Life Insurance 101: Everything You Need to Know to Plan for the Future
It’s almost May, and the era of adulting is nearly upon many soon-to-be college grads.
Just like (eventually) trading your sports car for a minivan, the whole idea of life insurance is one of those finer details of adulthood usually placed on the back burner. You’ll deal with it eventually, right?
If for no other reason, let’s take a peek into the basics and benefits of life insurance in honor of National Life Insurance Day on May 2 — which will mark 259 years since life insurance became available in the U.S.
Perhaps not surprisingly, recent studies show Millennials are the least likely to purchase a policy, but they aren’t exempt from the consequences of neglecting it.
“Young people and college students may not think they need life insurance, but if you have school loans you’re on the hook to pay back, having a life insurance policy is a very good thing,” says Lynne McChristian, communications consultant for the Insurance Information Institute. “If you don’t have coverage, your parents probably co-signed that loan for you, and they would be responsible for that debt.”
Among those of all ages in the United States, about 60 percent had some form of life insurance in 2018, according to the Life Insurance Marketing and Research Association’s 2018 Barometer Study.
For those without it, the good news is that same study says life insurance is likely cheaper than you think: 44 percent of Millennials overestimated the cost of life insurance — at an average of five times what it actually costs.
Life insurance benefits are frequently used to cover funeral costs, college tuition, mortgage and credit card debt. If you think you may need coverage, continue reading.
Do I even need life insurance?
It really depends on your personal situation. But generally if you have family members or other individuals who depend on you financially, you should buy life insurance.
If you don’t have any dependents, you probably don’t need life insurance. If you have a family but don’t generate a significant portion of the household income, you might not need life insurance. But even if you are a stay-at-home parent with no salary, bear in mind that you could be saving your family a lot of money on expenses such as child care, transportation, cleaning and tutoring.
If you died, your family might need to pay for those tasks.
If your salary is vital to supporting your family, life insurance will ensure that your family can meet their financial obligations if you die. Your family could also use the money to cover your funeral costs, your children’s tuition, and any outstanding debts, including your mortgage and credit cards.
Even if you already have a life insurance policy through an employer, it might not offer as much as you actually need. A $50,000 policy, for example, might sound like a lot but probably wouldn’t come close to meeting your family’s needs. And your employer’s life insurance benefit usually won’t follow you if you change jobs.
How much life insurance is enough?
There’s no one-size-fits-all life insurance policy, but a good rule is between five and 10 times your annual salary. You will need to figure out exactly how much money your family will need when you die. Consider the number of dependents you have and any additional sources of income.
The nonprofit LifeHappens.org suggests two key variables:
- How much will your family need to meet immediate obligations if you die?
Consider all final expenses including uncovered medical bills, funeral and estate-settling costs, debt load, mortgage balance, education costs and education costs. - How much future income will your family need to sustain the household?
You will determine this number after calculating the “present value” of cash flow that your family will need after you die.
There are two basic types of beneficiaries in a life insurance policy:
Primary beneficiaries: These are the beneficiaries who will receive the proceeds of your life insurance policy after you die.
Secondary beneficiaries: These are the beneficiaries who will receive the proceeds of your life insurance policy if the primary beneficiary dies before you do.
What types of life insurance are available?
Term life and whole life are the two standard types of policies, and there’s an ongoing debate over which one is best. The choice really comes down to your financial situation and your individual requirements.
Term Life: Term life insurance is generally the simpler and less expensive option for protecting your loved ones if you die prematurely. It’s sort of like “renting” an insurance policy. The protection period is temporary, meaning your beneficiaries will receive your coverage’s death benefit for 10, 20 or 30 years, depending on the length of your policy.
The tradeoff is that the benefit amount is generally smaller than what a whole life policy would pay out. Term life policies also do not accumulate any cash value. So if you die while your policy is active, your beneficiaries will receive the death benefit. But if you die after the policy expires, they will not receive any money because the coverage is no longer in effect.
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Some experts advise that if you are younger than 40 years old and in good health, you should opt for term life insurance. It is ideal for people who need life insurance only for a set period of time, are looking for an affordable way to protect their loved ones and want to cover debts that will likely be paid off after the policy expires.
Whole Life: This is the more traditional form of life insurance and is like “owning” a policy that builds equity. Whole life is the costlier option, but it offers lifelong coverage. The premiums stay the same over the life of your policy, which remains in effect until your death — even after you’ve paid all the premiums. That means your beneficiaries will receive the death benefit regardless of when you die.
You will build up a cash reserve, but you have no control over how it’s invested. The money either earns interest or goes toward other investments. A whole life policy that has been in effect for 25 years will provide a much larger benefit than a term policy.
Whole life is ideal for people who want to use life insurance as an investment, have expendable income and want lifelong protection.
There are three types of whole life insurance to choose from:
- Traditional: You are guaranteed to get back at least a minimum sum as your cash value builds up.
