How to Purchase Life Insurance

Life insurance is the orthodox solution to the financial problem posed by the risk of unexpected, premature death. By entering into a contract requiring an insurance company to compensate a named beneficiary or beneficiaries in the event of his death, an insured individual can transfer risk from his dependents to the insurance company.

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Techniques used to purchase life insurance are not different from those used to purchase other goods or services. First, find out whether the life insurance product is beneficial or not. Second, find out what it costs. Finally, determine whether or not the benefit outweighs the cost. If it does, buy the product.

Insurance Need is a Need Indeed

The benefit gained from life insurance derives from insurance need. Calculating precise insurance need is a job for an expert, such as a financial planner. It is not difficult, however, to describe the basic nature of the process in a simple case.

Basic life insurance need exists when people depend for their everyday expenses and future well-being on the income earned by somebody else. The breadwinner in a household has a classic case of life-insurance need. In order to fulfill this role, it is not sufficient to earn income that pays for the food, shelter and entertainment enjoyed by the dependents. The breadwinner must also make provision for his or her sudden, unexpected death.

A life-insurance contract transfers the risk of the insured individual’s death to the insurance company.  The company stipulates the amount of compensation received by the insurance policy’s beneficiary.  This money is paid when the beneficiary presents the insured’s signed death certificate to the insurance company. The amount paid determines the face value of the policy and is called (somewhat incongruously) the death benefit.

Calculating Insurance Need

It is sometimes suggested that life-insurance need can be met by a simple multiple of the breadwinner’s income, such as five or ten. In reality, each case should be calculated to reflect the specific needs of the insured.

To satisfy life-insurance need requires a capital sum that will throw off enough money to replace the insured’s income. In addition, the sum should also pay off long-term debt obligations such as a home mortgage. An individual with an annual income of $60,000 and an outstanding mortgage balance of $200,000 would need a capital sum of $1,000,000 to replace income, assuming a 6% rate of return on capital. Adding the mortgage of $200,000 yields a death benefit of $1,200,000. The individual should purchase life insurance with a face value of $1,200,000 in order to satisfy basic insurance need.

In Life, Timing is Everything

Once you have identified an insurance need, the next step is to decide whether it is temporary or permanent in nature. “Temporary” means that the need will disappear at some definite future point in your lifetime. “Permanent” means that you require the insurance to remain in force for the rest of your life unless you voluntarily surrender the policy.

The bedrock insurance need derives from the fact that some people depend on the income earned by others for their sustenance and future needs. Life insurance is designed to replace income that is lost due to the death of a breadwinner. The various insurance needs arising from the breadwinner’s death are usually temporary. Children, who are crucially dependant on income earned by their parents, eventually grow up, get an education and become independent income earners themselves. This process takes around 21 years. A 30-year home mortgage is issued contingent upon the mortgagee’s income. Eventually, the home is paid for and the mortgage expires. The breadwinner’s income also expires at retirement, after which there is no need to replace earned income because there is no earned income to replace. This insurance need typically lasts from 30 to 45 years.

There are, however, quite a few specialized cases in which permanent insurance is required, or at least recommended. Many people want insurance to pay for their final expenses after death – funeral, outstanding debts and more.  Since the date of death is unknown, the insurance must remain in place until the death of the insured. Estate planners use insurance to pay estate taxes upon the death of the insured. Once again, this is a permanent insurance need. Business owners use insurance to fund a plan of succession that will purchase their interest in the business when they die. They also insure key employees whose loss would seriously damage the prospects of the business. Business insurance need may be either temporary or permanent, depending on circumstances.

Everything in its Place

Temporary insurance needs are best met by temporary insurance. Term insurance was the original form of life insurance; it is effective for a specified time period or term. Its rates reflect only the cost of insurance (calculated by actuaries based on statistical life expectancy) and the costs of administration. The purest form of term insurance is annually renewable term, in which rates rise each year to reflect increasing risk of mortality. More popular are the standard level-premium term contracts for 5, 10, 15, 20, 25 or 30 years. Recently, a few companies have begun offering policy terms of any length between 15 and 30 years.

