Life Events
Financial Guides
Life Insurance: How Much and
What Kind To Buy
How much life insurance do you need? What type is appropriate? You should review your life insurance needs each time you have a major life event. Here is what you need to know to properly plan for your life insurance needs to buy enough and to get the most for your money.
Table of Contents
- Do You Need Life Insurance?
- How Much Life Insurance Do You Need?
- Types Of Insurance
- How Insurance Products Differ
- How To Shop For Insurance
- Shopping For A Policy
The prospect of planning for your family's life insurance needs may seem daunting. The array of confusing products available, coupled with the calculations needed to find the right amount of insurance, would put anyone off.
Yet the hard fact is that life insurance is an essential part of your family's financial well-being. The more you know about it before you go to your agent, the better your coverage will be. If you don't plan for your life insurance needs, the result could be a waste of thousands of dollars on inappropriate or ineffective life insurance or, worse, financial hardship due to not having enough insurance.
This Financial Guide gives you some basic guidelines about whether and when you should purchase life insurance, and provides you with a system for determining how much you need. It also discusses the types of insurance available, their suitability for various situations, and how to comparison shop for a policy.
Financial Guides
Do You Need Life Insurance?
The purpose of life insurance is to provide a source of income, in the case of your death, for your children, dependents, or other beneficiaries. Life insurance can also serve other estate planning purposes, such as giving money to charity on your death, paying for estate taxes, or providing for a buy-out of a business interest. These will not be discussed in this guide, however.
Related Guide: Please see the Financial Guide: ESTATE PLANNING: How To Get Started.
Whether you need to buy life insurance depends on whether anyone is depending on your income. If you have a spouse, child, parent, or some other individual who depends on your income, you probably need life insurance. You might also need life insurance for estate planning or business succession planning purposes.
Here are some typical insurance situations along with typical insurance needs:
Families or single parents with young children or other dependents
Adults with no children or other dependents
Financial Tools
How Much Life Insurance Do You Need?
Determining how much insurance to buy requires you to invest some time in calculating:
- Your current annual household expenses
- Your assets, debts, and other sources of income.
We've provided a worksheet, which we will refer to in our discussion.
Find out how much insurance you need before considering which type of insurance to buy. Having enough is more important than having the right type. You should provide for your insurance needs immediately, although you can always switch to a more cost-effective or investment-oriented type of insurance later.
The ideal amount of coverage is the amount that would allow your dependents to invest the insurance proceeds after your death and maintain their desired standard of living without touching the principal. Although the old rule of thumb to buy five, six or seven times your annual salary may serve as a starting point, it is no substitute for making the calculations to find out how much you really need.
By using the worksheet and our explanations, you will be able to make a fairly good estimate of your insurance coverage needs. You will need to make some assumptions about your family's future. It's important to be as accurate as possible in filling out the worksheet since an underestimation could lead to your being underinsured, and an overestimation will lead to money wasted on unnecessary coverage.
Here is a line-by-line discussion of how to prepare the worksheet.
Subtract "Other Sources"
Subtract "Other Sources”
The next item on the worksheet represents the income that your survivors will have. If there are sources of income other than the ones listed, do not neglect to include them.
To calculate Social Security benefits, you may wish to obtain an estimate of your benefit from the Social Security Administration. You can obtain a request form by calling SSA's toll-free number-800-772-1213.
Since you cannot predict the amount your survivors will receive (it will depend on your age at death, your earnings, and the ages of your children), you may use the following as rough estimates: $4,000 per year if you have one child under 16, or $5,000 for two or more children under 16.
Do not include other insurance proceeds here; this will be accounted for later.
Calculate The "Annual Income Needed"
Calculate The "Annual Income Needed"
The next item on the worksheet represents the income that your survivors will have. If there are sources of income other than the ones listed, do not neglect to include them.
To calculate Social Security benefits, you may wish to obtain an estimate of your benefit from the Social Security Administration. You can obtain a request form by calling SSA's toll-free number-800-772-1213.
Since you cannot predict the amount your survivors will receive (it will depend on your age at death, your earnings, and the ages of your children), you may use the following as rough estimates: $4,000 per year if you have one child under 16, or $5,000 for two or more children under 16.
Do not include other insurance proceeds here; this will be accounted for later.
Determine The "Shortfall"
Determine The "Shortfall"
The next item on the worksheet represents the income that your survivors will have. If there are sources of income other than the ones listed, do not neglect to include them.
To calculate Social Security benefits, you may wish to obtain an estimate of your benefit from the Social Security Administration. You can obtain a request form by calling SSA's toll-free number-800-772-1213.
Since you cannot predict the amount your survivors will receive (it will depend on your age at death, your earnings, and the ages of your children), you may use the following as rough estimates: $4,000 per year if you have one child under 16, or $5,000 for two or more children under 16.
