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What is life insurance? The full breakdown

At a glance:

  • Considering life insurance

  • Choosing the best life insurance for you

  • The cost of life insurance

  • Working with life insurance agents

  • Evaluating life insurance companies

  • Summary of life insurance

Choosing a life insurance policy entails a lot of thought. Once you're providing for other people's financial security, as well as your health and your finances, there are many factors to consider.

Before you make a choice, familiarize yourself with the questions you will have to face. They can make the process much easier to navigate.

BOSTON, MA - AUGUST 27: Home Health Care aid, Lora Lodkina, left, helps Galina Zhidkova in the morning with some shopping in the Brighton neighborhood of Boston on Aug. 27, 2019. It's the late-in-life financial hit that can wipe out your savings and your children's inheritance. Yet few in middle age want to think about, or prepare for, a time when they'll need long-term care. The cost of such care is growing as the population ages, straining family finances and Medicaid budgets. Holding out little hope that a gridlocked Congress will come to the rescue, states are jumping into the breach. At least a dozen are crafting policies ranging from caregiver subsidies to expanded home care services to insurance funded through payroll withdrawals to help millions of disabled seniors afford personal care assistance. (Photo by Suzanne Kreiter/The Boston Globe via Getty Images)
Home Health Care aid, Lora Lodkina, left, helps Galina Zhidkova in the morning with some shopping in the Brighton neighborhood of Boston on Aug. 27, 2019. It's the late-in-life financial hit that can wipe out your savings and your children's inheritance. (Photo: Suzanne Kreiter/The Boston Globe via Getty Images)

Considering life insurance

When choosing life insurance, you should consider your life situation now and in the future and then ask yourself some questions.

Do you need life insurance?

Life insurance exists to protect other people who normally depend on your income. Although some forms of life insurance let you cash it in early for yourself if you so desire, it is not actually designed for you; it's meant to be used by certain others after you die. Do you have any such people—children, a spouse, or any other dependents? If you have none, you probably don't need life insurance. If you plan to have some dependents, then you should at least consider it. If you do have dependents, how much money would they need to survive, and for how long would they need it? Do they have additional sources of income, such as public assistance or investments?

Would they be able to afford costs related to your death, such as a funeral? What about any debts of yours? Normally, those would get paid out of your estate; does your estate have cash to cover these? If not, would your valuables and other property have to be sold off by your survivors to pay these debts? Could your survivors raise enough money from selling them? If the answers are likely to be "no," then you might consider a life insurance policy to cover your debts.

To what extent can you already afford to pay for expenses?

Considering the kinds of expenses that your survivors will be faced with is a good starting point for determining whether you need life insurance. Remember that some of these expenses may be the sort that is left behind by you. You can avoid the need for life insurance if you have some other means of meeting them. For example, you could set up a funeral fund, or you could donate your body to science and avoid most or all funeral costs. And you could specify in a will how to pay for any debts you have at the time of death.

If you have dependents such as a spouse and children, your situation will be trickier. You will need to forecast their expenses over many years and factor in inflation and unforeseen costs like medical bills. Whatever you cannot cover with the wealth they will inherit from you could be covered with life insurance. For many people, this is the reason they buy it.

Choosing the best life insurance for you

Choosing a life insurance policy depends on many factors about yourself. It's not possible to use a single rule of thumb to tell you how much you need. You will have to take into account such things as:

  • Your sources of income

  • Your dependents

  • Your dependents' expenses now and in the future

  • How soon your dependents will stop being dependents

  • All your debts

  • Your age

A general guideline used by many is that you would need life insurance coverage of between 5 and 10 times your yearly salary. An insurance agent can sit down with you and help you figure out how much is appropriate for you.

Term vs. whole

When choosing a life insurance policy, you will be confronted with the question of term vs. whole. Term is pure insurance, meaning that it pays a death benefit upon your death to your dependents. It is fairly inexpensive if you buy it young, and the premiums eventually rise greatly in price as you age. Whole life insurance is a death benefit plus cash value, the latter of which comes from how it is invested by the insurance company (term does not have this cash value). The premiums stay level over the years that you pay them, because they are averaged.

Between the two, whole is more expensive. Large commissions and fees are built into it during the early years. An important question to ask, therefore, is how much you are able to pay for premiums. If it's not much, then you may find term insurance more suitable for you.

There are variations on whole life called variable life and universal life. Variable allows you to choose the investments that will fund it, while universal allows you flexibility in the amount and timing of your premium payments (though there will be fees for this privilege).

Are you looking for an investment?

Some proponents of term life apply what is called "buy term and invest the difference," meaning they take the difference between term and whole life premiums and invest it elsewhere, such as a mutual fund. They build wealth that way while avoiding the large commissions.