Permanent insurance needs require permanent insurance policies, such as whole life and universal insurance. Premium rates for these policies incorporate both the cost of insurance and a savings component. The cash-value account is conservatively invested by the insurance company and gradually generates a cash value. Thus, these policies combine risk protection and investment. For this reason, their premiums are much higher than those for term insurance. Whole life policies are slightly misnamed because they mature at either age 95 or 100, at which point the cash value rises into equality with the death benefit and is paid to the policyholder. Universal life policies allow the premiums to be paid (wholly or partly) by the cash value of the policy, thus reducing the effective premium cost of the policy and allowing more insurance to be carried. Universal life insurance is often combined with variable life insurance, in which the policyholder manages the cash value account and can invest the money in separate accounts that are functionally equivalent to mutual funds.

To Everything There is a Season

Young marrieds have the largest, and longest-duration, insurance needs. They also have the least income and wealth. Term life insurance is made to order for them. Its low rates allow them to fulfill all or most of their life insurance need for the longest amount of time. Level-term policies permit them to avoid the steady upward march of rates in an annually renewable term policy. Some term life policies are convertible into whole life insurance at maturity, which allows the satisfaction of an unforeseen demand for permanent insurance.

With age come certain insurance needs that demand permanent insurance. Final-expense concerns and estate planning come to the fore late in life. The older the applicant, the less competitive are term insurance rates. Some companies specialize in guaranteed insurance that requires no medical exam or underwriting. The face value of these policies is limited but sufficient to cover final expenses or fairly generous gifts. The ability to trade off cash value for premium reductions makes universal life insurance suitable for supplementing retirement income, particularly when combined with variable life insurance. Cash value can be accessed using tax-free loans that can be liquidated by the death benefit.

When the Going Gets Tough, the Tough Go Shopping

At one time, comparison-shopping for life insurance was difficult. Life insurance was considered a “relationship” product, sold through personal camaraderie between insurance agent and customer. The advent of the personal computer changed this. An independent insurance broker can canvass hundreds or even thousands of term life insurance policies to find the cheapest and best policy. The rewards for careful life-insurance shopping have never been greater.

Estate planning and gifting generally demand consultation with a financial planner or tax expert. Economy takes a back seat to due diligence; the primary objective is to make sure that the policy will perform in accordance with the policyholder’s wishes. Final-expense policies, however, do provide substantial scope for price comparison.

The Race is not Always to the Swift nor the Battle to the Strong – But That’s the Way to Bet

Perhaps the overarching point is that life insurance is not purchased in a vacuum or in isolation. It is part of a comprehensive and detailed financial plan that covers the years from young adulthood through retirement. Although no single part of financial planning lies beyond the mental capabilities of most people, the combination of qualities possessed by the planner is usually the result of training rather than heredity. Moreover, the increasing complexity of financial products and markets argues for the knowledge and judgment born of long experience. Recourse to a financial planner is not surrendering control over life, but rather enlisting the services of a professional navigator to insure that life’s journey follows the right course.

Summary

Mortality risk is an inherent problem for which life insurance is the orthodox answer. We purchase life insurance in order to transfer risk from our dependents to the life-insurance company. The purchase of life insurance is accomplished using basic economic logic: Calculate the benefit, compare it to the cost, then buy it when the benefit exceeds the cost. The benefit depends on insurance need, which can be complex but whose basic nature is clear. Basic insurance need requires a capital sum sufficient to replace the income of the insured and liquidate long-term debts.

If the insurance need is temporary, it can be met by term insurance. Young marrieds and businesspeople are classic buyers of term insurance. Permanent insurance needs require permanent insurance, such as whole life or universal insurance. Specialized needs, often connected with aging, are the source of demand for permanent insurance. These needs include final-expense, estate and tax planning, as well as gifting. Up-to-date technology affords unprecedented opportunity for careful life-insurance shopping, particularly for term insurance. The services of a financial planner can be valuable to those wishing to purchase life insurance.

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