Life Insurance

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Friend of the blog Matt sent in a great question this week:

Hi Jesse – do you have any recommendations when it comes to life insurance? I know Term is the way to go, but that’s about all I got…

I scanned your blog posts and didn’t see anything too specific with it but if you have any guidelines for pricing or coverage recommendations, please let me know!

Matt

Matt’s Right. We Want Term!

Matt’s right. Term life insurance is the best option in 99.99% of cases.

Other types of life insurance (Whole, Variable, Universal, etc.) are bloated products that are “pushed” and “sold” far more often than they’re genuinely sought after. These products try to combine investing with insurance and end up being overpriced versions of each.

Some things aren’t worth combining!

The smarter option is to buy insurance that only acts as insurance and then use your remaining money to invest in pure investments. Term life insurance is just that life insurance product. All it does is provide money to your beneficiaries if you die. If you don’t die, it doesn’t pay. It’s simple.

But Do We Need Life Insurance?

How do we determine if someone needs life insurance?

I use the same framework I would use for any insurance question (home, boat, pet llama insurance, etc.).

Are you exposed to a financial risk that you could not comfortably recover from using your current asset base?

Let’s say your house burns down. Does that present a financial risk you could recover from using your current assets (cash, investments, etc)? If you answer no, then you need home insurance. (If you have a mortgage, your lender likely mandates you have insurance so they’re covered should the house burn down).

If your wedding ring got stolen, does it present a financial risk you could recover from? Personally, I wear a ~$200 tungsten carbide wedding ring. If my finger got stuck in a tragic 3-ring binder accident while compiling someone’s financial plan, I could replace that $200 ring without issue. I do not need ring insurance. Granted, the cosmetic costs of finger reconstruction might make me wish I had better health insurance…

Back to the point: that’s the framework to use! Does the downside risk present an insurmountable financial burden to you (or your beneficiaries?)

The answer for many younger readers with dependents (spouses, children) is a screaming YES. As in, “If I died and the family lost my income, it would be very financially uncomfortable for many years!”

But how much coverage do you need?

My Preferred Methods: Income Replacement and “DIME”

The two methods I prefer (and suggested to reader Matt) are the Income Replacement method and the DIME method.

Income replacement suggests you replace your income for a certain number of years, typically until your children reach a particular age or until your spouse reaches retirement age.

In my personal case, I wanted to replace my income until my youngest child (who is still technically hypothetical) is out of the house. I chose a 30-year term policy equivalent to ~20 years of my income (with a small discount rate for future years). No matter when I get hit by that proverbial bus, 20 years of income should cover my youngest child until they’re out of the house.

The DIME method adds up any outstanding debts, add in your income for a certain number of years, then adds your remaining mortgage, and finally adds on future expected education costs. Debts, income, mortgage, education.

The DIME method double-counts a few things. For example, I’m using my income to pay my debts and mortgage. I shouldn’t need to double-count them. Nevertheless, I like the idea of itemizing the biggest future expenses (college costs, mortgage payoff, etc.) and ensuring your life insurance policy can cover them.

The Best of the Rest

Other strategies I’ve seen for sizing life insurance policies include:

The Human Life Value (HLV) method. It asks an individual to consider their annual income for each year until their retirement, add in other benefits and bonuses, subtract the income used for their personal consumption, and then discount future income to today’s value.

Done correctly, this method should provide the beneficiaries with a lump sum of the resources you would have expected to provide to them over the remainder of your working life. It’s just a bit too complicated and mathematical for most people to get right.

The Budget-Based method simply multiplies your household’s monthly expenses by the number of months you expect those expenses to be maintained. It’s similar to Income Replacement, but looks at expenses rather than income.

Lastly, the “Rule of Thumb” (which I think is a poor name!) suggests you multiply your income by 10. Very much “one size fits all,” which is why I don’t like it.

Granted, one detail to note is that most life insurance sizing strategies are intentionally conservative, leading to policy sizes that are large enough during the highest-risk years but end up being too large as time goes on.

For example: a young family might need a $2M, 25-year policy on each parents. But by the time the kids are in college, that $4M of total coverage is surely too much.

Thanks for the question, Matt!

And to all of you: term life insurance is a smart financial planning move. But I hope none of you ever need to collect!

Thank you for reading! If you enjoyed this article, join 8500+ subscribers who read my 2-minute weekly email, where I send you links to the smartest financial content I find online every week. You can read past newsletters before signing up.