Others like the ready-made investment nature of whole life. It is a product that takes care of a person's need to build up a nest egg for their dependents. This relieves them of the vigilance required to invest on one's own. Also, you can take tax-free loans out of a whole life policy, and you can also surrender it early (though that is contrary to its purpose). The earlier you surrender it, the lower its cash value will be. But once you do, you can use the proceeds for all kinds of important expenses, such as education or business use.

The cost of life insurance

Life insurance premiums vary a lot; ultimately, they are based on actuarial tables that project your life expectancy. Your risk as a covered person is also taken into account. If you are high risk—meaning you smoke, are obese, or work in a dangerous field or have a dangerous hobby—those risks will be factored into the premiums you pay. If you want to pay less for a policy but you are high risk, you will need to remove or lessen those risks.

What else matters?

Other factors that go into the price you pay for a policy include how much insurance you buy, whether it is term or whole (or some variation of these, such as universal, variable, accidental death and dismemberment, etc.), the amount of commission built into the policy, and the financial health of the insurance company.

Term vs. whole

Term life insurance costs less than whole life (although it rises over time and can eventually require higher premiums than whole). A group term life insurance plan offered by an employer is less expensive than an individual plan, because the cost and risk can be spread among several people. You will be covered as long as you are employed there; when you leave, you might have the option to convert it to a whole life policy.

Plan carefully

You should budget for your insurance premiums so that you do not lose coverage due to an inability to pay your premiums.

Working with life insurance agents

Life insurance agents are trained to help you with your life insurance needs. They will sit down with you and ask you questions about your financial life, your financial goals, and what you might need in an insurance policy. This discussion should come before, not after, talking about the insurance policies that the agent has to offer.

Here are some questions to ask the insurance agent you are talking with:

  • How many years have you worked as an insurance agent? Ideally, you want an agent with at least a few years' experience.

  • How are you paid? By commission? Fee? A combination of both? Not all agents get paid the same way.

  • What are your qualifications? By law, agents must have a separate life insurance license in each state where they practice. This is the minimum. A Series 6 license is also helpful. Other helpful designations include the Certified Financial Planner and the Chartered Life Underwriter.

  • What are your specialties within the industry? Does the agent specialize in estate planning, life insurance for younger people, or something other? Specialists can offer more focused service to you and your goals.

  • Have you ever been disciplined by your company or the insurance industry? Disciplined agents are most likely to have been terminated already, but it's a good idea to ask anyway.

Where is a good place to find an agent? Try another satisfied client. Or try asking:

  • Friends

  • Neighbors

  • Family

  • Co-workers

  • The agents who handle your other insurance policies

  • Professional colleagues

  • The Yellow Pages or your local newspapers

  • Your accountant

  • Your lawyer

Consider talking with several agents over the phone before making appointments with any one.

Evaluating life insurance companies

When choosing a life insurance policy, you will evaluate its premiums, its payouts, and any other provisions that are important. But equally important is evaluating the companies themselves? Why? Because their strength as an insurance company affects their ability to pay claims. After several years of paying thousands of dollars in premiums, you would hate to find yourself unable to get the insurance money you had counted on getting.

Keep tabs on any companies you are interested in by following them in the news. Bad news about them may indicate warning signs ahead. Continued good news can indicate good financial health.

The importance of ratings

Also look at ratings. Many insurance companies pay to be rated by various ratings services, such as Moody's Investors Service, Standard & Poor's, and Fitch, among others.

Ratings vary somewhat, but the closer to AAA or AA they are, the more financially sound they are. Ratings are an indicator of an insurer's ability to pay claims. High ratings mean that the company has enough assets and reserve money to continue paying claims. Keep in mind that you will make claims many years after you first buy a policy, so it's important to know that the company will stay in good health for decades to come.

Your state keeps tabs on insurers

Insurance companies are regulated at the state level; there is a state commissioner of insurance for this purpose. Many states gather complaints against insurers and compare them to the industry overall; they make this information available to the public. Complaint statistics can be helpful in gauging the quality of an insurer, because they say something about the policies themselves as well as getting claims paid.

IMSA

The Insurance Marketplace Standards Association is a membership organization for life insurers, created and run by the insurance industry. Its members must undergo evaluation and maintain high standards for sales and service in order to become members. If an insurer loses the endorsement of IMSA, that could be a warning sign of poor management.

Summary of life insurance

Not everyone needs life insurance. But if you do, now you know how to start looking for it. Evaluate your needs and the needs of any dependents. Project your financial state into the future as best you can. Evaluate insurance agents and the companies they work for. And change your lifestyle if you want to reduce the cost of your premiums.

Life insurance can buy you peace of mind, but it can also take a piece out of your wallet. Ultimately, you want to rest easy at night, knowing you have made a good decision.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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