In a properly designed financial plan, one of the most important areas of discussion is that of “Protection”, by way of Insurance. However, for one reason or another (usually because people don’t like to talk about it or feel they don’t need it), that area of the financial plan often gets overlooked or isn’t designed properly. Protecting your and your family’s lifestyle and standard of living is a very critical component in planning both while you’re alive, and when you’ve passed on. The importance of insurance needs to be addressed and its components need to be understood.
What people often think is that there’s just one type of insurance, but that’s not the case. There are generally 3 main components of Insurance Planning, which are Life Insurance, Critical Illness protection, and Disability Insurance. This post is going to discuss Life Insurance in detail, with the other 2 being discussed in later posts.
If I were to ask you, ‘what is your biggest asset?’ most people would answer “my house” or “my car” or some other form of tangible object. But, the reality is, the most valuable asset you have is your ability to earn an income. YOU are your most valuable asset. If you lost your ability to earn an income through death, illness or injury, what would your and your family’s life look like? This is a question that many people don’t think hard enough on, but it’s time to start paying attention.
There are many reasons why people get insurance. Replacing your income, education funding, home/property protection, estate planning, funeral expenses, debt protection, tax planning etc… The list goes on and on, and not every family gets insurance for the same reasons. Insurance is something that is very crucial in providing a sound financial foundation for you and your family, as well as providing peace of mind that you’re protected in case something happens to you. We protect our homes and our cars because we’re legally obligated to, but it seems that many people don’t see the true value in protecting themselves and their families.
Remember, Insurance is a privilege, not a right, so every person must qualify for it as well.
Essentially there are 2 main types of Life Insurance you can get: Term or Permanent. Their names pretty much say a lot about them, but let us go into a little bit more detail.
Term insurance is considered as ‘temporary coverage’. Most companies will provide coverage for a certain ‘term’, such as 10/20/30 years, but there are also other variations. Basically, we can imagine term insurance to be like ‘renting’ a house. Every month you’re paying a premium (rent) and if you’re still alive at the end term your term, you walk away with nothing. The only time a payment would be made to your beneficiaries is if you were to pass away during the term of your coverage – the payment is made as a lump-sum.
Say for example you buy a 10 year term policy. You pay your premium for 10 years, and at the end of that term, the coverage is expired. If you die after 10 years and 1 day, and you did NOT renew or replace the policy, then there is NO payout to your beneficiary, as the policy is no longer in force.
Term insurance is the cheaper of the two at the beginning, but over time it can be very costly. For example, if you’re 35 today, and you buy a 20 year policy, it can be pretty affordable (based on your health). However, if we fast track now 20 years later, that policy is now at the end of its term, and you are now 55 years old. The reality is, someone at that age will likely still need a good amount of coverage. Most companies have what’s called a ‘renewable’ feature where you can renew your policy after the term has been completed (without medical). What you will notice is that the premium will drastically increase, maybe even 5 or 10 (or more) times what you were initially paying.
The reason that it is so expensive upon renewal is that there is no need for medical underwriting upon renewing the policy. So this means, if within the first 20 years you get some sort of medical sickness or disease, you can still ‘keep’ the insurance upon it renewing — the insurance company cannot decline you based on your health situation. Once you are approved the first time, there is no need to re-qualify again if you are renewing. That being said, if you are healthy and your insurance comes for renewal, it’s actually a lot cheaper just to do a new insurance application and go through the medical underwriting again – the rates are much cheaper!
People often ask, “What happens when the term is up?”, and that’s a great question to ask. At the end of a term, you essentially have 4 options:
- Renew the Policy
- Cancel the Policy
- Convert the Policy into permanent (you do not have to wait until the end of the term to do this, often this can be done any time along the way)
- Apply for a new policy – this is cheaper than renewing IF you are in good health and can qualify for standard (or preferred) rates.
Now, term is not a bad product, IF it’s used for the right purpose. For example, if you know you will have a liability for a fixed period of time only (i.e. a mortgage or loan), then this type of coverage might fit your situation. Every situation must be assessed individually.
Now let’s swing over to Permanent coverage – there are 2 main types of plans out there: Whole Life & Universal Life; generally designed to do the same thing (cover you for your entire life) but they each have different features and benefits. There is a 3rd type of ‘Permanent’ called T100 (coverage until age 100), but that is not very common these days. For the purposes of simplicity, we won’t go through the details of each of the types of permanent – that will be for another post.
Once again, the type of insurance, essentially tells you how it covers you. This type of policy will cover you ‘permanently’ until you die – it doesn’t matter if you die at 35 or 52 or 93, your beneficiaries will still get compensated. Just as we used the example of term insurance being like ‘renting’ a house, permanent insurance can be thought of as ‘owning’ a house. Every month you’re paying into the policy, but you’re also building a kind of ‘equity’ within the policy, which is known as the ‘cash value’ or the ‘savings component’. The equity in the policy can be accessed later in life, left for beneficiaries, or used to reduce the overall cost of the insurance policy.
Just how term insurance is cheaper in earlier years, but can get very expensive in later years, the opposite can be said for permanent insurance. Initially, a permanent policy will require a larger investment, for 2 main reasons: because it is covering you for your entire life and there is also an investment component built into it. I say “initially” because over time, a permanent policy can cost less overall then a term policy. You can structure so that you’re paying the same dollar amount over a certain period of time and ‘pay up’ the policy — similar to how you have an amortization on a mortgage where you will pay off your house in 25 or 30 years. There’s also a ‘life pay’ option, where the premiums are essentially made until the insured passes away. This option is generally for those who want the permanent protection, but want to keep the costs down, and are not worried about having to pay until they pass away.
One of the main questions that come up in the Life Insurance discussion is “what type of coverage should I get?”. The reality is that the vast majority of most people’s responsibilities are temporary (i.e. raising kids, kids’ education expenses, mortgage etc…), so in most family’s situation, the majority of the insurance protection should be temporary as well. Although there is no one size fits all solution, one strategy that I find works well is doing something like a 80/20 split – Where 80% of the coverage is Term and 20% is Permanent. This will keep the overall cost of the policy low, get you the amount of coverage you need and will still allow for having a portion of your policy to cover off long-term/permanent needs. So, for example, if it’s calculated that you need $500,000 of coverage, something like $100,000 Permanent and $400,000 as term Coverage might work out nicely for you, both for cost effectiveness and for your overall insurance needs. This doesn’t mean that everybody should have an 80/20 split, but at least this is a good starting point for the discussion and calculations.
Each type of coverage has their pros and cons, and there is no one size fits all when it comes to insurance planning. The best thing for you is to have an Elite level Financial Advisor working with you to put together a proper plan that addresses all your needs, as well as to provide you with all the options. Insurance planning is an integral part of the overall financial planning process, and can help protect you and your family against unforeseen circumstances, but also can be a great tool to use in the estate planning process and leaving a Legacy.