Only 69 percent of families have any life insurance protection, and most of them have too little. The difficulty of facing the risk of dying and the seemingly vast array of life insurance products from which to choose makes this a financial decision that’s easy to put on the back burner. But if you have dependents, life insurance will prevent them from experiencing financial hardship due to your premature death.
In the insurance business, common wisdom says that life insurance is not bought, it’s sold. This doesn’t imply the use of high-pressure sales tactics, but rather that the salesperson often has to educate the consumer about why they need life insurance, how much they need and the products that are available. Obviously, if you come forearmed with some basic knowledge, you’ll be able to ask the right questions and make better decisions. Since I’ll only be able to give you a barebones sketch here, you should do some more research before making your insurance purchase. An informative (and unbiased) resource is on the Web at www.smartmoney.com/insurance/.
Let’s begin with how life insurance works. Like other insurance products, life insurance is based on the concept of risk pooling. You and many other policyholders in the insurance pool each pay a small premium, and if you die, your beneficiaries are paid a sum of money that they can use to offset any losses incurred as a result of your death. Unlike property insurance, where the insurance benefit is designed to pay you back for a specific dollar loss, life insurance is designed to replace the income you would have earned if you hadn’t died prematurely. The amount of insurance you carry is your decision and should be based on a reasonable estimate of the financial needs of your dependents.
Life insurance policies can be classified into two basic types: term and permanent (which includes whole life and universal life). Term life insurance is pretty simple: you pay a premium for death coverage for a specific term, often one year. If you die within that term, your beneficiaries are paid; if you don’t die, that’s the end of the contract. Since your risk of dying increases as you get older, term insurance may be unaffordable or unavailable for the old and unhealthy. For young, healthy families, it is usually the cheapest alternative – only a few dollars a month for purchasing a large amount of life insurance.
In contrast to term insurance, which provides short-term death protection only, permanent life insurance policies are multi-year – and often fixed-premium – arrangements that include both death coverage and an investment component. In its simplest form, you pay the same premium every year the policy is in force, often 20 years or more, thus spreading the cost of your death risk over your whole life. In the early years, you’re paying more than you would for term insurance, so the insurer invests the extra money to ensure that there will be sufficient funds to cover more expensive death protection when you’re older. The insurer credits you with a portion of the invested funds called the cash value against which you can usually borrow at favorable rates.
Although there isn’t room in this column to explain all the possible contract variations, one of the best optional features for term insurance is guaranteed renewability (without a health exam). Despite the advantages of forced savings in permanent life insurance, for most people term insurance will provide the greatest coverage for the least money. There are many other alternatives for investing.
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Vickie Bajtelsmit, Professor of Finance, Colorado State University College of Business, firstname.lastname@example.org