Life Insurance Made Simple

by Kiplingers

Buying life insurance is arguably one of the most important financial decisions you can make, and one of the most confusing. The number of policies to choose from, and the complexities of some forms of life insurance, can make comparison shopping difficult, if not impossible.

This tutorial was constructed to help you cut through the confusion, and determine the type and amount of life insurance you need.

When Should You Buy?

Your need for life insurance changes with the stages of your life, starting with no need when you're young, progressing to greater and greater need as you take on more and more responsibility, and finally beginning to diminish as you grow older.

When you're single

Sad though your death would be, it's unlikely it would create financial hardship for anyone. Any honest financial assessment of your situation would have to conclude that you have little or no need for life insurance.

An argument could be made that you should buy a policy now while you're young and rates are low. And if someone -- a parent, say -- depends on you for financial support, then by all means, consider life insurance.

But consider the interest you could earn by saving and investing your money instead of spending it on insurance premiums. Still, if somebody -- a parent, a grandparent -- wants to buy you a policy now to lock in low rates for later in your life, accept it gratefully.

Love and marriage

Married couples with no children may need little or no life insurance, especially if both spouses contribute equally to the household income.

The death of either spouse would not be financially catastrophic; the other could presumably survive on his or her own income.

Still, it could be a strain. Perhaps the survivor couldn't afford the mortgage or rent payments on a single income, or maybe you have big credit card debts. Also, there would be funeral costs.

Each of you should probably buy a modest amount of life insurance to protect the other.

Married with children

A one-income family with young children is the classic high-need situation. Basically, all of these people are dependent on one breadwinner for their total support, so insurance on that life is vital. And if the nonearning spouse should die, the other would have to pay for child care -- a very expensive proposition that argues for insurance on both lives.

This same high-need situation exists for dual-income households with children, for single parents, and for those caring for elderly parents who have limited resources of their own.

The golden years

The kids have grown and are making it on their own. You have a pension and considerable assets that can be used to generate a good income after you die. In circumstances like this, you clearly don't need as much life insurance as you once did.

The one caveat here is estate planning. If your estate is large enough to be subject to the estate-tax when you die (that is, if it's above $1 million), your heirs can use the death benefit to pay the IRS. If the policy is held by a trust, the benefit would not be counted as part of your estate.

If no one depends on your income for support, you probably don't need life insurance at all.

How Much Do You Need?

Deciding whether you need life insurance is pretty easy. Figuring out how much you need is not easy at all.

Many people just pluck some figure out of the air that seems reasonable and settle on that. Some lean on an old rule of thumb that says you need four to five times your annual income. That's better, but in this day and age you really should approach the problem more scientifically. Either way, here's what you'll need to consider:

Immediate needs. What would it take to pay off the mortgage or other debt and continue funding the children's college funds. Don't forget about funeral expenses, probate costs and, depending on the size of your estate,

Future needs. Basically, you will need to estimate the income your dependents would need to maintain their standard of living if you were to die tomorrow. Then subtract from that figure the income they could expect to receive in social security survivor's benefits (to get the form you need to estimate that, visit the Social Security Administration Web site or call 800-772-1213).

Income when you're gone. Next, subtract the salaries your dependents now earn or could earn, the value of investments and other income sources. The difference is the amount of income your life insurance should provide. You have to make a number of assumptions in the course of this exercise -- complex assumptions that scare many people away from the task.

For instance:

You can see what makes this task so difficult. Insurance companies will make the financial assumptions for you, using computerized programs developed for the purpose. These can be helpful, but many of the decisions described above are too important to turn over completely to the company trying to sell you the policy.

Eventually you will have to pick some total insurance figure that seems a reasonable compromise between what you'd like to have and what you can afford, using the companies' estimates for reference.

Keep in mind that the purchasing power of the insurance you buy today will be eroded by inflation as the years go by.

What Kind Should You Buy?

For most people, term insurance makes the most sense. If you're looking for a savings component, get ready for some real confusion. Life insurance companies are brilliant at devising new kinds of policies. But try to remember that whatever the name on the policy -- universal life, variable life, Irresistible Life, Irreplaceable Life, The Champion, The Solution -- all are in fact variations on the two basic kinds of coverage: term insurance and whole-life insurance (also called cash value or permanent).

The case for term insurance

The fundamental purpose of life insurance is to provide dependents with the financial support they would lose if you died. If you're straining to buy enough insurance to accomplish that goal, then term is what you should buy. Dollar for dollar, term gives you the most protection for your money. Period.

