What is Life Insurance?

Life insurance is like any other form of insurance. You enter into a contract with an insurance company who promises to pay a certain amount of money when needed, in exchange for you paying them a monthly premium.

The only difference is instead of medical or disability insurance, life insurance is paid only once, upon your death. This amount is a lump sum payment, known as a death benefit.

Why Buy a Life Policy?

Life insurance also differs from other forms of insurance because it isn’t designed to help yourself; rather it is for your family. Your life insurance plan is an opportunity to protect your loved ones from financial risks after you have passed away.

This money can be used to: make up for your lost income, fund your children’s education, pay off any debt, and cover your funeral and other related expenses [1]. Even if you are single or a stay-at-home parent, these costs could apply to your family too, making it necessary you have life insurance.

How Much Do I Need?

There are many ways to calculate how much life insurance you need. The first and easiest way is to multiply your income by ten. This method is an easy way to get “in the ballpark” of how much your policy should be but is oversimplified. The second calculation is to use the ten times rule, plus $100,000 per child for college.

Again, this is a simplified calculation that doesn’t take a detailed look at your family’s needs. A third way to calculate your needs is called the DIME formula. DIME stands for Debt and final expenses, Income, Mortgage, and Education.

This method takes a more in-depth look at your family’s needs but doesn’t take into account savings you already have and the contributions of stay-at-home parents.

A more detailed calculation is to add together your financial obligations and subtract your liquid assets [2].  To calculate your obligations you: Add your salary (times the number you years you want to replace) + your mortgage balance + other debts + future needs (like college and funeral expenses).

If you are a stay-at-home parent, this includes the cost to replace services you provide such as childcare, cooking, and home maintenance. From this total, you subtract your liquid assets, for example, your savings + existing college funds + current life insurance.

Another method of calculation is your replacement income need [3]. This method, like the previous method, takes into account everything you provide for your family. This number should include salary, benefits, and services you provide. You then subtract your personal consumption from this figure (i.e. Personal spending needs such as food, clothing, entertainment).

A final method of calculation is called a survivor needs analysis [4]. A survivor needs analysis is founded on ensuring that your family can maintain a particular level of income and lifestyle. You then compare these needs to your current assets (Such as existing life insurance and other income sources).

In addition to these calculations, there are multiple policy calculators for you to use. These calculators allow you to enter in your information, and they generate how much insurance you should purchase. You can also always speak with an insurance agent to get a more accurate prediction of the amount of insurance you will need.

How Much Does It Cost?

Each premium is different, as it is based on how risky insurance companies believe it will be to insure you. Some factors used to determine this are: age, gender, tobacco use, health status, personal medical history, family medical history, lifestyle (Is your occupation dangerous? Any risky hobbies?), and where you live.

As an example, compare two men, both healthy nonsmokers, ages 35 and 50. The 35-year-old will pay an average of an average of $430 a year for a 20-year term policy worth $500,000. The 50-year-old man will pay an average of  $1,300 a year for the same policy [5].

What Are the Different Types of Life Policies?

There are two primary forms of insurance: term and permanent. Within permanent life insurance, there are three main subcategories: Whole, universal, and variable life insurance.

Term life insurance is the most straightforward type of life insurance. Under term life insurance you select a policy length, generally 10 or 20 years, and your premium stays the same for that period [6].

Insurance companies may offer continued coverage after your policy has expired, but at a more substantial rate. Term life insurance is popular because it is usually less expensive than permanent life insurance.

Permanent life insurance differs from term life insurance because if offers a cash value component (in addition to the death benefit), and does not have a policy time limit. The simplest and most popular type of permanent life insurance is whole life. Policy premium payments for whole life insurance are fixed.

Having fixed payments means the amount you pay for your monthly premium will stay the same throughout the length of the policy, pending you not letting your coverage lapse. The insurance company then invests part of this premium, which is how the cash value of the policy is derived. These investments are allowed to grow tax-free [7].

Universal life insurance shares many of the same qualities as a whole life policy. It is a permanent policy and has a cash value element that can grow tax-deferred. The biggest difference between the two is that a universal life insurance plan offers a greater deal of flexibility than a whole life plan.

This flexibility is derived from the fact that universal plans allow individuals to raise or lower (within certain limits) their premium payments and coverage amount.

Variable life insurance, like universal and whole, is a policy that offers permanent life insurance, a death benefit, and cash value. Variable policies get their name because the cash-value component of the policy comes from investments in stocks, bonds, and equity funds. This form of investment results in your money being subject to the ups and downs of the market, or an increased variability.

Individual vs. Group

Group life insurance is a type of life insurance offered to a defined group of people through your employer, or a professional group. These group plans are provided as a portion of the employee benefits package, or as an elected benefit at a group rate. A group life insurance policy offers several potential benefits such as cost savings and a greater chance of acceptance [8].

The supplier of the group policy (employer, professional group, etc.) is usually able to negotiate lower premium rates than you would pay as an individual. Rates for group insurance are based on the volume and risk profile of the group, which means that there is no individual health assessment.

Having no individual health assessment gives you a greater chance of being accepted if you have a more serious medical condition.

There are a few disadvantages to group life insurance. The first is control over your coverage limits, and policy, in general, is in the hands of the group you purchased your life insurance through. Group policies also don’t allow for the freedom to choose among a variety of policy options, that shopping for individual coverage would.

Your group policy also might not offer enough coverage for your needs, requiring you to purchase additional individual life insurance. Lastly, group life insurance typically means if you leave your employer, or professional group, you leave your life insurance plan too.

Depending on your policy and your insurer, you may be able to convert your group plan to an individual one, but the cost could increase considerably.

References

[1] https://www.metlife.com/individual/life-advice/personal-insurance/life-insurance-policies/index.html
[2] https://www.nerdwallet.com/blog/insurance/how-much-life-insurance-do-i-need/
[3] https://www.metlife.com/individual/life-advice/personal-insurance/life-insurance-policies/index.html
[4] https://www.metlife.com/individual/life-advice/personal-insurance/life-insurance-policies/index.html
[5] http://money.cnn.com/retirement/guide/insurance_life.moneymag/index9.htm
[6] http://money.cnn.com/pf/money-essentials-life-insurance-policies/
[7] http://www.goodfinancialcents.com/types-of-life-insurance-policies-explained/
[8] https://www.nerdwallet.com/blog/insurance/life/pros-and-cons-of-life-insurance-through-work/