Few people like to talk about life insurance. Most of those that do are life insurance sales agents. With their commissions on the line, you may not be getting an honest opinion. How do you know if you should buy life insurance? Read on for details…
Risks
As we go through life, we take on many risks. The purpose of insurance is to spread the risk of some unlikely occurrence over many people. Insurance, while often necessary, shouldn’t be treated as an investment – the company selling the insurance needs to make a profit so it ensures that the odds are (slightly) stacked against you.
For example, you may be a good driver, but you could misjudge the distance or road conditions and end up damaging a very expensive car. Your car is your problem, but most jurisdictions around the world require you to have insurance to cover the damage to the other car you damaged. While you can control the former (the value of your own car) you have less influence over the latter (the value of the car you are going to hit). As a result, insurance can be used to cover this variable cost.
In the case of life insurance, the risk is that a person normally responsible (either entirely or partly) for supporting others can no longer do so, due to death. The risk could also be that a desired bequest (gift or transfer of wealth at death) does not currently have sufficient funding. With this purpose in mind, it is clear that an individual with no dependents or need for a bequest (that is not currently funded) does not need life insurance. Similarly, some kinds of insurance sales agents push “riders”, where children can be added to the life insurance policy. Unless the family is dependent on the child’s income, or funeral costs would be prohibitive, it makes little financial sense to pay the additional premium.
Term vs. Permanent Life Insurance
There are two kinds of basic life insurance: term and permanent. Other kinds, such as Whole Life, Universal, or Participating insurance also exist, but they are more complicated due to the fact that they have an investment component, and will be discussed in another blog post.
Term insurance is the more common of the two because it is generally cheaper. Following a medical exam, the insurance company will determine a fixed premium that needs to be paid for an agreed number of years. After this fixed number of years, called the term, new insurance will need to be found and purchased, likely at a higher premium, due to the increased age of the individual. In contrast, permanent life insurance guarantees the same premium forever. Because the premium doesn’t increase with time, it is generally much higher (frequently several times) than term insurance.
While possible, it’s very difficult to determine which kind of insurance is the better deal. If you are an aggressive investor, you may be able to get a better return by choosing term life insurance and investing the difference between the term insurance and permanent insurance. However, more conservative investors may be better off with permanent life insurance –in this way, the investment uncertainty remains with the underwriters of the insurance company.
One final thing to consider when deciding what type of insurance to get is the purpose of life insurance: to provide compensation to dependents if those who usually support them financially can no longer do so, or to provide for a bequest that is currently not fully funded. This generally means life insurance should be mandatory from when children are born to when they become independent, so about 20 or 25 years. Permanent life insurance continues forever, so could still be paying premiums for it long after it is no longer needed.
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