Beyond that important truth, the arguments for term are the arguments against whole life. True, the cash value in a whole-life policy could add to your financial resources as the years pass, you can't get your hands on the cash unless you surrender the policy (thereby terminating your coverage) or borrow some of it. Borrowing keeps the policy in force, but any unpaid loan balance will be deducted from the face amount if you die. To restore the full face amount of the policy, you'll have to repay the loan, plus interest.

How expensive are these loans? Some companies charge variable rates so that the interest they collect reflects the current market. Others reduce dividends to reflect the amount of the cash value encumbered by the policyholder's loan, an approach called direct recognition. Under direct recognition, in effect, the more you borrow the less your policy earns. Either of these approaches can make policy loans more expensive than they appear. In any case, you can leave your options open by starting with a term policy that you can convert to whole-life coverage.

The case for whole life

One of the strongest arguments for whole life is that the cash value in the policy builds up tax free, which substantially boosts the compounding power of your earnings. If you have maxed out on 401(k) plans, individual retirement accounts, and other tax-sheltered savings and investment plans, then cash-value insurance provides another option. It's entirely possible that a $250,000 policy bought at age 35 could accumulate a cash surrender value of $100,000 by the time you reach age 65 -- a nice addition to your retirement nest egg if you decide you don't need the insurance anymore.

Meanwhile, you can turn in your policy any time after the first several years and collect the cash value, no questions asked. The proceeds are tax free to the extent that the cash value doesn't exceed the premiums you've paid. Or you can borrow against the cash value and leave the policy in force, with no requirement that you pay the money back (although you will owe interest on the loan, and if you die with a loan outstanding, it will be deducted from the face amount paid to your beneficiaries). It's safe to say that cash-value life insurance has financed many a college education, even though there may have been better ways to do it.

How Do You Get the Best Policy at the Best Price?

The obvious way to compare costs of different life insurance policies is to compare the premiums charged by different companies for the same coverage. That works fine for term insurance, but not for whole life.

Dividends, cash values, interest you could have earned elsewhere and the number of years a policy is kept in force also play important roles in determining the actual cost.

And it is nearly impossible to tell in advance how your premium is divided among insurance coverage, commissions and company profits, how much goes into the cash-value fund, and how much interest you'll earn on the cash value.

A handful of companies use something called the Barnes standard as a way of disclosing policy costs to insurance pros and financial planners, but consumers are pretty much in the dark.

Whole life benchmarks. Any agent will gladly produce a "net cost" calculation for you. That adds up all your premiums over a period of ten or 20 years, subtracts anticipated dividends and cash value, then subtracts that number from total premiums to produce a startlingly low net cost of coverage. But the net-cost method ignores the fact that you could have done something else with the money and perhaps earned even more than the policy paid you in dividends.

Insurance industry analysts have tried to incorporate this factor into newer formulas that produce a couple of esoteric numbers called "interest-adjusted net-cost indexes." By adding a certain level of assumed earnings, say 5%, to the cost of your premiums, these indexes account for the possibility that you might have chosen to invest the money at that rate.

The "interest-adjusted surrender cost" is a measure of the true anticipated cost of keeping a policy in force for ten or 20 years and then surrendering it for its cash value. The "net payment cost index" assumes you hold on to the policy until you die.

What to ask the agent. Most states require agents to provide these numbers for cash-value policies if you ask for them. Interest-adjusted costs vary according to the type of policy and your age at purchase. Armed with these numbers, you can compare the costs of different policies within the same company and among different companies. What you'll discover is that the cost of whole-life insurance is all over the lot. Careful shopping can pay off big.

Ask the agent for the ten- and 20-year "interest-adjusted surrender costs" per $1,000 of face amount for the specific policy being recommended. Also ask for comparable data for the same kinds of policies issued by two other companies. The agent doesn't have to furnish information on competitors' policies but should be able to obtain approximate figures for some companies from manuals widely used in the insurance business. If the agent won't or can't help, call other companies yourself.

Useful though they are, the interest-adjusted net-cost indexes are not an invariably accurate guide to what a policy will actually cost. They are based on the assumption that the cash values will earn a certain amount per year.

When interest rates are higher or lower than that, the relationships between premiums and cash values are thrown out of whack, especially in the later years. But the distortions affect all policies, so you can still use the indexes as a relative measure of comparative policy costs over the years, provided the issue dates and death benefits are the same.

2003 The Kiplinger Washington Editors, Inc.

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