-Jesse

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If you have a whole life insurance policy that pays dividends, you may have the option of purchasing paid-up additions. Paid-up additions in life insurance are small additional amounts of coverage bought with your life insurance dividends.

Paid-up additions let you increase your death benefit — the payout your beneficiaries could receive if you die — without raising your premiums, because your dividends pay for the additional coverage in full. The extra coverage can help your life insurance keep up with inflation.

You’ll need a participating life insurance policy to earn dividends. Participating life insurance policies are available through mutual life insurance companies, which are owned by policyholders rather than shareholders. Dividends are never guaranteed, though some mutual life companies have a long track record of paying them.

If you use policy dividends to purchase paid-up additions (PUAs), you won’t need to provide new proof of insurability. This means you can get the extra coverage even if you’ve developed health problems. The additional insurance you can purchase is based on your age at the time the dividend is issued.

Alternatives to paid-up additions in life insurance

There are several alternatives to using dividends to purchase paid-up additions in life insurance. For example, you could choose to:

  • Receive the dividend payment as cash.

  • Use it to reduce your life insurance premiums.

  • Pay down outstanding policy loans.

If you’re shopping for life insurance and want the flexibility to increase your death benefit, there are several other ways to do so without a paid-up additions rider.

More about life insurance riders

Source: nerdwallet.com

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Extended term insurance is a way to use the cash value of a permanent life insurance policy to buy a term policy that lasts for a set number of years and has the same death benefit

. It can be useful if you can no longer afford your life insurance premiums but you still need the coverage.

Most permanent life insurance policies, like whole life insurance, charge higher premiums than term life and use part of this money to build cash value over time. These policies typically contain a “nonforfeiture” clause, which means you won’t lose the cash value that’s accumulated if you cancel the policy or allow it to lapse.

Extended term insurance is a nonforfeiture option that lets you keep your life insurance coverage for some amount of time, even though your permanent policy ends. It replaces your permanent policy with a term policy, typically of the same face amount, paid for by your accumulated cash value.

The length of the term depends on how much cash value the policy has, as well as your age when you stopped making payments. If you have an outstanding policy loan, your insurance company will deduct the amount from its cash value first. The insurer will use the remaining amount to determine how much term life insurance you qualify for

.

Pros and cons of extended term life insurance

The advantage of extended term insurance is that you can stop paying premiums and keep some coverage in place. If you die during the policy’s term, your loved ones will still receive a death benefit, which is the payout from a life insurance policy.

The downside is that you’re replacing permanent life coverage — which is typically meant to last your entire lifetime or until an advanced age — with short-term coverage. If you outlive the policy’s term, the policy will expire and your survivors won’t get a payout when you die.

If you decide you no longer need coverage or you can no longer afford premiums on a permanent policy, you’ll also typically have the option of trading in the policy for its cash surrender value.

Learn more about permanent life insurance

Source: nerdwallet.com

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A family income rider in life insurance is an extra feature that provides a monthly income to your family if you die while the rider is active. This life insurance rider is an add-on to a life insurance policy.

Most life insurance death benefits are paid in a lump sum. But if you’re concerned that your survivors may have difficulty managing a large amount of money in the long term, you could opt for a family income rider so that benefits are disbursed in monthly installments.

How does a family income rider work?

You can often include a family income rider to your term life policy at very little cost — or even no extra cost. This is because if you die during the term, your insurance company will probably have to pay a death benefit. But if the insurer hangs onto part of the death benefit and makes the payout gradually, the company can still earn interest on some of the money for a while.

The term of a family income rider begins when you add the feature to your policy. For example, if you included a 15-year family income rider on your policy and died 10 years later, your beneficiaries would receive income for the remaining five years. Usually, your family would receive a specified portion of the death benefit each month. At the end of the term, any remaining death benefit is paid in a lump sum.

Some carriers only offer a family income rider as decreasing term life insurance, which means the total value of the death benefit gradually drops throughout the policy’s term.

Like other life insurance death benefits, money your survivors receive through a family income rider generally isn’t subject to income tax. However, any interest earned from the death benefit is considered taxable and needs to be reported to the IRS.

Learn more about life insurance riders

Source: nerdwallet.com

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A term conversion rider in life insurance is a feature that gives you the option to convert a term life policy into a permanent life policy without new medical underwriting. Some term life policies automatically include a conversion option. Others require you to pay extra for this life insurance rider, and some policies may not offer it at all.

