Welcome to week four of our look at the varying types of insurance you may want to purchase. This week, we leave behind the legalese of business liability insurance for the high-stepping world of life insurance.
What it is
On the surface, life insurance is morbidly simple. If you have a policy, and you die during your coverage period, then your surviving beneficiaries will be due a payment from your insurer.
But, of course, there's more to it than that, thanks to insurers who like to use life policies to amp up profits. Let's review the four most popular types of coverage:
- Term life coverage: A very basic policy that covers your untimely death, just as auto insurance covers you in the event of an accident. There's no frills with this sort of plan, which makes it cheap. That's also why agents rarely push it and employers offer it as a perk.
- Whole life coverage: The most basic cash-value policy, through which a portion of your premium is invested in a vehicle that offers a fixed rate of return, such as an annuity. (More excellent coverage of annuities can be found here.)
- Variable life coverage: A step-up in cash-value policies, in that the investment component allows for stocks, mutual funds, or fixed-rate choices.
- Universal life coverage: Perhaps the most dangerous type of coverage, in that the premium and coverage levels may be adjusted according to the will of the insured. It's a little like a flexible mortgage that allows you to pay interest only from time to time.
What should you buy?
As a Fool, I'm a fan of investing on my own and paying only what I must for insurance. Most others on our discussion boards appear to feel similarly. Of the respondents I polled for this article, 79% had either term life insurance through their employer or via a separate policy.
Two had purchased some form of cash value policy, but one of those wrote that he has "been paying through the nose for over 14 years for seven whole life policies." He now says that he is switching to a term life plan that will save him $100 in premiums monthly. He'll also reclaim roughly $9,000 in cash value upon canceling his other coverage.
Are there ever conditions under which a cash value policy makes sense? Frankly, I'm not so sure. The argument that these vehicles create "forced savings" seems specious, especially in light of cancellation restrictions and high fees.
How high, you ask? A recent article in Smart Money pointed out that some cash policies charge up to 3% annually, plus an upfront cost that can equal an entire year's worth of the premiums you thought you were investing.
3 Foolish questions to ask before you buy
Knowing that, you may wish to stick with your employer's term life policy. I can't say that I blame you. Just remember that if you're like most with an employer-backed plan, your beneficiaries will receive the equivalent of your salary, or maybe even less. And while they'll be able to draw on some of your retirement savings to manage big expenses, statistics say that you probably have less than $50,000 saved. How long will that last?
Not long enough, in all likelihood. That's why most of us need some sort of supplemental coverage. Here are three Foolish questions to ask before you invest in a new policy:
1. How much income would be lost without you? You can't make an intelligent decision about insurance until you understand how much your loved ones stand to lose if you die. Consider your total annual income -- including bonuses -- and build that into your death benefit. Consider also how much breathing room you want your family to have. Would your spouse need two years to focus on the kids and find a job before he or she could begin replacing your income? Could your income ever be replaced? Think big when you first buy; you can always scale back your coverage if you hit the lottery.
2. What bills will your loved ones need to pay? I'm not really talking about funeral expenses. Again, you need to be thinking bigger. How far away is college for your kids? Do you want your coverage to set aside enough to help pay tuition? (You may not want to.) What about the mortgage? Cars? Consider everything you pay now and what you could pay later, so as to not leave your loved ones with a hurting heart and an empty wallet.
3. Can you invest on your own? If you're really intent on taking a close look at a cash policy, do your homework. What is your expected total return? How does your agent arrive at that total? Does he or she believe that you'll earn a completely unrealistic 15% a year on an annuity? What's the commission on the policy? What fees will you pay annually? And how would all of that compare to the 0.18% you'd pay to invest in a no-brainer index fund?
Follow the money
Life insurance seems simple. And it should be. But more and more agents are selling complex, commission-boosting products that do little for consumers. Be cautious and buy only the minimum. And remember that you don't need insurance to create "forced savings." You could just as easily pay extra to your mortgage.
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Fool contributor Tim Beyers is extending this series because of the response from readers. Next week's installment: auto insurance. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. Get a peek at everything he's invested in by checking Tim's Fool profile. The Motley Fool's disclosure policy is like insurance for your portfolio.