Not everyone needs life insurance. The first thing to do is make sure you need it.
Life insurance is really meant for your family members or other dependents who rely
on your earnings.
Why You Buy Life Insurance
You buy life insurance so that, if you die, your dependents can live the same kind of
life they live now. Strictly speaking, then, life insurance is only a means of replacing
your earnings in your absence. If you don’t have dependents (say, because you’re
single) or you don’t have earnings (say, because you’re retired), you don’t need life
insurance. Note that children rarely need life insurance because they almost never
have dependents and other people don’t rely on their earnings.
Life Insurance Comes in Two Flavors
If you do need life insurance, you should know that it comes in two basic flavors:
term insurance and cash-value insurance (also called “whole life” insurance).
Ninety-nine times out of 100, what you want is term insurance.
Term Life is Simple to Buy and Understand
Term life insurance is simple, straightforward life insurance. You pay an annual
premium, and if you die, a lump sum is paid to your beneficiaries. Term life
insurance gets its name because you buy the insurance for a specific term, such as
5, 10, or 15 years (and sometimes longer). At the end of the term, you can renew
your policy or get a different one. The big benefits of term insurance are that it’s
cheap and it’s simple.
Cash Value is Trickier
The other flavor of life insurance is cash-value insurance. Many people are attracted
to cash-value insurance because it supposedly lets them keep some of the
premiums they pay over the years. After all, the reasoning goes, you pay for life
insurance for 20, 30, or 40 years, so you might as well get some of the money back.
With cash-value insurance, some of the premium money is kept in an account that
is yours to keep or borrow against. This sounds great. The only problem is that
cash-value insurance usually isn’t a very good investment, even if you hold the
policy for years and years. And it’s a terrible investment if you keep the policy for
only a year or two. What’s more, to really analyze a cash-value insurance policy, you
need to perform a very sophisticated financial analysis. And this is, in fact, the
major problem with cash-value life insurance.
While perhaps a handful of good cash-value insurance policies are available, many—
perhaps most—are terrible investments. And to tell the good from the bad, you
need a computer and the financial skills to perform something called discounted
cash-flow analysis. If you do think you need cash-value insurance, it probably
makes sense to have a financial planner perform this analysis for you. Obviously,
this financial planner should be a different person from the insurance agent selling
you the policy.
What’s the bottom line? Cash-value insurance is much too complex a financial
product for most people to deal with. Note, too, that any investment option that’s
tax-deductible—such as a 401(k), a 401(b), a deductible IRA, a SEP/IRA, or a Keogh
plan—is always a better investment than the investment portion of a cash-value
policy. For these two reasons, I strongly encourage you to simplify your financial
affairs and increase your net worth by sticking with tax-deductible investments.
If you do decide to follow my advice and choose a term life insurance policy, be sure
that your policy is non-cancelable and renewable. You want a policy that cannot be
canceled under any circumstances, including poor health. (You have no way of
knowing what your health will be like ten years from now.) And you want to be able
to renew the policy even if your health deteriorates. (You don’t want to go through a
medical review each time a term is up and you need to renew.)