Do not include other insurance proceeds here; this will be accounted for later.
Determine the "Amount Of Proceeds Needed"
Determine the "Amount Of Proceeds Needed"
The next item on the worksheet represents the income that your survivors will have. If there are sources of income other than the ones listed, do not neglect to include them.
To calculate Social Security benefits, you may wish to obtain an estimate of your benefit from the Social Security Administration. You can obtain a request form by calling SSA's toll-free number-800-772-1213.
Since you cannot predict the amount your survivors will receive (it will depend on your age at death, your earnings, and the ages of your children), you may use the following as rough estimates: $4,000 per year if you have one child under 16, or $5,000 for two or more children under 16.
Do not include other insurance proceeds here; this will be accounted for later.
Add the "Lump-Sum Expenses"
Add the "Lump-Sum Expenses"
The next item on the worksheet represents the income that your survivors will have. If there are sources of income other than the ones listed, do not neglect to include them.
To calculate Social Security benefits, you may wish to obtain an estimate of your benefit from the Social Security Administration. You can obtain a request form by calling SSA's toll-free number-800-772-1213.
Since you cannot predict the amount your survivors will receive (it will depend on your age at death, your earnings, and the ages of your children), you may use the following as rough estimates: $4,000 per year if you have one child under 16, or $5,000 for two or more children under 16.
Do not include other insurance proceeds here; this will be accounted for later.
Determine the "Interim Insurance Proceeds Amount"
Determine the "Interim Insurance Proceeds Amount"
The next item on the worksheet represents the income that your survivors will have. If there are sources of income other than the ones listed, do not neglect to include them.
To calculate Social Security benefits, you may wish to obtain an estimate of your benefit from the Social Security Administration. You can obtain a request form by calling SSA's toll-free number-800-772-1213.
Since you cannot predict the amount your survivors will receive (it will depend on your age at death, your earnings, and the ages of your children), you may use the following as rough estimates: $4,000 per year if you have one child under 16, or $5,000 for two or more children under 16.
Do not include other insurance proceeds here; this will be accounted for later.
Determine the "Total Insurance Needed"
Determine the "Total Insurance Needed"
The next item on the worksheet represents the income that your survivors will have. If there are sources of income other than the ones listed, do not neglect to include them.
To calculate Social Security benefits, you may wish to obtain an estimate of your benefit from the Social Security Administration. You can obtain a request form by calling SSA's toll-free number-800-772-1213.
Since you cannot predict the amount your survivors will receive (it will depend on your age at death, your earnings, and the ages of your children), you may use the following as rough estimates: $4,000 per year if you have one child under 16, or $5,000 for two or more children under 16.
Do not include other insurance proceeds here; this will be accounted for later.
Life Insurance Worksheet
Life Insurance Worksheet
The next item on the worksheet represents the income that your survivors will have. If there are sources of income other than the ones listed, do not neglect to include them.
To calculate Social Security benefits, you may wish to obtain an estimate of your benefit from the Social Security Administration. You can obtain a request form by calling SSA's toll-free number-800-772-1213.
Since you cannot predict the amount your survivors will receive (it will depend on your age at death, your earnings, and the ages of your children), you may use the following as rough estimates: $4,000 per year if you have one child under 16, or $5,000 for two or more children under 16.
Do not include other insurance proceeds here; this will be accounted for later.
Insurance
Types Of Insurance
Although the array of insurance products may seem confusing, there are really just two types of insurance: term and cash value, which is more commonly referred to as whole life, universal life, or permanent life insurance. With term insurance, you pay for coverage for a specified amount of time, and if you die during that time the insurer pays your survivors the death benefit specified. Cash value on the other hand provides you with some other redeemable value in addition to paying a death benefit. For individuals age 40 or less, a term policy will almost always be less costly than a whole life policy. Although term policies do not build cash values, many are convertible to whole life policies without a physical exam. Thus, a term convertible policy may be a good option for someone who is under 40.
Term Insurance
There are various types of term insurance including:
Renewable
A renewable term policy is the most common type of life insurance where the policy renews automatically on a renewable term, e.g. every year, every 5 years, every 10 years, or every 20 years, which is the most popular renewal term. You do not need to take a physical or verify the fact that you are employed. The premium goes up at the beginning of each new term to reflect the fact that you are older. Most renewable term policies can be renewable until you reach age 70 or so.
Re-entry:
With this type of policy, you must undergo a physical exam after a certain period, or pay an extra premium.
Level:
With level term policies, the premium is guaranteed to stay the same over a certain period. This period may be shorter than the term of the policy. Nearly all life insurance bought today is level term insurance.
