Life insurance is a way to transfer the financial risk of someone passing away from the beneficiaries and heirs to the life insurance company. A life insurance policy is a contract between the owner of the policy and the insurance company which promises to pay a stated death benefit upon the death of the insured person, as long as the death occurs during the period of time covered by the policy. Life insurance is important because it can pay expenses left behind by the insured person after their death such as mortgage and credit card debt and the cost of the funeral and burial. Life insurance also provides income for beneficiaries who were depending upon the lost income of the insured person.
Why Life Insurance?
There is no getting around the fact that death is an unpleasant subject. However, when people are depending upon someone to provide for them financially, some plan must be made for this unfortunate circumstance. These are the most common methods implemented by people and their families for dealing with an early death:
Having Remaining Beneficiaries Increase Income After Death
This is a common tactic used when one spouse passes away, and the other spouse is forced to either go to work or work more hours after the passing. This is not always enough to mitigate the lost income because the other spouse may not be able to generate as much income as the deceased person. There may also be new costs associated with working more hours such as daycare and commuting expenses. It also places a burden on a family already under duress from death.
Saving For Death
Some people choose to put away a nest egg, which can be accessed by beneficiaries if they were to pass away. This is a good technique if it is feasible to save enough money before death occurs. The problem is that an early death is unpredictable, and unless you already have enough money put away there is a danger that the beneficiaries will be left short of what they need.
Purchasing Life Insurance
The choice many people make is to purchase a life insurance policy. This can provide a large amount of protection for beneficiaries for a very affordable price. Life insurance is so affordable because the risk of any given policy holder dying is fairly low. This means that those deaths that do occur are supported by all the policy holders who remain living. Because over a large sample size the statistics hold very true, the life insurance company can predict with a high degree of accuracy the percentage of policy holders that will have a death claim filed in any given year. This concept is known as the law of large numbers, and it is an important fundamental that makes all insurance work.
Life insurance will provide a large one time death benefit paid to beneficiaries, and there are a number of uses for this. It does not necessarily need to provide for beneficiaries their whole life, but can also be used in conjunction with other techniques such as saving and working more hours, for instance to first pay off debt and ease the transition period while the surviving members of a family find work.
Types Of Life Insurance
Life insurance is structured in the form of more than one product type, and the divisions are important to understand as they all serve a slightly different purpose.
Term Life Insurance
Term life insurance is a policy with an expiration date. This does not have a cash surrender value, and will not necessarily last for the whole life of the insured person (unless they die within the coverage period). Term insurance is useful for those who only need coverage for a certain period of time, for instance until retirement or until children can support themselves. Common lengths of term life insurance are 10 years, 20 years, 30 years, and coverage that lasts to a specific age such as 80 or 90.
Term life insurance is by far the least expensive form of coverage in terms of annual premium. Unlike other permanent forms of insurance though term life insurance does not carry a cash value, and if the insured lives to their life expectancy it is unlikely a payout will ever be made. Term life insurance premiums are typically level, but some policies may have rising rates. Term quotes are easy to compare and you may enter your zip code in our comparison tool to compare quotes for yourself.
Whole Life Insurance
Whole life insurance is meant to be there for the entire life, or “whole life” of the insured person. Whole life insurance will accrue a cash value, pay dividends, and withdrawals and loans can be taken against it. This type of insurance is good at providing both a way for savers to put money away and to also provide life insurance protection for their beneficiaries. Whole life insurance is more expensive on a yearly basis but over the long run will usually provide a positive internal rate of return for the money invested.
Universal Life Insurance
Universal life insurance is another form of permanent life insurance, meant to be there for the entire life of the insured person. Universal life insurance is also a policy that has a cash value, though it is illegal for it to be marketed as an investment. Universal life insurance charges a rising amount of insurance costs over the lifetime of the insured. The cost of insurance is taken from the cash value account each month. The cash value account pays an interest rate, which must be at least 2% but is higher when prevailing interest rates rise. Policy owners have the option to pay in more than the cost of insurance each month, and this increases their cash value and in turn the amount earned by the policy over time.
The potential benefit of universal life insurance policies is that if they are funded well the amount of money earned will pay the cost of insurance over time, and at some point additional premium payments may not be required.
Variable Universal Life Insurance
Variable universal life is similar to a universal life insurance policy in all regards, expect for the way the money is invested in the cash value account. Instead of paying a set rate of interest, the money is invested into variable sub accounts. These sub accounts are essentially mutual funds which fluctuate daily according to the change in value of their underlying investments. This is a way to combine the tax benefits of life insurance with the potential earnings power of an investment account.
Similarly to traditional universal life insurance, the cost of insurance rises over time, and the potential benefit of the variable policy is that a well funded policy which performs to expectations in regards to the investments in the sub accounts may not need additional premium payments to be made after some point. The risk with variable universal life insurance is that the policy will not grow and will perform poorly if market conditions are bad. This can lead to the policy needing more funding over time.
Life Insurance Is A Versatile Tool
Life insurance has a surprising amount of uses. Not only does it provide protection from an early death for families, but it can also protect companies and partnerships. For instance business partners may own life insurance on each others life, and if one were to pass away the other could buy out his partners share in the business from his family with the life insurance proceeds. Businesses also purchase life insurance on key employees, called “key man insurance” which protects the business financially if they lose someone critical to the functioning of the company.
Perhaps the most common use of life insurance besides as protection for families in case a bread winner passes away is it’s use as a retirements savings and investment tool. Life insurance enjoys tax deferred growth. Over the course of a lifetime this tax deferred growth can add up to big returns, especially when one considers the return net of taxes. Whole life insurance can provide significant income through dividends to supplement retirement as well. For more information about life insurance as an investment, read our article here.
Life insurance can also provide tax efficiencies for passing on a sizable estate to the next generation, and can fund trusts that can support heirs for generations to come.
Life Insurance Is Necessary
Life insurance can at first glace be an unpleasant subject, but once you understand all the benefits and uses, it becomes quite apparent how beneficial it can be to you and your beneficiaries. Life insurance is a necessary product for everyone to own, and its benefits are evident during every phase of ownership.