What Is Life Insurance, Really?

Life insurance is really pretty simple when you take away all of the marketing and advertising and boil it all down to the core. Life insurance is meant to be primarily one thing: a contract that will pay your family (or another beneficiary that you choose) a certain amount of money in the event that you die during the length of the contract. With all of the ads out there and all of the bells and whistles that life insurance can come with, you can get snookered into thinking that life insurance should be more than that. If you have been tricked into thinking that, it’s OK. Now you know the truth and we can move on.

Who Needs Life Insurance

Since life insurance is a simple contract that will pay your family in the event of your death, it’s not too hard to figure out who needs to get some life insurance. If your family would be significantly impacted financially by your death, then you need to get some.

The most common scenario for life insurance needs is a family with at least one wage earner and one or more dependents. Let’s take the Smiths for example. Mr. Smith is an attorney and is the sole wage earner for his family. His wife stays at home with their two children. In this scenario, Mrs. Smith and the children are financially dependent on Mr. Smith. If he were to die unexpectedly, his wife and children would be very negatively impacted financially in that their entire source of income had just stopped. So, not surprisingly, Mr. Smith needs some life insurance.

What may surprise you is that in this scenario, Mrs. Smith also needs some life insurance. Even though she’s not bringing in an income, the work that she does (housework, cooking, cleaning, staying at home with the kids) would have to be done by someone in the event of her death. Mr. Smith could either try and do all of that work himself (which would be difficult given that he already has a full time job) or he can hire someone to help him out. In either case, getting that work done is going to cost him (either time or money). So we see that Mrs. Smith also needs some life insurance.

Other common life insurance needs are for estate planning purposes, business partners, and mortgages. You may not have ever thought about this, but families are not the only ones impacted financially by an untimely death. If two people are in business together and each one is important to the success of the company, one of the partners dying could cause the company to go under. This would be a definite financial impact to the other partner. In this situation, business partners take out insurance on each other to protect themselves and their business.

How Much Life Insurance Do I Need?

Everyone’s insurance needs are going to be a bit different, so there’s no one formula that will work for everyone. The old standby is to multiply your salary by 10 (so if you make $75,000 then you would need to get $750,000), but I think that’s probably a bit low for most people.

The way that I prefer to look at it is to think about what exactly you would want your life insurance to do for your family if you died. Here are four categories to help your thinking:

Mortgage

Do you want to pay off your house if you die? Put your mortgage balance here.

Education

If you have children, do you want to provide for their education? Typical college costs are currently $10,000 to $15,000 per year, so $40,000 to $60,000 for four years per child.

Income Replacement

This is definitely the most important category to figure out. Regardless of whether you are bringing home a salary or not, your family will have ongoing expenses in the event of your death. The amount of money you need for this category has to be enough to provide a sufficient monthly income for your family to be able to pay their bills. The easiest way to come up with this number is to take the monthly income your family would need to live comfortably and multiply it by 200. (I’ll cover how we got that number in just a second.)

So if your family would need $5,000 of monthly income in the even of your death, then you would need ($5,000 x 200) $1,000,000 for this category.

***Math Alert***

The following paragraphs contain graphic descriptions of mathematics in action. Read at your own risk.

Allow me to explain how I came up with the numbers in the preceding paragraph. If you died, your family is going to receive a lump sum payment from the insurance company. Part of that money will be used right away, but most of it will be left alone. The smartest thing to do with the money that is not needed immediately is to invest it so that it produces interest, and then only withdraw the interest, leaving the principle alone. Using this strategy allows one lump sum payment of money to produce a monthly income for your family for years and years.

You can expect to get about a 6% return on the money invested after taxes. So this means that $1,000,000 invested would produce an annual income of $60,000, or $5,000 each month. You can work your way to the lump sum amount you need by multiplying out the percentages, or you can just multiply your desired monthly income by 200.

Final Expenses and Misc.

This category covers everything from funeral costs to medical bills to lawyer fees, or any other bill that arises as a consequence of your dying. $50,000 is usually sufficient for this category.

So, using what we learned in the categories above, let’s plug in some example numbers to find out how much life insurance we would need:

Mortgage = $200,000
Education – 2 children x $50,000 each = $100,000
Income Replacement – $5,000 monthly income x 200 = $1,000,000
Final Expenses – $50,000
Total: $1,350,000

Term vs Permanent Life Insurance

The last thing you need to factor in when considering life insurance is whether to go with term or permanent insurance. We’re not going to go too deeply into the difference between the two in this article, but to put things simply, term life insurance is straight life insurance – you pay a fee for the life insurance (called the premium), and the company pays your family if you die during the length of the contract. Permanent insurance, also known as whole life insurance, has a savings/equity option that builds value over the length of the contract.

What it comes down to is this: if all you want is low cost life insurance, then term is for you. If you are looking to save some money for long term financial goals as well as get life insurance, then whole life can be a good deal.

Term Life Insurance Cost

The cost of life insurance varies greatly by age, gender, health, height, weight, nicotine use, medical history, and the length of the contract. It can be difficult getting an accurate life insurance quote without talking to an agent because insurance companies generally want to know just about everything about you before they’ll agree to insure you. While it’s impossible to accurately guess the cost of a particular company’s life insurance, here are some general guidelines:

Male, age 30, non-smoker: $1,000,000 of 20 year term coverage goes for $40 to $60 per month.
Male, age 30, non-smoker: $1,000,000 of 30 year term coverage goes for $60 to $80 per month.

Female, age 30, non-smoker: $1,000,000 of 20 year term coverage goes for $30 to $45 per month.
Female, age 30, non-smoker: $1,000,000 of 30 year term coverage goes for $50 to $65 per month.

Low cost term life insurance companies include Transamerica, Genworth Financial, ING/Reliastar, Prudential and Lincoln Financial.