Decreasing:
With a decreasing term policy, a good option for insuring mortgage payments the face amount of the policy decreases over time while the premium payments remain the same.
Return of Premium:
Some insurers offer term life with "return of premium." Typically, premiums are significantly higher and they require keeping the policy in force to its term.
Insurance
Cash Value Life Insurance
There are four types of cash value life insurance: (1) whole life, (2) universal life, (3) variable universal life and (4) variable whole life. The first two types are the most common and have a guaranteed cash surrender value; in the last two types, the cash surrender value is not guaranteed.
Whole Life:
This is the traditional life insurance policy. It provides a death benefit, has a cash value build-up, and sometimes pays dividends. You do not need to renew a whole life policy. As long as you pay your premiums, you will have coverage, usually until your death. The premium for a whole life policy remains the same for the amount of time you own the policy; the premium is "level" in insurance parlance. Thus, when you are younger, the premium you pay for whole life will be greater than what you would pay for term insurance but when you are older, the premium will be much less than a term premium. Part of each premium goes into the cash value of your policy. Your cash value, which is actually an investment, is guaranteed to grow at a fixed rate. You do not have to pay current income taxes on the growth in the cash value-it is tax-deferred.
You can borrow against your cash value at a rate that is usually better than the prevailing consumer lending rates. If you die with an outstanding loan amount, the loan amount, plus interest, will be subtracted from your death benefit.
Dividend-paying whole life policies-termed "participating" policies are usually offered by mutual life insurance companies. Mutual life insurance companies are generally owned by policyholders while other insurance companies are owned by shareholders. The dividends are refunds of insurance premiums that exceed a certain level. They are paid when the insurance company does well during a quarter or a year. Of course, premiums for participating policies are usually higher than those paid for non-participating policies. Term policies can also be participating, but the dividends paid are usually minimal.
Universal Life
This is the traditional life insurance policy. It provides a death benefit, has a cash value build-up, and sometimes pays dividends. You do not need to renew a whole life policy. As long as you pay your premiums, you will have coverage, usually until your death. The premium for a whole life policy remains the same for the amount of time you own the policy; the premium is "level" in insurance parlance. Thus, when you are younger, the premium you pay for whole life will be greater than what you would pay for term insurance but when you are older, the premium will be much less than a term premium. Part of each premium goes into the cash value of your policy. Your cash value, which is actually an investment, is guaranteed to grow at a fixed rate. You do not have to pay current income taxes on the growth in the cash value-it is tax-deferred.
You can borrow against your cash value at a rate that is usually better than the prevailing consumer lending rates. If you die with an outstanding loan amount, the loan amount, plus interest, will be subtracted from your death benefit.
Dividend-paying whole life policies-termed "participating" policies are usually offered by mutual life insurance companies. Mutual life insurance companies are generally owned by policyholders while other insurance companies are owned by shareholders. The dividends are refunds of insurance premiums that exceed a certain level. They are paid when the insurance company does well during a quarter or a year. Of course, premiums for participating policies are usually higher than those paid for non-participating policies. Term policies can also be participating, but the dividends paid are usually minimal.
Variable Universal Life
This is the traditional life insurance policy. It provides a death benefit, has a cash value build-up, and sometimes pays dividends. You do not need to renew a whole life policy. As long as you pay your premiums, you will have coverage, usually until your death. The premium for a whole life policy remains the same for the amount of time you own the policy; the premium is "level" in insurance parlance. Thus, when you are younger, the premium you pay for whole life will be greater than what you would pay for term insurance but when you are older, the premium will be much less than a term premium. Part of each premium goes into the cash value of your policy. Your cash value, which is actually an investment, is guaranteed to grow at a fixed rate. You do not have to pay current income taxes on the growth in the cash value-it is tax-deferred.
You can borrow against your cash value at a rate that is usually better than the prevailing consumer lending rates. If you die with an outstanding loan amount, the loan amount, plus interest, will be subtracted from your death benefit.
Dividend-paying whole life policies-termed "participating" policies are usually offered by mutual life insurance companies. Mutual life insurance companies are generally owned by policyholders while other insurance companies are owned by shareholders. The dividends are refunds of insurance premiums that exceed a certain level. They are paid when the insurance company does well during a quarter or a year. Of course, premiums for participating policies are usually higher than those paid for non-participating policies. Term policies can also be participating, but the dividends paid are usually minimal.
Variable Whole Life
This is the traditional life insurance policy. It provides a death benefit, has a cash value build-up, and sometimes pays dividends. You do not need to renew a whole life policy. As long as you pay your premiums, you will have coverage, usually until your death. The premium for a whole life policy remains the same for the amount of time you own the policy; the premium is "level" in insurance parlance. Thus, when you are younger, the premium you pay for whole life will be greater than what you would pay for term insurance but when you are older, the premium will be much less than a term premium. Part of each premium goes into the cash value of your policy. Your cash value, which is actually an investment, is guaranteed to grow at a fixed rate. You do not have to pay current income taxes on the growth in the cash value-it is tax-deferred.
