An Introduction to Life Insurance
Published on - April 28th, 2009 (Modified on - February 17th, 2012) (by J.D. Roth) Many of you have asked for life insurance information, so Ray from Financial Highway offered to provide this guest post on the subject. This is new info for me, too.
Protecting your family from financial disasters is one of the fundamental components of financial planning. Life insurance should be a core part of that planning process. This article is a basic primer on life insurance, which should introduce you to the concept and give you an idea of how life insurance works.
What is life insurance?
Most people have a basic understanding of insurance. You receive financial compensation when an insured event occurs. Consider auto insurance, for example. If your car is in an accident or stolen, your insurance company provides compensation according to the terms outlined in your insurance policy.
On the surface, life insurance is pretty straightforward. When the insured person dies, the policy pays a prearranged amount to the designated beneficiary. The following parties are generally involved in a life insurance policy:
- The Insured. The person on whose life the policy is based.
- The Beneficiary. The person who receives the payment.
- The Owner. The person responsible for payment of premiums. It is typically the insured, but it could be the beneficiary.
- The Insurer. The insurance company that issues the policy promising payment.
Traditionally, both spouses have life insurance policies in order to protect their family in case one of them dies.
Why purchase life insurance?
The main purpose of any life insurance policy is to protect your family and loved ones against the risk of financial uncertainty. Life insurance can provide for the welfare of your family in face of your death. If you have a spouse, three kids, a mortgage, car payments, and credit card bills, what would happen to them if you were suddenly to die? Would your family have enough money to keep the house, car, pay off credit card debt, and send your children to college?
Life insurance can guard your family and loved ones from potential financial disaster.
Types of life insurance
While the idea of life insurance may be pretty basic, there are some complexities to consider. The most important point to remember is that there are several different types of life insurance products, which can make it difficult to select the right one for your family and your financial needs.
There are two basic forms of life insurance — term life and permanent life, the latter of which comes in several flavors. Here’s a quick breakdown of the basic policy types:
Term life is the simplest and (typically) cheapest form of life insurance. Term life is designed to provide coverage for a fixed period of time, such as 5, 10, or 20 years. The premium for the term policy is guaranteed for the duration of the term; if it is a renewable policy, the premium will increase with each renewal. The premiums for renewals are generally guaranteed when the original policy is issued. Because term life policy is for a specific period of time and the payout does not increase, the overall cost of term life insurance is usually very low.
The other three common types of life insurance are permanent policies &mash they last for the entire life of the insured, not just for a fixed period of time.
Whole life policies, for example, are designed to provide you and your loved one with coverage until your death. Unlike term life, there are no fixed periods for whole life coverage. Whole life is sometimes referred to as “cash value” insurance because it builds cash value over your lifetime. Whole life coverage contains both investment and insurance components. The investment portion invests your premiums, earns interest, and accumulates a cash value. On the other hand, the policy also has a stated insurance coverage amount that is paid upon the death of the insured.
One of the most popular forms of permanent life insurance is variable life. Variable life policies allow you to invest your premiums in the stock market. While a variable policy may offer more significant returns, it’s also at the mercy of stock market performance. In a poor performing market, the overall death benefit/cash value of the policy may decline — but never below a defined level. As a result, the policy may be more expensive because you may have to pay more to keep the policy active because less money is available to cover the policy’s premiums.
Universal life is a popular option that acts like whole life. It is a renewable policy — the investment component, premiums, and death benefits can be renewed and changed based upon the policy owner’s needs. The policy owner has flexibility over the policy — money can be moved between the insurance and investment components of the policy. The premiums, unlike whole life policies, can be paid out of interest from the accumulated savings.
Life insurance: A great tool
Because of its many options and overall flexibility, life insurance can be a powerful tool in your financial planning arsenal. Consider that life insurance can be used to pay for funeral costs, college tuition, mortgage payments, debts, and more. It can also serve as income replacement — providing your spouse and family with a greater sense of financial certainty. Make sure you compare multiple quotes from different providers to make sure you’re getting a good rate, but also be careful to make sure you’re being priced for the same level of coverage (here’s a table where you can compare different life insurance companies).
Remember, like all insurance policies, your coverage can lapse if you do not make timely payments. If you need help to cope with the complexities of life insurance, contact an insurance professional. You should also read the fine print closely (possibly with the help of your insurance professional) to understand if there are any limitations on the policy and what it covers.
Note: Ray has submitted a follow-up article that builds on this info to offer tips for purchasing life insurance. I’ll post that soon. Also, here’s a guest article on disability insurance that I hosted last year.
