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Life Insurance Basics

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Life Insurance BasicsYou have probably heard that many many people should own life insurance.  What is life insurance, why is it so important and how does it work?

Life insurance has significant tax advantages and is used for a number of purposes, such as:

  • Hedge against an untimely death
  • Fund charitable gifts
  • Pay estate taxes and other expenses
  • Forced savings
  • Retirement planning
  • Business continuity

It is most commonly used to take care of one’s family in the event of an untimely death.

Types of Life Insurance

There are many different life insurance policy products and features available to consumers today.  However, broadly speaking, there are only two main life insurance policy types, term and permanent.

Term Life Insurance Policy

  • Pure insurance—no cash value or investment component
  • Offers death-benefit protection for a certain term or until someone reaches a certain age
  • Initial premiums are much lower than a comparable permanent policy

Permanent Life Insurance Policy

  • Provides coverage for life
  • Has cash value or investment component
  • Loans may be taken out against the cash value of the policy
  • May generally be surrendered for accumulated cash value

The two most popular types of permanent policies are probably Whole Life and Universal Life policies.

Whole Life Insurance Policy

  • Premiums fixed for life

Universal Life Insurance Policy

  • Premium flexibility
  • Shareholder may choose to increase or decrease premiums (which will increase or decrease coverage)

Who Should Purchase Life Insurance

Life insurance is an incredible financial planning tool.  However, not everyone needs it.  For example, a child may not need any.

However, if your death will result in financial consequences to one or more people (i.e. spouse, children, business partners, etc) that you consider unacceptable, then you should probably purchase life insurance.

Many people assume that only a breadwinner should be insured.  This is not always the case.  For example, the death of a “stay-at-home parent” can cause financial hardship as well due to childcare and other expenses that previously did not exist.

How to Purchase Life Insurance

  1. Do your best to figure out which type of life insurance and how much life insurance is appropriate for you.
  2. Obtain life insurance quotes from a number of different companies to get a feel for how much it might cost you and to keep your life insurance agent honest.  Rates can vary widely by company, so you can save thousands of dollars by shopping around.
  3. Armed with life insurance quotes, consult a life insurance professional.  Choose an agent that is honest, fair, experienced, knowledgeable, and who provides quality service.  A life insurance professional may help in the following areas:
    • Confirm you are choosing the best type of insurance for your needs
    • Answer any questions you may have and explain the details of a policy
    • Confirm the amount of coverage your are purchasing is appropriate for your needs
    • Determine if it is beneficial to replace an existing policy with a new policy

Take your time.  This is not a decision you want to rush.  Shop around, do your homework, and make sure you are comfortable with a policy before signing on the dotted line.  If your agent is pressuring you, find another life insurance agent.

Practical Life Insurance Application

If you are still on the fence, let me give you an example of how life insurance helps families in real life.

Example Fact Pattern

  • Sole breadwinner unexpectedly passes away
  • Leaves behind spouse and five children
  • Family has a $250,000 mortgage
  • Family has no savings
  • Surviving spouse never finished college
  • 2 children will be attending college in the next 5 years; the youngest child is a toddler
  • Funeral expenses total $10,000

Clearly when someone passes away there are emotional issues and a myriad of other concerns besides just financial concerns.  However, let’s focus on the financial issues:  how will the family manage after this sudden and unfortunate death?

Issues to think about

  • The surviving spouse could go back to school but how would the family be provided for during this time?
  • The surviving spouse could get a job, but the job may not pay enough to support their accustomed standard of living.
  • Day care might now be necessary so that the surviving spouse can work or finish school
  • How will the funeral expenses be paid?
  • How will the children’s education be paid for?
  • It will take time to find a job or begin college.  The spouse may also need time to grieve before thinking ahead.  How will the family be provided for during this time?

If the family had no life insurance, such an untimely death could cause financial ruin, including possible foreclosure and bankruptcy.

How Life Insurance Could Help

Let’s suppose now that the family has a $1 million life insurance policy on the life of the deceased spouse.

  • $250,000 of the proceeds could be used to pay off the mortgage, significantly decreasing the monthly expenses of the family.
  • $100,000 – $200,000 could be used to pay for the children’s tuition in the near future.
  • $10,000 could be used to pay for funeral expenses.
  • The remaining proceeds could be used as follows:
    • Pay for the surviving spouse’s college tuition
    • Support the family while the surviving spouse is grieving and finishing up college
    • Pay for day-care expenses
    • Boost retirement savings
    • Supplement the surviving spouse’s potentially lower income to maintain the accustomed standard of living
    • Create an emergency fund and build some food storage

Final Thoughts

  • Every family is different, but an untimely death in almost any family could bring financial hardship if not planned for appropriately.
  • Most families would be wise to purchase life insurance on both spouses, regardless of whether both work or not (although amounts could vary).
  • Do your homework and compare quotes from a number of different insurance companies.  This can save you thousands of dollars.

Additional Information

For additional information on life insurance, you might read the below books:

What are your thoughts on life insurance?  What type of life insurance do you own and why?  What tips do you have about purchasing life insurance?  Leave a comment below!

Image: devon/bigstock


{ 3 comments… add one }

  • Sandy November 4, 2012, 6:51 pm

    Good article. Thank you for the information you share. I’d be interested in additional life insurance articles in the future.

  • Ryan December 16, 2012, 10:49 pm

    Good advice. I like the relevant application with example figures.

    • LD December 17, 2012, 12:37 am

      Thanks Ryan. I think the example figures make it a little more real as you say.

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