Insurance can be one of the least understood aspects of your financial plan. And unfortunately, you often hear of people being sold insurance they might not need.
It's valuable to educate yourself on what's right for you, so let's examine the types of life insurance available. That said, as countless books have been written on life insurance — you don't want to read them, trust me — this article just scratches the surface on a few points.
To begin, there are two broad categories of life insurance: term and permanent. Term insurance covers a certain period of time, or specific "term." Common "terms" are 10 years, 15 years and 30 years. It is a relatively simple and straightforward product, though different flavors exist. The traditional term policy is level-term. In a level-term policy, your premium and insurance benefit are constant. Other flavors include "decreasing term" and "return of premium term," which complicate and gimmick-up a relatively simple product.
Permanent life insurance starts off neither simple nor straightforward. It is designed, as its name implies, to provide insurance over your entire life and comes in a variety of forms such as whole life, universal life and variable life.
At its core, permanent life insurance bundles life insurance and a savings component. Simply put, this means when you pay premiums, the insurance company takes out administrative fees, pays the insurance expense (the cost of the life insurance being bought), and the rest is thrown into the savings bucket, typically known as the "cash value."
In a classic whole life policy, the idea is that the cash value component of the policy builds up over time and by some advanced age (normally 100), it will be equal to the amount of the insurance policy purchased. For example, if you bought a $100,000 policy, you would have a cash value of about $100,000 when you turn 100. The different flavors of permanent insurance tweak the investments side of the savings component or the amount of insurance or both. This is where things can get complicated fast.
In theory, there is nothing wrong with combining insurance and savings. The problem comes in how high the expenses and how crummy the investments tend to be. Often, you get expensive insurance, relatively poor performing investments or both.
There is also the reality that most people do not need life insurance coverage for their entire lives. Life insurance's core use is to protect dependents (kids, spouse, etc.) from the financial loss of a premature death. You tend to need less life insurance as you get older, your savings grow and you have fewer dependents needing your help.
Another issue with permanent policies is that they can lead to having much less in life insurance coverage from the outset. Consider the price difference between a standard whole life policy and a 30-year term policy as quoted from a national insurer known for low costs and excellent financial ratings (an insurer's financial stability is critical to consider). This example is for a 35-year-old man who takes medication for high blood pressure.
A 30-year level-term policy with a $500,000 benefit was about $790 a year. For $790, the man could buy only $65,000 in coverage through a whole life policy. If he wanted $500,000 in coverage through a whole life policy, the cost soars to $4,795 a year.
And this leads to the idea that you should buy insurance, not be sold it. I would like to think that all life insurance agents put their client's well being before their own. However, permanent life insurance is much more profitable to sell than term. That, coupled with life insurance being confusing, leads the incentives to be against the consumer's interest.
Sadly, I have heard more than once of people being pressured into some form of permanent life insurance that is inappropriate for their needs (including my parents).
This makes it critical to be careful in choosing where and how you buy insurance. I value expertise and like agents, but as an economist I understand incentives matter. If pitched a permanent insurance product, you would be well served to be skeptical and get a second opinion. In fact, I would encourage spending an hour or two with an independent financial planner, such as a certified financial planner, who does not sell life insurance or any other financial product. The person can help you construct a financial plan personalized to your needs that includes the amount of life insurance needed and type of policy.
Armed with that information, choose an agent to help you navigate the insurance market. Again, buy insurance, don't be sold it.
Now, permanent insurance is not inherently evil. It does have some very useful applications. And if your agent suggests it, it does not mean you are being taken. However, it makes little sense for most people, and I think it is pushed far too often. Rather than purchasing a permanent policy, a better approach in most circumstances is to keep savings and investment decisions separate from insurance decisions — and rely on simple, level term products for life insurance needs.