Sunday, February 1, 2009

Term vs. Permanent Life Insurance

The two main categories of life insurance are term and permanent life insurance.
Term life insurance policies are sold for a fixed number of years that matches your needs. Term life policies are often sold for terms of 10 or 20 years.
You may decide that you and your spouse will have enough income from Social Security and retirement pensions when you retire in 10 years. As a result, you decide you only need a policy in case you die in the next 10 years.
A term life insurance company underwrites your policy, using historical data on insurees with similar risk characteristics to calculate a premium. (Relevant risk characteristics include your health history, age, and gender. You complete a health condition questionnaire and physical exam in order to obtain a certificate of insurability.)
Once you receive a quote for a term life policy, you make level premium payments for the term of the policy. If you die before the end of the term, your beneficiary receives a death benefit. With term life insurance, your policy lapses if you stop paying premiums.
When the policy term ends, you generally have the option to renew, but at a higher premium. A higher premium reflects a greater likelihood of your death during the renewal term. (You're older, after all.) Insurers like to say that your mortality risk is higher, justifying the higher premiums.
Permanent life insurance is different from term life insurance. For one, permanent life insurance provides coverage until you, the policyholder, die. You may cancel, or surrender, a permanent life policy but will likely have to pay a surrender charge. Surrender charges are like paying a back-end load when you sell shares of a mutual fund—it lowers the investment performance of the policy.
A second major distinction of permanent life insurance is that your policy builds up a cash value. Cash value is also called cash surrender value (CSV). This buildup in cash value occurs because you invest a part of your permanent life premiums.
How these premiums are invested is what determines what type of permanent life insurance you have. The most common types are whole life, universal life, and variable life insurance.
For example, you may pay $1,000 in premiums over a 12-month period. If the premiums are invested and increase in value, the future premium necessary to keep your policy active may drop to, say, $500. As a result, your premiums accumulate a cash value of $500 after the first year.
Your cash value is the amount you are entitled to if you cancel your policy. With some types of permanent life insurance, you can use the cash value in your policy to adjust either your death benefit or premiums. Alternatively, if the cash value of your policy declines, your death benefit may also decline.
Cash value is a personal asset. You should include this asset when you prepare a statement of your personal net worth. When you apply for a loan, for example, you should disclose the cash value of an insurance policy as a personal asset. You can also use the cash value of an insurance policy as collateral for a loan request.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.

Estimating Coverage Needs

Life insurance provides payments to your beneficiaries that replaces some or all of your income if you die during the coverage period. These payments make up what is called a death benefit.
In exchange for insurance coverage, the insured person (insuree) makes periodic payments called premiums to the insurance company (insurer). To determine a policy premium, the insurer uses a method called underwriting. The insuree is also called the policyholder.
In order to be eligible for coverage, the insuree receives a certificate of insurability. This is an endorsement of the insurance company's willingness to sell a policy. A certificate of insurability is sometimes required for certain changes in policy coverage.
Most life insurance policies are taken out to replace family income in the event of an untimely death. As a result, these policies often designate a spouse, child, sibling, or parent as beneficiary. The policy may also designate more than one beneficiary.
Some types of life insurance allow you to change your premiums or stop paying them for a while. These premiums are called flexible premiums. This situation occurs if the investments that are funded by some of your premiums earn a higher-than-expected rate of return.
An expedient way of determining the right amount of coverage is to take a multiple of your annual salary. For example, a multiple of 5 and annual salary of $50,000 would equal policy coverage of $250,000. The following five steps can help you to more accurately estimate your coverage needs:
Determine your coverage period. For example, if you think the next 20 years of your life are essential to provide for a young family, a 20-year coverage period would be appropriate.
Calculate the expenses that require coverage. If you are a main breadwinner in the family and die suddenly, the family is sure to feel the financial impact. You might decide to buy a policy that insures half of your salary for the first 10 years of the policy and 25% for the subsequent 10 years.
Additionally, your death will have some expenses associated with it. Funerals routinely cost a few thousand dollars or more. You may also have other debts or funds that either need to be repaid immediately or replenished when you die.
Reduce the amount of required coverage by available assets and income. Assets that you own today can be sold to pay off debts or raise cash. Selling these assets might reduce the amount of necessary policy coverage. Additionally, any future income that your beneficiaries are expected to receive will reduce the coverage amount.
Add estimates for inflation, interest rates on savings, and taxes. Inflation leads to higher expenses in the future. If your beneficiary's income fails to grow at the same rate, your coverage may be inadequate. On the other hand, if interest rates on your savings keep pace with inflation, you shouldn't have to increase your coverage. For taxation of life insurance benefits, see IRS Pub. 525: "Taxable and Nontaxable Income."
(Note: This document is in Portable Document Format (PDF). If you do not have a PDF reader installed on your computer, you can download a version of Acrobat Reader for free at Adobe Systems' Web site.)
Find other ways to lower your premiums. Since your health is a large determinant of your premiums, consider avoiding tobacco and alcohol. A healthy medical history helps.
Skydiving, motorcycle riding, and scuba diving are activities with higher accident and fatality rates. Avoiding these kinds of "insurance risks" can help to lower your premiums.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.