Term life insurance is used primarily for pure income replacement (i.e., your human capital). When you apply for term life (non-permanent) insurance, you have to choose the amount of coverage you want ($50,000 to more than $2,000,000) and the term of the policy – usually a 10-, 15-, 20- or 30-year policy. The coverage amount and term depend on your specific needs, such as taking care of young children, or paying off the mortgage if you pass away unexpectedly.
Since term life insurance policy premiums stay level, i.e., the same, your premium does not change during the term. This causes the premium to be higher for longer terms. At the end of the term, you either lose life insurance coverage or apply to obtain a new policy with a different term, conditions and premium costs.
How the Premium Is Determined
Your premium is determined by your age, gender and health rating, multiplied by a stated factor for the term and coverage amount you’re applying for. The health rating component requires an insurance physical exam where a nurse visits you at home or at work, or you can go to a doctor’s office.
When deciding how much insurance to get, consider the costs of raising a child and potential college tuition, plus the mortgage, funeral costs and any other potential debt. For lower coverage amounts, such as under $250,000, many companies offer simplified issue insurance, which you usually receive advertisements for by mail from your mortgage lender or homeowner’s insurance company. This type of life insurance doesn’t require a medical exam and can be approved in just a couple of days.
The charts below show the difference in cost of premium for healthy male and female applicants applying for a $500,000 policy. As you can see, it’s much costlier for a 45-year-old applying for a 20-year term policy than a 25-year-old. The premium cost line for 30-year term policies cuts off at age 50 for both male and female applications. A 30-year level policy would be very risky for a life insurance company because the chance of you passing away between ages 50 to 80 is much greater than ages 30 to 60. Applying for a 30-year policy at age 50 and up requires more rigorous underwriting and higher premiums, and there’s a chance your application might be turned down.
What’s important to know is that once this policy is in effect, the premium can’t increase, even if you gain significant weight, start drinking excessively or take up smoking cigarettes. Granted, if any of these issues are present when applying for a policy, your premium would be much costlier, and there’s even the chance your policy won’t be approved.
Note that it can take up to three months from the time you apply for the policy to be approved and go into effect.
To determine how much coverage to apply for, a basic rule of thumb is 10 times your income (experts recommend 7 to 10). So if you earn $100,000 a year, you’d apply for a $1,000,000 term policy. The more comprehensive calculation requires adding up the separate costs in present day dollars, such as the living costs until retirement for a surviving spouse or family member, the cost of a child’s dependent care, college tuition, mortgage payoff, living expenses and retirement savings replacement for a surviving spouse. Take this number and subtract your existing financial resources (savings) to determine the appropriate amount of life insurance. This calculation can often lead to a higher required coverage amount. This coverage amount increases even further if you have several dependents who are minors.
This online calculator can be useful in completing the more comprehensive life insurance calculation.
Keep in mind that as you get older and you accumulate more wealth (retirement savings, taxable savings, inheritance, no mortgage, etc.), the need for life insurance declines. It’s more important earlier in your career when you’re just starting to accumulate wealth and have a family.
Coverage for a Non-Working Spouse
Even though a spouse may not bring home a paycheck, raising young kids has significant value. This value multiplies if you have more than one child. Consider if your spouse who is taking care of your young kids were to pass away. There would be additional costs for childcare and household expenses. Your career progression may be constrained due to your loss, along with your potential for growth of income and wealth accumulation. Importantly, the grief of losing a spouse along with taking care of the kids may cause you to leave work temporarily, or even permanently. At a minimum, consider the cost it would take to hire someone for childcare, cleaning, cooking, errands, etc., and multiply that figure by the number of years of support you think you’d need until the kids are at an age where they don’t require as much support.
Determining Term of Policy
This is where it’s important to remember why you are getting insurance in the first place. If your goal is to be able to provide for your young children and wife in the event of your passing, then a 20-year policy may make the most sense, as your kids will be adults and be independent, or on their way to being independent, by the time that policy lapses. If you have a child with special needs or one who’s mentally incapacitated and will require lifelong assistance, applying for a 30-year policy will be more appropriate to provide coverage for the longest period possible.
You may ask why you should get a 20-year policy instead of a 30-year policy if you’re expecting your first child or have young children. Well, if you plan to save or you have saved throughout your child’s life for their college tuition, and you’re expecting they’ll be independent, a term policy after they enter college may not be necessary from an income replacement standpoint. There’s also the premise that if you needed insurance separate from an employer group policy in 20 years, you will have worked your way up in a company and have a high enough income to afford the more expensive insurance. Consider where you will be financially 20 years from now.
Policies for less than 10 years can be useful to provide needed coverage to pay for a mortgage or other obligation that’s shorter term in nature.
Group Versus Individual Term Policies
Oftentimes, the only coverage families have is through the working spouse’s employer-provided group life insurance coverage. This coverage is usually one or two times your annual salary, and is often provided at no additional cost to the employee. This type of coverage is less expensive because it doesn’t require individual underwriting and you don’t need to get a doctor’s exam. Group insurance policies allow you pay extra to get insurance up to a certain maximum, which for some companies is $2 million.
So, if your employer provides an affordable, if not free, coverage option, why would you need an individual policy? There are several reasons, including the fact that the group policy may not allow you to get enough coverage for your obligations, or you aren’t able to keep the policy if you leave the company. Many companies allow you to keep the policy upon leaving, but the insurance company won’t continue giving you the group insurance rate. This will cause your premium costs to increase considerably. If you switch jobs every couple of years, an individual term policy is ideal as it will protect you no matter what the job market is, as long as you continue to pay the premium each year.
While life insurance isn’t the most enjoyable topic to discuss, it’s an important one, especially if you have a young family. You should periodically re-evaluate your coverage amount and term to ensure your loved ones are covered financially in the event of an unexpected death. If you acquired your policy prior to accounting for kids or when you had one child versus several now, it may be time to re-evaluate your life insurance coverage.
No client or prospective client should assume this article serves as a receipt of, or a substitute for, personalized from an insurance professional. The client or prospective client should consult with an insurance professional regarding their specific insurance needs.
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Geoff has always enjoyed talking with people about finance, learning about their investments, financial strategy, and business sense. His interest only deepened with time, and what began as a hobby has now become a life-long passion, with an unparalleled passion for continuing education that makes him an expert in many subjects from traditional taxes and investments to business succession planning and executive compensation negotiations.
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