Life Insurance 101
According to Encyclopedia Britannica1, insurance has been around for over 6,000 years! Bottomry contracts (weird name, huh?) in a nutshell were where shipbuilders took out a loan to build the ship and used the boat as collateral, but if the ship sunk, say in a storm, the lender lost out. Essentially the interest paid on the loan covered the insurance risk.
Turns out, even over 6,000 years insurance still works roughly the same.
What is life insurance?
Life insurance is simply a contract between you and the insurance company whereby you agree to pay premiums, and if you die prematurely, the insurance company will pay out a death benefit. Seems pretty simple, right?
What kinds are there?
The reason most people find insurance so confusing is because there are so many different types and add-ons and riders. Not to mention, life insurance is just one type of insurance; you’ve also got health, auto, rental, home, property and casualty, disability, etc. And each type has their own set of rules, riders, add-ons and contract norms.
For life insurance the types of insurance can be summed up into term insurance and permanent insurance. Term insurance is where you pay premiums for a specified period of time (usually anywhere from 10-30 years) and you’re covered under that term as long as premiums are paid. Over the life of the term, your annual premium doesn’t change, nor does your death benefit. At the end of the term, most policies do have the option to continue the coverage but at MUCH higher rates which will continue to increase each year.
Permanent insurance is what the name implies – it’s intended to provide lifetime coverage. There are several varieties of permanent insurance, each with their own rules, policy structure, and available riders. Some examples of permanent insurance are whole life, universal life, variable universal life, and indexed universal life.
Different permanent life insurance products can help accomplish different financial goals. For example, if you’d like to leave a bunch of money to your heirs upon death, you can do one type versus if your goal is to have tax free income in retirement (from the cash value of the policy) you’ll choose a different type. Some have features where you can adjust the amount of premium you pay each year, others you’re able to change the amount of death benefit (perhaps your need for insurance goes down because your investments have grown), and still others you’re unable to change either of those features.
How much do I need?
Despite Google search result’s 10x rule, there’s unfortunately not a simple way to say you need $X amount of coverage. Google search result’s 10x rule in many blogs and industry standards are to have cumulative life insurance in the amount of 10x your current income. This rule implies that as you get older (and generally earn more) that your need continues to grow, which is often the opposite effect of aging on your life insurance needs. In general, as you age you have less debt and more investments which tends to lower your overall need for life insurance.
As part of my financial planning process, The Custom Wealth Architect™, we do an in-depth analysis of your life insurance needs including your desires as it relates to leaving assets behind for heirs, your income, liabilities, assets, retirement goals, etc. With the help of our financial planning software, eMoney, we run what’s called an Insurance Gap Analysis to determine if you currently have any insurance gaps or if there will be any throughout the life of your financial plan.
After reviewing the Insurance Gap Analysis we’ll determine the best course of action to make up for any coverage shortfalls (taking into consideration your individual comfort level with risk) and include that as part of implementing of your financial plan.
The preceding two paragraphs are a relatively succinct way of saying that determining your life insurance coverage needs is a more involved process than many online resources lead you to believe. But, just because it requires analyses and financial forecasts doesn’t mean it’s too overwhelming to even consider – given the right financial advisor, the process should be seamless and low stress on your part.
If you’re wondering about your current coverage, if you’re looking for a second opinion on a policy, or if you’re just looking for more information, we’re available to set up a call or meeting!
- Encyclopedia Britannica. (2019). Insurance - Historical development of insurance. [online] Available at: https://www.britannica.com/topic/insurance/Historical-development-of-insurance [Accessed 5 Aug. 2019].