Investing 101: Life Insurance

(Welcome once again, dear readers, to the feature I like to call…Investing 101!  This time, we’re again going off the beaten path a bit, and looking at a product that is sometimes promoted as an investment, but also has insurance functions, as well.  That’s right, this week we’re looking at Life Insurance!)

Q: Wait, wait, wait.  How is life insurance a type of investment?

A: Well, amongst the other distinguishing features, life insurance comes in two distinct varieties.  The first type, term life insurance, is pretty straightforward: you pay a monthly premium determined by factors like your age, gender, and family history, and if you die before the term expires, your heirs will receive the amount stipulated in the term agreement.  You can choose from policies that renew every year, where the premium will likely increase over time as your likelihood of dying rises, or a level term policy, where you have coverage for a period of five, ten, twenty, thirty or more years, and the monthly premium stays the same for the whole term.  The initial premiums will be higher, but you’ll be locking in the rate for years, decades even.

The other type of life insurance is known as ‘cash value’ or permanent life insurance, because it lasts as long as you pay the premiums (regardless of your age or health) and builds up value over time.  It’s this increase in value (and the various methods that allow such insurance policies to increase in value) that make them a form of investing, on top of being insurance.

Q: Okay, so permanent life insurance is a type of investment.  What exactly is it?

A: When you pay a premium in a permanent life insurance policy, part of the money is used to increase the cash value of that policy.  There are three different methods through which the increase might occur, corresponding to the three types of permanent life insurance that are offered:

Whole Life: These are the most straightforward.  Part of the premium will add to the cash value of the policy, increasing the value over time.  The longer premiums are paid into the policy, the greater the value of the policy becomes.  Some policies also produce dividends, which can be used to help pay the premiums, buy more insurance, or be paid out as cash.

Universal Life: With these policies, premiums are added to a pot with the other policy holders.  Money is taken from the pot to pay administrators and to cover death benefits when any of the policy holders die, and the remainder of the money is invested.  This invested amount is divided proportionally according to how much each person paid into the policy.  The advantage of an universal life policy is the flexibility in payments; you can add more money to increase your stake of the investment proceeds, or add less (or none) and have your premiums deducted from the investment proceeds.

-Variable Universal Life: With these policies, the extra money in your premiums is again invested, but this time according to your directives.  The money can be invested in stock, bond, or even real estate mutual funds, increasing or decreasing in value according to the investment performance.

Q: Wow, that’s a lot of choices.  What’s the best one?

A: Almost without question, you will do better with a term policy than a permanent policy.  Unless you cannot save money except when you are forced to do so, you should simply buy enough term life insurance to cover your needs.  Term policies have several advantages:

1) They Are Cheaper.  Since term life insurance policies don’t build monetary value or allow you to invest any of the premiums, the costs tend to be much lower than permanent life insurance policies.  The money you save can then be invested elsewhere.

2) They Are Simpler.  Because they don’t have any investment or saving components, term policies are much simpler to compare and buy.  Not only does this make shopping for a good policy easier, but it means you can buy term life insurance online, without having to involve an insurance broker to sell you the policy.

3) Your Insurance Needs Change Over Time.  When you’re young and have no dependents, you don’t need much, if any, insurance.  Similarly, when you are older, getting near retirement, and your children (if you had any) have started families of their own, you don’t need much insurance (as you hopefully have enough retirement money to keep your significant other healthy and happy should anything happen to you).  It’s only in the middle part of your life, when you have children and possibly a spouse who depend on your income, but not enough in your investments to care for them should something happen to you, that you really need to worry about life insurance.

As a result, you probably don’t need permanent life insurance.  Rather, if you get a thirty year term policy in your mid to late twenties (when you are likely starting to settle down and raise a family), you will provide adequate coverage to your dependents until you reach your mid to late fifties, at which point you should have sizable non-life insurance funds for your spouse, in case anything should happen to you.

Q: That sounds…reasonable.  How much insurance should I get?

A: That’s a good question, one for which it’s hard to give a short and easy answer.  Most advisers suggest the equivalent of five to ten years of salary, which will be enough to provide for loved ones for quite a while, if you should die.  (Sorry to be morbid, but we are talking about life insurance.)  Running the numbers, with the most conservative predictions possible, will give you a clearer picture of how much to insurance to buy.

If you want to be conservative, you can simply take your income and multiply by twenty, and get enough life insurance to cover that amount.  This plan, as recommended by Suze Orman, has the advantage of allowing your survivors to invest the life insurance money relatively conservatively (with a 5% yield) and pay all their expenses out of the interest the investments generate.  If you’re fairly young and don’t have much in the way of investments or alternate income sources for your family, this makes a pretty good plan.

Q: That’s all well and good for life insurance, but what about all the other types of insurance I need?

A: We’ll have to cover the rest of the insurance products out there at some point in the near future, although probably not in an Investing 101 column, as they don’t really have any investment properties.

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