How to think about and evaluate life insurance (I)
Posted by: Joseph Kuo | February 11, 2019
First, I acknowledge that there are many products designed to address different situations. However, the main distinction of life insurance policy is between term-life and permanent-life. As most people already know, term life is for a specific period and is typically a “pure” insurance. Pure insurance means that you are only paying for insurance and nothing else. Conversely, permanent life insurance is typically a combination of insurance and investment. This means that a portion of the premium goes toward paying for insurance while the remaining going toward some sort of investment account. Within the permanent life category are whole, variable, universal, etc.
While I won’t go into the details of permanent life insurance here, the differences amongst the categories tend to be:
- The expected return of your investment.
- The riskiness of your investment.
- The flexibility of your premium payment.
It is worth recognizing that annuities are sold by insurance companies and are a form of insurance. Typically, annuities are used to insure your cash flow.
With these distinctions, I put forth that, for most people’s goals, term-insurance is the appropriate solution. Generally, people purchase insurance to cover things that they cannot afford to lose. In this case, life insurance is used to support people who depend on your income, when you are no longer around. Therefore, you need insurance during your working years. When you no longer need to generate income, there’s no need for term life insurance.
There are 2 main methods of evaluating how much life insurance you need.
- Income replacement: This method calculates your expected income for the remainder of your life. Because the beneficiary receives the payout in a lumpsum, you don’t need to replace 100% of income because the lumpsum can be invested for additional return. The exact amount needed depends on the average return and when the money will be used.
- Itemized funding: Another way to looking at insurance is that you are providing funding for the things you really care about. For many people, this includes paying off mortgage for their spouse and taking care of kids’ education. It is also common for married people to insure a little extra to help their spouse through the transition of a loved one dying and any potential medical bills.
Normally, the “Itemized funding” method results in lower insurance need. This makes sense because there is no need to fund what the deceased needs, i.e. retirement, medical, food, etc.
In the next article, I will share some thoughts on permanent insurance.