Life insurance can help protect the ones you love when you're gone—but you want to make sure that you do your research before committing to a plan.
On this blog, we often write about ways that people can protect their financial futures. Oftentimes, this advice boils down to one simple maxim: Be prepared for the worst. And is there anything worse than a person’s death leaving their loved ones in dire financial straits?
Luckily, that’s where life insurance comes in.
“Everyone who has someone who depends on them, and would be placed in a worse off financial situation were they to die, almost always needs some form of life insurance,” said Certified Financial Planner Joel Ohman, founder of InsuranceProviders.com.
But even once you decide to purchase a life insurance policy, there are still many more decisions ahead of you. Don’t worry. That’s why we’re here. When it comes to life insurance, here’s what you need to know.
How does life insurance work?
“A life insurance policy is a contract between you and an insurance company to provide you with coverage based upon your timely payment of premiums,” explained Chris Mason, senior vice president of sales distribution for independent health insurance agency HealthMarkets.
“It provides a death benefit to your named beneficiary (generally a spouse) upon your deaths. When you pass away, your beneficiary files a claim with the insurance company to submit proof (a death certificate) of your passing.”
“The death benefits from life insurance are often used to pay for burial and final expenses, replace the income of the individual who has passed, and/or to pay off a mortgage,” he continued. “If you leave behind a spouse, children or other loved ones, life insurance policies can help alleviate any financial burdens when coping with the loss of a loved one.
“Losing a parent, partner or spouse can be one of the most emotionally challenging experiences any one of us can face. If you add the financial aspects of this loss, it can seem unbearable. Having life insurance helps mitigate some aspects of financial stress.”
While some life insurance policies can be used for purposes beyond a straightforward death benefit payout, Ohman warned that consumers should be cautious with plans like these.
“Unless there are complex estate planning requirements or the insured has exhausted all other investment options, then typically the idea to use life insurance outside of a straightforward death benefit payout is a fool’s errand that will only result in a fancier car for your insurance agent,” he said.
Term life insurance.
When considering a life insurance policy, you’ll have to choose between two basic types: term life insurance and permanent (or universal) life insurance.
“Term life insurance generally offers the highest death benefit for the lowest cost, ” said Mason. “It covers a specific period of time, generally ten, fifteen, twenty or thirty years. Policyholders pay an annual or monthly fixed premium that is renewable every year. If you are young, premiums for this type of life insurance are low but as you get older, the premiums increase.”
Nelson Lee, managing partner of insurtech company Pacific Wealth Solutions laid out some of the pros and cons of both term and permanent life insurance. For term life insurance, his pros were the following:
- “In the short term, it’s much cheaper to buy the same death benefit compared to a permanent policy.”
- “Simple to understand, harder to be misrepresented. Die in this term and get this much. Die outside of this term you get zero. Easy to explain, easy to sell, easy to make a decision.”
As for the cons, here’s what Lee had to say:
- “If you die after the term expiration, you don’t get any death benefit claims. Zero insurance if you live too long.”
- “If you die after the term expiration, you don’t get any of your premiums back. Zero money back if you end up wasting the policy. There are a few rare policies that partially return the premium many decades after purchase, but they tend to be much more expensive than regular term (defeats purpose of term), and the amount returned would be worth very little due to inflation after 20 years, so it’s not a real return of premium value.”
Additionally, Lee shared some statistics that might lead you away from a term life plan.
“On average, most studies indicate that less than two percent (in some studies less than one percent) of all terms ever pay out,” he said. “In other words, 98-99% of all term clients end up wasting their money, gifting it to the insurance carriers in exchange for nothing when they die.”
“This is an average, meaning if you’re a younger person, your odds are even worse, simply due to life expectancy and age relationships.”
Permanent life insurance.
“Permanent life insurance is policies that will cover you until you die as long as the premiums are paid,” explained Mason. “Part of the premium goes toward cash value, allowing you to accumulate tax-deferred savings. Most permanent life insurance policies do not have a significant cash value in the early years, but they can perform very well over time if funded properly.”
If that sounds a lot like an investment account—similar in some ways to a 401(k) —that’s because it is!
“Permanent life insurance carries a “cash value” that is like a bank/investment account, that the client can use as a savings/investments tool, or simply to make sure they can withdraw cash when it’s needed in the future or get some of their money back,” said Lee.
Here are Lee’s pros for permanent life insurance, which came with a warning that these benefits, while great, are still often overstated by proponents of these plans:
- “As long as you keep the policy in force, you never ‘waste’ your money because insurance is permanent and never expires. Not possible to outlive your benefits.”
- “You get a ‘cash value’ that gives you the opportunity to make investment gains on the premiums paid, in addition to simply wanting to get your money back at some point.”
- “You have the opportunity to get all (or even more than) the premiums paid back, and still keep the insurance in force. Keep both, get money back and keep the insurance permanently.”
- “You can loan against the policy cash value for tax-free or tax-deferred income/gains.”
- “Death benefit can grow larger with time, as opposed to a fixed amount like term.”
- “In some products, payment amounts and periods can be fixed and guaranteed.”
- The top products will provide high rates of guarantees and very competitive risk-adjusted returns that may provide better risk-return tradeoffs than other investment alternatives.”
Similarly, Lee cautioned that his cons for permanent life insurance policies were also often misrepresented by those hoping to sell consumers on term policies instead:
- “If you pick the wrong permanent policy, you could lapse it, and end up paying more than term, and still get no insurance when you die, if it lapses before death.”
- “Mathematically and conceptually much more complicated than term, harder to understand, easier to misrepresent, easier for low-quality products (or agents) to disguise as competent ones.”
