Understanding Life Insurance

What do you know about life insurance? If you are like me (before I became educated on the topic) then very little. Growing up I never discussed life insurance with my parents probably because death in general isn’t a pleasant topic of conversation. The extent of my life insurance knowledge came from soap operas and pushy salesmen. Which caused me to have a few misconceptions about the topic. The more I learned I quickly realized that it is a legitimate financial product that can be an important part of your financial plan. However, in order for you to find the best plan for your needs you need to understand how it can benefit you and the responsibility you are taking on when buying it. The last thing you want is to be offered life insurance by an agent without knowing the answers to these questions first:

What is life insurance?

Life insurance is a contract between the insurance company and the policy owner (you). Which guarantees the insurance company will pay a sum of money (death benefit) to the beneficiaries when the insured dies. In exchange you pay a premium to the insurance company during your lifetime.

It is important to understand that life insurance is NOT intended to be an investment. Investing means deferring spending in hopes of financial gain but life insurance is not meant to create a financial gain upon your death. Like any other type insurance it is meant to avoid a financial loss. In this case the financial loss would be any negative financial impact that would be created for your loved ones as a result of your death.

Why do I need life insurance?

The amount you receive is meant to cover any financial loss that can occur upon your death. Here are a few things that may create a need for life insurance:

• Funeral expenses – Funerals are expensive in general but may even be more expensive for those who want to be buried in their home countries.
• Mortgage and other debts – If you are the breadwinner in your family and are in charge of making these payments your death would result in these being inherited by family and becoming a financial burden for them.
• Income replacement – Does your families well-being depend on your current income? If so, your loss would also mean that your family would also lose their primary source of income. A life insurance payment would not replace a lifetime of income but it could be helpful temporarily while your family figures out how to replace that source of income.
• To support aging parents – Being first generation often means that we are likely to become our parents financial support during their retirement. This means that our death would create a financial burden on them in their later years. A life insurance payment can be useful to replace the support we would have provided in their retirement.

Who should be insured?

When evaluating the need for life insurance it is important to identify who the insured will be. Typically this will be the family breadwinner whose death would cause the greatest financial loss. In immigrant families this may not necessarily be our parents. If you are financially in charge of your parents or are willing to cover these expenses that may come up upon their death; then they may not necessarily need to be the insured in a life insurance policy.

On the other hand; if no one depends on you financially then you can probably do without life insurance right now.

How much life insurance do I need?

Take a moment to think about the financial losses that would occur upon your death and quantify them. If this amount is overwhelming then life insurance could be what you need to provide that peace of mind. To estimate the amount of life insurance you need take those financial losses and subtract your assets. The gap is the remainder that life insurance would have to fill.

On the other hand you may realize that you have enough savings to take care of these situations. In this case you can decide to forgo life insurance. You will still want to make sure that the appropriate beneficiaries are listed on all your accounts. This would ensure that your money goes to who you want it to go upon death.

P.S. Some employers offer life insurance as a benefit. You may want to take this into consideration when determining how much life insurance you would need for your situation.

What are the different types of life insurance offered?

Here is a basic overview of the different types of life insurance available.

Term Life Insurance

Term Life Insurance provides insurance protection for a certain period of time this can be 10, 20 or 30 years. The policy is only active for that specified amount of time. If the insured dies while the policy is active the death benefit is paid out to the named beneficiaries. If the insured lives beyond the term and they want to extend the term of the contract then they will likely need to pay higher premiums. Term life insurance is the most affordable type of life insurance. Term life insurance is straightforward and usually enough to provide protection for the average person.

Permanent life insurance

Permanent life Insurance provides insurance protection “permanently” or for your entire life. It means that your beneficiaries will receive the death benefit as long as you are paying your premium; regardless of when death occurs. Another key feature of this type of insurance is the cash value component also known as the savings component. The cash value component serves as a “living” benefit for the policyholder from where they can withdraw funds. Here are a few other things to know about the cash value and how it can be used:

• The cash value grows over time at a low interest rate that is set by the insurance company
• The cash value amount does not begin to accumulate until 2-5 years have passed
• Once this cash value accumulates it can be used to:
  • Make cash withdrawals – It is important to know that these withdrawals reduce the death benefit.
  • Borrow against the cash value – You can take out loans but they need to be repaid (with interest!) in order to keep the death benefit.
  • Once the cash value accumulates to a high enough level it can be used to pay the insurance premiums.

The cash value component is a big selling point of permanent life insurance but it comes at an expense. The premiums are higher since part of the payment goes towards the cash value. That is why permanent life insurance is 5 to 15 times more expensive than term life insurance and is generally best for high earners with long term financial obligations.

The most common types of permanent life insurance are whole life insurance and universal life insurance.

What else should I consider?

You do not want the first time you learn about life insurance to be from a life insurance agent because they may have a motivation to sell a bigger policy than you actually need. Life insurance agents are paid based on commissions so the more they sell the more they earn. They receive a large upfront commission based on the cost of the first years premium. They may also receive an ongoing commission for every year the policy is in force. This is why they may likely push for whole life insurance instead of term insurance.

That is why having an understanding of how life insurance works before meeting an agent is so important. Because although life insurance is a legitimate financial product that can be an important part of your financial plan you want to make sure you understand how it can benefit you and the responsibility you are taking on when buying it.

Life Insurance Key Terms

• Death Benefit – The agreed upon amount that the insurance company will pay when the insured dies.

• Beneficiaries – The people who will receive the cash payment upon death of the person insured under the policy. The beneficiary can be one person or divided between different people.

• Premium – The monthly or yearly cash payments needed to keep the policy in effect.

• The insured – The person whose life is insured.

• Cash Value – A “cash” amount that builds over time and can be cashed out or borrowed. This only applies to permanent life policies.

• Assets – cash that can be used to cover financial losses.