It's tough to predict what the future holds, or what your loved ones would need financially in the event of your death. What you want to try to do is have enough life insurance to provide a financial safety net for your family, whether that's to take care of a mortgage, loans or just continue to live the lifestyle to which they are accustomed.
What is Life Insurance?
Life insurance is a contract between you and an insurance company that states that in exchange for regular premium payments made by you, the company will pay a benefit to your beneficiaries upon your death.
A life insurance policy essentially provides a measure of security for your loved ones, especially if your income was a source of support for them. Beneficiaries can use proceeds from your life insurance to cover day-to-day living expenses to paying for college to eliminating debts.
Life insurance can also compensate a family to help pay off any financial liabilities or business expenses you may leave behind.
Do I Need a Life Insurance Policy?
The best way to determine if you need life insurance is to ask one simple question: Would your death financially impact the people in your life? If the answer is “yes,” you should consider obtaining life insurance coverage.
Digging deeper, it’s a good idea to have a life insurance policy if, in the event of your death:
- Someone would inherit your debts
- Your spouse or partner relies on your income
- Your children depend on your home
- Your heirs would owe estate taxes
- You have outstanding student loans
- Your funeral expenses would be a financial burden
- Your business, and the people it employs, might fail
What Type of Life Insurance Coverage Do I Need?
Typically, life insurance falls into two categories: term life insurance and permanent (whole) life insurance.
Term Life Insurance
Term life insurance is a type of coverage that guarantees payment of a stated death benefit if the policyholder dies during a specified term.
With term life insurance, the policyholder agrees to pay a premium for a specific period of time, or term – usually between 10 and 30 years. In return, the insurance company agrees to pay a specific benefit amount, usually tax free, to a beneficiary upon your death.
Once the term expires, the covered person can either renew it for another term, convert the policy to permanent coverage or allow the term life insurance policy to terminate.
How Do I Choose a Term?
Your term length is based on three factors: how much coverage you need, how much you can afford and how much you qualify for.
A term length should cover all your financial obligations and outstanding debts. Factors to consider when choosing your life insurance term include:
- The term of your home mortgage
- The age of your children
- Funeral expenses, unless they are pre-paid
- How much your family will need to maintain their current lifestyle
- Any liabilities you may have, such as loans, credit card balances or other debts
Permanent (Whole) Life Insurance
Whole life insurance policies last your entire life (as long as you continue paying the premium). In addition to paying a death benefit, whole life insurance also contains a savings component in which cash value may accumulate on a tax-advantaged basis.
The savings component can be invested; additionally, the policyholder can access the cash while alive by either withdrawing or borrowing against it, when needed.
Whole life insurance coverage might be a good option if you:
- Are looking for lifetime life insurance coverage
- Are the parent or guardian of a special needs child
- Want to provide an inheritance when you die
- Want to maximize a pension
How Does Life Insurance Work?
Before figuring out what type of policy and how much life insurance you need, it's important to understand how a life insurance policy works.
A term life insurance policy has two main components—a death benefit and a premium. A permanent or whole life insurance policy, in addition to a death benefit and a premium, also has a cash value component.
The death benefit is the amount of money the insurance company guarantees to the beneficiaries identified in the policy when you die. For example, if you are a parent, your beneficiaries may be your children.
You will choose the desired benefit amount based on your beneficiaries' estimated future needs. The insurance company will determine if you qualify for coverage based on the underwriting requirements related to age, health and lifestyle.
The premium is the money you will pay for the insurance policy. Upon your death, the insurance company will pay the death benefit to your beneficiaries as long as premiums are payed as required.
Your life insurance premium is based in part by how likely your insurance company will have to pay the policy's death benefit based on your life expectancy. Again, your life expectancy is determined by age, health and lifestyle.
Cash value comes into play in permanent life insurance policies and is basically cash that accumulates on a tax-deferred basis that you can use during your lifetime. Some restrictions may apply; for example, if you take out a loan against the policy's cash value, you may have to pay interest on the loan principal. While cash value is a living benefit, any outstanding loans against the cash value will reduce the policy's death benefit.
How Do I Determine How Much Life Insurance I Need?
A large part of choosing how much life insurance you need is based on determining how much money your loved ones would need to remain on firm financial ground after you're gone.
Rules of Thumb to Consider
There are a number of ways to calculate how much life insurance is best for your circumstances, but there is more than one rule of thumb to keep in mind before you make your final determination.
Human Life Value (HLV)
The Human Life Value (HLV) approach is usually calculated by taking into account a number of factors, including, but not limited to, your age, gender, planned retirement age, occupation, annual wage, employment benefits, as well as the personal and financial information of your spouse and/or dependent children.
HLV can be calculated by two methods: the income replacement method, which states that whatever income that is used to support the family must be replaced through the life insurance policy, and the needs-based method, which is a calculation of the amount required to cover the needs and goals of the beneficiaries.
10 Times Your Income
One rule of thumb says you should have one or more life insurance policies with a total death benefit equal to roughly 10 times your annual salary (before taxes and other paycheck deductions).
This strategy doesn’t take into account your finances other than your income, existing assets or the needs of your beneficiaries; however, it’s a basic starting point.
Another way to calculate your coverage needs is to multiply your annual salary by the number of years left until retirement. For example, if a 40-year-old man currently makes $20,000 a year, he will need $500,000 (25 years x $20,000) in life insurance.
The DIME Formula
Another rule of thumb is the DIME formula to determine how much coverage you need. DIME stands for:
- Debts and final expenses: Add up all loan balances except mortgages, plus an estimate of your funeral expenses.
- Income: Multiply your annual income by the number of years you think your dependents will need support. For example, it could be until your youngest child graduates from college.
- Mortgage: Determine how much you owe on your home, including any second mortgages or lines of credit against it.
- Education: Estimate the cost of paying for education for any children you have.
By adding all of these obligations together, you get a much more well-rounded view of your life insurance needs.
You can also modify the DIME method to include additional expenses, such as medical expenses or retirement funding.
There are also a few items that you may be able to subtract from this number, such as the amount of coverage on a group life insurance policy, funds from your retirement plan or any other savings you’ve accumulated.
How Do I Qualify for Life Insurance?
Life insurance policies come in all types and sizes. When you apply for a life insurance policy, you will be asked for basic information such as your name, address and employer. You will also have to provide your height, weight, date of birth, lifestyle habits (such as smoking, drinking, exercise, etc.) and financial information, including your annual income and net worth.
Most policies will require you to complete a medical exam, called a paramedical exam, which will be arranged by the insurance company. In that exam, you'll provide a medical history of yourself and your family. In the exam, they will:
- Take your blood pressure
- Listen to your heartbeat
- Check your height and weight
- Draw a blood sample
- Get a urine sample
- Ask about lifestyle habits that could affect your health (e.g. exercise, smoking, drinking, recreational drug use, frequent travel, high-risk hobbies)
From there, an underwriter (someone who assesses and evaluates the level of the risk involved in insuring a potential policyholder) will review your application and medical exam results.
This information will help them determine if you qualify for the policy and what premium to charge you based on the financial risk you represent to the insurance company.
In general, the younger and healthier you are, the easier it will be to qualify for life insurance, and the older and less healthy you are, the harder it will be. If you smoke, drink, are obese or engage in risky hobbies, you may find it harder to qualify for coverage and/or find your premiums are much higher.
The decision to purchase life insurance is a personal one, and deciding can be based on a number of factors. Talk to one of our life insurance experts who can help you determine if you need life insurance and if so, what type and how much would be most beneficial for you and your loved ones.