Key person insurance and buy-sell agreements can be funded with life insurance to provide money needed to provide continuity in the business and make sure it doesn't die when the owner dies. 
    • To pay taxes Life insurance policies are also used in estate planning where the death benefit is used to pay taxes that might be due upon death.
    • To make charitable contributions Some people have special causes they like to support when they die and use life insurance policies to provide those charities with money.

    How Much Life Insurance Do You Need?

    How much life an individual needs will vary from person to person and their attitudes towards the people they want to help and about life insurance in general. These attitudes will range from an "I want to do everything I can to help if something happens to me" to "I don't care what happens".

    If you want to be a sophisticated planner, you can use a life insurance calculator to help you calculate a specific amount. An easy way figure up what you need is to estimate the cost what a funeral might be, add to that the balance of your mortgage and other debt you owe to an additional lump sum amount you want to leave behind.

    Typically, since a lot of  people are on a budget, what most people do is buy an amount of life insurance they can afford each month rather than insure every possible need.

    Keep in mind, if you have a large estate or business needs, this will definitely affect what you might need. 

    Advantages of Life Insurance

    Life insurance does possess some unique advantages that you might not realize unless you took time to really look at it. Let's look at a few of those advantages:

    • Income tax free Life insurance as I write this is income tax free to the beneficiary that receives it.
    • Pays direct to beneficiaries If you make sure you've named a beneficiary, life insurance passes outside your estate. This means that creditors you owed can't take the money. Your beneficiary could use it however they want.
    • Available quickly Life insurance benefits are typically paid pretty fast - much faster than the time it takes to settle an estate which could be months down the line.
    • Can build and protect wealth Rich people use life insurance to protect and pass on wealth. Rich people don't let each generation start from scratch. They don't say I did it, my dad did it, my grandfather did it and so they have to too. The problem with everyone starting from scratch with nothing is that it gets harder and harder with every passing generation to build something. This is one reason the rich get richer and the poor get poorer.

    Life insurance is one of those products that when you see the end result of how the money paid helps people, that you truly understand how important it is. And that's why the right kind of life insurance is the first product I bring into every group I work with.

    Here are some additional articles I've written about life insurance:

    Let me know if you have any questions you have about life insurance in the comments below and I'll try and do the best I can to help you with your questions.

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    Michael is a champion of guaranteed issue for employees in the workplace. He's been an insurance agent since 1992 and has worked with thousands of employees.