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True, but that does not mean they are not salesmen like the rest of the industry. They still have to sell themselves and may receive a fee for their time.
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I really did feel like I was reading a brochure instead of an analysis. And some other commenters have said, an intro to life insurance would be more like what does it do?, what can it do for you?, when shouldn’t you get it? and when should you get it?
Some basic analysis comparing the overhead costs of getting a policy versus self-insuring or managing your own investments would also be appreciated.
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I’m looking forward to part II, as this is something I’ve been wondering about lately, too. Thanks, Ray.
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Thanks for the feedback, everyone. Ray’s second post will go up in about 40 minutes. It’s still not going to satisfy those that are hungrier for more meat, but that’s okay. What we’re trying to do here is a lay a foundation for future articles on life insurance. As I mentioned elsewhere, I’ve always avoided this topic because I don’t know anything about it. I wanted to start at ground zero so that we can build from there in the future.
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Ray re employer-sponsored policies. Disagree – can be a good deal IF they’re portable, in other words, if you can take them with you when you leave the company. Many employer-sponsored policies ARE portable and you get the option of converting to an individual policy. The conversion usually carries over the group rate you were getting through the company, so you’re paying less than if you went out and bought an individual policy.
ALSO – would like to see more about options related to those of us non-breeders who enjoy matrimony sans kids. My hunch is to go with a term policy that would help my S.O. pay off the house if he wants to, and also helps make up for the fact that there’s just been a drop in joint earnings and savings.
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@The Beagle
Once you’ve been “cancer free” for five years you are eligible again. Check into it!
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Very insightful post there GRS, thanks.
One of my friends is actually a life insurance broker and been in the industry for around 4 years now, prior to that he was a car sales man and a bloody good one, he could sell snow to inuits if he needed to.
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Aron re Beagle, insurance underwriting is a whole other confusing story. It really depends on the type of cancer, treatment, stage, grade, and quality of follow-ups. I’ve seen standard insurance offers within a few years and declines outside of eight years.
Everybody’s different and every agent has access to different expertise and distribution channels (also no one agent has access to all companies). We really need personalized quotes from multiple perspectives. Other options fall short, in my opinion.
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Regarding the many people saying that you don’t need life insurance if you are single and have no dependents-
Personally, I have set my parents as beneficiaries for my policies in the event that I get myself killed in some stupid stunt that young people often do.
I consider it the least I can do to repay them for spending so much of their life’s earnings to raise me and put me through school.
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Dave C
Although I do agree with your point, when I tell my clients that they have no need for insurance, I still recommend they get at least enough to bury themselves with and cover any unexpected medical bills.
As for repaying for taking care of you, that is what paying for a nursing home is for.
Just kidding.
The other side of that though is this. What if you have, say, $900k in the bank, no dependents, no debt, you have no real need for it (assuming average middle class here).
Or even married with no dependents and no debt with $500k in the bank. Again, no real need, but a nice want.
Every situation is different.
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All types of insurance serve a different purpose. Term life is great if you covering something specific for a certain amount of time, be sure to pay attention to your state laws regarding at what age term insurance is no longer in force. Whole life is a great way to be insured while building cash value to provide flexibility in your life. Universal Life is a very similar to term, in that it is pure insurance with a very small cash value, whereas term has none. Variable life is a universal life insurance product, not a whole life product. It is set up similarly to a basic universal life product, but it has a separate rate account that is tied to the market, similar to how a brokerage account would hold mutual funds. Hope this helps clear some things up, and corrects some of the article.
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Jesse, spoken like a true cash value agent.
Last I checked my states laws, there was no limit on length of term insurance EXCEPT for what the company is willing to offer.
Whole life’s cash value is LOST upon death. The insurance company keeps it to offset their losses related to your death.
Universal Life was created to combat AL Williams & Associates on Buy Term and Invest the Difference. Sadly, the average it does after fees is around 5%. Although it gave you the chance of a higher death benefit, you had to PAY for it with even higher premiums.
Variable Life allows the premiums/face amount to fluctuate as to what you could afford.
Variable Universal Life took the best of both Variable and Universal. Averages about 7% after fees (the underlying funds still average around 12%). Same as Universal Life regarding the cash value, you have to pay MORE to keep it.
When you break all these products down to the core, they are all TERM products with a low yield savings plan with higer fees.
The only real benefit Cash Value products offer, is a lower risk to the insurance company and a higher commission for the agents selling them. The user get screwed. Or did you forget about the FTC investigation in ’79? The same one that caused the commissioner to get fired and the insurance companies that created those cash value products to push a law through preventing any further investigation into the industry without the industry’s permission? Kinda like you have to ask the Feds permission to sue the Fed.
