How Life Insurance Works (Part 2)
Our previous installment of this article by David Roos from HowStuffWorks.com discussed the basics of life insurance. This week we look at who might need life insurance and what types of life insurance are available.
Who Needs Life Insurance?
Not everyone needs life insurance. The general rule is that you only need life insurance if you have dependents. Typically, dependents are children who still live at home or have yet to graduate from college. But a dependent could be anyone who is financially dependent on you, like a spouse, sibling or an aging parent.
Life insurance is generally designed for younger, working people with families. Here's why: Life insurance is meant to replace your "value" to your family once you're gone. For a working parent, a big part of that value is your salary. If you die, you'll want your family to receive enough money to replace your salary for at least the next five to seven years.
Even if you're a stay-at-home parent, you still have financial value to your family. Let's say you care for two small children. If you die, then your spouse will need to keep working, which means the kids will need a nanny or day care. You might not need a huge life insurance policy, but you can buy a policy that fits the financial needs of your family.
Some people buy life insurance policies when they get married, particularly if the insured person makes considerably more money that the spouse, or if either the insured or the spouse have other financial dependents, like parents or siblings. Many people buy life insurance when they get pregnant with their first child.
Once you've reached retirement age, there's less of a need for life insurance. Now your children are most likely financially independent and you're ideally already living on retirement savings and investment income. One reason for an older person to keep a life insurance policy is to provide extra money for his or her spouse to cover unexpected medical and long-term care expenses later in life.
Some older people hold onto life insurance policies as a way to pay for "end of life" expenses like the cost of settling an estate. But the most basic reason for retaining a life insurance policy later in life is also the oldest reason: to cover the cost of your funeral and burial.
Another reason to buy life insurance to is to pay for a particular expense. If you buy a home, it's common to sign up for a 30-year mortgage. But what if you die in 10 years? There are special life insurance policies that are tied directly to mortgages, decreasing in value as you continue to pay off the mortgage debt.
A less common reason to buy life insurance has to do with business rather than family. Let's say you're a partner in a small business and the success of the business relies significantly on your ability to bring in clients and money. Some people buy life insurance policies that name their business partner as the beneficiary. This chunk of cash could help the business stay afloat while they learn to get along without you.
So now you have a better idea of who needs life insurance. But what type of life insurance policy should you buy? Are they strictly for emergencies or can they also be reliable investment tools?
Types of Life Insurance
The most basic type of life insurance is term life insurance. Term life insurance policies cover the policyholder for a set number of years, anywhere from 1 to 30. For younger, healthy people, term life insurance is the least expensive option. You pay relatively low rates for a fixed number of years with a high level of coverage.
Something to consider if you choose term life is that the premium is only fixed for the length of the policy. If the policy expires and you want to renew, you'll pay a higher premium because you're older now, and may be less healthy. Term life policies have no cash value of their own. They don't accrue interest and you can't borrow money against them. Basically, they're "pure" insurance products. If you don't die, you can't collect.
All of the other types of life insurance fall under the heading of permanent life insurance. As the name implies, the policy is good from the day you buy it until the day you die, no matter when you die. Permanent life policies can either have a fixed or flexible premium.
The biggest difference between term and permanent life policies is that permanent policies include a cash value component. This means that the insurance company invests your premium payments to build up cash reserves in your account. The advantage of permanent life is that you aren't taxed on investment earnings until you cash in the policy, and you can borrow from your cash reserves tax-free. The disadvantage is that premiums are much higher than term life policies and investment performance can be volatile.
There are several different types of permanent life policies:
- Whole Life is the most basic permanent life insurance policy with a fixed premium. It has a savings component that earns cash value, but the policyholder has no control over how or where the money is invested.
- Universal Life allows the policyholder to shift funds between the insurance and savings components of the policy, even using savings to make premium payments. Premium rates are also flexible.
- Variable Life gives the policyholder control over where his or her savings are invested (stocks, bonds, mutual funds, etc.). The rate of return on investments not only affects the cash value of the policy, but increases or decreases the amount of the final death benefit. Premiums with this policy are fixed.
- Universal Variable Life combines the flexibility of universal life with the investment control of variable life. Premiums are flexible and the amount of the final death benefit and cash value depend on the performance of investments.