Term life insurance covers you for only a specific period of time, usually between 10 and 30 years. If you outlive the policy’s term, your coverage expires. Permanent life policies like whole life insurance often provide lifelong coverage, extending to a maximum age such as 100 or 121. But these types of policies are usually far more expensive than term life insurance because in addition to permanent insurance, they have a savings component called cash value.

A term conversion rider lets you lock in the ability to buy permanent coverage in the future, while allowing you to pay lower term life premium rates. You may want to secure the option to obtain permanent life insurance in case your health or financial obligations change. Or perhaps you can only afford term insurance now, but you’re hoping you’ll make more money and will be able to buy permanent life insurance later.

How much does it cost to convert a term policy?

Usually there’s no fee for converting your term policy to a permanent one, but you can expect your premiums to increase significantly. Since a term conversion rider doesn’t require new underwriting or a life insurance medical exam, your health status won’t affect your premiums. Your age will be a factor in how much you pay, though.

You may have a limited window for converting your policy. For example, some policies require you to exercise your conversion option before you turn 65, at least 18 months before the end of the policy, or in the first five or 10 years of your policy’s term. With other policies, the conversion provision remains in force until the policy expires.

Many insurers allow for a partial conversion, which leaves you with two separate policies: your remaining term policy (with a lower life insurance face value) and your new permanent policy.

Be aware that when you convert, you typically can’t choose from all the permanent policies an insurer may offer. You’ll probably have only one conversion option, and it may not be the right policy for you. It’s a good idea to check out other permanent life insurance options on the marketplace, especially if you’re in good health.

A term conversion rider can give you additional flexibility in case you need to purchase permanent coverage in the future. If you’re interested in a policy that includes this rider, consult with a life insurance agent or broker.

More about life insurance riders

Source: nerdwallet.com

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What is increasing term life insurance?

Increasing term life insurance is a type of insurance where you can increase your death benefit over time without new underwriting. This kind of life insurance is relatively rare.

The most popular form of term life policy is level term insurance, where the premium and the death benefit remain fixed throughout the term. However, some people buy increasing term life insurance because they anticipate needing more life insurance in the future. For example, you might purchase this kind of policy if you expect to earn a higher salary, plan to start a family, anticipate more financial responsibilities in the future, or are worried that inflation will erode your death benefit’s value.

Some increasing term life policies offer fixed premiums, but many increase premiums as the death benefit increases. If your premiums are fixed, they’ll typically be higher than level term insurance premiums.

Depending on the insurer, your death benefit may increase by a lump sum or a specified percentage each year. Some policies may allow for incremental increases on a different schedule. Your insurer may limit coverage increases to the early years of the policy, such as the first five years. In that event, your coverage will continue for the length of the policy’s term, but you won’t be able to automatically step up the death benefit.

Increasing vs. decreasing term life insurance

In contrast, some people buy decreasing term life insurance, which is the opposite of increasing term life insurance. Over time, the death benefit on a decreasing term policy becomes smaller. This coverage is usually cheaper than increasing term life insurance or level term insurance because the death benefit gradually shrinks. The premiums generally are level, so you are paying the same amount for less coverage over time.

People sometimes buy mortgage protection insurance, a form of decreasing term life insurance, to pay off the balance of their home loan if they die.

Alternatives to increasing term life insurance

If you expect your life insurance needs will go up over time, an increasing term life insurance policy isn’t the only option. Here are some alternatives to consider.

  • Guaranteed insurability rider: This life insurance rider allows you to increase coverage periodically without a new medical exam or underwriting. You’ll pay higher premiums if you choose to step up the death benefit. A guaranteed insurability rider is relatively uncommon on term life insurance policies. 

  • Cost-of-living rider: A cost-of-living rider allows you to increase the death benefit to keep pace with inflation.

  • Purchase additional term coverage: Another option is to purchase a new term life policy as your coverage needs increase. The downside is that you’ll need to undergo new life insurance underwriting. Also, even if you’re healthy, life insurance is more expensive as you age, so premiums will likely be higher.

Learn more about term life insurance

Source: nerdwallet.com

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A 20-year-old worker has a 1 in 4 chance of becoming disabled before reaching retirement age, according to the Social Security Administration.

Insurance can provide valuable financial protection against loss of income while you’re disabled.

One option is purchasing life insurance with a disability income rider. A disability income rider is a life insurance add-on that provides you with a monthly benefit if you become disabled. Usually, the monthly benefit is a specified percentage of your policy’s face amount. For example, if you have a $250,000 life insurance policy with a disability income benefit of 1%, you could receive $2,500 a month if you meet your insurer’s criteria for disability.