If you are going to speak truth, speak ALL truth and not just sales pitch truth.
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I sell life insurance. And I confess that I steer clients to the policies I like. I like certain policies because I believe they are a better value. I buy them for myself.
The amount of rash judgment towards life agents in these posts is a little disgusting to me. Some of you said not to listen to an agent because he is an agent and receives commission. That is not advise, discussion or reason but rather an ad hominim attack on a whole profession. It sounds as brainless as talk radio to me. Whatever.
I recognize that 50% will not consider anything I say because of my profession. Too bad for them. I now work with high net worth individuals because articles such as this have poisoned the water for selling to the middle class. They ( the middle class) are just no longer worth the effort and it really is too bad for the middle class, because whole life is the one most suitable financial product for the middle class that there is. How has your 401(k)done the last ten years? Is it safe? Is it liquid? Is it there as cash when you really need it? Can you get equity out of your home when you are between jobs? The answer is yes to all of those questions with whole life except in the early years when the cash value stinks because of the up from commissions. After the early years, it start to work very well.
In contrast, qualified plans (IRAs and 401k’s) and aggressive equity investing has hurt a lot of people. Most middle class people over rely on equities in 401(k)s and home equity on the asset side of their balance sheet. As a result they are very illiquid in this bad environment. Also, putting so much saving in qualified plans has encouraged the use of debt to provide household operating capital. This reliance on debt for normal household capital expenses (cars, roofs, weddings etc.)becomes a lifelong leak in capital formation and creates long term wealth…for the bankers.
I have clients with old whole life contracts that have provided insurance for twenty plus years and have returned North of 5% on premiums paid in cash value and that will provide North of 10% if the client were to die this year. So what has been the “cost” to the client of insurance? Not exactly a screw job. Now the consumer does need to be careful as there are bad companies and bad products, but whole life insurance from a mutual company is a good asset in terms of a family balance sheet.
Also, these old whole life contracts have outperformed the S&P 500 over the last ten years. Bonds have now out performed stocks since 1968 according to John Mauldin. For an intelligent discussion of stock vs bond returns see: http://www.safehaven.com/article-12949.htm If one assumes a 4% risk premium for equities over bonds going forward, it is hard to make a case for whole life. At this point, I’d say it is pretty hard to make the case that equities can deliver that kind of premium and an aging culture such as is ours.
I hate to sound mean, but reading through these posts sound a lot like listening my fourteen year old son when he gets together with his friends and they talk authoritatively about things they don’t really know very much about.
My advise, talk to an agent from a mutual life insurance company and fully disclose your situation and let him come up with a plan. It will contain whole life. It might be a crummy plan, but I suggest you look at his work with an open mind and look how the contracts have performed historically. Use your head, ask lots of questions and look at the merits. But if you do buy cash value insurance, be sure to buy whole life and only from a mutual company. You will also need to buy some term insurance in order to afford the total amount of coverage you need.
Sorry for the long post.
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You’ve made a good case, Robert. I’m really sorry to say this but people in our profession have brought us the bad name. Hence, the stereotype that insurance agents will always misguide you for their interests. Nowadays, however, I’m hoping that the feeling has changed a bit since online quotes are being offered. When consumers compare the rates and different options, they feel more comformtable discussing them with the insurance agents. Probably because in the process of getting a quote they have done their homework. It leaves less room for insurance agents to scam people and consumers have more constructive questions to ask. But there will always be a dearth of insurance agents who are sought after and who have the ability to help their clients make more informed and calculated decisions. That’s why many times it depends on how good your insurance agent is because that’s why they are professionals in the industry by making a living out of helping people meet their needs and theres nothing wrong with that. If one believes that an insurance agent will always sell you something that is of more benefit to him than the consumer, then everything is a scam. Stop watching commercials, listening to radio, and doing business at all. Not everyone likes to sit in the corner behind the desk. interests drive initiatives and a better life.
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My clients love the way I present to them, but first I have to tell them how I operate. I am a independent broker so that means we, the client and I, get to shop the entire realm of insurance. When we are happy, I put the hat of the insurance company we chose on and act as their agent for the day. This way I get paid by the insurance company.
First they love that as a team we can review the hidden agenda of the insurance carriers, underwriting guidelines and financial strengths. But surprising to me originally is that they are happy the insurance company pays me a commission. That means I get paid regardless of which carrier they want to go with. This means whatever they decide my work for them is rewarded.
But I also back up this benefit by working really hard and being very patient and honest about the agenda of the insurance companies.
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