The inside story on Life Insurance

What is life insurance?

Life insurance is a contract between you and an insurance company which states that the company will pay some amount of money (the "face value" of the policy) to someone that you designate (the beneficiary) upon your death.

Life insurance is designed to provide a cash cushion to your family, loved ones, or business partners to help them pay their bills and expenses after you die. It is also frequently used to pay expenses associated with your death such as medical, legal, and funeral costs.

Depending upon the amount of your life insurance, your beneficiary may still have to find additional ways to supplement their income after you are gone.

Do I have to die to collect life insurance?

The answer to that depends upon the type of policy that you've purchased. Some types of life insurance include a savings or investment plan which you can draw upon when you retire. Others provide a "loan value" which you can borrow against and never have to pay back. Well, you sort of pay it back because the life insurance company deducts the amount that you borrowed from your final death benefit that goes to your beneficiary.

Do I need life insurance?

Does anyone depend upon you for their support? Are you married? Do you have dependent children? Are you a partner in a business venture? If you died tomorrow would the people that you care about be able to support themselves? These are some of the issues that you need when determining whether or not you should buy life insurance.

Even if your current situation dictates that you do not need life insurance, what will the future hold? If you are twenty-something right now, you might not even envision having a spouse and children. But, as time goes bye, your life may change. Since life insurance gets more expensive as you get older, you might be better off buying it now while you are young. If you end up dying without a family you can always leave the money to your dog or favorite charity.

If you are single then you still need to have a way to pay for your funeral expenses. You could direct your estate to pay those expenses out of your savings or investments, I suppose, but a small life insurance policy could cover th average funeral 100%.

If you are a stay-at-home parent, and your spouse is the breadwinner, it still makes sense to have life insurance. If you die while the children are still young, your spouse is going to have to pay someone to care for the children while the spouse is at work. Your life insurance could cover that situation nicely.

How much life insurance do I need?

An old rule of thumb was to purchase life insurance in an amount equal to five to ten times your annual income and to increase that amount as your income goes up. This is a pretty general statement and it does not take into consideration your family's specific needs.

You need to take into consideration the ages of your children, expected educational expenses, the cost of medical insurance if your spouse is no longer eligible to participate in your group plan after your death, your mortgage and other debt costs, as well as general household living expenses. In addition you need to decide if you want your spouse to have to work after your death or not.

If you really want to get detailed you can build a spreadsheet that lets you determine the total amount of annual income your family will need and how long they will need it for.

When creating the spreadsheet, make line items for at least these categories:

Emergency funds
College education (per child)
Your final Medical expenses
Burial expenses
Estate settlement costs
Debt payoff amounts
Spouse's retirement needs
Special needs for family members not covered above
Mortgage (if not paying off)
Utilities
Food
Entertainment (yes, they will eventually want to have fun even after you're gone)

While this may seem like a bit of work it will get you pretty close to a figure that makes sense for your situation.

What kind of life insurance should I buy?

Although there are lots of variations on life insurance, there are basically only two types. they are: Term, which provides coverage for a specific amount of time and whole life or universal life which pays a death benefit and also generates some sort of cash value.

Term insurance allows you to buy life insurance coverage for a fixed period of time. If you die before that period of time then the insurance company pays the face amount of the policy. If you outlive the term insurance policy then they do not pay off. It's a straight gamble where the life insurance company is betting that you will live longer than the term of the policy.

Term insurance is generally the least expensive life insurance that you can buy. Although it does not build any cash value, most term policies can be later converted to a whole life policy without your having to take a medical exam.

Whole or Universal Life insurance provides a death benefit plus it creates a cash value as you pay into the policy and, depending upon the type of policy, may also pays dividends.

A whole life insurance policy stays in effect for as long as you pay the premiums. Your premium generally stays the same for the entire life of the policy. That;s why it's a good idea to buy whole life insurance while you are still young.

A portion of each premium payment goes into funding the cash value of your policy. Your cash value is usually guaranteed to grow at a tax-deferred fixed rate. Once you build up enough of a cash value you can borrow against it at a rate that is generally much lower than whatever the current interest rates are. If you die with an outstanding loan balance then the life insurance company simply deducts it from the amount that is sent to your beneficiaries.

Dividend-paying whole life

These are called "participating" and are typically offered by mutual life insurance companies which are companies that are owned by the collective policyholders. The dividends that these type of policies pay are actually refunds of insurance premiums that exceed the company's pay outs, expenses, and liabilities for a specified period of time. They dividends are paid when the company is producing a profit for the reporting period which may be quarterly, semi-annually, or annually.

Universal Life

Universal life is also called "flexible premium adjustable life" is works a lot like whole life except that it offers flexibility in how you pay your premiums. Each monthly premium payment is credited first to your cash value and then to the cost of your death benefit and policy-related expenses.

These costs are somewhat equal to what it would cost you to buy a term life insurance policy. Your cash value grows at a guaranteed minimum interest rate which is tax-deferred. Like whole life, you can borrow against the cash value.

Variable Universal Life

Variable universal life insurance lets you choose the investment vehicle that will be used to fund the growth of your cash value. Although you can potentially greatly increase your cash value, you also have the potential to generate a loss. Either way, your face death benefit is not affected.

Variable Whole Life

The basis of variable whole life is that both the death benefit and the cash value of your policy depends upon the performance of the investment vehicle that you choose. While this type of life insurance offers the greatest potential for gain, it also offers the greatest potential for loss.

Hopefully we've help you wade through all of your life insurance options. You should discuss the various plan types with your financial advisor or life insurance agent so you can be assured of selecting the policy type that suits your needs best.