You can borrow against your cash value at a rate that is usually better than the prevailing consumer lending rates. If you die with an outstanding loan amount, the loan amount, plus interest, will be subtracted from your death benefit.
Dividend-paying whole life policies-termed "participating" policies are usually offered by mutual life insurance companies. Mutual life insurance companies are generally owned by policyholders while other insurance companies are owned by shareholders. The dividends are refunds of insurance premiums that exceed a certain level. They are paid when the insurance company does well during a quarter or a year. Of course, premiums for participating policies are usually higher than those paid for non-participating policies. Term policies can also be participating, but the dividends paid are usually minimal.
Financial Guides
How Insurance Products Differ
Here, in table form, is a summary of the different features of the various types of life insurance.
| Terms | Term Life | Universal Life | Whole Life | Variable Whole Life | Variable Universal Life |
| Policy term | Stated in policy | Until age 95 | Life | Life | Life |
| Type of death benefit | Determined | Variable | Determined | Variable | Variable and determined |
| Existence of cash value | No | Current rate, guaranteed minimum | Fixed rate, guaranteed | Variable rate, not guaranteed | Variable rate, not guaranteed |
| Ability to choose cash value investments | N/A | No | No | Yes | Yes |
| Regulatory agency | Insurance | Insurance | Insurance | Insurance and securities | Insurance and securities |
How To Shop For
Insurance
In order to be able to shop for the best premiums, it's a good idea to know how premiums are calculated by insurers. Bear in mind that premiums vary among insurance companies, and it is a good idea to ask several insurers for their rates.
Insurance companies place individuals into four risk groups: preferred, standard, substandard, or uninsurable. The premiums charged will be commensurate with the category you are placed in. Thus, a standard risk will pay an average premium for similarly situated insurers.
If you have a high-risk job or hobby, you will be considered substandard, a high risk. A terminal illness at the time you apply for insurance will render you uninsurable. Having some type of chronic illness will place you in the substandard category. People with conditions such as diabetes or heart disease can be insured, but will pay higher premiums.
One company's category for you may not hold with another company. Thus, it still pays to shop for insurance with other companies even though one may have labeled you "substandard."
Once an insurance company approves you for coverage, you cannot be dropped unless you stop paying your premium.
You Can Trust
Shopping For A Policy
In most states, there are rules, set by a group of state insurance regulators, requiring the agent to calculate two types of cost indexes that can help you to shop for a policy. You can use the indexes to compare policy costs.
One type of index, the net payment index, gauges the cost of carrying your policy for the next ten or twenty years. The lower the number is the less expensive the policy will be. This index is useful if you are most interested in the death benefit aspect of a policy, as opposed to the investment aspect. The other type of index, the surrender cost index, is useful to those who have a high level of concern about the cash value. This index may be a negative number. The lower the number, the less expensive the policy.
One type of index, the net payment index, gauges the cost of carrying your policy for the next ten or twenty years. The lower the number is the less expensive the policy will be. This index is useful if you are most interested in the death benefit aspect of a policy, as opposed to the investment aspect. The other type of index, the surrender cost index, is useful to those who have a high level of concern about the cash value. This index may be a negative number. The lower the number, the less expensive the policy.
These two indexes apply to term and whole life policies. With universal life policies, focus on the cash value growth and the cash surrender value to make comparisons. Cash surrender value is the amount you receive if you cancel the policy. It is not the same as cash accumulation value. If you are shown two universal life policies, and they have the same premium, death benefit, and interest rate, then the one with the higher cash surrender value is generally the better policy.
Here are some questions to ask about policies:
- How do cash values accumulate? An early, rapid build-up is generally preferable.
- How has the policy's cash value performed in the past? You can get this information from a publication called Best's Review, Life and Health Insurance edition. Determine how the policy performed in comparison with the company's projection and with other insurers.
- Are any special features merely bells and whistles, or do they add value for you?
- What is the company's rating with Best, Standard & Poor's, and Moody's? You can find these publications in public libraries. The rankings should be in the top three to ensure that a company has financial stability.
This Content is for informational purposes only. Nothing contained herein constitutes accounting, tax, financial, investment, legal or other professional advice, and, accordingly, the author and the distributor assume no liability whatsoever in connection with its use. This Content is not an exhaustive explanation of any topic, practice or process. You should seek the advice of a licensed professional before making any accounting, tax, financial, investment or legal decision.
