Of all the persistent myths about life insurance, the notion most people don’t need it is arguably the most damaging.
That’s because the truth is closer to the opposite. Most people do need life insurance coverage, including those without dependents or massive debts.
But the myth that life insurance is often unnecessary is comforting for busy people who feel like they don’t have time to research their life insurance options and shop around for the best policy. It’s much easier to put something off when we convince ourselves it’s not essential.
Understanding the Different Types of Life Insurance Policies
That’s where the misconception about the necessity of coverage collides with another enduring myth about life insurance: that choosing and applying for life insurance is outlandishly difficult and time-consuming.
It’s not. While shopping for life insurance is no one’s idea of fun, the process rarely devolves into some grueling ordeal. And it’s a great deal easier when life insurance shoppers understand what they need.
Life insurance policies come in two distinct forms: term and permanent. Both pay tax-free death benefits to policy beneficiaries.
Term life insurance policies remain in force for a set term, then expire, though usually not without offering the policyholder an option to renew for additional one-year terms.
Permanent life insurance policies remain in force indefinitely and accrue tax-free cash value over time. Unless canceled or cashed out, they provide coverage for the policyholder’s entire lifespan and therefore charge far higher premiums than term policies.
Term Life Insurance
Every term life insurance policy has a fixed initial term and a fixed death benefit. Terms typically range from 10 to 30 years, with 10-, 15-, 20-, and 30-year terms being the most common.
Policy premiums remain fixed for the length of the initial term but can rise steeply if the policyholder opts to renew for one or more one-year terms.
Term life insurance has several advantages that make it a superior alternative to permanent life insurance for many policyholders.
First, term life premiums cost a fraction of permanent life premiums — typically less than 20% and sometimes as little as 10%. That reduces policyholders’ out-of-pocket costs and frees them to invest in market-traded securities that may offer higher long-term rates of return than permanent life insurance.
Term life is exceptionally affordable for young, healthy policyholders. So it’s better to purchase life insurance early in life, even when major life events — such as upsizing to a larger home or expanding your family — remain in the future.
Term life’s affordability makes it feasible for the policyholder on a tight budget to acquire relatively high amounts of coverage at a low cost. That’s important for those with high debt-to-income ratios or expectations of substantial future expenses, such as higher education bills for multiple children.
And life insurance needs generally decline over time as policyholders realize more of their total lifetime earning potential, pay down debts, and increase their net worth.
So term life’s impermanence is often a strength rather than a weakness. If you’ve chosen your term well, you shouldn’t need coverage after your policy’s initial term ends.
Permanent Life Insurance
Also known as cash-value life insurance, permanent life insurance remains in effect indefinitely and accrues cash value over time.
Once a permanent life insurance policy accrues sufficient cash value, the policyholder can tap that balance before their death by making a withdrawal, taking a loan against the balance, using the cash value to pay premiums, or canceling the policy altogether and taking a lump sum “surrender value.”
A policy’s surrender value is its cash value minus any surrender fees or penalties, which insurance companies commonly assess in the first 10 to 15 years of the policy term.
Permanent life insurance is more complicated than term life insurance. There are several different types of permanent life insurance, the most common being whole life insurance, universal life insurance, variable life insurance, and variable universal life insurance.
Each type occupies its own place on a continuum of risk and flexibility:
- With fixed premiums and steady cash value accrual, whole life is the least risky and least flexible.
- Universal life allows policyholders to temporarily reduce or suspend premiums, enhancing flexibility during periods of hardship or change, but its death benefit is less predictable.
- Variable and variable universal life tie cash value to market-traded securities, increasing risk despite greater flexibility on the premium side.
All permanent life insurance policies share a crucial benefit: the assurance of coverage at any age. However, despite enhanced flexibility in certain subtypes, policyholders pay a literal premium for long-term coverage.
Permanent life insurance premiums typically cost five to 10 times more than premiums for term life policies with identical death benefits, depending on the policyholder’s age and health status, the corresponding term policy’s length, and the permanent policy subtype.
Permanent life insurance has other important drawbacks. Compared with diversified equity investments, permanent life policies are generally poor long-term investments.
Additionally, the market-traded investments that determine permanent policies’ cash value often carry higher commissions and fees than low-cost mutual funds and ETFs.
And permanent policies cashed out in the first 10 to 15 years usually incur surrender charges, which can drastically reduce the cash value payout. In the first few years, surrender charges often negate the cash value entirely.
For these reasons, permanent life insurance isn’t appropriate for many would-be policyholders. Despite the apparent advantages of permanent coverage and tax-free benefits, it’s not always a sound investment.
A long-term financial strategy that combines adequate term life coverage with regular contributions to tax-advantaged investment accounts like IRAs and 401(k)s could be a better fit. But you should always consult a financial advisor before making any financial decisions with long-term implications.
Assess & Calculate Your Life Insurance Needs
After figuring out which type of life insurance is right for you, it’s time to assess and calculate your life insurance needs. That requires you to ask and answer two questions:
- How much life insurance do I need?
- How long do I need coverage?
How Much Life Insurance Do You Need?
There’s more than one way to answer this question correctly — or at the very least, in a way that doesn’t leave you without adequate life insurance coverage.
The key consideration is what you’d like your coverage to achieve. If you’re interested only in covering the expenses you either know or expect you’ll leave behind when you die, plus a buffer to account for inflation and unexpected expenses, you need much less coverage than you’d need to replace all the income your family stands to lose if you die prematurely.
