Article

How to Survive in the Life Insurance Jungle

Financial planning means an individual takes a multi-period approach to her financial situation, a look at her sources of cash inflows and her consumption patterns. It implies a desire and a design to maximize the utility of lifetime income by spreading its spending in a planned manner.

Life insurance is one piece of the financial planning puzzle. It provides a measure of certainty by guaranteeing funds will be available for future consumption upon the death of the individual. These funds will be required, at least initially, to meet burial expenses and income tax considerations that will certainly arise. Beyond these necessities, insurance proceeds can assist family and others who will suffer a serious financial loss due to the death of the insured.

Life insurance policies fall into two groups: temporary and permanent. While permanent insurance is in force until death, and is generally more expensive, traditional term insurance, if renewable, is regarded as temporary insurance because it usually runs in five or ten year cycles.

The premium and death benefit of a term policy are guaranteed to stay constant over the life of the contract, but once the term has expired, the consumer must pay a higher premium to maintain his or her level of coverage. It cannot be renewed beyond the point of his or her actuarial life expectancy, typically about seventy-five years of age.

The traditional form of permanent insurance is the whole life policy that features fixed premiums and protection over your lifetime, provided it is a “non-participating” policy that does not distribute dividends to its holder.

There is a savings component to whole life insurance. In the early years of a permanent policy, the consumer will pay more than the insurance company’s true cost of insuring his life. These payments are held in reserve to fund the policy in future years when it becomes more expensive to insure him. Meanwhile, the difference between the premium and true mortality cost earns interest and produces a cash value for the policy.

A “participating” policy provides dividends back to the policyholder as means of returning some of the overpayment of premium that it exacted in the early days of coverage. Or he can borrow against this amount and be charged interest for the privilege.

Traditional renewable term insurance is cheaper at first, but becomes more expensive over time. You can think of renewable term insurance in terms of paying rent on a house and permanent insurance as buying the house outright. It costs less to rent on a monthly basis but in the end, you have no equity. When you buy a home, your payments are initially higher, but in the end you own something of value.

If you cancel term insurance, you get nothing back. With a whole life policy, you can draw upon your built up savings should you wish to cancel.

The decision between term and permanent insurance is often a contentious one. However, more experts in recent years have opted for the former. Their reasoning is that most persons have greater insurance needs when they are younger, with a family to feed and a mortgage to pay. As they get older, the children leave the nest and start to make a life for themselves. At this time, the insurance needs of the parents diminish. Consequently, the real issues are those of coverage and affordability. Term insurance typically provides more insurance for the same dollar.

If you go the term route, the best value is in five, ten and twenty year renewable policies. These are important because it means that you will always have the right to renew the coverage without having to take a medical examination to prove that you are insurable. It also means that the renewal premiums will be guaranteed.

This is not to say that permanent insurance does not have a place in your financial plan. For anyone whose estate will need a large amount of cash upon death, having some permanent insurance will always come in handy to pay taxes and other unexpected expenses.

If you purchase a “convertible” term policy, you can change to a permanent policy without having to prove insurability.

One variant of permanent insurance is the universal life policy which was developed in the late 1970’s to provide the benefits of the then high interest rates to policyholders. In addition to an insurance component, it includes a tax-sheltered cash-value fund that fluctuates with current interest rates. The death benefits are not guaranteed but are adjusted by the insurer as prevailing interest rates change. Most such policies will charge you a fee to opt out of the plan within the first fifteen years of its purchase.

The last and by far not the least most important consideration in the purchase of life insurance is how much coverage to buy. The best way to answer this question is to tally up (a) how much money you will need to meet your last expenses, including funeral costs, taxes, debts and clearing your mortgage and (b) how much money your family will need to replace your lost income stream, including inflation. Then, determine what investments and other monies will be forming your estate and term this (c). The amount of insurance coverage you should be carrying can be seen as (a) + (b) - (c).

Article ©1998 The Quarterly Dividend
Reprinted with permission