For many, discussing life insurance is about as interesting as watching paint dry. Above all, contemplating payments and payoffs surrounding one’s demise is quite an uncomfortable exercise for many. That said, life insurance is important for a variety of reasons, especially if you have a young family. The two major questions surrounding life insurance are how much and what type? We explore the first question in this blog post “How much Life Insurance do I need?”. Which leaves us with the second question, which type?
Types of Life Insurance
There are two types of insurance, term (temporary) and perm (“permanent”). Term insurance lasts for a specific period (like renting), typically anywhere from 10 to 30 years. “Permanent” insurance can last forever (like buying) but there are many caveats and assumptions.
Term insurance typically has as a level premium (cost), which means the premium is the same every year until the end of the term – very simple. The cost can also start out lower (compared to the level term) and increase annually (Annually Renewable Term (“ART”)). At some point, the ART policy can become much more expensive so the purpose of obtaining this policy is for a short-term solution (typically less than 7 years on average). Otherwise, the level term policy is the way to go.
What is convertibility and why is it important?
Most term policies are convertible to a “permanent” policy with no proof of insurability. If your health takes a turn for the worse and you are no longer insurable, or less insurable, you can convert your term policy – at the same health rating – into a new “permanent” policy with the existing insurance company. You are able to convert up to the full amount of insurance you already have but your premium will be based upon your age at the time of conversion and commensurate with the new product costs. If you are healthy, you can always reapply for insurance anywhere. The conversion option is a good safety net but is only as valuable as what you can convert into. Some insurers and products are better than others, so be sure to work with a credible insurance company with good products (both subject to change).
Why are there quotation marks around the word “permanent”?
Unless your product has a specific guarantee to last for your lifetime, the product is not truly permanent! This is a very common misconception. There are two types of “permanent” policies: whole life and universal life.
Whole life insurance is typically guaranteed and very expensive because, in addition to the death benefit, you accrue cash value. This type of policy is neither flexible nor transparent. This is a long-term commitment and you will not know what you are paying for. Conversely, universal life insurance is flexible and transparent. You will know exactly what you are paying for and you can change the premium payment and reduce the death benefit over time.
The cash value in a traditional whole life policy (typically) accrues based upon the company’s stated interest rate and non-guaranteed dividend. The cash value in a universal life policy can accrue based upon the company’s stated interest rate or by stock market performance. What most people do not know is there are two triggers the insurance company can pull to change the way these policies work. What you initially bought can change which may mean you need to pay more money down the road. The insurance company can increase the internal cost of insurance and reduce your cash value crediting rate down to a stated minimum. If one or both of these things happen, you may need to pay more money to keep the policy in force for as long as you initially intended. The reason for this is that the cost of insurance increases over time and the insurers use some of this cash value to offset your future premium payments. If the cost is higher and/or the cash value is lower, you need to pay up to make up for the difference!
Term vs. Perm Life Insurance
For most, term insurance is the way to go because you can obtain more insurance for less cost. The need for insurance typically diminishes as you approach retirement age since your debts may be less, your assets may be more and kids (hopefully) are out of the house. “Permanent” insurance is popular for those in need of estate planning to help offset estate tax costs. Some like to have “permanent” insurance in order to provide liquidity if their estate consists of illiquid assets such as real estate.
If you currently have life insurance, it is always a good idea to have it reviewed regularly by a trusted insurance agent. If you need to obtain life insurance, you should talk to a fiduciary financial advisor for advice. “Independent” life insurance brokers are desirable as agents as they can work with multiple top carriers instead of pushing proprietary products.