Note too that life insurance needs invariably increase with the policyholder’s actual and proportional income (relative to their spouse or partner’s income). That’s true even if the policyholder intends to cover current and future expenses only.
A surviving spouse earning 70% of the household’s income is in a far better position to continue making mortgage, car, and tuition payments than a surviving spouse earning 30% of the household’s income.
And they’re infinitely better placed than a nonworking surviving spouse, whose earning potential is very low in the short term (especially if they’re obligated to look after young children). Some measure of income replacement coverage is all but essential for primary or sole breadwinners.
All that said, there is a very general answer to the question of what constitutes adequate life insurance coverage: 10 times your current annual income.
More accurately, that’s a starting point to think about the amount of coverage you need. It’s by no means set in stone.
If your annual income is $50,000 at age 30, and your most significant expense is a $2,000-a-month mortgage payment you share with a spouse who also earns $50,000 per year, $500,000 is more than enough life insurance coverage at present.
If you could peer 20 years into the future to watch your graying self decorating your third Ivy League dorm room in as many years, you’d no doubt find that same $500,000 policy to be woefully inadequate.
Pro tip: Ladder includes a calculator on their website that helps you understand exactly how much life insurance you should have.
How Long Do You Need Coverage?
If you’ve decided a permanent life insurance policy is the way to go, you can skip this step. You know the answer already: “indefinitely.”
If you’ve ruled out permanent life insurance and settled on term coverage instead, you need to figure out how long your coverage should remain in effect.
An income replacement strategy requires enough coverage to replace the income you would have earned between your death and your expected retirement date.
That doesn’t mean your life insurance policy must last through your last year of work — only that the death benefit, whenever it’s paid, is adequate to replace the income you never earn.
or example, if you expect to earn an average of $100,000 per year during the last five years of your career, a $700,000 death benefit paid five years before your expected last day of work would be more than enough to see your surviving loved ones through.
Life insurance needs generally decrease with age, and premiums generally increase with age. As such, many would-be policyholders choose to ladder multiple life insurance policies with varying term lengths rather than purchase a single longer-term policy with an identical death benefit.
A life insurance ladder provides ample coverage in its early years, then steps down as the policyholder’s potential income and expenses decrease — resulting in lower monthly and lifetime premium costs and less excess coverage.
Shop Around for the Best Policy
Now that you have a good sense of how your life insurance policy or ladder will look, it’s time to shop around for the best policy at the right price.
The life insurance industry is very competitive, with even the best life insurance companies quite competitive on price, so you should have little trouble finding a good deal with a bit of effort.
As you shop around, consider the following:
- The amount of underwriting you want (chiefly, whether you want to undergo medical underwriting to save money or opt for a quicker, more expensive no-exam policy)
- Monthly premiums (life insurance costs) compared with otherwise identical policies
- Financial strength ratings, a measure of insurers’ expected ability to pay death benefits
- Nontraditional underwriting or shopping options that can result in lower premiums, such as brokers that offer preferred rates to active or health-conscious policyholders
Medical Underwriting vs. No-Exam Policies
Most term life applications ask detailed questions about the applicant’s medical history, known health conditions, family medical history, and habits likely to affect long-term health outcomes (such as tobacco use). Most insurers also ask applicants to consent to the release of their medical records, which can confirm or contradict applicants’ self-reported health status.
Some term life applications stop there, skipping what’s known as “medical underwriting.” Medical underwriting typically requires a medical exam, which involves vital sign measurements (blood pressure, pulse rate) and the screening of blood or urine samples for indicators of possible health problems.
Because the medical exam provides a much more complete and accurate picture of the applicant’s actual health than self-reported answers, policies issued after medical underwriting almost always carry lower premiums than equivalent no-exam policies.
If you’re young and have no known health conditions, the benefits of medical underwriting (notably, lower premium payments) outweigh the risks (a concerning test result that results in higher premiums or an outright denial of coverage).
If you’re older or have reason to believe you’re not in perfect health, skipping medical underwriting could be a wise move — even if it costs more. However, most insurers cap no-exam coverage at $1 million or less.
Comparing Premiums on Term and Whole Life Policies
Because no two insurers use precisely the same risk model, premiums can vary significantly for the same policyholder, coverage amounts, and term lengths.
Financial Strength Ratings
While they’re not foolproof and can certainly change during the multidecade course of a life insurance policy, third-party financial strength ratings provide a reasonable assessment of an insurer’s ability to pay death benefits.
Some life insurance quote aggregators or brokers offer perks or incentives that can (but aren’t guaranteed to) reduce applicants’ net premiums.
For example, HealthIQ specializes in life insurance (and other forms of insurance) for active policyholders. Applicants who ace its health knowledge exams and demonstrate evidence of healthy living (such as participation in long-distance bike rides or footraces) qualify for special rates from participating life insurers.
Shopping for life insurance isn’t the ordeal people often make it out to be. Still, anyone who tells you they relished the process is probably not being honest with you. In that way, getting life insurance is a lot like other tiresome but essential chores, like applying for a cash-back credit card.
Nothing can transform life insurance shopping into something would-be policyholders leap to undertake. But knowing what to expect and how to choose the right coverage can significantly reduce the stress and uncertainty around it.