If you’re diagnosed with a qualifying disability, you’ll typically have a waiting period (sometimes referred to as an elimination period) before you can claim the disability income benefit. For example, if your policy rider has a 90-day elimination period and you’re severely injured in a car accident, you would need to wait 90 days before you would start receiving payments. Some policies will pay benefits for a limited period only, such as 24 months.

If you purchase a disability income rider, it’s important to know how your policy defines disability, as the definition varies by insurer and can be different for two policies with the same insurance company. You may be ineligible for this life insurance rider if you work in a high-risk occupation, like law enforcement, firefighting or public utilities.

An alternative to a life insurance disability income rider is a stand-alone disability policy. Many employers offer disability insurance as a benefit. You can also purchase an individual disability policy if your workplace doesn’t offer coverage or if you want to supplement an existing policy.

Learn more about disability income and life insurance

Source: nerdwallet.com

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What is a term life insurance rider?

A term insurance rider adds temporary coverage to a permanent life insurance policy for a set amount of time, usually 10, 20 or 30 years. Life insurance riders offer additional coverage to complement standard policies and the options vary among insurers.

Adding term insurance to a permanent policy

Term life riders can typically be added to permanent policies, such as whole life insurance or universal life insurance, often for an extra fee. The payout from a term life rider can be used to cover temporary or short-term costs in the event of your death. For example, you may want to add a term life rider that lasts as long as your mortgage or until your children finish college so these larger expenses are covered if you die unexpectedly.

Let’s say you take out a permanent life insurance policy worth $100,000, which may be sufficient to cover your beneficiaries if you die after retirement or with fewer financial obligations. Adding a 20-year term life insurance rider worth $100,000 could help fulfill financial needs and bridge gaps if you die within that time frame.

It’s often cheaper to add a term life insurance rider to a permanent policy instead of buying a term policy now and a permanent life insurance policy later.

🤓Nerdy Tip

Most life insurance riders can’t be added to an existing policy. If you’re in the market for life insurance, explore all the riders and opt in to the ones you want or need when you buy a policy.

Types of term and permanent insurance riders

There are two main types of life insurance: term life insurance, which offers coverage for a fixed number of years and pays out if you die during the “term,” and permanent life insurance, which typically covers you for your entire life.

While the names can be confusing, a term life rider generally refers to temporary coverage added to a permanent life insurance policy. Some companies allow you to add a term life rider to a term life insurance policy to bump up your coverage even more, though this is rare.

Some of the most common life insurance riders include:

Alternatives to a term life rider

Assessing your needs can help you determine whether you need a permanent life insurance policy with a term life rider, or a different type of life insurance altogether. For many people, a standalone term life insurance policy is enough to provide their beneficiaries’ with a financial cushion.

Since the premiums for a term policy are usually cheaper than a permanent policy, you could save and invest the difference to plan ahead for yourself or your loved ones after the term ends. If you want to leave the option for permanent coverage open, consider adding a term conversion rider to your term life policy. This allows you to upgrade your policy to a permanent life insurance policy before a deadline specified by your insurer.

Frequently asked questions

Source: nerdwallet.com

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When you buy life insurance, you’ll typically have two types of insurance companies to choose from. A mutual life insurance company is a company that’s owned by policyholders, while a stock insurance company is a company that’s owned by shareholders.

Only about 15% of life insurance companies doing business in the U.S. as of 2020 were mutual life companies, according to the American Council of Life Insurers

.

In a mutual life company, policyholders elect a board that directs management, whereas with a stock mutual company, the board of directors is chosen by shareholders. Essentially, the policyholder is both a customer and an owner in a mutual life insurance company. With a stock insurance company, policyholders are customers only. Shareholders are the owners of a stock insurance company.

One big difference between mutual life insurance companies and stock insurance companies is that when a mutual life company needs to raise money, it must issue debt or borrow from policyholders. That money is repaid from the insurer’s operating profits. A stock insurance company can raise money by issuing debt or by issuing more stock. The ability to raise money by issuing stock gives stock insurance companies more flexibility.

Many insurance companies have demutualized over the years. Demutualization is the process of changing the legal structure of an insurance company from a mutual form of ownership to a stock form of ownership. When an insurer demutualizes, it typically issues stock or other compensation to policyholders for their ownership in the mutual company

.

Top mutual life companies in the U.S.

These are the five largest mutual insurance companies in the U.S., based on 2022 market share for individual policies, according to S&P Global Market Intelligence.

Source: nerdwallet.com