- Interest-sensitive: Your cash back is calculated on a variable rate. The upshot is that if the economy is booming, your death benefit could increase without you having to pay a higher premium. The downside is that your cash return could be lower if the stock market takes a dive.
- Single-premium: These policies are designed for higher-income individuals who are capable of buying an insurance policy in one lump sum. It ensures you a cash return, and the returns are tax deferred.
Universal Life: This is a flexible policy that features both term and whole life. You can adjust your premium payments and the amount of your death benefit over time by using part of your accumulated earnings to cover part of the premium cost. This flexibility comes with higher fees, but the premium is usually inexpensive compared to whole life, but higher than term life insurance.
Variable Life Insurance: This is the most expensive option because the money that you pay in premiums builds up a cash reserve that you can invest. The value of your death benefit depends on how well those investments perform.
Variable Universal Life Insurance: This option combines variable and universal life insurance.
How much should life insurance cost?
According to LIMRA research, eight in 10 households who believe they need more life insurance say they don’t buy it because of other financial priorities, or because they can’t afford it. But prior research shows that on average, people estimate life insurance to cost three times what it actually does.
When asked how much a $250,000 term life insurance policy would be for a healthy 30-year-old, the median estimate was $500 — more than three times the actual cost. The true cost is roughly $160 a year for a 20-year policy.
Here’s another estimate: For a $300,000 term life insurance policy, a healthy 30-year-old man could expect to pay about $300 a year. The same amount of coverage under a cash value policy would cost over $3,000 annually.
How does your medical family history affect rates?
You might be worried about how much your life insurance is going to cost if your grandfather died young of a heart attack, or if your mother had high blood pressure. But a history of family health problems isn’t necessarily going to erase your chances of getting an affordable life insurance policy.
Your family’s medical history “won’t keep you from getting coverage, assuming you are relatively healthy,” says Scott Cody, a financial planner with Latitude Financial Group in Denver.
“What it can do is keep you from getting perhaps the best or highest health rating.”
A lower health rating could mean that you pay up to 20 percent more for your coverage, Cody says. But that’s assuming you qualify for the highest health rating from your life insurer, and that’s usually not the case.
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Tammy Johnston, president and CEO of The Financial Guides in Alberta Canada, says most insurance providers ask only about your immediate blood relatives, meaning your parents and siblings. And their primary concern is when an illness or death took place.
“If your dad had a heart attack at 68, that would cause few problems with issuers,” Johnston says. “If he had it before 45, that would mean big problems. IF both mom and dad had heart attacks, that would be bad. If only one parent had a heart attack, the impact might not be as severe.”
Insurers will also look at whether a family history of an illness such as cancer is due primarily to genetics or lifestyle choices. If your father was a smoker who died of cancer, your policy might not be affected if you don’t smoke.
If you are still worried about your family’s medical history, you can apply for insurance that won’t require a medical exam or blood samples. Just know that these policies are usually more expensive because insurers are taking on more risk by not screening you.
Do you understand your life insurance policy terms?
Buying a life insurance policy is the first step. But you still need to make sure you have a clear understanding of what your policy actually says.
It’s important to take the time to review your policy thoroughly and make sure there are no surprises for you or your beneficiaries.
Even if your insurance agent explained your coverage, it’s important to read your policy to make sure you have what you think you have, says Tony Steuer, an insurance literacy advocate and author of “Questions and Answers on Life Insurance: The Life Insurance Toolbook.”
Here are a few things to watch for:
- Jargon: Does what you’re reading actually makes sense? If you run into confusing insurance verbiage, check your policy for a section that contains definitions of industry terms you might encounter. Your agent can also help explain whatever is unclear.
- Charts and tables: Most life insurance policies include tables and illustrations that map out how your death benefit, cash value and sometimes your premiums may change over time. Make sure these tables are in sync with what your specific policy promises and with what your agent has told you.
- Your rights and privileges: You usually have about 21 days to return your policy for any reason. You also have the right to change your beneficiary at any time. The exception is if you have an irrevocable beneficiary, which means you must get that person’s consent before you can have someone else replace that person as beneficiary.
- Coverage exclusions: There are usually certain risks that your insurance provider might not cover, such as suicide or risky lifestyle behaviors, such as recreational drug use, that you did not disclose on your life insurance application.
- Settlement options: This is an explanation of what your beneficiaries will need to do to file a claim and how the policy will pay out the money.
- Declarations page (schedule of benefits): This is the front section of your policy that summarizes your coverage. It specifies the name of the person insured, the amount of your premiums, how much money your beneficiaries will receive after you die and other basic information.
- Insuring agreement: This is the section of the policy that summarizes the insurer’s promises and provides a detailed breakdown of what the policy covers. It usually includes illustrations, definitions and information about how the death benefit will be distributed.
Editor’s note: This is an updated version of an article originally posted in April of 2018.
