Life Insurance Basics - Part 1
By Financial Security Advice I Give
Quick Summary
You can use life insurance to help achieve your financial goals
Life Insurance isn’t sexy like stocks, crypto, and options
Part 1 will go over some of the basic uses of life insurance you may not have known about
Life Insurance
I get it superman, you are young and going to live forever and are bulletproof.
Also, you are going to be so filthy rich that you don’t need stinkin’ insurance.
And when you are old you will have retirement covered and won’t need to worry about financial security for a family.
Or maybe you just think insurance companies are greedy, overcharge you, and you aren’t giving your hard earned money to the Man.
Well all the above reasons are wrong….(well maybe that last one isn’t entirely wrong)….but the other ones definitely are.
There is many uses for a life insurance product. Insurers have created a ton of unique life insurance products for different needs. Each life insurance is designed for a customer archetype and can be used by young or old, rich or poor.
No matter where you are in your life and financial situation, you may want to consider if life insurance can fit into your situation.
And I get it…life insurance is boring, it is confusing, and it seems expensive. Most insurance is still purchased through a financial advisor who can help. But knowing some basics will put you in a better position for that conversation.
Also, many young people wait too long to get their first policy and end up having to pay much more later.
Introduction to Life Insurance
When you buy a policy, you pay a premium and if you die while the contract is in place then the insurance company pays the death benefit to whoever you named in your contract (the beneficiary).
The insurance company sells many policies to different individuals. In any given year, only a portion of policy holders will die and by pooling the risk of many customers, the company is able to pay out the claims on those policies.
The people in the pool who don’t die are paying the death benefits of those who do die.
The premium you have to pay is based on your expected mortality. The healthier you are, the longer you are expected to live, and the less you need to pay for your policy. Most insurance requires you to go through underwriting where you give blood and answer questions for the insurer to gauge your health.
That is life insurance at its most basic. Lots of people pool money together and as members of the pool die, money comes out of the fund. The concept started 100s of years BC. “Burial Clubs” were formed by Roman soldiers to pay for members funerals. In the 1300s sailors could buy insurance contracts before setting sales. London England in the 1700s had the first widespread use of more ‘modern’ insurance contracts and mortality tables were being put together in the 1800s. Blah Blah….point being, pooling risks to protect yourself in case of an untimely demise has been around a long long time.
Do You Need Life Insurance?
Listen, if we all knew when we would die, you could plan optimally for it.
You don’t.
Most people think of life insurance as providing security for your survivors when you are gone. However, there is more than one use of life insurance.
Protection
Accumulation
Estate Planning
Locking in insurability
1) Life Insurance for Protection
This is what you typically think of with life insurance. You buy a policy to protect your beneficiaries in case you die earlier than expected. For example, you don’t want your wife to have to eat cat food because you died and she ran out of money…or maybe she started really nagging you at the end and you want to have her cat food soufflé go with a nice side of “look at all the money I left to my pet dog instead of you”. Either way, this is the typical thought of insurance.
You can also buy policies to replace lost income, to match up with a particular liability (ie- pay off the mortgage), or fund a future expense (ie-children’s college…or you could save money by just having them read this).
2) Life Insurance for Accumulation
There are insurance products that are tax-efficient accounts to accumulate value. Tax laws are always changing so you should work with an advisor on any strategy. However, you can put money into a life policy and grow the account tax free. Any capital gains or dividends earned are tax-free. You only pay tax on the gains over your cost basis at the time you withdraw.
But guess what?
When you are ready to withdraw money from your account, most products allow you to take loans against the policy. This way you can access the money, but not pay taxes yet since its not a withdrawal. When you take a loan, you borrow from the insurer and use your cash value as collateral. An added bonus is that you still earn any interest on the full account value despite there being a loan out.
In short, you can use a life insurance policy as another tax-deferred investment account.
3) Life Insurance for Estate Planning
Estate planning is where a good advisor can make a huge difference. Each situation is unique, so below is just some general concepts.
Life insurance can be used to efficiently pass money to beneficiaries. For instance, setting up irrevocable trusts and using a life policy may allow for avoiding death tax on large estates.
Business owners can use life insurance to protect their business. For example, having a policy on a business partner that provides a large enough benefit to the surviving owner to buyout their shares. This set-up allows for smooth continuation of the business and removes contentious legal issues with heirs.
If you are the sole owner or vital to ongoing operations of the business you can go with key-man insurance. (Note: when I say vital, I mean like the company can’t operate without you. If you work at a small shop and are the only person who can use the machines and if you aren’t there then nothing gets made, you are a key person. If you are a middle manager who makes themselves a bottleneck to feel important…sorry Ken, you aren’t key to anything despite the amount of jargon you throw around.)
High-net worth individuals can use life insurance to pay for estate taxes and provide liquidity to their estate if the family wealth is in illiquid assets.
4) Lock-in Future Insurability
This is absolutely the most under-looked aspects of insurance by young people. You buy a low cost term insurance policy when you are young. In your youth, you are likely more healthy than when you get older. The healthier you are & the younger you are, the lower premiums you pay for the insurance. Most term policies have a ‘conversion option’ that allows for you to convert the policy into a permanent policy without going back to underwriting.
You are basically take advantage of being young to lock in the best underwriting class on any future permanent insurance. Depending on the size of the policy, there can be $1,000s in difference in the annual premiums for a healthy vs less healthy life. Young people can get $1 million term coverage for $100s a year. Therefore you get a lot of insurance for cheap AND later in life you have the option to convert and save on a future policy.
For example, you are a healthy 25 year old. You get the best underwriting on a 10 year term. Nine years later you have a family. You go to doctors and find out you have cancer. If you were to apply for a new insurance policy, you would get the worst rating class and have huge premiums. But you can convert your term policy to a permanent product and keep the best underwriting class.
Wrapping up
Part 2 will go into more details about the actual types of life insurance products. Part 2 will also try to align the 4 use cases above to these different product types. However, you should see how life insurance can fit into nearly any financial plan.
Life insurance is a versatile tool for your financial planning. Even if it is boring.
I got a 30 year policy when I was around 32. Didn't know about making that a permanent product. Will look into that.