- “Some (not all) products have ‘perpetual’ payments built in, meaning you must pay premiums every single year as long as you stay alive, or in some instances require you to pay at least until age 90 or 100, although this type is becoming rarer and less popular, and don’t perform well. This product type pays the highest commissions (of course).”
- “Much higher premiums initially for the same amount of death benefit compared to term (although long term with proper cash value gains you more than making it back).”
- “Some product designs have variable returns and variable costs that provide no downside protection or guarantee for clients, making it riskier than the client might perceive.”
Which should you choose?
Sorry to disappoint, but there isn’t really a right or wrong answer here. The right policy for you will depend on your age, means, and other circumstances. Still, one thing you should do no matter what is to dig in deep and understand the policies you’re choosing from before you make your final decision.
In terms of the age factor, Lee offered these thoughts:
“If you are an older person and you don’t expect yourself to outlive the term of your policy (you think you will die in 10 or 20 years), and you don’t mind not getting your money back if you do live longer, and also don’t mind getting zero insurance if you live longer, then term might be a good fit for you.”
“If you are younger (younger than 40), you have likely more than 99.5% chance of just wasting your money on nothing. At the benefit of agents and carriers.”
Lee also warned about the dangers of making sweeping assumptions about term policies versus permanent policies:
“Overly broad generalizations in investments/insurance are exactly that—overly broad, almost never true, and almost always misrepresented to exaggerated. The credibility and bias of people making such oversimplified claims must and should be examined.
“Term and permanent life insurance are both very broad terms that each cover thousands of different products. It is simply not possible to say which is better in a cookie-cutter manner, and each has a place in the insurance industry.
“Which is better depends on the desired outcome, age of the client, investment requirements, acceptance of worst outcomes, expectations, carrier selection, product design, tax situation, etc.
“How much the pros and cons out-weigh each other really just depend, and that first assumes you were accurately informed of the pros and cons in the first place (unlikely),” he concluded.
Ohlman, however, has a different assessment. “It’s very rare that you need any type of fancy life insurance policy other than a plain vanilla term life policy. Term life is simple, straightforward, and likely much cheaper than you think,” he said.
He cautioned that the worst thing you could do was make a decision—any decision—unprepared:
“The options for life insurance are vast: From whole life insurance to universal life insurance to many variations and permutations of the above, some with market participation and investment exposure and others with a dizzying array of riders and features that will make your head spin. Be very wary about purchasing something that you don’t fully understand.”
How can you save money on life insurance?
No matter what plan you end up choosing, you should try and find the most cost-effective solution possible. That doesn’t always mean finding the deal with the lowest price tag. Far from it. Paying slightly higher premiums and getting a lot more from your plan can be better than paying less and getting less.
When you’re starting out, Ohlman recommends using an online calculator to help you determine how what level of coverage you’ll need.
“There are many different life insurance calculators online that will give you a good ballpark estimate of how much life insurance you may need,” he said. “Be sure to do a little homework and at least understand some of the different variables that go into determining how much you need before speaking with your insurance agent or another financial professional.”
“The nice thing about using a life insurance calculator online is that you don’t have to do any math (unless you like doing math, of course!). Just plug in the numbers and press the button!”
“If you find yourself getting bogged down with all of the various calculators and different formulas used,” he added, “then take a step back and just ask yourself this question: ‘What is the absolute minimum amount of money that my loved ones would need if I passed away to not have to worry about money, not have to change their lifestyle or dreams, and not have to get a new job?’ Now double it.”
Mason also had three great pieces of advice to help you save money and find the most cost-effective plan:
- “One of the most impactful ways to save on life insurance is to complete a needs analysis, as sometimes there is an overstatement or understatement. Doing the analysis with a licensed agent helps ensure you are buying the right amount of coverage and not buying too much, which could drive up the cost.”
- “Buy life insurance while you are young! It only gets more expensive as you get older. I always advise people to not procrastinate because every year you age, the cost almost always goes up.”
- “Work with an agent who can represent multiple carriers so they can see what might be the most competitively priced product for your needs. Different insurers have different stances on various health concerns, so having an array to review and choose from can help with costs.”
In the end, shopping for life insurance is a lot like shopping for any other large purchase. Do your research, carefully weigh the pros and cons, work with a professional when necessary, and then choose the plan that you feel works best for you!
Take care of your money—and your loved ones.
Taking out a life insurance policy is one of many things you can do to protect your family members and loved ones from financial disaster. In that way, it’s not all that different from building your savings, paying down your debt, and maintaining a good credit score.
When people don’t take care of those things, that’s how they end up needing substantial help when an unexpected bill or other financial shortfall takes them by surprise.
Nelson Lee began his career in Finance as an Investment Banking Intern at J.P Morgan, before spending 7 years at Northwestern Mutual (one of the largest mutual life insurers in the US), and Pacific Advisor, a 156-year old financial consulting firm, where he became its youngest ever Advisor of the Year in 2016, specializing in quantitative mathematics analysis of insurance transactions. Nelson founded Pacific Wealth Solutions in 2017 in pursuit to solve the most prevalent epidemics in the life insurance industry.
Joel Ohman (@JoelOhman) is a Certified Financial Planner™ and the founder of InsuranceProviders.com and has been mentioned in many different publications including AllBusiness.com, AOL.com, Banks.com, BusinessInsider.com, ChicagoTribune.com, Forbes.com, Inc.com, Newsweek.com, Reader’s Digest, USA Today, WashingtonPost.com, WiseBread.com, Yahoo Finance, etc.
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